Beware the Lure of the IPO
On Average Most Investors Lose Money
It’s a crapshoot.
From the Bleachers, Vol. 22
The S&P 500 fell 2.6% last week to close at 2752.06. The index is below its 200-day moving average, which sits at 2774. Furthermore, the 20-day moving average fell below the 50-day moving average on Tuesday 28 May. Traders consider the 20-day moving average’s drop below the 50-day a short-term negative for market direction, while the decline below the 200-day moving average is potentially signaling a renewal of the bear market that may have begun in September of 2018. The S&P 500 is now down 202 points from its most recent 1 May record high of 2954, or about 6.8%. The S&P 500 is also down 4.2% since Jan. 26 2018 – over 16 months ago.
There is likely a better than 75% chance of a down open Monday, barring any major positive fundamental news between now and then (I’m writing this article on a Sunday morning). The S&P 500 held support at 2800 three times in the last 14 trading days, including last Tuesday when it basically closed at that level. The index gapped down on Wednesday below 2800 and penetrated the 200-day moving average intra-day before rallying to close above. Traders attempted to rally the market on Thursday but failed early at…2800. The S&P 500 sold off the remainder of Thursday, hitting an afternoon low and bouncing off the 200-day moving average before rallying late in the trading session into the close and finishing just above its morning open – a stalemate day. Friday saw a gap down below the 200-day moving average to 2750, an attempted rally that failed well shy of the 200-day by mid-day, and a steady afternoon decline back to the 2750 early morning low.
There is a possibility (maybe 20%) that we get a big gap down opening on Monday as investors take the weekend to digest the deteriorating fundamental news surrounding both the China trade war and the new attack on Mexico, one of our other largest trading partners, and decide to sell. The path of least resistance for traders is down. The risk parity crew – pension plans, hedge funds, private institutional investors – will almost certainly be looking to reduce risk in the face of the trade wars threatening the economy. The sharp retreat in bond yields last week is one indication of just that type of risk reduction behavior. Yields fell sharply as investors sought safety, leaving the 10-year Treasury at just 2.13%, with the 3-month Treasury at 2.32%. The futures market is now pricing in two rate cuts by January, a sharp change in thinking from last December when the futures market still saw rate increases on the table for 2019.
Much has been written about the recession predicting ability of an inverted yield curve; yet there is a growing chorus of “this time is different” beginning to swell up from the talking heads. Some market strategists from major wire house brokerage firms are taking to the airways to predict that we’re only experiencing a run of the mill correction that will end at around 10% - and that they saw it coming of course!
Perhaps, but in the absence of positive news on the trade front, or an increase in corporate earnings expectations, or an increase in real GDP growth expectations, or some further indication from the Fed that it is prepared to ride to the rescue with rate cuts, it is more than a little likely that we will see new lows in the stock market for the current down trend in the coming weeks as the economic data continues to soften. Currently, the Atlanta Fed is forecasting a mere 1.2% in Q2 annualized real GDP growth. The New York Fed is predicting a slightly stronger 1.5% annualized real GDP growth for Q2. Meanwhile, an inverted yield curve is forecasting recession. Of course, a looming recession would all but guarantee further downside in the stock market in the next few quarters. All in all, we still think a retest of the December 26th low of 2346.6 is at least as likely in the coming months as a rebound to new highs. We also think further short-term downside is highly likely in the coming weeks, regardless of whether we test the 2346.6 low later this year. Risk management for those investors with near-term spending plans remains the order of the day.
The Lure of the IPO
Investors lose money in IPOs on average. In fact, more than 60 percent of more than 7,000 IPOs from 1975 to 2011 had negative absolute returns after five years, according to a UBS analysis using data from University of Florida professor Jay Ritter. Furthermore, from 2000 to 2016 the six-month absolute and excess return (return above the market return) has both been negative.
Among other issues, investors buying into IPOs are at a disadvantage due to asymmetric information bias, also known as information failure. Put simply, sellers know far more about their company than buyers and can extract an above market price from investors when they take their companies public. There is almost no chance of you scoring a deal on an IPO by buying assets for less than they’re actually worth. Yes, the occasional Microsoft, Google, Amazon, or Facebook does end up making big money for that handful of investors who buy early and hold on for the long haul, but it’s a rarity, and it’s despite the high initial purchase price.
Rather, those handfuls of investors made the big money in those handfuls of storied names because they owned the stock over many years, recouping the money “lost” from the excessively high initial purchase price before going on to big gains. Unfortunately, those handfuls of big winners are far outnumbered by the many companies that crash and burn within a few years of their IPO. It’s only in hindsight that we learn who won the lottery; only in hindsight that we say to ourselves, “Why didn’t we buy Google? Wasn’t it obviously a winner from the very beginning?” Hindsight bias is pervasive in the human species. It can make you a little nutty. But of course, it wasn’t obvious that Google was a winner when the company went public and it wasn’t obvious that the right thing to do was to continue to own it since. Don’t beat yourself up over it and don’t expect to be able to pick the next Google.
We’ve written about IPOs in the past but thought it was worth revisiting as we’ve had a number of clients interested in buying into cannabis, ride sharing, and vegetable burgers lately.
Christopher R Norwood, CFA
Chief Market Strategist