Wall Street Research and What is Normal?

One of our themes at "A Dash" is the woeful state of Wall Street Research.  (Readers new to our site should follow the links for full evidence.)  There are several problems:

  • Reseachers must look smart and get on TV.  That means that they must "explain" the current market.  Sometimes what has recently happened has no good explanation!  It might be the frequent over-reaction to some anecdotal data point, pounced upon by the ever-growing population of young hedge fund managers.  It might be that the market is missing the big picture, while focusing on local efficiency, assuming that today’s price is a true valuation for a stock or the market.  This is exactly what happend in 1999-2000 where the leading Street gurus told us that there was New Paradigm.  Earnings didn’t matter.  If you were not "explaining" what was happening in those days, you were out of touch.
  • I follow the quantitative work from several bulge bracket firms.  The top strategists have all changed their models over the last three years — sometimes multiple times — to adjust to the "new circumstances."  They think that it’s different this time, just as it was in 1999.
  • There is no peer review.  Street research is a club.  Researchers are always on perilous ground, since their work cannot be directly related to corporate trading and profits.  If they seem out of touch, they are "history."  Since researchers never know when they will be looking for work, it is best not to be too critical of others, even if the resesarch is suspect.
  • There is no real science, which depends upon falsifiability.  If a theory cannot be challenged or disproven, it cannot really contribute to a body of science.  Anyone trained in social science research, as we were in the Old Days, understands this.
  • There is not time for review, since researchers must analyze each twist and turn of the market, "explaining" everything.  They publish on weekly schedules.  No one can have meaningful insights that rapidly.

The result of this is an ascientific approach heavily reliant upon anecdotal evidence.  In the current market, it means that those without a solid basis for market valuation interpret data as follows:

  • If there are fantastic corporate profits without concomittant wage gains, the worker is losing out and will not be a good consumer so it is bad for the market.  If wages start to rise, that is also bad (even if corporations can afford to pay a little more and still have great profits) because that is inflationary.
  • If payroll employment declines to a rate of growth consistent with the long-term healthy trend for the market, that is bad.  It shows a weakening economy.  Direction nonsensically trumps level.  If employment growth is strong, then the Fed is going to step in and kill the economy.
  • If commodity prices decline, it shows the market wisdom that the economy is heading for a recession.  If prices increase, we will have excessive inflation and the Fed will kill the economy.
  • If GDP growth is a bit over the long-term trend, the economy is "too hot."  If it is a bit under, the economy is headed for a recession.  There is no understanding that GDP quarterly figures vary significantly around the trend line.  That is normal data for a healthy economy, but most market pundits do not understand what "normal" looks like.
  • The yield curve is inverted, that is bad, even though it keeps fixed rate mortgages affordable.  If the ten-year rates rise, that is also bad, since stocks compete with bonds on valuation.  And of course — the Fed will kill the economy!
  • If some companies warn about earnings, or give a cautious forecast, the current punditry jumps on each data point, ignoring the overall picture.  This pattern has now persisted for thirty months.  It has happened partly because many pundits are drawing upon the hype of analysts and corporations from 1999-2000.  They are fighting the last war!  There is a certain arrogance in thinking that as a pundit or hedge fund manager one learns from the past, but corporate executives have ignored the same lessons.  Jim Cramer wrote today on TheStreet.com site that analysts no longer have a reason to hype — that they are tripping over each other with "sell" ratings.

There is a way to profit from this.  It begins with knowing three things:

  1. What is currently "baked in" by the current market valuation?  Any pundit who does not have a good valuation model is suspect.  Valuation is the ultimate test of sentiment.  Indicators like the AAII bull/bear report or what hedge fund managers are doing can change on a heartbeat and do not reflect the withdrawal of individual investors from mutual funds and the market.  They shall return.
  2. What is the risk?  What if there is a real economic slowdown?  What would happen to corporate earnings and the PE multiple for the market?  I have written about this, but my voice is a lonely one.
  3. What economic numbers are consistent with The Glide Path?  Any time the economy slows, there is an increased risk of recession.  How big is this risk?  A "normal" risk rate might well be 20%.  What should we expect when we all want to see some slowing in the economy and a cessation of rate increases?

A Glide Path solution will involve some variation in GDP growth, payroll employment growth, and inflation, as (temporary) energy price shocks work through the economy.  Wages should move higher.  There will always be some earnings misses, but will the ratio continue to be as strong as it has for nearly three years?  Companies, in general, are avoiding overly bullish forecasts.  Analysts are already low-balling earnings because they think they are economists.

The thoughtful individual investor or hedge fund manager can profit nicely from this situation.

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