What Matters Most When Investing – Part I

The stock market is a mysterious beast to those who do not study it. Correlations between stock prices and everything from the economy to lunar cycles are drawn by those wishing to divine some sense of the movement in stock prices. At times there appear to be very clear correlations between the stock market and another asset class, such as the dollar or US treasury securities. However, in the long-term these correlations invariably break down and leave people wondering why.

The market’s behavior is so confounding that many have subscribed to the ‘random walk’ theory of the markets, which states that price movements in stocks have no discernible pattern. The biggest detractor from this hypothesis is the fact that the stock market as a whole does display price patterns and trends that repeat over and over. The random walk theory was devised before ETFs and index funds existed, so it is somewhat forgivable. However, fortunes are made by the best trend-followers, even in years like 2008. In fact, a fund run by consummate trend-follower John Henry, who is also owner of the Boston Red Sox, was up 91% last year.

The problem with trying to determine why the market is moving a particular way is that it is a fool’s endeavor. There are simply too many factors that affect the market for one to accurately evaluate and anticipate in a given week, month, or year, and much less to do so in a repeatable fashion. In very short timeframes, such as a few hours, it is possible to trade profitably based on news and asset correlations. However, even such short-term trading is difficult, as news and events are now reported and disseminated so quickly that anything not anticipated can ruin a week’s worth of profits in a matter of hours.

Instead of asking why the market is moving as it is, consider looking simply at how it is moving. That is, look at the trend of price movement as divorced from all other factors, and you will have a much better understanding of how to profit in the stock market. The underlying trend for the past 200 years is clearly up. However, there have been periods of significant multi-year declines throughout. In the past decade, stocks have produced about a 0% return before dividends, but the S&P500 rose over 100% between late-1996 and 2007, then retreated over 60% by March 2009. There is ample opportunity to profit during such times, and there will be many more such opportunities in the future.

Stay tuned for a primer on technical analysis tools and how to use them at the appropriate time.

The Bears' Dilemma

The S&P500 and NASDAQ have both met the three conditions necessary to confirm a new primary uptrend, as per my last post. The intense rally from early March to early May had the appearance of a bear market rally, as it was sharp, volatility remained high, and there was very little backing and filling. However, two months of consolidation led to a resurgence of buying in mid July, and the indices confirmed their new primary uptrends by breaching their prior highs and rallying so hard that their 200-day moving averages began to slope upward.

The upslope of the 200DMA is key, as it had been in decline for 18.5 consecutive months until mid July. This shows a major long-term shift in buying patterns from market participants. As the primary uptrend matures, very likely there will be periods of sideways movement and intermediate-term downtrends. However, most of the time the market is likely to be in rally mode, as long as it remains above its 200DMA.

There are headwinds aplenty that will constantly challenge the uptrend. A major shift, and new trading challenge, that has taken place in the market since last Fall is the speed with which the market moves. Timeframes, which had already been shrinking before the Crash of ’08, have since become so short that moves that would previously take a year or longer are now happening in a matter of weeks. The March-June period produced the largest rally for such a short timeframe since the 1930s. The more recent rally from the July low to the August high in the S&P added 17% to the index. For some perspective, the entire range of trading for all of 2007 was only 15.5%.

With such extreme moves in such a short amount of time it is understandable that investors do not feel comfortable putting money to work in the market. Such sharp moves indicate an underlying instability in the market, which likely means that, at least in the next few months, the market may continue to move in fits and starts. The days of clean, non-volatile uptrends are not likely to return for some time.

Another ‘headwind’ to the market rally is the fundamental picture. This is not a true headwind, however, as the fundamentals are already known to be generally bad, which has already been priced into the market. As a very intelligent and insightful market commentator writes, “Technically, all my charts are damn Bullish! But for reasons I’ve been noting for years, I just can’t believe what I’m seeing is real.” This commentator is expressing the precise emotional state that occurs when a primary trend has changed direction: disbelief. The commentator goes on to declare himself a “big bad Bear.” This self-identification is pointless and quite damaging, as it fails to account for the fact that equity markets are smarter than individuals in the realm of discounting future economic conditions. When will such a person shed himself of his bearskin? Most likely when every piece of the economic puzzle is perfectly in place, and the market has been making new highs for years.

The Bears’ dilemma right now is understandable. The fundamentals have been frighteningly negative until recently, and there are huge problems, such as commercial real estate refinancing and a ballooning balance sheet at the US Treasury, that leave one wondering if the US economy will be able to right itself sustainably any time in the next few years. However, the stock market rallied over 50% from its lows in the face of these and other troubling fundamentals. How is this possible? Answer: these bad fundamentals are YESTERDAY’S NEWS. The market cares not about what has already happened to the economy, but rather what lies ahead. What is difficult for many to swallow, especially those with the burden of knowledge about the economy and financial markets, is the fact that the market is smarter than any given individual, as it represents the aggregate of all market participants’ analysis of where the underlying fundamentals will be within six months or so.

It is true that banks are failing on a weekly basis. It is true that home foreclosures are at historically high levels. It is true that the US government has borrowed a frighteningly large amount of money from foreigners in order to save its banking system. However, the stock market sees something in the future that has it excited. It could be the fact that short-term interest rates remain at record lows and the yield curve is the steepest it has been since the beginning of the last economic expansion in 2003. Perhaps it sees the government bailout of the banking system as an impetus for lenders to take on additional risk and make new loans. Maybe it is the combination of all of the Fed’s liquidity programs that has the buyers back in control. Or it could be the replenishment of company inventories that the market is anticipating.

The end result is that it matters very little what the causes are for a market to shift long-term primary trend direction. What is important is the fact that it does so at all. Indeed, the market is already looking past the coming improvement in fundamentals to the next stage of the economic recovery, the stage where the economy either takes off in a ‘V’-shape, flattens at a low level of growth, or retracts again creating a double-dip recession. It is a distinct possibility that the market may even sell off on the coming good news if it is not good enough. On August 18th, for example, when Japan reported that its GDP grew 0.9% in the second quarter versus the first quarter, the NIKKEI spent half the day in negative territory and finished with only a mild gain of 0.15% for the day. After four straight quarters of GDP contraction, one would think that the report of growth would have produced a fantastic rally. However, this news was already discounted by the market, as the growth rate was in line with consensus expectations. So, even if US GDP advances in the third quarter, a sell-off in the market would be likely if the advance were significantly lower than anticipated.

Price trends defy human logic, as they at times persist despite currently known data at odds with the trend. This is because market participants buy and sell with the intent of correctly determining where the economy and financial markets will be at a certain point in the future. However, such information about the future is always incomplete in a free and open market, and therefore, as price trends are self-reinforcing due to humans’ herd mentality, markets almost always overshoot to the extremes in shorter timeframes. Therefore, it is likely that the market’s advance over the next few months will be characterized by intermediate sell-offs, improving fundamentals, and plenty of bearishness among market commentators.