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
- 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.
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.