Making sense of a two-faced market

The market messages are more confusing than ever.

Summary: Markets have rallied this year on the back of rising consumer confidence, and confidence has risen as markets have rallied. Add to that the fact that markets have been volatile over this month amid concerns the US central bank will soon wind down its economic stimulus measures – a signal that the US economy is recovering – and investors have good reason to be confused.
Key take-out: Market reactions to current events and announcements remain inconsistent and inexplicable. Based on the mixed messages from authorities, one must presume a component of the rally is pure artifice.
Key beneficiaries: General investors. Category: Economics and strategy.

Prepare to be confused and confounded. In a blissful and virtuous circle, the US stockmarket rallied overnight on Tuesday, reflecting the general rise in consumer confidence. Indeed, the Conference Board measure of US consumer confidence rose to a five-year high of 76.2 in May, from 69.0.

And why is confidence rising? One of the reasons cited by economists and others is the continued rally in equity prices. Nice! The stockmarket goes up because confidence has risen, and confidence has risen because the stockmarket has gone up.

The reported rise in the Conference Board’s measure of consumer confidence was attributed to a combination of stockmarket strength, falling gasoline prices and the US housing recovery.

Here’s the conveniently forgotten problem. If confidence, and subsequently consumption, improves it will feed into an easing of bond purchasing known as quantitative easing (QE). And an end to QE is one of the market’s current and greatest fears.

So what is an investor to make of this? On the one hand, improving confidence must be good for growth, which is positive for stocks. On the other hand, stronger economic growth would mean less need of assistance from QE.

Rather than confidence, previous market reactions to official pronouncements from the US Federal Reserve that the period of “maximum assistance” is drawing to a close have reflected fear and trepidation.

The situation prompts me to suggest that this market rally cannot be trusted. Indeed, when officials describe their activities as “assistance”, one must presume there is a component of the rally that is pure artifice. Now, don’t go thinking I have gone all ‘herbal’ and turned away from my roots as a long-term value investor in quality stocks … perish the thought!

What spurred me to write today’s column is the desire to shine a spotlight on the idea of whether investors should listen at all, to any commentary about market sentiment.

The reason is simple: sentiment, and the resultant reactions as reflected by the market, are inconsistent. I will never forget the day, some years ago, the market sank amid fears that a US troop invasion into Iraq was imminent. The next day the market rallied on confirmation that the rumoured invasion had commenced!

As the renowned mathematician Benoit Mandelbrot elucidated, “Financial economics, as a discipline, is where chemistry was in the sixteenth century: a messy compendium of proven know-how, misty folk wisdom, unexplained assumptions, and grandiose speculation.”

Obviously, that is all markets can be when people, “who are neither intelligent nor emotionally stable” are moving them.

I won’t ever propose that my own superior returns (to date) have been the result of any ability to predict share prices. Indeed, I agree with conventional economists who say that share prices are not predictable in any practical way. I do propose, however, to show that my method of investing can help investors avoid losing as much money as they frequently do, thanks mostly to their underestimation of the risk of permanent capital loss – what economists refer to as the risk of ruin.

One step on this path is the realisation that market reactions to events and announcements are inconsistent and inexplicable.

Take, for example, the combination of market strength and readings of weak investor sentiment. US indices have recently registered major milestones, with the S&P 500 rising above 1,600 for the first time and the Dow breaking 15,000 on an intraday basis for the first time. Strengthening employment, and the aforementioned improvements in housing and confidence, are cited as the drivers.

However, the American Association of Individual Investors (a group not unlike our own Australian Shareholders’ and Australian Investors associations) publishes data for a weekly sentiment poll. The survey has been conducted since July 24, 1987. Recently, the poll showed that just 31% of respondents were “bullish” – well below the 39% average going back to 1987.

Back in September 2008, when Lehman Brothers filed for bankruptcy, and just prior to the depths of the GFC stockmarket sell-off, the bullish reading was 39%.

While the current gloomy sentiment readings appear to be completely inconsistent with the strength of the stockmarket, the reading merely means one of two things: either AAII investors will be right, or AAII investors will be wrong.

Closer to home is yet another example: the impact of the Australian dollar on the outlook for resource companies. Die-hard supporters of BHP and Rio will tell you that the weakening dollar is a positive for their investment case. But I am not enamoured with BHP’s $110 million improvement in earnings from every 1 cent decline in the dollar (assuming commodity prices remain static of course – which they won’t). Putting aside the fact the company’s capacity to record “exceptional”, or so-called one-off losses of $1.4 billion in a six-month period, as occurred in the most recent half year, more than offset the marginal improvement in earnings from a slide in the currency, the fact remains that a falling $A remains a signal that demand for our commodities is waning.

Consider that the $A slides because overseas investors are discounting our growth prospects and factoring in the slowing demand for commodities. On the flipside, $A slides are making BHP and Rio more attractive because their earnings per share rises (assuming commodity price falls don’t more than offset the benefits).

As an aside, in the time I have been articulating my dislike for BHP shares, their price has fallen from about $40 to a low of about $30, and very close to my estimated intrinsic value.

Or here is another example. Interest rates are declining in Australia reflecting the fact that the domestic economy is weak and investment in manufacturing, retailing and tourism, is catatonic. But declining interest rates on term deposits spur investors to buy bank shares for their relative attractive yield, and despite their anaemic credit growth.

I don’t believe that you can glean any useful investment insights from reading the reasons offered as to why a market went up or down on a particular day. No sooner have you begun to agree with the argument, market reactions to the very same influences reverse, leaving you exposed and usually poorer. The same can be said for reading economic signals.

For what it is worth, the US recovery has, up until recently, been subdued if not lacklustre. Signs are emerging, however, that the economic “malaise” could be giving way to more self-sustaining and even stronger growth.

On the one hand, what is holding back the growth is the US is the weakness of global economic growth and tight fiscal policy.

You would think that if the US economy strengthens, this will mean good things for China and, in turn, good things for Australia. But before you get too excited, I suggest the current positive sentiment about this scenario transpiring could quickly reverse if QE is reined in.

And then, just when you think that the implication of scaling back QE is universally negative for the market, the market could be buoyed by the fact that a slowing of QE reflects a strengthening economy.

Good luck!

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