“Davidson” submits:
Without someone ringing a bell, without any geopolitical news and without any change in economic fundamentals market psychology has suddenly become more positive from its ‘end of the world’ pessimism of last week. Market psychology is just like that. It does not make sense. It can be so against common sense that it causes investors to question their sanity. Then suddenly market shifts. Market psychology represents the perceptions enough investors with control of enough capital to cause markets to swoon or soar. More often than not this is not the majority opinion of investors, but just enough capital to push prices in one direction or another. We often hear that “…the market says…” as if the market were a single entity with intelligence. The markets are mostly believed to be omniscient by many. The markets are believed to capture and respond to all information available well before that information becomes common knowledge. The changes and direction of market psychology is wholly unpredictable. Nonetheless, when a change occurs, one can feel it much like a change in the weather. Market psychology has turned more positive the past few days. It has done so without any obvious reason. The term ‘bi-polar’ has often been applied to this behavior. Psychology does rule markets short term, but it is fundamentals which rule actual business returns and there is no investor who will leave a good return on the table. In the long term, it is fundamentals which eventually drive market psychology. Short term much of what we have seen has come from our ‘Inflation Thinking’
What should have been obvious the last 7yrs of market pessimism is that economic trends indicating recovery from the 2008-2009 recession did not support investor pessimism. The Household Employment Survey just reported an additional 530,000 employed. It is not the specific numbers but the trends which are important. This week’s reports on Light Weight Vehicle Sales and Employment support the earlier reports on Personal Income and Retail Sales. All have continued higher without pause. It has been non-stop fundamental ‘Good News’ since early 2009. In spite of a clearly defined recovery, investors have faced 7yrs of pessimistic forecasts. Can you believe it? 7yrs of pessimism which eventually grew into a series of ‘end of the world’ forecasts as oil prices fell last year. Pessimism shifted to a crescendo last month. Then, suddenly over a period of only a few days, oil has begun to trade higher and dire forecasts have mostly disappeared. Turns in psychology occur like that. This particular turn is so sharp you can actually feel it. It is palpable! Analysts are stunned into silence that oil has not collapsed to $0.00 as some predicted. How many bank and oil bankruptcies were predicted even last week? Market psychology went deep into the weeds of pessimism till common sense finally prevailed. The economic data shows we have been in an uninterrupted recovery since early 2009 with that up-trend continuing today.
Two headlines from March 2nd reflect the shift towards optimism:
- Hedge Funds Turn Bullish on Oil Despite Glut http://www.wsj.com/articles/hedge-funds-turn-bullish-on-oil-despite-glut-1456924051
- Why Big U.S. Banks Can Ride Out the Oil Bust http://www.wsj.com/articles/why-big-u-s-banks-can-ride-out-the-oil-bust-1456939227?mod=djemheard_t
The ‘Inflation Thinking’ story;
Our pessimism comes from our belief that ‘Inflation is Good!’. Most investors have been taught that inflation is a natural part of economic activity. Inflation is ‘good’ for assets and protects bond holders because inflation inflates asset values and it has long been believed that higher asset values provide greater protection for bond holders during recessions. We have been taught to have great fear of deflation which many believe would result in a total collapse of our financial system. The Fed’s extreme expansion of M2 beginning in 2008 had this calculation in mind. Many Hedge Funds bet early in the recovery that M2 expansion would result in severe inflation. The media were full of stories concerning inflation fear. Fear grew to high levels when the Fed having done QE1 and QE2 without the desired inflation result began Operation Twist in September 2011. The Hedge Fund community ratcheted their inflation expectations to include the expectation that the US could enter hyper-inflation much like that experienced by Germany of the 1920s and Venezuela today. Many shorted the US$. The problem is that this did not occur then and inflation has remained well under 2% since.
Then comes along Vladimir Putin who invades Ukraine early 2014. The net effect was to cause foreign investors to flood the US with capital seeking a safe haven. This upset the hyper-inflation bets many investors had made for a weaker US$. Now investors were forced to reverse their inflation bets. Commodities which have always been used as inflation hedges in portfolios had to be sold. Reversing inflation bets drove oil and other commodities lower and the US$ higher. Compounding the situation was the belief that China’s economy which had seen heavy commodity consumption was suddenly slowing. For much of the past 2yrs we have seen inflation fear morph into deflation fear as commodity prices fell and the US$ rose. Deflation fears rose to such a point that many were worried that banks would fail along with many natural resource producers. In the space of 2yrs we had essentially shifted from hyper-inflation to deflation. Both of these were believed to be ‘end of the world’ scenarios. Neither scenario occurred!
Now that it has become clear that the ‘end of the world’ has not occurred, market psychology has shifted away from its position of panic only a few days ago. Our fundamentals remain steady in spite of our fears. Inflation as reported by the Dallas Fed is only now beginning to rise slowly at 1.9% having ranged 1.3% to 1.7% since 2009.
http://dallasfed.org/research/pce/index.cfm
Inflation has long been thought to propel stocks higher with the belief that when inflation rises bonds are negatively impacted forcing investors to turn to equities. Investors often chase commodities, mining, oil and infrastructure issues as a result. The factual outcome of inflation is that price increases inflate GDP which is calculated using product and service prices. It is the long term GDP rate which is part of the Value Investor analysis. As this rate rises, the earnings from equities and interest from bonds are both priced lower. To say this another way, inflation hurts both stock and bond relative returns. Nonetheless, investors tend to believe that inflation works to boost stock earnings and this causes stocks to rise. Investors shift away from bonds to buying what they believe are ‘inflation-sensitive’ equities. This causes rates to rise as bond prices fall.
As Value Investors, we need to know how this market psychology works if we expect to navigate the ebb and flow of fundamentals vs. the impact of market psychology. During ‘Bull Markets’, market-inflation psychology is usually opposite to fundamentals because most investors do not apply inflation adjustments to earnings. Most investors see unexpected ‘earnings growth’. They ignore that it may have come from inflation and believe that corporations have something called ‘pricing power’. They push those equities higher. With inflation, corporations can raise prices. The reported earnings on stocks rise, as interest earned from bonds remain fixed. Investors shift towards buying stocks and selling bonds. Inflation only has fundamental pricing impact at market lows when Value Investors exert the greatest influence.
It is important to note that there are two basic types of investors, Value Investors and Momentum Investors. Value Investors include the fundamental pricing impact from inflation in their analysis. Their pricing methodology only becomes evident during recession lows. This is when inflation as a factor of pricing business returns shows up in market pricing. Recession lows are created by long term Value Investors who incorporate inflation as part of their pricing analysis. This is the basis for the SP500 Index vs. SP500 Value Investor Index. Today the SP500 continues to range close to the SP500 Value Investor Index. The Value Investor Index dropped from $2,000 last month to $1,927 as the 12mo Trimmed Mean PCE rose from 1.7% to 1.9%.
Rising inflation causes existing earnings to be worth less in the eyes of Value Investors. As markets rise during economic expansion it is Value Investors who come in to buy whenever markets pull back with the ebb and flow of Momentum Investor perceptions. Momentum Investors generally dominate market pricing with their trend-following algorithms. Rising earnings even if due to inflation causes them to rush into equity markets. The differences in market perceptions between Momentum Investor trend-followers and Value Investors are huge. One needs to be aware of how all investors think if one wants to be appropriately invested as the economic/investment cycle evolves.
- Value Investors buy value which they recognize in the context of historical fundamental returns adjusted for inflation. Value Investors are virtually the only buyers of stocks during recession lows.
- Momentum Investors buy price-trends. Momentum Investors chase earnings increases. They make no adjustment for inflation. Momentum Investors buy ‘inflation-sensitive stocks’ when inflation rises.
- Momentum Investors buy and sell every news announcement as if each provides a forecast of future prices. Value Investors ignore look through headlines to broad economic trends.
The reason some of this may seem confusing and so contrary to consensus thinking is that so few investors understand where inflation comes from and how it impacts markets. Mostly what we hear in the media is the repetition something said by someone who was thought to be very smart. The media repeats whatever appeals to its viewership at the time. It is called “Advertising”. One of the ‘insights’ often repeated comes from Milton Friedman who said “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. …” The Counter-Revolution in Monetary Theory (1970). This ‘Inflation Thinking’ has dominated markets for many decades. With the data available today, we can see that the source of inflation can be identified more specifically. Inflation can be tied directly to surges in government spending and is not purely a ‘monetary phenomenon’.
The relationship between government spending and inflation:
In the chart US Real GDP vs. Total Govt Expenditure&Investment from Jan 2000 to Present it can be seen that there has been a drop in government spending since 2008. This is in the so called discretionary government spending and does not include Social Security and Medicare transfer payments. Only now are we seeing a rise in discretionary spending. The decline from 2008 represents the downsizing of military spending as the US withdrew from Iraq and Afghanistan.
Look at the long term US Real GDP, Private Economy, Govt Exp&inv, M2 & Core Inflation chart. In my opinion, it is the decline in Real Govt Exp&Inv shown as the declining LIGHT BLUE DASHED LINE which has been responsible for the decline in inflation represented by the declining RED DASHED ARROW. In fact all rises/declines in inflation in our long term data show a strong correlation between discretionary government spending and inflation. That inflation is not connected to sharp rises in M2(Money Supply) can be seen by comparing inflation and government spending to the rising M2 PURPLE DASHED LINE. The Fed has attempted to stimulate the economy by stimulating inflation. At this point in time, many have come to see the Fed’s actions as not having the impact expected.. Here we have for the first time in US economic history the evidence which refines Friedman’s connection between the expansion in the money supply and inflation. It is discretionary government spending which is mostly responsible for inflation. This is a more subtle explanation than attributing inflation solely to the expansion of the money supply. This explains why bets on inflation have failed to materialize and why we have witnessed such a swing from a position of high inflationary expectations to one fearing deflation the past 2yrs. With the recent Dallas Fed 12mo Trimmed Mean PCE rise to 1.9%, market perception is about to change in my opinion.
The Fed’s multiple attempts at trying to inflate the economy by rapidly expanding M2 have been ineffective. Declines in government spending have trumped M2. Additional confusion due to low inflation has caused many to miss the current economic recovery. Many have used as historical economic references the trends in ‘Nominal’ (not inflation adjusted) prices of goods and services produced and wages paid. Inflation is part of all price and wage measures. To fully understand current personal income growth, growth in retail sales and wage growth, they must all be inflation adjusted. Great confusion has occurred because most have not used inflation adjusted data which left them believing we have weak economic growth which requires additional stimulation. Adjusting for inflation reveals that in ‘Real’ terms (inflation adjusted) our economy is running at close to its historical norm. There is nothing slow in our current economy about Real wage growth, Real retail sales growth or Real Gross Domestic Production growth when one makes the inflation adjustments. It is my opinion, this is why many have remained so pessimistic for so long.
In the current 12mo Trimmed Mean PCE report, indicates that inflation may now be on the rise. It is my opinion that this is most likely due to the rise in US military spending rises to counter ISIS in the Mid-East. A recent rise in government spending can be seen in the short term US Real GDP vs. Total Govt Expenditure&Investment chart. As the US becomes more re-involved militarily, we can expect inflation to rise further. A rise in inflation filters thru to prices and wages which causes many who do not adjust for inflation to believe that the economy is accelerating with added benefits for all. Those who are now pessimists will likely become optimists and drive equity prices, especially those they deem ‘inflation-sensitive’ much higher than they are at the moment.
Summary:
- Most have believed the economy has been weak since 2009 when data adjusted for inflation reveals that growth has been in the same range as the 1990s economy.
- Now that govt spending is accelerating, so will inflation which is likely to convince many that this is an improvement in economic growth.
- My recommendation is that investors should remain invested in LgCap Domestic & Intl equities as well as have an allocation to Natural Resources. Add to portfolios if possible.
- Markets look poised for a sustained rise as investor psychology shifts towards optimism.
