Should Investors be Scared Witless?

Are you an investor or a trader?

It is an important question I raise each week in my WTWA series. Investors need to evaluate fundamentals while traders try to guess the market. Which are you?

A business report anchor led off his program tonight by saying that “investors pulled the rip cord.” Not true. Every financial media source can revel in the news value of a sharp, two-day decline in asset prices. It is newsworthy and attention-getting.

Let us take a closer look.

The Investment Perspective

If you are an investor, you focus on a long time frame and market fundamentals. Stock prices depend upon corporate earnings, the competition from other assets (principally bonds), the risk of recession, and the risk of financial instability. All of these factors can be objectively measured and analyzed. I frequently capture the story in the following table:


The data show that stocks are much more attractive than they were at the pre-recession highs. This is true of the market overall and especially true of many individual stocks.

A real investor understands that market prices fluctuate more wildly than the fundamentals. Investors take advantage of the sentiment-based mispricing of stocks. If you lack a sound method, a valuation anchor proven over many years, then it is easy to be sucked in by the financial news cycle.

What Happened?

  1. From the Fed perspective, not much. Bernanke clarified the criteria for a threshold to begin a reduction in the current bond purchase program. It would require a significant reduction in the unemployment rate and significant economic growth. If that improvement actually occurred (great news for stocks), then there would be a modest and unspecified reduction in how heavy the pedal was to the metal.


    There was not a lot of new information beyond the idea that 7% unemployment might be a threshold for thinking about cutting back bond purchases.

  2. There was the “flash PMI” report on China, showing a decline to 48.3, a nine-month low. This is a relatively new indicator with an unknown methodology and margin of error. The “official” result (in which I have no more confidence) is usually stronger. The WSJ has a relatively objective account. Other sources are in a race to the bottom as exemplified by the Washington Post, which quotes ZeroHedge as an “economics site.” I am astonished! What an embarrassment for the Post. Don’t they have any editors these days?
  3. And it is options expiration week, which can exaggerate surprise moves that rip through strikes thought to be dead. The effect occurs because traders think that expiring options are throwaways and refuse to pay anything to get them off of the sheets. I always taught our group to make a cabinet bid, pay a penny, and sleep well. The guys that had “big ones” always wanted to let their short options expire worthless, collecting the premium. The big-time traders look smart for many an expiration and then they blow out via over-confidence.

    Options expiration is magnifying the fear factor.

The Final Destination

As the investment world returns to a more normal state, we can expect the following:

  • A return to trend GDP – 3%+ or even better
  • Stronger employment growth
  • Higher interest rates – think of 4% on the ten-year note
  • Higher market multiples – because the relationship between stock multiples and bond rates is curvilinear. None of the top Wall Street economists has gotten around to replicating my research, but they will. Unlike them, I’ll be happy to share the data for verification.
  • Lower unemployment
  • Reduced profit margins
  • Stronger total profits and revenues
  • Reduced budget deficits, especially as a percentage of GDP

These are all correlated. Bulls cannot cherry-pick the good stuff and ignore the others. Neither can bears. No fair asking what stock prices would be if profit margins and interest rates “normalized” without allowing for other variables to change as well. See here for details.

Investment Conclusion

Stock prices and interest rates are on a path to the Final Destination. This should be your guide to choosing investments.

The worst investments are those linked to interest rates – bonds, utility stocks, and the grandma dividend stocks.

The best investments are those with low current PE ratios and sensitive to the economy. Bernanke told us that he expects stronger economic growth and the pedal will be mostly to the metal even so. This is bullish for technology, cyclical stocks, discretionary consumer stocks, and financials.

There has been a knee-jerk reaction to sell everything. There is also a continuing distraction comes from those on a mission to sell bonds, sell gold, or sell fear. Josh Brown explains so well.

The most important thing for the individual investor to keep in mind relates to sources. Those who have been continually wrong about the economy, the market, and the fundamentals, attribute everything to the Fed. They do this because the slogans are easy and persuasive to the average person. There is little analytical content. They use the Fed as a fig leaf for their errors, as I explained here.

Any serious analysis would show the false claims of the QE chart creators. Do you remember when higher oil prices, corn prices, and gold prices were all supposed to be a function of the Fed? What happened to those claims? What about the idea that the Fed was debasing the currency? No support from charts on the dollar. What about sparking inflation? Another swing and a miss. The popular charts showing QE and stock prices get shifted for both starting and ending. Sometimes they include anticipation – and sometimes not. None of these simplistic methods includes any other simultaneous economic effects. See here for more details.

If you are seeking advice about the Fed and investment results, why would you look to those who have been wrong for many years?

The path to the final destination can include a significant correction. I explain to investors in our long-term stock program that there is a 15% correction in most years — even the best ones. It is unrelated to fundamental value and cannot be reliably anticipated. Most of those who “predicted a correction” did so long ago and missed the rally to date. Investors should be wary about claims by market timing geniuses.

To summarize, if you own bond funds, utility stocks, or other yield proxies, it is time to worry. If you own solid companies with good valuations, just focus on your regular job. If you happen to be overweight in cash, you can go shopping.

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  • rafaminos June 21, 2013  

    this is very well articulated.
    Most of the crowd has not undersdood that, as always, QE is data dependant and not just exogeneous.
    The natural rate moves with the state of the economy.
    If anything, the 7% threshold has clarified further the exit strategy, which is a good news.
    One can just wonder if, as it has been the case for several years, the FED is not too optimistic.

  • Claude June 21, 2013  

    Hi Jeff,
    who’s the best investor? an accountant who can analyse a stock and find good value or an economist who will invest according to his study in the economy?
    Do the average investor loses to much time worrying about interest rate, GDP and so on?
    Right now, I find good value, with growth and good dividend (in the canadian market) and I read all of your post and I know there is no recession ahead. So I invest all of my capital and I sleep like a baby.
    Thank you very much for your good work!

  • Praxeologue June 22, 2013  

    But with respect, in regards to not listening to those who have been wrong for years, you use Fed forecast of future growth to justify owning certain stock sectors but the Fed’s record has been the most wrong at the most critical times and has been permanently over optimistic about growth. Any one familiar with youtube can find complications of their clangers.

  • oldprof June 22, 2013  

    Praxeologue — I am not using the Fed forecast in particular. I follow the Blue Chip economics survey, the WSJ survey, and updates from private firms like MacroEconomics. You could do a youtube video on any source, because there have been a series of interruptions to the return to normal growth — including events like the Japanese tsunami, the European austerity push, and U.S. fiscal drag.
    The private economic surveys call for 2.8% in 2014 and the Fed is at 3.2%.
    I agree with you that we should not depend just on government estimates. The Fed estimate does have special interest because they have a strong team of 350 or so economists and it is what they are using. I want to know what they are thinking.

  • Art June 30, 2013  

    Do you consider MLPs to be a proxy for bonds?

  • oldprof June 30, 2013  

    Art — Not exactly a proxy, since there are many valuation factors and tax considerations.
    With that in mind, the attractiveness for many is the yield, which will trade at a spread to risk-free rates. If those rates go higher, and the spread remains the same, the MLP value will decline.

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