Uncertainty is a Constant

The past few months there has been plenty of talk about uncertainty in the future of corporate earnings and the US economy. Since the market lows in March, skepticism about the market rally has been aided and abetted by these arguments (high unemployment; fears about a commercial real estate crash; ballooning government deficits; lack of real economic growth after government stimulus is stripped out; fears about a weakening US dollar). Prior to the start of the rally, the market declined in very volatile fashion for almost a year and a half, again, amid uncertainty (bursting of the housing bubble; seized up credit markets; massive losses at banks; massive financial institutions failing). Prior to that, stocks rallied for over four years without a 10% decline in the S&P 500 amid uncertainty (skyrocketing oil prices; wars in the Middle East; rising interest rates; fears of the housing bubble collapsing). Before the 2003-2007 rally, the market declined for two and a half years after the turn of the millennium due to uncertainty (bursting of the internet bubble; massive corporate corruption – Worldcom, Enron, etc.; Wall Street analyst fraud; terrorism in the US). The only time in recent history that there has been ‘certainty’ in stock investing was the late-1990’s, nearly 20 years into a secular bull market. By 1999, after multiple currency crises, Russia defaulting on its government debt, and Long Term Capital Management nearly unhinging the world financial system, the market continued to make new all-time highs, as everyone ‘knew’ that we had entered a new economic era driven by the untold wonders of internet technology. This brief period of 'certainty' led to massive declines that still have yet to be recovered. After more than doubling in the final seven months of its push to all-time highs reached in March 2000, the NASDAQ remains 58% below that high, and it has never gotten within 40% of the high since its post-internet-bubble low in October 2002.

The point is that trading the market is nearly always fraught with uncertainty. If the future were certain, there would be no purpose to the market, as everyone would simply calculate where earnings were going to be in X number of years and discount those earnings back to their present-day value. There would also be no premium in stock prices, as premium is derived precisely from the uncertainty inherent in the future. Those who are waiting for certainty in the market should never put a dime into any investment except US treasury securities, as uncertainty is a constant in risk assets.

Further, certainty is a feeling, not a fact. Therefore, market participants at all times have varying levels of certainty, which is why the market fluctuates. Going into this week, for example, many market participants felt certain that, due to a lack of upcoming economic and earnings data, there was little to prevent the market from going higher for at least a few days. Others now feel certain that there is no way that the government will be able to successfully mop up all the liquidity that they have let loose, so they are certain that the market will go lower from here for months on end. Others, still, are certain that the economic recovery will be much stronger than the consensus estimates, and that the market will rally into the first quarter of 2010 at least. And some believe that, until the FOMC begins hinting at an impending rate hike, the market will continue to rally.

All of the aforementioned ‘certainties’ can be boiled down to an individual’s feeling about the facts, and about the relative importance of various facts. Of course, it is a flawed strategy to say, simply, “I am going to buy stocks today because earnings next year are going to beat consensus estimates.” Even if you are 100% correct, and earnings do beat the estimates, what if there is a big, perhaps massive, exogenous market event? Take Apple (NASDAQ: AAPL) in 2008 as an example. The company beat earnings estimates in all four quarters of 2008. AAPL also beat fiscal year 2008 estimates that analysts made in late-2007. However, the stock was down 57% in 2008, which was even worse than the S&P 500’s 38% loss and the NASDAQ’s 41% decline. As foolish as it is to look solely at individual data points when making investment decisions, this is how many investment decisions are made, and it is the reason why the market is in a constant state of motion. The fact is that just about everything affects stock prices – each factor just waxes and wanes in importance over time. While aggregate corporate earnings have the highest long-term correlation with aggregate stock prices, the swings in the price-earnings ratio, which is largely influenced by sentiment, make this correlation useless for trading the major stock market indices in timeframes of less than a year or so.

Whether or not the big rebound in corporate earnings that has been predicted by the stock market continues, sentiment remains divided going into the end of the first decade of the new millennium. Perhaps the only certainty is that uncertainty will remain, regardless of which direction the stock market goes from here.