Asking the Right Question

The solution to many problems starts with asking the right questions.  For investors who actively follow the news, there is a daily fixation about what "caused" the market to blip higher or lower on a given day.  This is inevitable.  If you or I had the job of daily market commentary we would feel compelled to find and write about the day's market action.

In fact, many (most?) moves are within the range of regular volatility.  It is "noise" not "signal."

Let's try a little test.

People saw two things happening at about the same time and inferred causation.  Yesterday the market was up about 1%.  Much of the punditry attributed the gain to the improved chances of the GOP in the Massachusetts Senate race.  Many also opined that if the victory occurred, the market would stage a monster rally.

So the victory did occur, and anyone who wished could have bought S&P futures overnight at an attractive price.  What happened?  The market opened low, moved lower, and rebounded.  The trading wiped out yesterday's gains.  Some opined that this was a "sell the news" action, but that is a very lame explanation.  The Brown victory was not certain yesterday, and in any case, the gains would not have been completely wiped out.  This explanation is often suggested after the fact, since knowing what is already reflected in market prices is difficult.

So much for what people were watching.  Now try this question?

Among the pundits yesterday (or last week) who was suggesting a focus on China and bank lending?

Apparently no one had this yesterday, although that was the big explanation for today.

The Lesson

In one of the best articles from my recent reading (and I read hundreds of them) Charles Kirk explained a key concept.  One thing I like about the article is that it is based upon independent research, a survey of his readers, and therefore has information you cannot get anywhere else.  It is hard work to collect data and do research.  Most bloggers do not bother.  The next thing I like is his innovative presentation of the results, with a word cloud for fears and hopes.  It is a dramatic and effective presentation of the conclusion, and you should read this effective and brief article for yourself.

Putting it into words, he wrote as follows:

In my experience, usually the things we fear the most are the things that impact the market the least. I've seen this happen time and time again. Much like life, the things we don't know to worry about is usually what we should be worried about the most. Likewise, the things we hope from the market, usually work against us like they have for many who've been sidelined or short since last March and who are hoping for a correction now.

Investment Implication

There are two investment conclusions — one strategy and one tactics.

Strategically, we can remember to learn a little more about China and keep the relevant indicators in mind.  Here is a key quotation from the Merrill Lynch team (now brought to you by B of A).  You will need a relationship to get this regularly, but it is very helpful commentary.

China's loan data might be the most important macro indicator in China and one of the most important for the globe in this global crisis. But confusion on this data leads markets to occasionally overshoot or undershoot. Today several media reported that the CBRC (China's banking regulator) asked some banks to stop increasing new loans, but some incorrectly interpreted this as regulators required banks to "stop lending". We think China is to change its policy stance and withdraw from emergency measures (click here for our note on the coming change of policy stance), but it's not a U-turn, and there will be no credit squeeze. – Ting Lu, TJ Bond, Xiaojia Zhi.

So let's get this straight. There are a bunch of pundits who were not even thinking about China.  We get a few stories that misinterpret key indicators.  Everyone ignores the great earnings stories of today and the reduced chances for tax increases and turns instead to a new source of worry.

Meanwhile, China's fourth-quarter GDP was up 10.7% over last year.  And this is supposed to be bad news?

Tactically, the key question is how to participate in a rising market.  Any advisors trying to find good entry points for new clients has faced frustration.  It is exactly what Charles Kirk describes — the hope for a correction.  Whenever there is a dip, I am looking for names that I like at attractive prices.

A Final Thought

The focus for investors is clear and simple:  Earnings.

The earnings picture is strong and improving.  It is leading the economic indicators because of cost-cutting and leverage.  The Bearish Broadcasting Network has a spin for every earnings report.  I especially liked the one about Intel (we own it and are buying for new clients).

The idea was that Intel has high gross margins on their products and it can only get worse.  I guess if you have enough variables, you can find one to prove any point, but this is really stupid.

Here is a company that is expanding, showing operating leverage, and excellent earnings growth.  It is at an attractive part of the cycle.  If the economy continues to improve, people will buy more products with Intel chips — a lot more.  It is a low point.  What is not to like?

If investors focus on the many good earnings stories, there are plenty of great buys.

Instead, many people are obsessed with employment and other lagging economic indicators.  An investor focused on employment is like a deer in the headlights.  These investors will remain motionless until the rally has passed.

I am truly sorry that people are unemployed.  I study the issue in detail, and track the progress each week.  I sincerely hope that we can create more jobs.

But it is a lagging indicator for investors.  I do not help the unemployed by staying in money market accounts.  I can help more by investing in solid companies.

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  • Paul Nunes January 21, 2010  

    This was great Jeff! Have a great weekend.

  • Adam January 21, 2010  

    Imagine if the Dem. had won in Massachusetts and the market had sold off, the cause/effect would have achieved permanent narrative status.

  • Mike C January 22, 2010  

    Here are 2 questions I’d be interested in your take on. Take this chart:
    Question 1: What changed in 1996 to sever and disconnect the historical range on the relationship between GDP and aggregate market capitalization. There must be some logical explanation why an entirely new range has existed for the past 15 years?
    Question 2: If we are looking out the next 20-30 years, which dataset is more likely to be predictive of the future, the 1996-2010 range or everything that preceded it. If it is the 1996-2010 range, why is everything before no longer valid?
    I come at this question with a bias but I am very interested and open to both views here.

  • Jeff Miller January 22, 2010  

    Mike C — I do not think that this chart provides any useful information, and I am surprised that you do.
    There is a method for doing research. It starts with forming a hypothesis. You then look at changes in independent and dependent variables to test the hypothesis.
    What you do not do is put up some chart and make a vague hypothesis about “ranges.”
    As a descriptive chart, it is OK, but there are many reasons why investment in public companies as opposed to other investments may have changed over time.
    In particular, trying to look at this as some sort of valuation measure is lacking on many fronts (although it does capture that as one element).
    To summarize, and not meaning to pick on Barry in particular, most of those doing charts and “research” have not had any formal training in research methods. They start with a conclusion and look for some evidence to “prove” the point.
    Meanwhile, I really prefer to work from my own agenda of what I think is important. Articles like this can be thrown up in a minutes. They seem compelling to true believers. It takes hours to do a comprehensive refutation and even then, you will not convince anyone.
    Why don’t you try getting Barry to deal with some of my work?

  • Mike C January 23, 2010  

    I appreciate your response, although I genuinely had hoped you might directly address the question, rather then be “surprised” I thought it was a right question to ask or go in the direction of who does or doesn’t have formal training. I’m not really sure what me trying to have Barry address your work has anything to do with the price of tea in China.
    Incidentally, not that it makes it unquestionable, but Buffett himself has cited this valuation metric which I assume you might find surprising (you have cited Buffett in many of your blog posts):
    I’m not a “true believer” in anything, and actually am very interested in why a metric Buffett espouses may not be totally valid. I posed this question in several forums looking for some specific answers, and received some answers. One reason was lower tax rates the past several years on capital gains and dividends which raises the after-tax cash flows investors receive, and the other reason was a more globalized economy where this metric isn’t capturing foreign revenues that companies like KO and MCD have. Anyways, I can see why this metric Buffett likes is flawed.
    Meanwhile, I really prefer to work from my own agenda of what I think is important.
    Not really sure how to take this. I was simply asking what I thought was the “right question”. I knew Buffett liked this metric, and Buffett is much smarter than me, yet I intuitively thought there must be some reason a new range had been established and was simply looking for direct answers from other smart people and you certainly qualify.