By valueplays. Originally published at ValueWalk.
Pessimism is infectious. Disasters are what drives us to listen to news and drives us to media to learn more. We worry that bad things could happen.
We feel better when we learn that they have not happened to us and they occurred elsewhere. When we get too much good news we tend not to trust it and look for the ‘chinks in the armor’ The Muppet’s Statler & Waldorf characters ran a short skit now famous beginning by praising a show then ending deciding that it was awful. Here is a 15sec audio-Youtube piece: https://www.youtube.com/watch?v=NpYEJx7PkWE
Seth Klarman: Investing In A Tech Bubble
Market perception is much like that. Good news always has someone saying, “Well, it was not that good….Maybe it was really awful.” Once someone thinks they have found an imagined flaw, all the rest seem to fall in line. It is this tendency towards pessimism which drives prices higher during economic expansion. Real Personal Income & Real Retail and Food Service Sales show economic recovery similar to that in the past.
Real Retail & Food Service Sales and Real Personal Income for May 2017 have been met with the same gloomy perception expressed for most of the 2009 to date. The reality is, we have a very decent economic recovery at present which shows no sign of slowing.
Market prices rise as investor and media pessimism are surprised by economics which are ‘better than expected’. Most investors believe in markets as measures of economic activity, i.e. markets are thought of as ‘efficient’. The reality is that most investors do not understand the relationships between economics and market prices. When economic news is better than expected, most investors believe markets reflect the past gloominess and now justify higher prices. They buy more stocks. Economic activity evolves slowly. Changes in economic trends take months to develop. By the time an economic outcome becomes a headline, it is more than 6mos old. The majority of investors invest after the fact. They are trend-following Momentum Investors.
Momentum Investors: When earnings are higher than expected, when an economic measure is better than expected, they justify paying higher prices for stocks. When the news is worse than anticipated, they sell. They invest on news. Stories alone without economic value will cause investors to reprice securities. Even the same story repeated over several months can have a similar impact each time. Most investors are not logical. They simply run with the crowd and is why markets don’t seem to follow common sense. Momentum Investors are trend-followers. They follow the news, they follow price-trends. Economics factor little in their investing, even though they say otherwise.
A much smaller group of investors are known as ‘Value Investors’. Value Investors understand “The 1% Solution”. They make connections between economic fundamentals and market prices. They are known for becoming almost giddy when market prices fall far enough. Warren Buffett has often confused the world with his optimism during major market corrections. His NY Times October 16, 2008 Op-Ed, “Buy American. I am”, had many investors at the time questioning his judgement http://www.nytimes.com/2008/10/17/opinion/17buffett.html Value Investors invest with a long-term historical perspective based on long-term fundamentals. Prices for fundamentals are cheapest only in recessions. Howard Marks, another Value Investor, wrote about the importance of understanding market cycles in “The Most Important Thing”, 2006, https://cup.columbia.edu/book/the-most-important-thing/9780231153683. Value Investors seem like aliens from other planets when compared to Momentum Investors. There are so many more of the latter than the former that it is fair to think of Value Investors as having “The 1% Solution” to understanding markets.
Market misperceptions are many.
Here are a few which are repeated every week in the media:
1) The economy is awful, we need more jobs, we need higher wages, government should spend more
2) We need higher inflation to produce a better economy
3) The Fed should raise rates to spur the economy, lower rates means easier lending.(contradictory concepts)
4) The Fed controls rates and economic growth
5) A strong US Dollar(US$) is good for the US economy/weak US Dollar is bad for the US economy
6) The US trade deficit is bad for the US
7) The Fed controls inflation
None of these are correct. That a decent recovery has been under way since 2009 is reflected in Real Personal Income & Real Retail and Food Service Sales and many other economic trends. Our perceptions are framed by the consensus which is what we hear day-in-day-out in the media. The media reports are misinformed. It is why Value Investors remain bullish. The SP500 Value Investor Index, a measure of fundamentals behind Value Investor thinking, remains relatively close to the SP500. The difference in the SP500 Index vs. the SP500 Value Investor Index is a rough measure of market psychology. The SP500 is priced today about 10% higher than the Value Investor Index. High market prices which come from excess investor optimism have the SP500 at a 50%-100% premium to the Value Investor Index. There are few signs of equity market excess today.
The Wicksell “Natural Rate” today is 4.76%, which is the rate of growth of the US Real Private GDP + 12mo Trimmed Mean PCE. The SP500 Value Investor Index uses the “Natural Rate” and long-term SP500 earnings trend as its inputs. The 10yr Treasury rate should be slightly above the “Natural Rate’ when investors have a balanced risk profile between Equities and Fixed Income. Today, we see a relatively high level of investor pessimism vs. past market cycles as foreign capital has flooded US and other Western markets seeking protections to property not available in home markets. This has created a bubble in Sovereign Fixed Income and real estate. While some equities are extremely over-priced, think F.A.N.G type stocks and Private Equity Unicorns, many well run companies with excellent long-term business returns remain under-priced. One can easily build a portfolio with the high likelihood hood of out-performance the next several years. Contact me if you want to discuss.
http://www.dallasfed.org/en/research/pce.aspx
In the US we have a long history of measurement. What drives economic activity is the desire for improving our family’s standard of living. It is the basic driver behind what we call economics. The drive for improved standard of living is relentless. The recurring fears that markets will ‘utterly fail’ at some point, especially believed during economic corrections, become widely broadcast in the media. This is utterly unfounded. Human history is the history of cooperative living through markets. Markets have cycles precisely because human psychology tends to cycle. History reflects many, many cycles which occurs as society leans too far in one direction and then corrects too far to the opposite. Howard Marks and Warren Buffett know this. It is this knowledge which is their greatest investment tool. Humans have survived and evolved sharing individual skill-sets through markets for millions of years. They never fail, they evolve. The investment markets are simply a sub-set of a market-based species.
Markets are us!
Gauging the next market peak is not
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