The Economy Can Be Measured Within Reason, Market Prices? No

“Davidson” always seems to come to bat in down periods with a healthy dose of common sense. For those who are not familiar with him, he has been on ValuePlays as an opinion since 2008. It was in March 2009, just days before the market hit their lows that he said, “It is time to go all in, this is a generational opportunity”. Given the sheer panic out there are that time, it was amazing call. From that day since he has yet to be wrong about the markets and the economy’s direction.

Whatever he posts is worth reading.

“Davidson” submits:

The basis of my investment advice is the perspective of past business cycles, how the data develops “data point by data point” to form economic trends and finally how these trends become reflected in market prices. The fundamental concept is simple, but compiling the data and doing the analysis is the bulk of the work. The perspective is an investment history of hundreds of years, but the up-cycle can vary from a few years to longer than 10yrs. The goal is to capture a significant part of the investment up-cycles as long term capital gains and avoid the down-cycles. Importantly: Economic data develops over years. It creeps along! One cannot trade it, but I believe it to be very investible if one has patience and a time frame of 10yrs+.

Why does history show it is nearly impossible to predict market and security prices with precision?

Economy can be measured and predicted within reason, but stock and bond prices not so much! Every couple of minutes there is someone in the media predicting with some precision market and individual security prices using economic information as a basis. It is believed by most of those in academia and on Wall Street that precision in security pricing is possible. My research has convinced me that precision is not possible.

The reason I come to this conclusion is based on historical research. By observing where the major market lows and highs occur, comparing these events to what various investors are doing and saying one can tell what people are thinking at these crucial market turns. As one tracks these investors over the period of the investment cycle one begins to understand that Value Investor buying tracks the SP500 Intrinsic Value Index (An index created by using the long term SP500 (SPY) earnings mean capitalized by the long term Real GDP mean+12mo inflation measure). My observations lead me to believe that it is Value Investors who create market lows. Growth and Momentum Investors who are far more numerous wait till the Value Investors have caused a market bottom and even wait till the market turns higher before beginning to make commitments. My observations lead me to believe that this is due to dual beliefs in the concepts of “The Invisible Hand” and “The Efficient Market”. Basically those who are not Value Investors believe that markets carry some hidden wisdom and further that markets somehow magically know best where securities should be priced. Once these investors gain confidence in price movements, they invest in the trends they perceive. “The trend is your friend!” is one of the most common of investor sayings.

We have long developed and used mathematics as a tool to unravel complex problems we wanted to solve. Mathematics and science have been developed together since Zeno 550BC as E.T. Bell documented in “Men of Mathematics ”. Mathematics requires “hard” data or data which does not vary from circumstance or time. The predictive power of mathematical relationships is how scientific advances occurred. Mathematical models of our solar system and the physical properties and the chemistry of water let us determine the likelihood of habitable worlds light years away.

The problem of using mathematics to predict security and market prices comes from the fact that people have used market and security prices as the primary inputs. The primary fault is in market prices themselves. Prices are a direct result of what investors think something is worth. Once a price trend has been established, investors develop higher confidence that the trend will continue. Many believe that longer price trends are more predictive of future prices. Much of this resides in a psychological term called “The Recency Effect”. It is human pattern recognition which having observed a pattern over time leads us to higher and higher expectation that the pattern is likely to continue. With investing, “The Recency Effect” is on the order of 2yrs-3yrs. Our assessment of new facts is colored by the past 2yrs-3yrs of experience and therefore, we tend to ignore news which is turning economically positive at market lows and similarly we ignore news which is turning economically negative at market tops. “The Recency Effect” causes us to believe that higher prices at market lows are not justified but that higher prices at market tops are. The average investor buys at tops and sells at lows! These varied psychological inputs into price are precisely why mathematics which requires “hard data” fails as a tool to reveal market relationships. Mathematics is not a tool which should ever be used to determine market prices! Most investors are simple trend followers in my opinion!

As long as market prices are “market psychology” dependent, mathematics is useless as a tool and precision analysis is impossible.

What is possible and doable is monitoring our economic patterns and observing how these translate into market prices. While not precise, there is useful predictability in doing this. Markets and the economy are fairly closely correlated. One can see in what direction an economy is moving, one can make some very good assessments as to roughly how far a market can go in either direction and be roughly right about the timing. “Roughly Right” means identifying market lows and highs within a range of 15%-20%, sometimes closer. One only has to be roughly right at the major turning points, and develop a strategy to participate in equities during economic upturns when markets rise and avoid equities during economic downturns when markets fall. From lows to highs equity markets often rise more than 200% during an economic cycle. The past 2 market corrections were in the 45%-50% range. Capturing most of the rise and avoiding most of the correction would have left one’s portfolio with an acceptable return. To accomplish this, one needs to monitor the economic trends and accept the market volatility which comes from temporary switches in market psychology.

The past couple of days which has seen rising rates on the 10yr Treasury has spooked many traders towards selling. Short term changes in the market’s trend has been a frequent occurrence the past 4 ½ years for one reason or another. The economic trends, however, remain as positive or more so as they have been the 4 ½ yrs. Trends continue to indicate that economic activity should expand with very likely ~5yrs of expansion yet ahead.

Rising rates are at this stage of an economy a sign of future economic strength. Investors and businesses are selling fixed income to invest into higher returns elsewhere. Rising rates improve bank lending, low short rates keep loan costs low and higher mortgage rates improving bank profitability. Expanding bank lending is directly dependent on bank profitability. First we get a rise in the long term rates as short term rates remain relatively lower. This increases bank lending rates and bank profitability. Banks become more comfortable lending to broader segments of the population as profits improve. They continue lending till the short rates begin to catch up with mortgage rates and lending spreads shrink. At this point in the cycle bank lending slows rapidly. For this reason rates peak when the T-Bill rates move very close to the 10yr Treasury rates. Also, rates peak at the same time the market peaks! Rates rising today is normal in the this part of the economic cycle and is something we should all desire for higher equity prices. Equity prices have a long history of being correlated to economic activity.

Rising rates are a sign of money moving out of fixed income into investment and business activities!

Optimism continues to be warranted, in my opinion.

Disclaimer: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.