S&P500 dropping to 600 by spring 07

[qcomer]

Stocks are leading indciators because price of current earnings have been priced into stocks and then you pay a premium for stocks with more potential profits and get discount on stocks that have poor forecasts. e.g. You hold COP and where has it gone after reporting a stellar quarter recently and why is it back at 63 now when its recent earnings have been absolutely phenomenal? GM has been reporting huge losses but have done well in the last quarter or so, why? Tech and Semi stocks reported stellar current quarter earnings last quarter but fell further back because they lower earnings forecasts. Housing stocks have been doing terrible since 2005 because market had sensed the housing collapse much earlier than actual home owners.

It is the game of expectations on Wall Street and sometimes it makes sense to just follow the momentum/trend. At times of economic uncertainty, investors get more attached to future forecasts then what a company reported last quarter.

[davelj]

Poway, stock prices are a leading indicator. Period. If you are convinced otherwise, don’t hestitate to contact the economists at The Conference Board, which handles the Consumer Confidence Index and the Index of Leading Economic Indicators, as they have classified stock prices as a “Leading Indicator.” I’m sure your insights will be given the consideration they deserve.

Regarding H&R Block, if you look at the company’s chart what you’ll see is that the stock had fallen (in fits and starts) from $27-ish to $23-ish over the year prior to its most recent announcement. What does this tell me? The market was anticipating bad news – which was reflected in the stock’s falling price – but the recent news was just worse than the market expected. So, the price was still forward-looking in nature, but the market underanticipated the degree of the bad news. “Forward-looking” does not mean “omniscient.” What the market appears to be discounting at any given time may turn out to be just plain wrong. But that doesn’t mean that, on average, stock prices are a not a leading indicator, anecdotes notwithstanding.

[powayseller]

This is very interesting. So if stock prices are a leading indicator, then all you have to do is look at the stock market valuations to know where the economy is going. GM’s rise from $20 to $30 in the last few months is a leading indicator that GM’s future is brighter than people thought back in April? This assumes the market has all information, and is efficient.

I just wonder how leading of an indicator the stock market was in 1999. The stock market was saying that company profits would grow to the stratosphere. Yet, the market was wrong, and thus, the prices finally crashed. Many mutual fund managers, including top-rated Janus Funds, lost lots of money.

For this reason, I’m not sold on the idea that the market is rational and has perfect information and pricing power. Toll Bros reached a high of $58 in 7/20/05, at the top of the housing bubble. I wasn’t paying attention to the company at that time, but perhaps others were; what made the stock starts its downward slide? Did investors realize the housing market would go down, or was the stock punished as a result of a lowered earnings announcement?

[davelj]

Poway, first a few definitions to aid in this discussion:

“A”: the word “a” means one. For example, “Stock prices are A leading economic indicator.” Not THE leading economic indicator, but rather one of many. Consequently, aggregation of the OTHER leading indicators may trump what stock prices are telling people about the future of the economy, OR THEY MAY NOT, which leads to the definition of…

“Indicator”: as in “indication” or “a person or thing that indicates.” An indicator does not arise from the Oracle of Delphi, does not suggest a future certainty, and thus may turn out to give the incorrect signal in hindsight. (Hence Paul Samuelson’s oft-quoted quip that, “The stock market has predicted 9 of the last 5 recessions.”)

Consequently, you will find MANY examples of situations in which stock prices or other indicators sent the wrong signal. Sometimes they’re right; sometimes they’re wrong. ON AVERAGE, however, these indicators convey valuable information. So going through all of your anecdotes is a fool’s errand.

I suggest you go back and re-read your post in the context of these two definitions.

You keep mentioning market efficiency and now I realize that you don’t understand the nuances of what the term actually means. I’ll be as brief as possible given the complexity of the subject. Market efficiency exists in three “forms,” or degrees – weak, semi-strong and strong – and over two time horizons – short-term and long-term. I’m too lazy to explain all of this, but I’ll explain where I stand on the issue and perhaps you can figure out the rest.

I believe in the “strong form” of market efficiency for the short-term. In other words, it’s very hard to outperform the market over a short period of time – let’s say less than 18 months – because today’s price is an “unbiased estimator” of future short-term price movements. In other words, because most professionals are concerned with the short-term (the average mutual fund manager holds onto a stock for 1 year), their varying informed opinions about where prices will go in the short-term will cancel each other out on average leaving a price that reflects the “right,” or “unbiased,” price for the stock in the short term. Therefore, unless you have information that’s not known by other participants, you will have a tough time outperforming the market ON AVERAGE in the SHORT TERM. (Keep substituting “unbiased” for “correct” or “right” when thinking about market efficiency and it’ll make more sense.)

I believe in something between the “weak form” and “semi-strong” form of market efficiency for the long-term. In other words, the longer your time horizon, the more patient you can be, the greater your arbitrage opportunities. While market participants may on average dictate the “right” – or “unbiased” – price in the short-term, that price may be completely “wrong” (that is, it over- or under-reflects the stock’s long-term risk-adjusted return potential) due to other factors that will affect the stock in the long-term. As an investor, if you can properly ascertain and analyze such factors and have the intestinal fortitude to hold onto the position for a period longer than the average investor, you MAY have the opportunity to generate above-market risk-adjusted returns. But even here you have to know what you’re doing. And you have to remember that as your investment time horizon increases, by definition so does the variance of possible exogenous factors that will influence the stock’s fundamentals and price. That’s the downside/challenge of long-term investing that Chris J correctly alluded to in an earlier post.

Right or wrong, most successful long-term investors (like Buffett) and even many academics hold both of these views.

So when you discuss the market’s “rationality,” or lack thereof, you have to specify to whom, to what degree, and over what period of time. Actions that may seem completely irrational to a short-term trader may be completely rational for a long-term investor, and vice versa. Where an investor/trader stands on these issues often depends on where s/he sits.

I know you think I’m a condescending prick, which is largely true. But if you’re going to start a consulting business that has anything to do with economics (as you suggested previously), it’s better for you to discover the gaping holes in your knowledge base here in the blogosphere, rather than in a client meeting, which would be both embarrassing and professionally damaging.

[powayseller]

Thanks davelj, for your response. I stand corrected: it is general consensus that the stock market price is a leading indicator of the economy.

[(former)FormerSanDiegan]

Today the S&P 500 closed at 1300. Only 700 more points to go. That’s only -3.5 points per trading day between now and the end of May.

[Chris Johnston]

Chris Johnston
iamafuturestrader.com

I hate to rain on the parade of gloom and doom, but we are not going down anywhere near that far folks.

[powayseller]

I’m not saying we are either, although no one knows for sure. I have no idea where the S&P is going.

It’s important to know that recessions are a lagging indicator. The stock market declines before a recession, and starts rising in the middle of it. You can see this in the charts in Ahead of the Curve.

Roubini writes that the market peaks 9 months before a recession, and recovers about 5 months before the recession ends. This is because the equity market is forward looking.

The peak to trough resulted in a 28% drop in the S&P500 in the last 6 recessions, taking anywhere from 3 to 18 months to reach the trough.

Thus, if we have a recession, the S&P 500 will most likely bottom out at a little over 900.

You can read Roubini’s entire post, with charts of the past 6 recessions.

[(former)FormerSanDiegan]

Chris –

My reply was tongue-in-cheek. Just pointing back to the ridiculous notion in the original post that an xx% decline in the housing index predicts an xx% decline in S&P 500.

My (near-term) bet is that S&P 500 tests lows in the 1200-1250 range over the next 1-3 months, then rallies at least once more before the $h!t hits the fan.

[powayseller]

FormerSanDiegan, where do you think the S&P500 will end up?

[Chris Johnston]

Chris Johnston
iamafuturestrader.com

Former – I knew you were tongue in cheek, the comment was just targeted at this thread in general. It is so hard to predict what will happen, but I do think people get too carried away with negative thoughts at times. It is much easier to scare people for some reason that it is to prop them up with optimism.

PW – if that lag is true then the recession you are looking for is a long ways away if my stock model is correct. We should peak spring to summer of next year, so 9 months after that I guess by what you are saying takes us into 2008.

As I always say, I could be wrong, but I wonder if Roubini risks 7 figures on what he writes like I do? I bet he risks zero. I do find his writing compelling but like alot of the doom and gloomers, I think he carries out some things too far. How often are these doom and gloom predictions accurate? Ask Bob Prechter, or what about Bill Gross and his 5000 DOW call a few years back.

Maybe at the end of the day I just cannot live my life thinking the sky is about to fall on me. This may cloud my judgement in viewing these very negative economic forecasts.

[Nancy_s soothsayer]

What I got from davelj is that in order to “sound” “like” “a” “consultant” or “analyst”, “you” “have” “to” “talk” “round and round” in circles”, saying statements “like:” “Sometimes they’re right; sometimes they’re wrong.” It sure sounds very professional, particulary dwelling in syntax and semantics and perfect “grammer.” Professor Higgins preaching to Eliza Doolittle did not sound as condescending as davelj to PS.

Just you wait and see, Professor Higgins!

[powayseller]

Chris, I really enjoy these lively discussions with you, because you are so smart and such a good trader. I wish I could fast forward time, to see how the stock market and economy will be in one year. I place Chris and Roubini in equal high regard. Chris uses technical analysis, and expects a stock market gain of over 20%, while Roubini uses economic analysis and expects a stock market fall of 28%. We’ve got a #1 trader vs. a #1 economist. Who will be right?

As we head into the fall, I expect that the technical indicators will start showing the bear market approach. As housing continues cooling, companies’ earnings will keep getting hit, and as foreclosures rise, investors will start worrying about lenders and the consumer’s ability to keep consuming. It just takes time for this all to unravel.

I don’t know what Roubini risks in the market, but he is certainly risking his reputation and future income as a consultant by his predictions. He is boldly sticking out his neck in predicting a recession. I don’t consider accurate analysis “doom and gloom”. By 2008, as foreclosures mount and the stock market is caught in a rut,, I hope Roubini and I will be blogging about the next upturn; nobody will believe it though.

Chris, let me ask you this: if I say that tonight at 8pm it will be dark, would you call me a doom and gloomer for bringing up the subject? The economy is the same way: it goes in cycles of bull and bear markets. It’s the law of nature at work. Rest and activity are the steps of progress. It is one of the laws of nature.

[davelj]

Nancy, I think you confuse “talking round and round in circles” with “objectivity.” And unfortunately being objective means presenting more than one side of an issue. Every single discussion I’ve entered into here I’ve taken a specific position and clearly explained why. If you disagree, you can point out the issue – and please be very specific. You won’t hurt my feelings.

Unfortunately we, and clearly you, live in a soundbite world. But investing and economics are not soundbite professions despite CNBC’s indications to the contrary. They’re full of nuances and complications, many of which are not understood well by the general public and some of which I try to address in my posts. Unfortunately, even these dumbed-down posts take up a little space. But I’ll try to be more cognizant of your short attention span and reading comprehension difficulties in the future. A piece of advice: Stay away from things called “books” – many words, sometimes very complicated – you won’t like them. Oops, that was condescending, wasn’t it? 🙂

[Nancy_s soothsayer]

Bravo! Wow… I am awed, inspired and amazed at the supreme intelligence and class shown by davelj. Top of the food chain. Cream of the crop. Davelj — you must have been valedictorian (Summa Cum Laude?) from Yale, Princeton or Harvard Business School. My hats to you. You win again. You Tarzan, me jane, you win again. –End of line—

[Author]

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