May 2001
Four Stupid Questions
| "He who chooses the beginning of a road chooses the place it leads to." |
| -- Henry Emerson Fosdick |
OT TOO LONG AGO, I ENCOUNTERED a lost traveler in a local restaurant. He wanted to know how to get to Highway 98, which I gladly told him. Later that day, my wife asked if I was able to help the poor guy find his way to coast. Unfortunately I hadn't, I'd answered his question and told him to get to Highway 98 that doesn't go to the coast.
This isn't an uncommon problem. The answers we get are always a function of the questions we ask. If the traveler had asked how to get to the coast, I would have told him, but since he only asked how to get to Highway 98, I had no reason to think he wanted to go to the coast -- especially since that road doesn't even go there.
Investors make these same mistakes: They look for good companies rather than good stocks. They look for low P/E stocks instead of companies that can expand their multiples. They look for cheap stocks rather than undervalued stocks. The list goes on.
Recently the focus on misguided questions has been elevated to new heights. As is often the case, the media plays a major role. On any given day, there's and extremely high likelihood that turning on a financial news program or opening a financial publication will expose you to one of the following four questions:
- Are we in a recession?
- How low will interest rates go?
- Are equities in a bear market?
- Has the stock market hit bottom?
While these may be great debate questions, they're all irrelevant. Let's take a quick look at each to see why.
Are We in a Recession?
Economists typically define a recession as two consecutive quarters with negative GDP growth. "Negative GDP growth" is economist talk for decline, so a recession occurs when GDP falls for two quarters.So far, we haven't even experienced one quarter of declining GDP. While the 2% growth in the first quarter of 2001 wasn't anything to write home about, it still wasn't a decline. Technically, then, the economy has yet to fall into recession.
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 Source: Baseline The economy may not be officially declining but profits sure are. As of early May, consensus estimates for the S&P 500 are down 2% from 2000. Even worse, the estimates continue to fall. |
But it sure doesn't feel that way. Stock investors have seen $4 trillion melt away over the past year. The economy has slowed to the extent that earnings estimates are lowered daily, if not hourly. Many companies are already suffering through the second (if not third) quarter of declining earnings. This may not be a true economic recession, but it sure is a profit recession.
At this point investors really shouldn't worry if this slowdown will ever satisfy the technical definition of recession. A few tenths of a percent of GDP just won't make that much difference. With the equity market experiencing a recession of its own, there's no sense in fretting about recession.
How Low Will Interest Rates Go?
Of course the one outfit that really is concerned about recession is the Federal Reserve. They're so concerned, they lowered interest rates by 2% in less than four months. They didn't take their usual baby steps, but instead moved ½% each time. Perhaps even more noteworthy is the fact they broke with tradition and twice moved between meetings.|
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 Source: Baseline The Fed keeps lowering the Fed Funds Rate (FEDFU) but interest rates on the 10-Year (T10) and 30-Year (T30) Treasury Bond keeps rising. This isn't the way it's supposed to work. |
This has a variety of folks wondering how low rates can go. You'd expect bond investors to be interested since falling rates increase the value of outstanding bonds. Borrowers -- and potential borrowers -- are also watching, hoping to lock in lower rates. The mortgage industry may need to brace itself for another round of refinancings.
However the markets aren't acting as you might expect. Following the Fed's last surprise rate cut, interest rates have actually moved back up. The ten year Treasury that had been in the 5.8% range jumped back up to 6.1 - 6.2%. The thirty-year Treasury -- the basis for many 30-year mortgages -- trades around 5.5 - 5.6%.
All of this isn't as strange as it seems. By lowering rates by 2%, the Fed has more than reversed the 1-3/4% increase it took them twelve months to achieve. The speed at which they've moved demonstrates their resolve to head off a recession.
On the other hand, the fact that GDP is still growing (albeit by a smaller rate) indicates a recession may not be in the cards. If that's true, we may already be at the end of this easing cycle. If so, there's no reason for the bond market to factor in additional cuts, as was the case with the 10-year Treasury below 6%.
So there's not a lot of reason to question how low rates can go. Even if the Fed moves again, rates are unlikely to fall below the levels seen in late March and early April. Face it folks, this easing cycle's about done.
Typically that would be bad news for stocks as funds would flow out of equities into the higher returns of bonds. But even as interest rates stabilize, they're still relatively low -- at least by recent standards. Higher interest rates aren't drawing funds from stocks, fear is.
Are Equities in a Bear Market?
Few investors are brave enough to take any major positions in stocks, fearing the dreaded bear market. Although many aren't even old enough to remember the last real bear market of the 1970's, investors know enough to shun slow painful losses they bring.Nevertheless, it's our sense that the love affair with equities hasn't ended. Investors really do want to jump back in the market; they just want some assurance before they do. That's why so many folks have fixated on wondering if this is truly a bear market.
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Source: BaselineDespite the recent rallies in the equity markets, when compared to the 30-year Treasury (T30) stocks (as measured by the S&P 500 (SPX)) still trail bonds this year. |
Like the previous questions, this one's irrelevant, too. Technically, a market is said to enter a bear market when it falls more than 20% from its near-term high. (Similarly, it enters a bull market when it climbs at least 20% from its near-term low.)
Under this definition, most major indexes -- including the Nasdaq and S&P 500 -- have hit bear market levels. The only holdout is the old-economy laden Dow, which despite two intra-day excursions into bear territory, has yet to close below the magic number.
But so what? Does the 20% figure really mean anything? Ever since late last year the market has been trading as if it was in a bear market. All the classic signs were there:
- Short-term highs and lows were consistently lower over time
- Rallies were short lived and powered by short-covering, not long-term investing
- Volume was low on up days and high on down days
- Earnings warnings and bad news far outnumbered any positive developments.
The fact that the Dow avoided closing at a 20% decline by a fraction of a point doesn't change the fact most investors feel like they're deep in bear territory. Similarly, the fact that Nasdaq has recovered more than 20% from its low doesn't mean the bull is back -- at least not yet.
It just doesn't matter if the current conditions satisfy the (random) definition of a bear. It feels like a bear market and it trades like a bear market. From where we sit, that's good enough reason to declare it a bear market and move on from there.
Which brings up the final stupid question:
Has the Stock Market Hit Bottom?
Turn on CNBC any hour of any given day and you'll hear the morons debating this one. It doesn't matter if the market's up ("We may be beginning the next leg up after finally putting in a bottom.") or down ("The market's still searching for that elusive bottom."), this question will come up.Obviously if you were fortunate to invest at a market bottom, you'd maximize your gains as it headed up. But this isn't the reason everyone's so interested in calling the bottom.
Instead, there seems to be a prevailing presumption that as soon as the market hits bottom, it'll take back off to the upside. Evidently investors
are quite Newtonian, believing every action has an equal and opposite reaction. Apparently they think the market is like a rubber ball that when dropped from a great height bounces back up immediately upon hitting the ground (its "bottom").
That's where all this silly debate about a "V-shaped" vs. a "U-shaped" recovery originates. The former is the immediate bounce-back while the latter has a basing period between the final decline and initial rebound.
Investors favoring the "V" point to the quick recoveries of 1990 and 1994 while those arguing for the "U" cite the long basing pattern in the mid-70s. But you know what? It just doesn't matter.
This debate treats the equity market like it's subject to some physical force, completely independent of actual fundamentals. Just as gravity doesn't cause bear markets, physical properties (or chart patterns for that matter) don't cause recoveries.
Corporate earnings are the real slayers of bear markets. When investors can confidently predict profit improvements, they'll tiptoe back into stocks. At that point it won't matter if the economy's technically in a recession, or if the indexes are 20% off their highs or above their lows. That stuff just won't matter.
What will get things moving is an end to the profit recession. It won't come this quarter and it may not come in the third quarter, but it will come.
Investors won't wait for the actual earnings. Instead, they'll jump back in the market as soon as improving profits can be predicted for the next quarter or the next year. This can actually occur relatively soon as prospects for the fourth quarter and 2002 pick up, especially against a backdrop of easier comparisons.
In the meantime, there's no use fretting over stupid questions.
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