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 January 2007 True, False, or Maybe? The Real Implications of Market Truisms
Raw data by itself is meaningless without context and interpretation. Often what separates a successful investor from an also-ran is the ability to correctly assess the true meaning of economic and market information. Pundits frequently discourage blind adherence to the consensus opinion. In many instances, that's good advice, but what do you do when the consensus is negative one day and positive the next -- based on the same data?
This is often the case when investors attempt to digest economic information. Consider, for instance, the effects of reports showing manufacturing is slowing. Initially investors take this at face value, seeing it as an indication that the economy is slowing which is usually a bad environment for stocks. The first reaction is to sell. But it's not surprising to see a quick recovery in the following days when investors have more time to interpret the data. In the latter part of 2006, signs of a slowing economy were actually seen as a positive sign that the Fed would have to cut rates sooner rather than later in order to shore up the faltering economy. Lower interest rates create a favorable environment for stocks as well as bonds, so its a buy, not a sell signal. One of these interpretations must be wrong, yet you frequently hear market commentators taking both sides. For that matter, sometimes the same market commentators take different sides on different days. Although this could certainly be seen as an indictment of pundits' credibility, it's more importantly an illustration of why it's important to correctly interpret the available data. What follows is a look at some frequently reported economic data and market truisms, and an analysis of whether they're good, bad, or simply indifferent. You may not agree with our conclusions, but it's at least worth considering both interpretations before forming (and acting on) your own opinions.
Economic Facts and Fantasy
•High rates of economic growth lead to inflation. Con: Economies rarely reach full capacity and inflation seems more closely tied to the money supply than to economic growth. Conclusion: Although the connection between economic growth and inflation makes sense in theory, there's little actual evidence to support it. In fact, some of the worst bouts of inflation (e.g. post-World War I Germany) have occurred when economic conditions were actually depressed rather than booming. While few things are conclusively proven in economics, it seems fairly safe to say this one's false. •A drop in the unemployment rate signals a strengthening economy. Con: It's important to realize what the government's unemployment figures actually measure. It's not just the number of adults out of work. There are many, such as students and retirees, who aren't seeking employment. Instead, the unemployment rate is the result of dividing the number of adults not currently working but actively seeking a job by the total number in the workforce. It's not uncommon for the unemployment rate to decline when the economy is mired in a recession. During such periods, unemployed workers may become discouraged and stop looking for a job. At that point they're no longer considered "unemployed", and the unemployment rate declines. It's not that more jobs are being created, just that fewer people are seeking employment.
Conclusion: False. While it's true that unemployment tends to rise during economic contractions and fall during expansions, it's difficult to get a solid reading on the economy from the monthly figures. If anything, unemployment readings are a lagging not a leading indicator. Businesses usually reduce existing inventory before resorting to hiring, so the economy has generally turned the corner before many new jobs are created. Because of this, it's usually more realistic to view unemployment figures in the broader context of overall economic readings rather than based on a single monthly change, either up or down. •The Federal Reserve will lower interest rates in an attempt to head off a recession. Con: Don't count on it. The Fed's primary concern is inflation and at the opposite end of the spectrum, deflation. Recessions and expansions are both part of the economic cycle and no action from the Fed (or anyone else) can change that. Over the past half century, the Fed's biggest challenge has been controlling inflation, especially when it became deeply entrenched in the 1970s. Don't expect them to forego this battle to head off a recession. Conclusion: False. The economy tends to turn in its best performance during periods of price stability. This is the goal of monetary policy, not fighting recession. When the Fed has intervened to cut interest rates in the face of a recession, it's been because prices are too high and possibly even rising. It would be nice if they could act to prevent recessions, but there's only so much the Fed can do with the monetary tools at hand. •A strong dollar is good for the U.S. economy.
Con: Even in the U.S. the economy is much more global than it was just a decade ago. Many domestic firms generate revenues overseas only to see the value diminished when profits are translated back into stronger dollars. Also when foreign currencies are weak relative to the dollar, multinational firms find it difficult to sell their products abroad, reducing their earning potential. Conclusion: This one depends on your perspective, but it's probably true. A strong dollar can cut into exports and reduce profits of multinational corporations, but it's still better than the alternative. A weak dollar might help exports (just think of Japan trying to export itself out of its deflationary funk) but it has other, negative implications, as well. For example, a weak dollar is usually accompanied by falling foreign investment, a slowing economy, and declining asset values (think of Japan again). Given these alternatives, a strong dollar looks preferable.
Market Truisms -- and False-isms •Low P/E stocks are the best investment. Con: This doesn't apply in all cases. In fact, for cyclical industries (e.g. auto manufactures and retailers), the periods with the lowest P/Es may actually be signaling a market peak. For example, automobile sales tend to run in cycles with high revenue growth followed by declines, and finally a low point followed by a recovery. When earnings are the highest, P/Es for the industry will often be the lowest, yet buying at that point is almost certain to lead to a loss when earnings taper off. On the other hand, when earnings are at their lowest, the P/E will probably be near its peak. Investors who buy at that point may have the opportunity to ride both share prices and earnings when things turn around. Conclusion: This is one of those situations where one size doesn't fit all. Low P/E isn't a particularly good measure for cyclical stocks but it is a good gauge in almost all other instances. Other metrics (such as return on invested capital) are arguably better because they allow a true comparison of stocks from different sectors of the market. While all fundamentals aren't as easily calculated as P/E ratios, they can be more informative. •Buy what you know. Con: Of course that explains why Mr. Buffett has never bought a tech stock. In fact, if most investors used this approach, they would never buy a tech stock. That might have served them well in 2002 when the tech bubble popped, but it would have fared a lot worse in the late 1990s as tech stocks soared. Truth be told, there are very few stocks individual investors can claim to know well outside of retailers and a few utilities or banking stocks. Limiting yourself to this narrow range of possibilities negatively impacts portfolio diversification, raises overall risk, and may reduce potential portfolio return. Mr. Lynch was fortunate that consumer staples -- one of the few sectors individual do know -- was the market leader in the 1980s. You can't reasonably count on the same happening in any given year.
Conclusion: Strictly speaking this is false. Most investors can only claim a working knowledge of a handful of sectors and industries. Limiting investment to those can result in an overly concentrated portfolio with higher risk and lower potential return that even a simple indexing approach. On the other hand, if the "buy what you know" dictum is seen as admonishing investors to do their homework before buying, then it's definitely true. It's amazing that investors base so many of their investment decisions -- requiring the outlay of thousands of dollars -- with less due diligence than when they're shopping for the freshest bell pepper. Any means of encouraging more rational, thought-out investment decisions can't be viewed as false. •It's not timing the market, it's time in the market. Con: Then again, some wounds are greater than others. While there's no denying the benefit of a long-term outlook, there's also no denying an ill timed investment can take years to overcome. As an illustration, consider the varying results for a one-time $6000 investment in the S&P 500. Chart 4 shows the December 31, 2005 values for $6000 investments at the beginning of each of the six preceding years. As you probably recall, the S&P 500 fell into a bear market in 2000 that lasted until late 2002. As a result, an investor entering the market in 2000, 2001, or 2002 suffered initial losses and then saw some recovery in the subsequent years. On the other hand, one who kept his or her cash safely in the mattress until 2004 or even the beginning of 2005 would have roughly the same returns with much less volatility. One lucky enough to have invested at the start of 2003 would be considerably ahead of the rest while the 2000 investor would still have a loss. Conclusion: Presumably an investor, as opposed to a trader takes a long-term view of the market. Long-term is typically defined as five years or longer. Even with that definition, time in the market may not be sufficient to overcome poor timing -- just ask the investor who bought the S&P 500 in 2000. Over longer periods of time, the short-term difference do tend to wash out, but in this era of information overload and rapid-fire trading, will most investors wait long enough to see the benefits?
•Dollar-cost averaging is the best investment approach for the average investor. Con: Most equity investors believe the market rises over time. In fact, statistics show there are many more up days than down days. Again assuming investors take a long-term approach, the sooner they enter the market, the more they stand to gain. Dollar-cost averaging helps steady nerves in a volatile or falling market, but in most instances -- when the market is rising -- it actually diminishes returns. That's not a good approach for any true investor. Conclusion: There's no denying dollar-cost averaging can, at times, provide sparkling results. Chart 5 provides a clear illustration of how it can make sense in a volatile market. But markets aren't always volatile. For example, which approach do you think would have worked the best from 1994-2000? Dollar-cost averaging certainly wouldn't have been at the top of the list as it would have kept funds on the sidelines as stocks consistently climbed. Nevertheless, dollar-cost averaging may be the only way more cautious individuals find the courage to ever enter and stay in the market. These are investors who are willing to concede top-notch gains for the safety it affords. If this is what it takes to make them investors and not just simply CD owners or passbook savers, then it truly is the best approach for them. In that sense, the statement is true. You may or may not agree with the above conclusions, and that's OK. Although they are based on a review of the facts, our conclusions are just that, considered opinions. Even if you disagree, you've critically examined not only our conclusions, but the truisms themselves. Economic and market adages are generally based in fact, but they, themselves, aren't. They need to be periodically examined rather than simply accepted on faith -- especially when new facts or evidence point in the other direction. Search this site! Just enter you key word or words:
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HE ADVENT OF THE INTERNET, CABLE and satellite programming has greatly multiplied the the average investor's access to information. Timely data, once limited to large institutions, is now equally available to all. Access is no longer a major issue, but interpretation is.
