“Davidson” submits:
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
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 that difficult if one examines our financial history. Economic/financial history busts the concept that the Fed controls rates and inflation. First, markets control rates and this is connected to market psychology. Markets which represent all humanity are far larger than any Central Bank policy. It is not low rates which spur economic activity. Low rates are a sign of investor pessimism. Investor’s fear to own other investments causes them to pile capital into safe haven investments which is why we have such low global interest rates today. In the current cycle the US and Western markets have seen a tremendous influx of global capital as investor fears rose with Russia’s, Iran’s China’s and ISIS’s threats to wealth. That this occurred can be connected to Us foreign policy.
As can be seen in the 2015-June 2017 daily T-Bill/10yr Treasury Rate Spread & FedFunds the Fed Funds Rate follows changes in T-Bill rates. The Fed does not lead. It follows. The data shows this has been so since 1963(history available). The only time history shows the Fed leading was Chairman Volcker’s emergency actions to quash inflation in the early 1980s. The other feature(not shown) in this data is that the T-Bill/10yr Treasury Rate Spread is highly correlated to the business cycle. Business cycles expand with widening spreads and correct once the spread falls to or below 0.2%. Markets have always expanded and corrected with business cycles. Spreads fell prior to the US election, rose briefly afterwards and fell again till the past week when they began to rise once again. What has kept the 10yr Treasury rate below the “Natural Rate”(today at 4.76%) has been an over abundance of foreign capital.(see below) The T-Bill rise represents investors and businesses becoming gradually more positive on higher returns else where. Economic corrections have never occurred with spreads this wide. My estimate is that several years out we may see T-Bill and 10yr Treasury rate spreads narrow to 0.0% once 10yr rates have shifted to the 5% range. Till then, the economy can be expected to expand with increased lending and markets can be expected to follow by pricing higher.
Investor psychology and perceptions of returns impacts the US$(US Dollar). The monthly US$ from 1973 Trade Weighted US$ Index Major Currencies vs. $WTI Crude Price has had 3 periods of significant strength. Each was a period of imbalance when capital flocked to the US for higher returns. The early 1980 period was a response to Chairman Volcker’ 18% rate action to quash inflation. 18% was vey attractive. The 1995-2002 period drew capital into the US’s Internet Bubble. US markets had explosive price growth. Expectations of high returns on capital have always lured investors. The more recent US$ strength came not from seeking excess returns, but global investors seeking safety(see below). Eventually, each period of unusual US$ strength ended as the cycle normalized to the US$’s long-term trend line.
The US$ is shown relative to the $WTI price. It shows how investors have gradually inversely correlated the US$ with oil prices as oil and other commodities evolved into having the mixed character of both economic and financial assets as global trade has expanded. There has been a more prominent inverse correlation after 2003 with the introduction of computer run algorithms.
A strong US$ has always been temporary. The reason for this is that the US manufactures its ‘old-but-still-very-useful’ technology in lower cost foreign countries. Air conditioners are a prime example of this. This effectively extends the profits from US technology using lower cost sourcing and continues to add to the US standard of living. The net/net of global outsourcing one’s old technology in continuous improvement of one’s own standard of living is to raise the currencies of foreign countries. As long as the US continues to be a global technological leader, the US$ will decline in line withe the long established trend.
All periods of US$ strength have been negative to US manufacturing and employment. An overly strong US$ acts as a barrier to trade and has always forced US manufacturers who compete globally to establish operations abroad in response. The only defense to currency fluctuations is to establish foreign production facilities. Companies with advanced technologies which manufacture in foreign countries cause standards of living to rise globally. It also assures that periods of US$ strength will normalize. The daily Trade Weighted US$ Index Major Currencies vs. $WTI shows a suggestive pattern. From Jan 2015 the 2003 US$/$WTI was inversely correlated. Then roughly mid-2016 the inverse correlation began to disappear and seemed to become directly correlated as the US Presidential election loomed. The US$ peaked in Dec 2016 and since has rapidly declined. The US$ has fallen 8% from its peak as of July 1st. Suddenly, oil prices appear to have regained the inverse correlation. It appears as if there was a period of investor confusion from Nov 2016 to July 2017 which has now been resolved. Oil prices appear to be on the verge of rising as the US$ falls and algorithms impose the inverse correlation.
The weaker US$ comes after the US has begun to reassert its protections to individual property rights and Democracy globally. This is a significant US foreign policy change. The statement that the US would defeat ISIS quickly was just affirmed with last week’s fall of ISIS in Mosul. Last week the US defended innocent people from Syria’s chemical weapons with a simple threat the US would respond in force. Investors are responding with higher T-Bill rates and weaker US$ as capital which had pooled in the US begins to return to foreign markets. This is all good!
What is occurring today is CNBC saying “Wow, we have surprising revenue growth. Real earnings!…It’s a real surprise!”, Bob Pisani, July 3, 2017. It is not really a surprise to Value Investors. The Chemical Activity Barometer(CAB) and the Job Opening data published by the St Louis Fed reflected the strong US$ impact on US manufacturing. US industrials lost 6%-8% (some more than that) as they adjusted operations in response. There have been many acquisitions using US$ strength to by foreign corporations. This is how it appears jobs are being exported. Since ~April 2016, the CAB reflected a surge in US industrial activity. The last 2mos reflect a surge in industrial job openings.
It is all good!
Markets are us. They are complex with and cycle with market psychology, but our relentless desire to improve our family’s standard of living(not only in the US but globally) is what drives the underlying fundamentals. Long-term, markets and GDP have always grown with standards of living. If you always keep this in mind, then one can see the cycles and can anticipate market shifts even though one cannot do this with precision. It looks like a form of magic but it comes from developing a ‘fuzzy logic’ of how value has been created over many decades. This is what Buffett, Marks and other Value Investors do.
Markets do not have precision, but it does not mean one cannot predict broad shifts and invest with them. Those who try to study Value Investing too closely miss the point that Value Investing is not in the details which one can learn and apply. Value Investing occurs in the very broad context of human activity in which one perceives broad patterns. Once one has developed broad knowledge, a pattern is perceived, a cycle identified and at what part one is within the that cycle. It is in this context that one invests with skilled CEOs and portfolio managers.
Today, we find ourselves 8yrs into economic recovery with relatively persistent pessimism. Only now are we being surprised with economic growth which has actually been present since 2009. The conditions remain for continued global expansion. Markets have always shifted higher with positive surprises.
I continue to recommend that investors add to Equities and to avoid Fixed Income.