Critical Thinking: Cyclical Stock Potential

At a time when many investors are taking a hard look at their portfolios, good information is more important than ever. Sadly, it is even harder to come by. There is no substitute for applying your own critical thinking skills to the opinions you see. A featured guest on CNBC, Senior Investment Analyst for a major firm, provided a test of that skill. (CNBC put the interview behind their paywall, but I record these programs to verify my analysis.

Interview

The guest had just issued a downgrade for the industrial sector.

  1. His first reason was that the stocks were back to levels at the start of 2019. He questioned the 30% rally in the sector when earnings were only up 10%. He called the 20% difference a “ballistic move” in the stocks, pushing them to excessive valuations bordering on those of the late 90’s.
  2. The size of the stimulus package proves that the economy was weak at the start of 2020.
  3. Expected year-over-year declines in consumer spending are “multiples of what they were in 2008-09 and back to levels of the 1930’s.
  4. Industrial production in a downturn is leveraged to about four times the consumer spending decline. A 2% decline from consumers means an 8% decline in industrial production. Their economists’ estimates for consumer spending would imply a 40% reduction in industrial production, although he didn’t think it would be quite that bad..

Asked about the impact of the stimulus bill, he had a rather lame answer that he did not analyze politics and wasn’t sure what the impact would be for the group.

Analysis

Critical thinking begins with Asking the Right Questions. (My favorite professor wrote the book on this topic, now in the 11th Edition). Here is my own analysis. Some of it does require a little background, but nothing that is a surprise to a knowledgeable investor.

  1. Using comparisons that begin with calendar 2019 is extremely misleading. The market collapse of December 2018 cannot be ignored. The popular explanation is that the Fed “pivoted” from prior statements reducing recession fears. Whatever the reason, December represented recession expectations and the 2019 record includes a reversal of that sentiment.
  2. This is an amazing statement. The size of the stimulus package reflects estimates of the size of the problem. It tells us nothing about the pre-coronavirus economy. Please compare this statement with the subject’s answer at the end of the interview.
  3. With most of the country staying safe and in place, there is naturally a reduction in many types of expenditures. It will certainly be sharp and affect many businesses. The exact size cannot be estimated without knowing the extent of the COVID-19 effects. Anyone claiming a solid economic forecast right now is blowing smoke.
  4. The industrial production relationship is obviously some sort of regression analysis relating the two variables. There are some tipoffs in the summary. It refers to “declining periods.” How many of those are used and how much data? What is the margin of error of that result? Even more important is the comparability of the current situation. The past cases involve economic downturns affecting everything. The current crisis targets certain economic sectors. Industrial production is much broader than the consumer sectors, including things like utilities, mining, and consumer and office products still in demand. The 4-1 ratio is just silly under these circumstances.

One problem with research from big firms is that they do not share the underlying data and are not very specific about the methodology. I have read thousands of these reports. Very few would stand up to a peer review, although nearly all would benefit from such criticism.

Conclusion

Suppose your job requires regular reports, market recommendations, and getting visibility for your firm. You must always have an opinion even though the evidence supporting it may be scant. The result is a constant flow of unsupported opinions, each a trap for the individual investor.

I am working on my own project for identifying the survivors and thrivers on the other side of the crisis. It begins by admitting what we do not yet know. The next step is to have a sound factual basis for conclusions. (Write to me via info at inclineia dot com to get on our Great Reset email list).

For now, I do not have specific sector recommendations. I am confident that the analysis I am discussing here is seriously flawed. While the conclusions might be “right for the wrong reason” I am leaning the other way on industrials.

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11 comments

  • wkevinw April 1, 2020  

    Oldprof- put simply (to me anyway), the systems people in (professional) finance use are made mostly for non-volatile markets, i.e. mostly bull markets. This makes a lot of sense because that’s where the markets spend the most time.

    The real money is made (or retained, as Prof Hussman often says), during the volatile times. I believe that no matter what, given typical legal and other “requirements”, these (professional) systems will never do well in these times.

    Example- the systems I use started getting quite bearish in Feb and have continued through Mar. Some systems can avoid a lot of the bear moves.
    I often say “the risk was rising”. Risk vs. reward has not been favorable for the bulls for ~ 2 months- when the pandemic started showing in the economic data, basically.

    The tide is going out and the naked swimmers (corporations that did buybacks and have lots of debt, for example), are showing up.

    Thanks for your observations.

    • M P Sunday April 1, 2020  

      Wkevinw,
      Can you briefly and concisely share with readers here the systems you utilize as your timing appears to have been spot-on accurate. Most of us who read here regularly are quite interested in avoiding bear moves. As Jeff shares so much good insight & intel with all of us weekly, I look forward to hearing back from you. Thank you in advance for your prompt response to this request.

  • Mike N. April 1, 2020  

    Jeff, I can’t make up my mind on the Industrials. My bear argument would be centered around my concern for oil prices. Low oil under-cuts ethanol. That under-cuts the famers. That is not good for John Deere & CAT. They just went through that dance 2015-16. Frankly, low oil is not positive for Aerospace and Autos, either. Low gas prices drive down the pay-back on buying newer, more fuel-efficient cars (or planes).
    On the other hand, our US leadership is already talking about “phase 4” of COVID relief spending. The current talk is for $2T in “roads & infrastructure” spending. Of course, that would be good for JD & CAT.

    • oldprof April 1, 2020  

      Mike —

      Yes, it is really a guess. I hope that was my point. So many opinions and so little information!

      Thanks for your observations — well worth watching.

      Jeff

  • Lee Cash April 5, 2020  

    Thank you, I have added “Asking the Right Questions” to my Amazon list. Soon it will be beside my copies of Annie Duke’s “Thinking in Bets,” and “Superforecasters” by Philip E. Tetlock, and Dan Gardner. Each of these point to a fundamental point you make about first understanding your risk.

  • Peter G April 5, 2020  

    Professor

    I have not visited here before. My loss. As Arnold would say, “I’ll be back.” As to your key point, it’s all about the questions. I used to ask my students what they thought they had purchased with their tuition. What I wanted them to get was that they had bought the “questions,” generally forty sets in the form of a pile of course syllabi. Early on they needed these outlines to frame the questions for each subject and a path to the mainstream answers. By the end, however, it was my hope that my students they should be able to chart their own path and pose their own questions to seek their own answers so they could teach themselves. Those that could do this properly were well on their way to success. Sadly, many didn’t get the message.

  • EDWARD LUNT April 5, 2020  

    Oldprof;
    My son “a young prof.), laments the total lack of “Critical Thinkinking” among his college students and my wife is sick and tired of listening to me spout off about the news media and their inability to read let alone accurately explain a simple graph, not only as to what it says but often more importantly, what it doesn’t say.
    In the US Capitol Building, there are quotes written above many of the doorways in the building. On the “House” side, there is/was a quote that I read one day as I was wandering the halls of the Capitol that has become one of the guiding principles in my life.
    “It is not enough to state the facts, One must convey correct meaning”. I don’t recall who gave the quote and I have been unable to find any record of it. Regardless of who may have said it, it is a “truth” that too often is totally ignored by those who we depend on to defend and promote truth above all else, (the media comes to mind). This means that since we can’t depend upon even the defenders of “truth” to not mislead us, that the ability to think critically is more important in our world now than ever before.
    Thanks for your article. It and you are much appreciated.