I had an interesting call this weekend from my most astute investor. Since he wants to be anonymous, let’s call him "Bob". Here is our conversation, with a few pointers and charts included — items that he requested I send him by email. [Readers will benefit from taking the time to follow the links to past posts.]
Bob: I enjoyed reading your research reviews last year, and I have a question. What was the most expensive Wall Street research for 2006?
Jeff: Do you mean the report that had the highest price tag?
Bob: (chuckling) No! I mean the one that cost people the most money.
Jeff: Ahh. Good question and the answer is easy. The research on what happens when the Fed is trying to achieve what people call a "soft landing."
Bob: That would not have been my guess. I was thinking the election cycle or something. What was so bad about the Fed and the soft landing.
Jeff: It was a perfect storm for harming the individual investor and average trader. First, the original work was a poor research design, but subtle enough that it took some skill to see the problem. Second, it came from a big name firm so it got a major play in the media – basically accepted as gospel on CNBC. Third, the concept was elusive, and subject to misinterpretation. Finally, the leading blog sites gave it a big play. The result was that anyone listening missed a big rally.
B: You sound like a professor. But I asked the question, so what was wrong with the research.
J: Lack of data is the main problem. There have not been enough Fed tightening cycles to draw sound conclusions. You have to reach too far into the past, and then you still do not have enough cases. The researchers used all of the data they had without regard for relevance.
A technique used in Research Design 101 is to look at a time series of results. The reported research results assumed that the Fed is no better now than it was in the Hoover Administration. This is typical of Wall Street. Fund managers all figure that they are smarter and better. In any other field of study we expect that there has been great progress – nuclear power, space exploration, biotech, DNA matching, weapons development, better airplanes and cars – you name it. Despite this, the Street thinks that decades of Nobel Prize winning research in economics and the development of computer modeling make no difference. Criticizing the Fed is a game, like second-guessing football coaches.
Take a look at some real data on recessions. A good question is what proportion of the time the economy has been growing versus in recession. This chart shows that by decade.
It is readily apparent that the economy is now more resilient. But the chart does not tell the whole story.
Fed tightening cycles have also had less impact on stocks. Recessions — whether or not they result from tightening cycles — have had little impact on the overall earnings prospects of the market, as measured by earnings expectations for the S&P 500.
Recessions, when they occur, are briefer and with a smaller impact. This is the best way to look at the data — as a continuous process of economic performance. It reflects many factors, not just the Fed.
Even if one looks at the data from the perspective of a discrete series of Fed moves — the wrong method in my view — the stock market effect is quite different from that suggested in the original research.
If one looks at "recent" data — say from the last thirty years or so — the result is much different from the conclusion drawn from the "dead ball" era used in the original research. If you are trying to forecast, would you think that thirty years was far enough back to go? In running your business, would you look at the recent trend or go back to the 20’s or the 50’s?
B: I remember hearing and reading about this repeatedly. Everyone said a soft landing was nearly impossible.
J: That’s right. We pointed out these problems in mid-August, but the media was running with the story. CNBC quoted the study repeatedly. Major writers featured it. The big-time bearish blogs called it a myth. They utilized pejorative symbolism which frightened the individual investors. I warned about this out on "A Dash" and also in individual conversations.
B: So those who listened to the mainstream media and the blogs lost out?
J: Big time. Those who did not understand this Fed cycle have missed a big rally. Even if there finally is a correction or recession, stocks may not dip back to the August levels. Look at the chart.
[click to enlarge]
Investors have missed 15% in the S&P 500 and 20% in the Nasdaq while waiting for a Fed-induced correction. (Meanwhile, Vince’s intermediate-term models gave us a buy signal on August 8th.)
Even if we eventually have a correction or a recession, the pullback may not take us down to the August levels.
B: What do you mean about "understanding this Fed cycle." You are not suggesting that this time is different are you? We all know that is a mistake.
J: When the tightening starts from a level that is far below "neutral" and proceeds very gradually to a point that is slightly above neutral, it is different. It is not like a tightening cycle where inflation was already out of control, and the Fed needed to choke the economy. I repeat that there are not enough cases for a quantitative analysis of tightening.
B: Personally, I have followed your advice and remained invested. Some of my friends have not. What would you tell them?
J: I am not surprised that many have missed out. The misinformation on this subject reached many — perhaps millions of investors, while "A Dash" has a loyal readership best measured in hundreds. That is actually a good thing for those who are just now getting involved. Most still do not understand, and we will see some fund managers chasing for performance.
Despite the rally, I feel that most of the opportunity remains. Stocks have only begun to catch up with the record run of earnings growth. I have tried to illustrate that in my valuation stories on "A Dash".
B: I have been reading that earnings are going down, reverting to the mean.
J: That just means that we are returning to normal growth instead of exceptional growth. Don’t confuse a lower rate of growth with an actual earnings decline. Take another look at the chart of forward earnings.
Meanwhile, I’ll try to cover the subject of misleading articles on earnings. The list of topics grows….It is more difficult when writing fresh analysis.
And our conversation reverted to the normal subjects — sports, bridge, poker, kids, and good restaurants. It is nice to have some astute investors who ask good questions.