When Fundamentals and Perceptions Collide
What action is right when market perceptions conflict with fundamental valuation methods?
Let us put aside whether our valuation or the market perception is correct, and turn to the interesting case where there is conflict between the two.
For Warren Buffett or other Benjamin Graham followers the question is easy. They recommend buying businesses that are undervalued. If Mr. Market comes to them with a lowball offer, they do not care. With Mr. Buffett’s track record, there is no need to worry about adverse fluctuations in value, even if these persist for quite a long time.
For most fund managers this answer does not work. One has a mixture of holdings reflecting different time frames. If properly done, the expected edge must vary with how long one must wait.
Let us suppose that one holds "Stock X", a company that is about to announce earnings. Your valuation methods show that the stock is very under-valued. Recent LBO’s provide some evidence that this example is not so far-fetched, even for major companies, as Paul Hickey explored in an excellent article on TickerSense.
Let us further suppose that you have listened to past conference calls from Company X. You know that the management does not hype earnings prospects, and frankly discusses anything of concern. Company X has, as a part of its business, exposure to housing construction. You fully expect that management will mention "the H word" during the conference call.
While this has no significance for your long-term projection, you might choose to take a trading position reflecting the market expectations. In a hedge fund, for example, one might choose to use options to hedge the positions, or lighten up holdings until after the call.
For the individual investor it is much more difficult. Psychologically, the most difficult move is to re-establish the position if the stock actually moves higher after the call. Your hedging decision was wrong. The manager must think in different time frames and trade accordingly. This is more difficult for individuals.
Let us next apply this thinking to a perspective on the overall market. Regular readers of "A Dash" know that our long-term view on the market is quite bullish, and that we also take tactical short positions in accounts geared to trading. Others, like Doug Kass and Barry Ritholtz, have an overall bearish view, but make astute trading calls to take long positions. Using the time frame effectively can work if one is willing to trade against the overall outlook. Some recent criticisms of bearish pundits strike us as unfair, since none of them trade exclusively based upon a long-term market viewpoint. This may be difficult for their readers to follow, but those observing them carefully should be able to note their bullish counter-moves.
To get to specifics, many market participants have (among many concerns) two that stand out as major market threats. As we often do, we look to Barry Ritholtz to identify these concerns. Since we have occasionally (!) disagreed with Barry, let us look to two recent observations where we are in complete agreement.
- The Fed. Barry really nailed this story. He analyzed the news and interpretation of the recent Fed statement and minutes in a series of posts. We agree that the Fed is not about to cut rates, and suspect that another hike may be in the future. This is because the Fed (correctly in our view) sees strength in the economy and is pursuing a policy of planned slowing to quash inflation expectations. It is quite clear that the market, which has little respect for the Fed, has a fixation about the need to lower interest rates. This poses a problem for trades or investments using a longer time frame.
- Rhetoric — particularly about "stagflation." In a strong post today Barry added some analysis to a great story from Caroline Baum of Bloomberg. We have discussed the power of symbolic language, and the freely-used stagflation term catches the attention of many. This may be particularly true of individual investors or, as Baum suggests, younger fund managers. This is also a problem of positions in two time frames. While we do not fear a stagflation scenario, we do expect that various (lagging–see CXO Advisory) economic indicators, like unemployment and inflation readings, may get worse before they get better. With each report, even though the moves may be small, the stagflation scenario might seem more real.
At some point the market psychology will change. Identifying the catalyst for this change is a thorny problem.
We will try to pursue this with the analysis of some specific stocks.