Here on A Dash, we encourage individual investors to keep a cool head and focus on the fundamentals. Of course, we do this in contrast with the mainstream financial media – which often seems more concerned with ratings than accurate information. Fear can be very profitable for bloggers and news networks, but that is not the case for individual investors. Most will find that their biggest losses come from staying out of the market during upward moves.
We base our approach to trading on a relatively simple idea: That the market climbs a Wall of Worry. At any given point in time, there will be dozens of crises worldwide (be they political, economic, military etc). It is easy to speculate on the worst possible outcomes. It takes more patience to assess the most likely resolutions of conflicts and act accordingly.
Below are a number of potential issues that could be keeping individual investors on the sidelines, followed by our take on the potential threat. Click a link below to jump straight to a common fear.
- Profit margins are too high and will revert to mean values
- Stocks are “over-valued” by various measures
- Fears of deflation
- Fears of inflation
- Too long since last correction
- This year is just like (any two variable chart)
- End of QE
- Collapse in Europe/China/Emerging Markets
Profit margins too high and will revert to mean values
As a recurring theme in 2014, we asked readers to differentiate between complacency and vigilance in investment. Consider not only what appears to be going well in the market, but also what surprise risks might change your mind about the landscape moving forward. One thing we thought would change our minds would be “Declining profit margins that were not accompanied by strong economic growth and increased revenues.”
This is a pernicious myth that has been around in some form or another for many years. In February of 2014, we broke down this “mystery method” to explain its misapplication to the market.
- Profit margins have a powerful mean-reverting tendency
- Margins are at unsustainably high levels
- Stocks are wildly over-valued as a result. Expect a 30-40% haircut.
This analysis is actually a concealed pairs trade, as is any such argument that involves a ratio. The subject of the mean reversion argument combines two elements: Profits and revenue. Assuming that you agree on the main theme –margins have expanded beyond the normal relationship, the discrepancy could be resolved in any of the classic three ways:
- Profits could decline while revenues remain constant
- Revenues could increase while profits remain constant
- Some combination of the two
The Pundit Error
If a hedge fund employee spotted a potential pairs discrepancy and took only one side of the trade, what do you think would happen?
It would be treated as a rookie mistake – a blunder. He would be admonished or fired if beyond his trading discretion.
Meanwhile, pundits insistently, year-after-year insist that the profit margin issue will be resolved by declining profits. They are betting the ranch on one side of the trade, and picking the wrong one at that. They do not seem to understand that margins are high because revenues are pressured and companies got lean and mean. As the economy and revenues improve, then there will be more competition and profit margins will become more normal.
In the past, we have cited Michael Batnick as a reputable source on why this myth is so persistent.
The thing about these perma-bears that makes my blood boil is that when they’re wrong they still win, it’s their investors who get burned. These people can stay wronger longer than you can stay solvent because they’ll collect their fees regardless of the outcome. The unfortunate reality is that the uninformed don’t know that this snake-oil salesman has called 14 out of the last 2 bear markets. The certainty with which these people deliver their message is amazing, they have been telling stories for so long they actually believe their own lies.
You might notice that these people are never wrong and the reasons why is an ever expanding list of nonsense. QE is bearish, nope, the end of QE is really bearish. Unsustainable high profit margins are bearish, low profit margins are also bearish. Oil prices falling are bearish because it is indicative of a slowing economy. High oil prices are even more bearish because it is a tax on consumers. You get the point.
On June 20, 2015, we awarded the weekly Silver Bullet to Pierre Lapointe for poking a hole in this one. The chart below illustrates how many years it can take before declining margins actually impact the price of stocks. Regarding equities, Lapointe correctly noted that it “isn’t at all clear that margins will contract further” – thereby staving off persistent rumors of an impending “disastrous scenario.”
This issue was recently prominent when second quarter earnings were reported in July 2015. Our prediction was for earnings to outperform expectations. Noting that estimate reductions usually set the bar too low (see chart below), we encouraged cautious optimism.
As a contrarian approach to the punditry, try taking what the market is giving you. Avoid making crowded trades when stocks and sectors are cheap.
Stocks are over-valued by “any” of the measures
- Tobin’s Q
- Shiller P/E (CAPE)
- Buffett Indicator
- Long-term trends
Any given earnings season is accompanied by these dubious market valuation measures. An all-time classic article can be found here, but this highlight should be enough to raise the alarm for individual investors.
Let me start with what we do not hear.
- This stock is a poor investment because it has a bad Tobin’s Q ratio. Readers are invited to correct me if someone is offering an opinion that Google has a poor replacement value. How do you even think in these terms? This method is an outdated approach in search of a modern critic.
- This stock is over-valued based upon the Shiller CAPE method. Readers are invited to correct me with examples of specific stocks where people think that the P/E ratio should be based on the earnings over the last decade, adjusted for inflation and divided by 10 (or some close variant). Has anyone ever made any money using this method?
- The earnings of the company should be ignored because it is happening in the midst of a counter-trend rally in the midst of a cyclical bear market. Readers are invited to correct me with examples of analysts on specific stocks who thought this was relevant.
- The current value of the company should be compared to its earnings in 1870. In 1910. In 1935. In 1950. In 1970….and so forth. Readers are invited to submit examples of recent earnings analyses where anyone thought this past history was relevant to the current stock price.
Stocks react dramatically to earnings reports. None of the price changes had anything to do with the factors above. None. No one ever makes a dime from applying these methods in real time.
What did we actually hear?
- Did earnings meet the Street expectations? How about earnings quality?
- Did revenues meet expectations?
- What is the outlook for the upcoming year – with special emphasis on macro concerns like Europe, recession chances, and China.
- Are there special factors affecting the outlook?
Every major stock move is explained in these terms, or a variant thereof. The ability to understand and answer these questions is the key to investment success.
The Overall Investment Implication
Anyone who thinks objectively about these questions is driven to a rather obvious conclusion about market valuation:
How can a method advertised as a good measure for the overall market fail to explain any of the components?
There is another group of pundits who embrace Tobin’s Q, CAPE, and cycles extending farther back than the dead-ball era in baseball. The enthusiasm of their followers approaches cult status. For these analysts the market seems to be in a permanent state of over-valuation. The followers are not investors, but merely spectators. They never get a “buy” signal.
“Media questioners always try to get him to predict an imminent crash. Market bears use his CAPE ratio as the foundation for demonstrating an over-valued market. Most people would be surprised to learn that he continues to hold over 50% stocks, an aggressive allocation given his age.”
If the creator – and largest proponent – of a given model isn’t using it to make money, why would you think you would?
Recession fears – deflation
While the US economy shows a strong performance, perma-bears point to lagging indicators from other world markets as a sign of imminent collapse. We continue to emphasize the flaw in trying to invest from this sort of thinking. In order to succeed as an individual investor, you need an edge – something more than your daily newspaper can provide. We dedicated the Weighing the Week Ahead post on October 5, 2014 to exactly this topic. The full article is worth a read, but a small highlight appears below:
The picture among the major economies remains mixed. I like this summary chart from the helpful Schwab Market Perspective article:
The Schwab team summarizes the other major economies as follows:
Outside the United States, Europe is flirting with another recession and deflation, Japan is trying to pull itself out if its long-standing malaise, and Chinese growth is slowing. Emerging markets look attractive.
They also note that despite the international risks, a US recession does not seem to be imminent.
This is completely consistent with the excellent indicators that I update each week, so my answer to the headline question [Will global weakness drag down the US economy?] is “No.”
“The noise box in your den (and on the wall of your trading room) has been tallying a catalog of potential crises and hazards. That parade of terribles seems to be getting longer each day. Although none of them are new, it is as if all of them have suddenly risen in unison, a chorus of noise, funk and angst. Markets are expensive, the Federal Reserve’s stimulus of quantitative easing and zero interest rates is ending, the euro is collapsing, deflation is a threat, rates are rising, residential real estate is a mess, biotech is a bubble, oil prices are plunging, Grexit will arrive any day.”
In looking at the expected speeches, the negative stories were prominent. Whenever there is a long list of widely-known negatives, investors should also ask whether something might go right!
More recently, there has been an increased emphasis on deflationary fears as a function both a stronger dollar and persistently low oil prices. We note that this has raised a number of questions, notably:
“What is the message from falling commodity prices?
And also – Will the Fed be watching?
There are two basic viewpoints on the commodity question.
- Some prefer commodities as an economic indicator. The prices are not revised, not surveys, and not created by the government. Short-term trading has been linked to oil prices for months. The parade of pundits cites lower oil prices as a sign of global economic weakness. Some recession models (like the ECRI’s) prominently include commodity prices.
- Some emphasize traditional economic data, often using a variety of indicators.”
Our response to those questions are as follows:
“In fact, commodity prices have not been a trustworthy economic indicator. The prices reflect both supply and demand, of course. The actions of producers are the important driver of prices. In fact, demand for oil and other energy sources has grown more in 2015 than in 2014. The strong dollar also creates the appearance of weakness in commodities, as this chart (McClellan Financial Publications) of copper priced in both yen and dollars illustrates:
It is also obvious that the copper price in dollars has not correlated with economic growth for several years.
For investors, this means opportunity when there is general selling of stocks that are not directly related to commodities. This includes cyclical names (think Honeywell or GE), bank stocks, and technology.
For traders, the accuracy of the economic correlation really does not matter. As long as so many believe there is a relationship, and trade accordingly, we must adjust our own actions to these perceptions.”
CNBC (and others) give a disproportionate amount of time on their network to pundits warning of increased inflation. Their theories on why inflation is imminent are inconsistent (recently ranging from the Fed, to drops in commodity prices), but they continue to insist. We noted as recently as November 22, 2014 that those fears are unfounded.
Inflation remains low. The stubborn unwillingness of many investors to accept this conclusion is a big source of error – mostly from misreading the Fed and buying gold. Remember when many complained about using core inflation because food and energy were important? Now that energy prices are lowering the overall inflation rate many complainers have moved on to a new argument.Rex Nutting has a nice article explaining that “stuff” that we buy is getting cheaper while services are not. Barron’s shows that core inflation is better described as the trend, including this chart:
As recently as July of 2015, these fears have remained baseless – much to the consternation of doom-and-gloomers.
- They include food and energy when these items make the data seem worse, usually making sarcastic comments about how the Fed excludes items – never giving any recognition to the reasons. Then, when these items are improving the headline data the pundit focuses on the core. Amazing.
- They use high inflation to scare people witless (TM OldProf euphemism). When inflation is low, it is cited as a “miss” of the Fed’s inflation target, showing that the economy is weak.
Maybe we need a pundit position project.”
See the “End of QE3” section below for more on perma-bears and the Fed.
Too long since last correction – market timing
The Hindenburg Omen continues to gain traction as a market timing “tool” despite its dubious statistical authenticity. We’ve cited Barry Ritholtz as an authority on this subject on multiple occasions. Writing for the Wall Street Journal, he notes two important reasons why the Hindenburg Omen gets much more attention than it deserves.
• The 25% track record is simply too weak statistically to pay any heed to (its worse than flipping a coin)
• The psychology that follows a major crash lends itself to what I called “Recession Porn” — an emphasis on all things bleak and negative. The Hindenburg Omen fits the profile perfectly.
In a later post, Ritholtz presents this chart of false positives – which should be more than enough to give the individual investor a moment’s pause.
This year is just like… (insert your favorite contrived two-variable chart)
Causation/Correlation fallacies are a common source of fodder here on A Dash. The less scrupulous economics and finance writers will go out of their way to weave independent data into a story that fits their worldview. “Don’t be fooled! This rally is just like 2008…or 1987…or 1929.” In many cases, you’ll find that even statistically significant correlations are matters of pure coincidence. We addressed this in our Silver Bullet “Best of 2014” awards by highlighting Tyler Vigen’s work in making this point abundantly clear. For reference, here are a couple salient examples:
End of QE
Pundits have speculated endlessly on the “real” impact of QE3 – usually suggesting that it had propped the market up, and a collapse would immediately follow its tapering off. We gave Ethan Harris of Merrill Lynch due recognition as a Silver Bullet award winner for his thorough deconstruction of this issue.
“Every time the end of a QE program looms, pundits warn of a big shock to markets and the economy. In the business press, the story of exactly how this happens keeps shifting to fit the facts.”
The main target of Harris’ critique is the above chart, which has been a favorite among the “QE-truthers,” or folks who believe the Fed’s policies are directly responsible for the rise in the stock market.
But the big problem Harris has with this chart is, well, basic statistics.
“Implicitly, this chart assumes that the markets are not forward looking and it is the implementation of Q that drives the stock market: when the Fed buys, the market booms and when it stops, the market swoons,” Harris wrote.
“As our readers know, we think this relationship is a classic case of spurious correlation: anything that trended higher over the last 5 years has a 90%-plus correlation with the Fed’s balance sheet.”
With the Fed’s QE policy still a subject of frequent debate, we mulled over a couple different approaches to the subject in October, 2015.
“Dovish. A rate increase is not imminent, and is likely to be delayed until mid-2016. Tim Duy, a leading expert on Fed watching, draws this conclusion from a speech to business economists by Fed Governor Lael Brainard. Prof. Duy raves about the implications of this exciting speech. (Only a true expert and policy wonk could reach that conclusion, but that is why we should pay attention). Brainard is a real all-star, with outstanding academic credentials, consulting experience, and award-winning work for think tanks and government. His key takeaway? She may join with an important Fed coalition that is less committed to an early rate hike.
Hawkish. The Fed bank boards are more supportive of an increase in the discount rate. For some years this rate has been 50 basis points above the fed funds rate, so it is an indicator of opinion about a rate increase. The bank presidents are frequently more hawkish than the appointed Governors, and their voting rights on the FOMC go through a rotation. Even so, an excellent and experienced observer, Bob Eisenbeis (via Barry Ritholtz), shows the dramatic shift in the positions of the bank boards.”
My own guess is “no change” at this meeting, but I have not ruled out a December shift.
- The entire rally has been based upon central bank policy and increased liquidity
- Even a gradual withdrawal of policy accommodation constitutes “tightening.”
This leaves us with the ongoing market dilemma – time frames. Are we trading or investing? The former is a matter of psychology, while the latter rests upon your determination of the actual value of each potential investment.
A change in Fed policy is unlikely, but if it happens, it is not really important for long-term investors.”
Collapse in Europe/China/Emerging Markets
Elected officials and government bureaucracies are the lowest-hanging fruit for bearish pundits. In this classic post, we outlined the danger in mixing politics and ideology with your investing.
We continue to see a prevailing viewpoint that has a certain pattern:
- The pundit expected government to be powerless to deal with economic challenges.
- The pundit is surprised at a massive reaction by the Fed, using many tools that no one contemplated a year ago.
- The pundit is surprised by aggressive action by the President and the Congress.
- Mistaken in predicting the government response, the pundit now turns to criticizing everything. It will all turn out badly.
It is a simple case of confusing ideology, politics, and investing. Here is a simple fact to consider. It is a fact, not a matter of speculation.
Those in power in government are continually working to prevent further economic distress, using whatever means available.
Anyone who does not get this fact is out of the loop. This fact has been true for government officials of both parties. They are not going to stand idly by and watch a further economic collapse.
Some investors are using a foolish litmus test. They ask whether a pundit had some sort of prediction related to the economic crisis. It does not matter whether the prediction was many years too soon. It does not matter whether the causal mechanism was completely wrong. Anyone who “called the collapse” is a genius.
It is now a new game, and it is called looking forward. The time frame is significant. Even long-term investors should be looking a year or so ahead, and preparing to adjust.
In a very real way, it doesn’t matter if the topic of conversation is Greece or China. Placing your money on economic collapse as a result of government incompetence is a losing bet. Small compromises that may appear to “kick the can down the road” are actually incremental policies that form the basis of future progress. All parties have a vested interest in strong economic growth – and nobody wants to be responsible for a collapse.