INVESTING FROM THE TOP DOWN

A Macro Approach to Capital MarketsBy ANTHONY CRESCENZI

The McGraw-Hill Companies, Inc.

Copyright © 2009 McGraw-Hill, Inc.
All right reserved.
ISBN: 978-0-07-154384-2

Contents

Chapter One

Top-Down Investing Has Arrived

The world has become more complicated than it used to be, and investing has certainly become more complicated too. Luckily, there has evolved a way to empower investors and make investing simpler, a way of investing that has been around for ages but which only recently has reached critical mass and made it possible for everyone to use. Such is the promise of top-down investing, an investing concept that relies upon indicators which carry implications that are crystal clear and highly dependable thus making it relatively easy to devise investment strategies, especially for those with very little understanding of balance sheets or the world of finance in general. It is an investment approach that also fits perfectly with the evolution of our society, where attention spans for just about everything from television to newspapers and board games have shrunk. It is thematic investing, where an investor buys an idea first and then buys the stocks, bonds, currencies, real estate assets, and other forms of investment that fit with the idea.

Top-down investing is an investment approach that has a multitude of advantages over other styles of investing, including its formidable counterpart, bottom-up investing, which relies mostly upon value investing, an investment approach that begins with scrutiny of the asset being bought. For example, in the case of corporate equities, a bottom-up investor would start with the idea that company XYZ might prosper enough to justify buying shares in the company which appear to hold value relative to the company’s prospects. From there, the investor would analyze the company from the “bottom up,” looking particularly at the company’s balance sheet, its cash flow projections, and so forth, and do so in the context of the share price to decide whether the shares are worth investing in. Yes, this takes a lot of work, and if you do the work, you probably will choose a fairly good number of investments that work. Given the rewards, it seems we should all do the work to ensure that we are making the best possible investment decisions.

The problem with bottom-up investing, however, is that investors don’t always have the tools to take on such a task nor do they have the time. How many of us truly know how to pick apart balance sheets? Who really wants to? Who in this day and age really has the time? I say, free yourself from this burden because top-down investing has proven itself to be a terrific way to formulate an investment strategy, and it is a strategy better suited for the twenty-first century than other styles of investing. I make this clear throughout this book.

THE 2007–2008 CREDIT CRISIS, A CASE IN POINT: BOTTOM-UP INVESTING FAILED

Epic were the events of 2007, when in response to the subprime mortgage crisis a full- blown credit crisis developed, requiring extraordinary actions by the Federal Reserve. By August 2007 the crisis was in full bloom, and each day brought its own harrowing episode. Throughout the period there was nary a bottom-up tool to help both in understanding what was happening and how to deal with it, particularly with respect to deciding upon what to do in response to what were very big movements in market prices. Bottom-up value investors were crushed by their approach, which puts valuation ahead of the big picture. Take, for example, the buy recommendations that bottom-up analysts were making on a variety of companies at the heart of the mortgage crisis. In one case, when the credit crisis first swelled in February 2007, one major Wall Street investment firm recommended that investors buy shares in Ambac Financial Group, which were trading at that time at around $90 per share. Through its bottom-up eyes, the firm saw value in Ambac, rating it as “outperform,” which is Wall Street jargon for buy. The stock ended 2007 at $25.77 per share and kept falling.

The 2007 credit crisis was a clarion call to embrace top-down investing. When the crisis was in full bloom in August, there emerged a variety of signals about the types of investments to choose and those to avoid. For example, during the crisis it became very difficult for companies to obtain credit, with investors avoiding bonds of almost every variety, including those issued by companies with excellent reputations. Most loathed were issuers with exposure to the mortgage sector, including the commercial paper market where asset-backed securities either having or being perceived as having exposure to the housing sector were avoided like the plague. Figure 1.1 illustrates the abrupt change that occurred in the market for asset-backed commercial paper. As the chart shows, the total amount of asset-backed commercial paper plunged in August 2007, falling 35 percent or about $420 billion over a period of 20 consecutive weeks before stabilizing in early 2008.

Aside from its abruptness, remarkable about the contraction in the commercial paper market was what it said about risk attitudes in general, something that a top-down investor should always be keenly interested in. Here was a segment of a market that had seen only seven defaults since 1970, far less than in other segments of the fixed-income market, yet investors were fleeing it with reckless abandon. This was a clear top-down signal to scale out of assets that generally underperform when risk aversion increases. One of these was junk bonds, which did very poorly in 2007, particularly beginning in the summer when the credit crisis broadened. Figure 1.2 illustrates this point, showing the increase that occurred in yields on junk bonds during the credit crisis. The junk bond sector was clearly a sector to avoid (given, of course, the fact that bond prices move inversely in relation to bond yields). Bottom-up investors were blindsided during the crisis, lured by the idea that many companies continued to have fairly good cash flow prospects, compelling these investors to buy junk bonds on weakness, a move that would prove a mistake throughout 2007 and early 2008.

The credit crisis also signaled the potential for economic weakness, which manifested itself in a rise in the U.S. unemployment rate, which increased by an amount that since World War II had always been followed by economic recession (see Figure 1.3). For the top-down investor this had a plethora of implications. For example, it was a signal to avoid transportation stocks, which tend to underperform during times of economic weakness and especially during economic downturns, as can be seen in Figure 1.4 on page 6. It was also a signal to buy U.S. Treasuries where, as Figure 1.5 on page 7 shows, yields fell decisively in anticipation of interest-rate cuts from the Federal Reserve, which were expected to be implemented to counter the negative effects of the credit crisis.

There would be many other investment ideas generated by the events of 2007 and 2008, and top-down investors had an edge, not only because top-down investing arms investors with tools that help to indicate what it is that they should be doing next, but also because it is an investment approach that makes investors more prone to look for changes in the big picture that could materially affect the investment landscape, as was the case in 2007. This is one of the reasons why top-down investing is so much better than other investment approaches; it is more dynamic. We talk more about this throughout the book.

THE GLOBALIZATION OF THE FINANCIAL MARKETS: TOP-DOWN INVESTING IS THE ONLY WAY

Let me get this straight: There are now scores of companies in foreign markets to choose from, abundant challenges presented when analyzing these companies and their markets because of factors such as language and cultural barriers, as well as questions over how to value securities in foreign markets in light of the fact that what is cheap in one market could be seen as expensive in another. Moreover, there are a swath of asset classes to choose from including commodities and currencies, for example, whose price movements tend to be dictated mostly by macro trends—particularly global ones—and we are supposed to use bottom-up investing as our main approach to constructing a diversified global portfolio? Spare me! In today’s integrated markets this looks perilous.

Imagine, for example, a U.S. investor considering buying a stock in Russia. For starters, the investor would, in the absence of research written about the company involved, have to hope that the company distributes or makes available information about itself in English (unless, of course the investor understands Russian). Second, the investor would have to consider investment laws concerning foreign investment in Russia in order to be abreast of the potential impact Russian’s laws could have on any investments there. Third, the investor would have to weigh the impact of other laws or decisions that could be rendered at any time by the Russian government with respect to foreign investment, domestic policies, and much more, something that even for insiders is a difficult task. I do not mean to single out Russia; investment returns have been very good there in recent years, and most feel that the prospects for Russia remain good (particularly if the price of oil is high), but what I mean to do is bring to light the idea that every country presents investors with its own set of challenges, whether lingual, cultural, legal, geopolitical, or whatever. In this case the only safe way for investors to get a grip on the big picture is with top-down investing.

THE GOLDEN COMPASSES: KEY INDICATORS

One of the most appealing aspects of top-down investing is the toolbox that this remarkable investing approach arms investors with to enable them to navigate today’s complex markets. For decades other investing approaches have for the most part ignored these indicators, which you will find throughout this book and especially in Chapter 14, but doing so in today’s global marketplace is ignorant and does investors a disservice.

In the top-down investor’s toolbox is an array of tools, and each and every one of them has a use that when combined makes the job of formulating an investment strategy a snap. I get excited (forgive me, but this stuff is a big part of my life!) when I find a new indicator or when I find a new use for an old one because I know that the indicator will help me to see more clearly the best possible investment alternatives for the situation at hand.

In Chapter 14 of this book we look at 40 of the best top-down indicators, but here are a couple of them now, and a note on how they might be used:

Birth statistics: This is pretty simple. If you knew, for example, how many babies there were in the world, wouldn’t you have a pretty good idea about how many diapers would be sold? Or if you knew how many people were going to reach an age where hearing-aid devices normally become necessary, wouldn’t you have a good sense as to whether investing in companies that sell such devices might make sense? Sure, it takes a little bit more work to figure out what to do with this kind of information, but it certainly is a great start, which is the whole point of top-down investing—to get you started with a solid investment thesis.

Commercial paper issuance: We saw in 2007 the importance of the commercial paper market to the overall economy, when it began, as I showed earlier, to contract rapidly, unsettling the financial markets and contributing to weakness in the economy. The commercial paper market is a market that for years, virtually unbeknownst to most investors, has correlated strongly with inventory investment, with companies using the issuance of commercial paper to finance short-term transactions, as is required by rules dictated by the Securities and Exchange Commission. What does this mean for investors? When the issuance of commercial paper fluctuates, it casts a compelling signal to the economy, which in turn helps to dictate what types of investments to choose. There are a tremendous number of ideas that result in the different stages of the economic cycle.

YOU’VE SEEN THIS MOVIE BEFORE; YOU WILL SEE IT AGAIN

Those who use technical analysis often use charts to derive a forecast about the future because they generally expect past patterns to repeat. There is a great deal of credence to this, and there are a variety of technical indicators that are true golden compasses, the reasons for which is described in Chapter 12. A few of these indicators are described in Chapter 13 of this book. While I rely upon technical indicators for important signals, particularly on market sentiment, it makes me nervous to put too much weight on them unless they are backed by fundamental factors. For example, unusually high levels of bullish sentiment (a contrary indicator) about a particular commodity carry far more weight when they are coupled with bearish fundamentals such as rising supplies. Still, what I glean from technical analysis as far as it relates to top-down investing is the idea that certain patterns have a strong chance of either repeating themselves or behaving similarly enough to be useful when formulating an investment strategy. With top- down investing, this holds true with the best of the top-down indicators—the golden compasses, each of which has a highly dependable track record of foreshadowing events and aiding the selection of the best performing investments. It is why when a particular indicator behaves a certain way, top-down investors immediately recognize that it is a movie they have seen before. In response, these moviegoers know what to do next. It is one of the more comforting aspects of top-down investing.

BABBLING, BORING BALANCE SHEETS

In a poll of U.S. adults conducted in 2005 by the Associated Press and America Online, by far the subject that respondents said that they hated the most in school was math. This sentiment might be changing if data from the Brown Center on Education Policy are any guide, as it found that math scores for grades 2 and 4 have been increasing steadily since 1990. In fact, according to the National Assessment of Educational Progress (NAEP), which was developed by the U.S. Department of Education to assess what U.S. students know and can do in various subject areas, the increases in math scores seen between 1990 and 2007 indicate that fourth and eighth graders in 2007 knew more than two additional years of mathematics compared to fourth and eighth graders in 1990. Despite these hopeful facts, people just seem to hate math, as the AP and AOL survey and table- talk discussions indicate. This means that there are an awful lot of investors out there who will do whatever it takes to steer clear of math, especially complex math and by all means anything to do with those babbling, boring, balance sheets. There is of course no escaping the use of math when it comes to investing, but most investors can leave the misery of dissecting balance sheets to others if they invest from the top down. We talk more about this in Chapter 9.

YOU CAN DO THE MATH, SO DO IT!

As I said, investors can’t escape using math completely; numbers are what make the financial world go around. What astounds me, though, is that people are so loath to do math that they often avoid it almost completely, failing to do the math on big-picture ideas that in concept carry much more weight than the numbers do. The most glaring example I can think of in this regard is the failure by very large numbers of market participants to do the math on the impact that rising energy prices would have on consumer spending and the overall economy when energy prices first began to surge in 2003. It was said about the surge that consumers would buckle, be hamstrung, or otherwise be strained to such an extent that they would almost certainly stop spending on everything else, and the economy would henceforth stop expanding. This idea proved wrong until the end of 2007 when a renewed surge in energy costs combined with the weak housing market, the credit crisis, and other factors produced a sharp slowdown of economic activity. This means that investors who failed to do the math were wrong for about five years. Such was not the case for top-down investors, however, as they had the simple tools needed to avoid this trap, a trap that let top-down traders win investment dollars from the crowd. We talk more about this in Chapter 14.

YOU’RE NOT WARREN BUFFETT—GET OVER IT

Warren Buffett has said that an IQ of no more than 125 is needed to understand and use value investing, the investment approach that involves the selection of stocks in companies trading at levels deemed to be below their intrinsic value, which is determined by comparing a company’s share price with its future cash flows. Benjamin Graham, widely considered the founder of the modern concept of value investing thanks to the publication in 1934 of his and David Dodd’s groundbreaking classic book Security Analysis, depended heavily upon these principles, describing intrinsic value as a company’s acquisition or liquidation value, or the collateral value of its assets and cash flow. As Buffett said, applying Graham’s principles of value investing requires very little intellectual capacity. Fair enough. The problem, though, is that successful value investing nonetheless requires at least a modicum of intellectual capacity. In other words, while it is probably true that investors need not be rocket scientists in order to have the capacity to apply the principles of value investing, investors nonetheless must have at least some knowledge of it.

(Continues…)

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