What’s Up with the Stock Market?

[poorgradstudent]

powayseller wrote:
“I don’t buy it though. Why did homebuilders go up recently? Why are some stocks trading at PE/s over 15? Why was there even a tech bubble, with stocks earning no profit trading at high prices?”

Stock prices generally project future earnings, not just current and trailing earnings (which is where the P/E value comes from). Unfortunately, accurately predicting growth and future earnings is difficult. Most stocks that trade at high P/Es have good growth potentials. The tech bubble was a combination of unrealistic growth expectations and “irrational exhuberance”.

Companies do attempt to manipulate their stock prices. I read one study (wish I could cite it) that said something like 60% of actual earnings reports beat the market estimates. From that we can conclude one of two things: Analysts are bad at their job, or companies will do what they can to “juice” the numbers and boost the stock price a bit. The fact earnings tend to skew to the positive suggests the latter is probably true.

powayseller wrote:
“We also have shorting and options and all kinds of trading which further distorts the true value, as those people treat the market like a casino table, rather than being true investors which pay for a stock what they think it is worth. They are buying only for short term holding to play small changes in the price.

Maybe markets were efficient before all the games and the before the speculators took over.

To me, the stock market does not reflect the accurate value of a company’s stock. It just shows what a bunch of speculators are willing to game it for, at this moment.”

Short term traders really only affect the short term price of stocks. Long term investors can still buy and hold the companies they feel are undervalued and are fundamentally strong.

Opportunities come when “Mr. Market” overreacts to good or bad news, or neglects a solid company or sector that doesn’t happen to be in vogue at the moment. But overall, I don’t think you will see a lot of ridiculously mispriced stocks.

[qcomer]

“The Dow is up about 8 percent since mid-July and seems poised to break its all-time closing high set in 2000.

But while the Dow index has performed well of late, the Russell 2000 index – the most-watched index of small-cap stocks – has dropped more than 10 percent since May.”

First of all, the statement above, craftly yet unfairly uses May timeline for Russel2000 but July timeline for Dow. To have a fair comparison, both Dow and Russel2000 are up about 8-10% from their July lows. Both Russel2000 and Dow are in the positive for the year. So the bounce is there across all stocks but considering the upcoming slow down in economy, focus has shifted from small caps to large caps and from growth to value. Small caps are generally more volatile, risky investments than large caps and small caps had outperformed large caps for the last 4 years and naturally there is a change in leadership this year.

Stocks are up simply because there are large group of people who believe that the US will have soft landing, who don’t agree that a recession is going to hit the US and that the slowing housing sector alone is not sufficient to bring a recession with other sectors being strong. They believe that the mid of 2007 will spur another growth cycle as Fed starts to cut rates and these guys are positioning themselves early. Note that there also loads of very smart people with numbers and stats to make their point for the case of soft landing. There are no absolute truths, only interpretations (Nietzsche). We shouldn’t be bewildered as to why the stokcs are behaving against our theory, instead we should be discussing a strategy (diversification, stop losses, hedges, etc) to minimize the losses if market turns to prove that we are wrong.

[powayseller]

October Yamamoto Forecast is at its most bearish position ever. He, and Barry Ritholtz talk about the huge disconnect between the perception of investors and reality of the market. Being in cash is safe, regardless of the outcome. Great post, qcomer!

[ltokuda]

[img_assist|nid=1776|title=Historical DJIA 1960-Present|desc=|link=node|align=left|width=466|height=356]

This is a historical chart of the DJIA from 1960 to the present. The vertical bars indicate recessionary periods. Here’s some observations that I thought would be of some interest.

1) The market generally doesn’t seem to anticipate a recession. In other words, the market goes down when the recession hits, rather than 6 months in advance. In some cases, the market didn’t react until after the recession hit.

2) The market tends to bottom out midway through the recession.

3) The market generally recovers by the time the recession ends. I think this is why some people say that the stock market rises during a recession. This is true in the sense that the market is generally higher at the end of the recession than it was at the beginning.

4) It seems possible to have a recession during a mid-term election cycle rally. Recessions historically have lasted between 6-18 months. If a recession started early in 2007, it would probably end by the middle of 2008. We would expect the stock market to recover by then. The mid-term election cycle started in October of 2006 and ends in October of 2008. Since the cycle would outlast the recession, its possible that the markets could still see a net gain over the 2 year span. In other words, the recession (predicted by the housing bust) and the stock market rally (predicted by the mid-term election cycle) could both turn out to be true.

Although not shown in this chart, I did see a case prior to 1960 where the US was in a recession and stocks continued to rise. This was in the mid/late 1920’s before the stock market collapse. So the market doesn’t always drop during a recession.

[powayseller]

Thanks, Itokuda.

I have a question I cannot solve.

Many of us expect the stock market to decline in anticipation of a weaker economy, due to falling housing and thus falling consumer spending.

But: where will the investor put their money when they are fearful of recession? As of now, they are loading full force into the Blue Chips, the Dow 30 companies.

The money has flown out of real estate, and into the stock market. Today, WalMart had a bad earnings report, and that is going to be the beginning of the bad news coming out of corporate America. But the stock market can only go down, IF and ONLY IF investors sell their stocks. If investors stay in stocks, the stock cannot go down.

Why shouldn’t investors stay in stocks? Where else to go? Gold? THey are fearful of the volatility. Treasuries?

If you can predict where the mutual funds and hedge funds and big money goes, you can get in early. If they stay in stocks, maybe it was bad to sell our stocks, bec. stocks will keep rising.

[rseiser]

I am baffled, too, to say the least. (But my stops on lenders, builders, and QQQQ haven’t been hit, so maybe there is a last chance for the market to crack.) It wouldn’t take much to get investors out of stocks, just the equivalent of Amaranth at an equity fund. Here is another possibility what people could do if they sense bad times: stop consuming and pay back their debt. I know it’s unlikely that this is going to happen, but not impossible. It works for me, downsizing expenses and increase savings, just to make sure I have some buffer if bad times strike.

[sdduuuude]

powayseller – I think the answer is short term bonds. Anyone else ?

[powayseller]

3-mo. Treasuries, yup. In our retirement account. Are you saying investors will flock from equities to short term Treasuries?

Here’s another investing idea: inverse funds. Yesterday I got my monthly Yamamoto Forecast, and the entire newsletter was about the disconnect between the economic slowdown and the Dow going higher (although he reminds us the rise is limited to just the biggest caps). So the idea is why not get an inverse fund, like the Rydex Inverse Fund? That ought to be a safe way to go against the market, without having to short or get puts.

[powayseller]

CNN is reporting in bold red headlines: Dow is at its highest for 2nd day in a row. Below, headlines are Bernanke’s and Fed Chief Hoehnig’s warning about the slowing economy. Walmart’s earnings were up only 1.3%, instead of 1.8% as announced earlier this week. If you look at what’s up in the Dow, only a few companies are benefitting. The tech stocks are down…Dobbs reports that the middle income people are squeezed and spending the highest percentage of wages on housing in our country’s history: 30%. So the headlines are paradoxical.

Do you think there is a plunge protection team that is buying up shares of just a few Dow companies, enough to make the entire index go ballistic and prove via the media that the economy is hot?

[sdduuuude]

I have a little sub-portfolio of 6 stocks that isn’t performing well in my IRA. I’m seriously thinking of pulling the trigger and getting that into a 1 year bond.

[sdduuuude]

All you traders out there – does this make sense?

As interest rates fall, stocks tend to rise because as rates fall, the expected no-risk return on your investment from a bonds goes down and investing in stocks looks more attractive.

(If you can only get 3% on your money with a bond, the stock market looks good. If you can get 8%,the stock market doesn’t look as good).

Thus, as we head into a recession, we get bad news about the economy and the stock market responds positively to that news because it suggests the feds will lower rates.

I think the news of the economy slowing drives up stocks in the short term, then, as the economy starts crapping out and earnings reports suffer, the stock market comes down with the economy. I think the Christmas season will really let us know if we are going into recession early 2007 or early 2008.

[Anonymous]

I’m not sure whether interest rates drive the stock market or vice versa.

For you old-timers out there, does anyone remember 1987? Bonds were tanking the entire year up until the October crash.

Stocks roaring higher, and bonds plummeting lower.

Then the market crashed, and the long long bear market in Treasuries came to an end.

Sorry, no graphs to display but perhaps someone graphically inclined will post the plot.

Most commentators agree that investors pulled out of the stock market and went into Treasuries, but was the reverse true earlier in the year? Was all that money going into stocks coming out of Treasuries or out of the mattress?

[powayseller]

I think that investors take the economic slowdown as a sign that the Fed will lower interest rates. The masses, even professional investors, believe still in a soft landing.

Lower interest rates are favorable to business, so the stock market rises when interest rates fall. We saw many “Fed-is-done” rallies in late spring and summer, as investors bid up the stock market upon hoping or finding out that the interest rate rises were done.

Today was a wake-up call, but delusional investors did not heed. Kansas City Fed Chief and Bernanke issued economic slowdown warnings, and Walmart’s earnings report was lower than expected due to less consumer spending. How many more warnings do these dreamy investors need, before they wake up? They own shares of companies whose profits are falling, so they are losing value in their shares by the minute. The E part of P/E is falling, making the P/E much higher by the week. By the time the market falls, it’s gonna be fast…

[Steve Beebo]

I invested in six separate mutual funds about 18 months ago, and on average, the return is almost 15%, with only one under-performing fund, (a bond fund).

[davelj]

Stock prices reflect the constant struggle between expected interest rates, expected earnings and expected changes in risk premiums. It’s that simple. Most bulls know that the economy is slowing but they’re buying stocks because they believe that we’ll have a soft landing – thus their bet is that earnings will hold up o.k., but interest rates will decline and therefore that valuations will increase. The bears, on the other hand, believe that even if interest rates decline (as they will in a slowdown), that the decline in earnings will more than offset the decline in interest rates and thus valuations will fall.

To use an overly simplistic example, let’s say the market is represented by a single Stock A. EPS for Stock A will be $1.00 this year and are discounted at 7.5% (which reflects current long-term interest rates, earnings growth and a risk premium). The value of Stock A today is $13.33 ($1.00/7.5%).

The bulls believe that next year’s EPS for Stock A will be $1.06, long-term interest rates will decline by 50 bps and the risk-premium will remain steady, yielding a discount rate of 7%. So, they believe Stock A will be worth $15.14 next year.

The bears believe that next year’s EPS for Stock A will be $0.85, long-term interest rates will fall by 75 bps and the risk-premium will remain steady, yielding a discount rate of 6.75%. So, they believe Stock A will be worth $12.59 next year.

Again, this is an overly simplistic example, but my point is that the challenge for the bears (and I’m one) is that EVEN IF earnings stay flat or decline, the decline in interest rates may overwhelm the impact of reduced earnings from a present value standpoint – not even considering the issue of the risk premium – and stocks could go up. Interest rates and earnings are like a seesaw with the risk premium sliding around in the middle. You have to get at least two of the three right and even then sometimes the third overwhelms the other two. It ain’t easy.

I made a long post a while back regarding efficient markets that I thought explained the theories fairly succinctly. I guess I was wrong. I’m too lazy to go over it again, but the key issue is not to focus on “right” and “wrong” but rather “biased” and “unbiased.”

[Author]

Posts