Charles Dickens had it right - "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness....it was the Spring of hope, it was the Winter of despair..."
Confirmation bias is the human tendency to remember most clearly those things which confirm our preconceived notions, to notice only things which support our biases and to interpret ambiguous evidence to support conclusions we have reached in advance. It is a notoriously powerful delusion and has had disastrous effects in military strategy, criminal law, intelligence, and, perhaps worst of all, financial decisions.
In the stock market, this is a particularly serious problem because most events, developments, data, rumors, and even market assessments are subject to multiple interpretations. The same piece of data can easily be used by both bulls and bears with minimal creativity. When we start to see the repeated assertion that "bad news is good news," we must start reaching for our wallets. Because I have begun to hear that line of argument more and more often, I am beginning to become more nervous about the market.
Let's go through some of the news items that can be spun in either direction.
1. Macroeconomic Data - It isn't hard to imagine how a bullish case can be built on strong economic data evidencing solid GDP growth, increased employment, and stronger earnings. It is interesting, however, that we have recently seen the argument being made more and more often that weak economic data is actually "bullish." The argument goes like this: as long as the economy is weak and growth is sluggish, the Federal Reserve will have to continue its expansive monetary policy and that policy virtually guarantees that stocks will go up. I heard a version of this argument during the early 1990's. Back then, we had S&L failures every week and, after the spectacular failure of a large S&L, the market shot up sharply with the argument that the S&L failures assured that Chairman Greenspan would have to keep cutting interest rates. In fairness, the argument proved to be eerily accurate.
2. The Strong Dollar - If all else is equal (as, admittedly, it rarely is), a strong dollar is bad for the economy and bad for corporate earnings. Many large US companies have substantial foreign sales and operations and if foreign currencies decline against the dollar, the dollar denominated value of those foreign sales and operations automatically declines. A strong dollar makes it harder for US companies to export and to compete against imports and that tends to reduce dollar denominated GDP. So how could a strong dollar be part of a bullish argument? The argument would be that 1. the strong dollar will attract foreign investors to dollar denominated assets including stocks and 2. the strong dollar is a sign that the US economy is recovering and strengthening or at least that the "smart money" thinks it is. We are beginning to hear this refrain as the evidence accumulates that the dollar is moving up (at least against the yen).
3. Washington Gridlock - Second Presidential terms are notorious for preoccupation with "scandals," investigations and political sniping. Heading into this year, it was hard to imagine how Washington could become more dysfunctional, but recent events suggest that it may just exceed itself in this dubious category. One would think that a dysfunctional political system would be bad for the country, its economy and its businesses. However, in the 1990's rally, we constantly heard that "the market loves Washington Gridlock" and I am sure we will hear it again. The argument is basically that most of what the federal government does is bad for the economy, business and the stock market and that a gridlocked government is likely to do the least of all. Having lived in Washington for some 40 years, I am a bit sympathetic to this line of thinking, but part of me finds it overly cynical.
4. The Consensus of Market Pundits - I used to gauge market trends by monitoring how often Marc Faber and Nouriel Roubini were interviewed on CNBC and Bloomberg. The more often I heard their guttural pronouncements of doom, the more confident I was that it was a good time to buy. Of late, some of the apocalyptic seers have seemed to fade away from the public stage. We hear more and more from bullish "experts" and less and less from prophets of doom. I really believe that this is a very bad sign, but it is also easy to be persuaded by savvy experts making a bullish case.
5. Federal Reserve Announcements - The Federal Reserve often plays the role of the riddling Sphinx or the Delphic Oracle, making cryptic statements subject to multiple interpretations. When it takes action, one would think that the implications would be clearer, but once again Fed action can be spun in either direction. In the past, I have seen the bearish case made that a lowering of interest rates or other Fed expansionist action is a bad sign because it shows that the Fed "must know" something is really wrong with the financial system that the rest of us haven't figured out. The opposite argument will doubtless be made if QE is phased out; this will be interpreted as a sign that the Fed is confident in the soundness of the financial system and the economy and all is well.
It is a trite old saw that the stock market is not like the swimming pool at a summer camp I attended in the innocent 1950's; they don't ring a bell when it is time to get out. But one ominous sign is the emergence of an "all news is good news" confirmation bias in the media and among market "experts." I have been on the other side of a lot of these debates for 4 years now, trying to refute bears who argued that "all news is bad news" and I find myself with more and more time on my hands.
The answer to this dilemma is for an investor to keep his or her eye on valuation metrics - price earnings ratios, balance sheet data, dividend yields, and cash flow. Stocks are not like hemlines, hair styles, and rock stars - while they go in and out of fashion, they revert to mean and in the long run must be valued as shares in the businesses they represent. I do not think we are at the end of the bull market because dividends will continue to rise and to propel stocks higher for some time. I do think, however, that we are at the point at which investors should start listening for the warning signs that tend to emerge when "lightening up" is in order. I wish they would just ring a bell, but, even in summer camp, I was one of the last guys out of the pool and I don't want that to happen again.
Stocks that are still trading at reasonable multiples and have the cash flow and/or balance sheet strength to continue to increase dividends are still much better alternatives than bonds. The ability to keep increasing dividends in a low interest environment is likely to be critical as we go forward. Although the large cap tech sector has begun to rally, valuations are still very conservative and I think an investor will do well with a combination of Cisco (CSCO), Intel (INTC), Apple (AAPL) and Microsoft (MSFT). Each of these stocks has an extremely strong balance sheet, the ability to borrow at very low rates if necessary and continued strong cash flow. Dividends from the group should continue to increase substantially from year to year. In addition, while the "disk drive duo" of Western Digital (WDC) and Seagate Technology (STX) has already moved up considerably, each of these stocks produces strong cash flow and should be able to enhance shareholder returns with a combination of share repurchases and dividends. Investors should focus on buying a share of a business at a reasonable or, when possible, cheap price and not worry as much about the overall direction of the "market" and whether any of the ambiguous events described above provide meaningful guidance to investment decisions.