Perception and Reality
At "A Dash" we try to distinguish between actual data –especially economic reports and corporate earnings — and market perceptions. When there is a significant difference between the two, it provides an opportunity for traders and investors.
Background: Last Week
As we noted in our article on the ISM report, and also in our preview of the payroll employment report, extreme negative sentiment has taken hold. There is a line of reasoning that goes as follows:
- Weak economic data proves that the US is on the brink of a recession;
- The Fed is out of touch and hopelessly slow in addressing economic issues;
- The recession will have an extreme impact on corporate earnings and US equity prices; and
- This is all a surprise to the markets since current prices are close to record highs.
This causal chain has a superficial plausibility since the US economy has slowed in reaction to the planned tightening of interest rates by the Fed and the additional impact of various "shocks". These include the housing market, the credit markets, and rising energy prices.
Because the factors are easy to understand in descriptive terms and make good news, they have all been highlighted in various media accounts. This has led to a growing discrepancy between estimates of recession probabilities by the economic community, and the expectations of various pundits and individual investors.
The Gap Between Perception and Reality
Let us consider each element of the causal chain.
Recession chances. Economic growth in the 4th quarter seems to be tracking at a rate of about 1.5%. This is below economic potential, but not at recession levels. December economic data from jobless claims, the ISM, payroll employment, and the unemployment rate are not at levels typically associated with a recession. The December data are weaker, and recession chances have increased.
The Fed. Market observers have joined in criticizing the Fed. The chorus of voices saying that the Fed is "behind the curve" is now almost universal. While some economists and former Fed Governors share this viewpoint, many economists take an important alternative perspective. We cited those showing that the Fed has acted more quickly to cut rates than in past potential recessions.
More importantly, nearly everyone is underestimating the creativity and determination of the Fed. What most observers do not understand is that the Fed has not only added liquidity, but acted to make sure that it is targeted to financial institutions that could not otherwise get loans. Last week’s expansion of the TAF program, increased in both size and frequency, is a perfect illustration. The Fed has succeeded in lowering LIBOR rates and maintaining lending through commercial paper.
Grading the Fed strictly by the pace of reduction in the fed funds rate is mistaken. Lowering short term rates is one tool, but it works with a lag. The TAF had an immediate impact. The Fed will probably continue to lower rates, but doing so as one of several policy options.
Corporate Earnings. Earnings are related to economic growth, but recessions are not like a light switch. Slower growth means lower earnings, even if the rate of growth remains positive. Even in recessions, earnings continue. Moreover, markets look through recessions to forward earnings and future prospects. In nearly 30 years of our data on forward earnings, the greatest year over year decline has been 18%, at the end of 2001 after 9/11.
Market Impact. In the short run, as we saw last week, markets react to sentiment and psychology. For those able to take a longer view, markets trade on the fundamentals of expected earnings and interest rates. While earnings forecasts have declined, the earnings yield of the S&P 500 remains very high, especially when compared to the low prevailing interest rates. By this aproach, the S&P 500 offers the best buying opportunity in the last five years. We are having no trouble finding attractive stocks and sectors.
Conclusion
It is part of human psychology to panic when our investments decline. It is that psychology that leads most investors to sell at the wrong times and miss buying opportunities.
The declines in many leading stocks (Apple Computer, Inc. down 15?) on Friday was out of line with the economic evidence. Last week’s selling saw the worst first week of the stock market since the depths of the Great Depression.
Sentiment will improve as more evidence emerges, but the best opportunities are often the hardest to grasp.
“Slower growth means lower earnings, even if the rate of growth remains positive.”
I’m confused by this statement with the mixing of “lower earnings” and “growth remaining positive”. Do you expect 2008 corporate earnings to show YOY growth or contraction?
It seems to me that one of the bullish arguments over the past 5 years was the consistently strong YOY growth in corporate earnings, and that growing earnings should be followed by rising stock prices. I’m not sure I follow the argument (if it is being made) that contracting earnings also result in the broad market going up. Is the takeaway conclusion that the market is always going to go up regardless of increasing or contracting earnings? Is there an “earnings scenario” under which a substantial market drop is likely?
“Even in recessions, earnings continue. Moreover, markets look through recessions to forward earnings and future prospects. In nearly 30 years of our data on forward earnings, the greatest year over year decline has been 18%, at the end of 2001 after 9/11.”
Not sure if you posted on this before and I missed it, but have you run a regression analysis on YOY changes in forward earnings and S&P 500 performance? I would be very interested in the correlation of that number.
I think one problem is people are taking a sector that is in a major recession – housing and related industries – and extrapolating to the whole economy. At the same time, they are totally glossing over the good news in other areas. Although housing and real estate finance are important, they are a minority of economic activity. A similar thing happened in 2001-02, where tech was rightly slaughtered, but other areas like real estate, commodities, finance, and basic industries were not really in bad shape at all. The early 90s recession also had similar sentiment – people got universally bearish, instead of bearish on the affected sectors. The fact is that bad news gets disproportionate weight in the media.
So I think it’s pretty clear that sentiment is overdone here – yes, some things are bad and will get worse; but other things are good and will get better. In 2010, what stocks will still be suffering as a result of the 2008 slowdown/recession? Maybe 5 or 10% of the market, at most i.e. the most overextended housing & finance companies. The rest will not only be fine, they will also have benefited from cheap interest rates and lower cost growth for 2 years.
The case becomes even more compelling when you look at the alternatives. If not in stocks, where should a passive investor put money? Cash is a terrible long-term investment, and right now rates are mediocre and likely to fall further. Bonds are even less appealing, with current yields below 4% on the 10 year. Commodities are the only real alternative, and not exactly appropriate for a 100% weighting. So that means any sane investor right now simply has to have a large chunk of their portfolio invested in the stock market.
Perhaps you could give us some pointers to which sectors and/or stocks you think look most compelling on a valuation basis right now? Finance and real estate have been hit very hard, but the valuation there comes with a fair degree of risk since the balance sheets are hard to get a handle on in the current environment. I think some of the investment banks look appealing here. 2 slightly offbeat plays I like: Japanese equities are cheap in valuation terms (half the index is selling at or below net assets), real estate is in an early bull market not a bear market, the performance of stocks there has been very poor for 18 months, and sentiment is bearish. They are also coming off a 13 year bear market from 1990-2003. Equities there are even cheaper relative to bonds and cash (yielding 1.5% and 0% respectively) than in the US. Another interesting sector is German real estate.
+1.5% annualized GDP growth in 4Q07? I would take the “over” on that one, if I were bet on GDP. Keep in mind, Jeff, there’s a big difference between “economic growth” and GDP growth.
I’m not a defender of the Fed, indeed, I don’t think they should even exist, but has there EVER been a time when pundits thought the Fed was doing the “right” thing? Yeah, that’s what I thought. So why listen to the pundits’ critiques of the Fed at all? When was the last time any of those windbags thought the Fed wasn’t in a box, behind the curve, and across the tracks? An indicator that only reads one thing is called a “stopped clock.”
Earnings can still exist, i.e., be positive, while shrinking [ex. Earns $100 instead of $110]. Earnings can still be growing, although at a slower rate [ex. Earns $90, $99, and $106 in sequence]. Any change in earnings is marginal, as in, “at the margin.” For earnings to actually contract, they would need to SHRINK, not just grow at a lower rate.
This is a common point of ignorance, often played up in the political budget-making process. I remember a proposal to decrease the budget for a certain agency from 4% annual growth to 3% annual growth being spun as a “huge budget cut” by opponents – and the argument got traction! thanks to this logical “blind spot” that so many people have.
Earnings season will be a big tell.
Nice point by Jeff and Matt that the indices are not monolithic. Energy, consumer non-cyclical, utilities, medical devices, and utilities still looking pretty good based on momentum if you’re limited to investing in domestic U.S. sectors. Longer timeframes might be finding value in some sectors, I know the SWFs think they’re finding value. The last “bear” market wasn’t a bear market in every asset class, sector, or industry, and I suspect (but don’t have the data to prove conclusively) that this is the case in each and every bear market.
Certainly the U.S. stock market has had a “recession trade” being put on it by various participants over the last six months or more, and they are pressing their bets now. We’ll see if it pays off for them!