When it comes to rhetoric, 2009 followed the script as well as can be expected: Stock prices have roared well ahead of earnings. If investors aren’t careful... yada, yada, yada... you know. We’ve also heard much about the lost decade and the horrible economic obstacles still before us. Actually, though, if we add some perspective, we may see that there’s more reason for optimism than many realize.
Market commentators generally speak of such things as GDP, unemployment, inflation, the deficit, the dollar, oil, corporate earnings, home prices, consumer debt, interest rates and so on. In the short term, such factors do seem relevant. But they aren’t the whole story. Each of those factors, and many others like them, are driven by other things that get less attention from those concerned with day-to-day trading. What might those less-discussed big-picture factors tell us about the stock market?
Let’s work our way up to what I refer to as mega-trends as follows.
Point 1: Stock prices depend on corporate earnings. It may not be a day-in, day-out thing, or even a year-in, year-out thing (as we saw in 2009). But ultimately, over a prolonged period, there needs to be some sort of relationship between stock price trends and earnings trends. OK. This shouldn’t be a hard sell for this audience. Moving on...
Point 2: Earnings trends depend on sales trends. Again, this is not necessarily day in, day-out or even year-in, year-out. Sometimes, businesses get soft and sloppy and we see margins wither. Other times, executives become cost-cutting fanatics at which times earnings grow faster than sales. Again, this is standard stuff, not a hard sell. So let’s get on with the good stuff...
Point 3: Sales trends depend on economic trends as a whole (GDP and so forth). This ought not be a hard sell, but actually, the concept is easy to forget as we plunge into the heat of day-to-day market battles. Back when I started working as an analyst at Value Line in 1980, I was taught that the process of estimating earnings began with a chart (on graph paper – this was before PCs) showing a the historical relationship between a company’s sales trends and GDP (or some other relevant indicator) and using economic projections as a basis to extrapolate sales trends into the future (allowing for a tendency of a company to outperform or underperform GDP and such reasons as we could muster as to why that seemed likely to continue, accelerate or decelerate). Then, we’d do all sorts of things as we went down the financial statements line by line, but for present purposes, it’s important to reinforce the link between economic activity and sales.
Point 4: Economic trends depend on and reflect a broader set of mega-trends such as population, technology, literacy, culture, health, and so forth.
So there we have it, at least for purposes of this discussion: In the short term, stock prices can depend on pretty much anything; estimate revision, interest rates, P/Es, the Super Bowl indicator, Ben Bernanke’s REM sleep patterns, tarot cards, anything at all. But over time and in a big picture sense, stock prices need to somehow or other be anchored to mega-trends.
To see how that’s been working out, consider Figure 1, a Yahoo! Finance screen shot showing a maximum-length price chart of the S&P 500. As you look at it – actually, I hope you’ll linger a but – assume there really is something to this notion of stock prices reflecting mega-trends, if not every day then at least over the long term.
Figure 2 is a repeat of the same S&P 500 chart but this time including a trend line added by me, representing one possible view of something that may correspond to the underlying mega-trends.
I’m not trying to argue that this admittedly subjective interpretation of the mega-trend line is exactly correct. I encourage you to go to Yahoo Finance! print out this chart on your own, and get a pencil, an eraser, and a ruler, and have some fun trying to articulate your own interpretation.
I obviously can’t know how you drew your mega-trend line, but based on mine, I can make a few relevant observations.
Something went very much, if pleasantly, awry in the latter half of the 1990s causing stock prices to run way ahead of the mega-trends. Something had to give somewhere along the line because by 2000, things had gotten very much out of kilter.
Things did, indeed, give – big time. Re-tuning stock prices to mega- trends was not a one-time thing, and actually involved quite a bit of adjustment (including, as we just saw, a financial crisis that’s been squeezing all kinds of excesses out of the system).
As we move into 2010, we may or may not be fully re-tuned. This assessment will vary from person to person depending on how you drew your trend line.
Regardless of how you drew your line, assuming you were trying to do something that had some sort of defensible relationship to the S&P price trend, it looks like stock prices in the U.S. are now more reasonable than at any time since the early 1990s. There’s room to argue either way about what’s likely for 2010. But based on this, it appears that a significant and prolonged bear market starting in the new year is a very low-probability scenario. It’s not impossible. We could undershoot the mega-trends for a while (a mirror image of the late ‘90s). But based on this, I’d expect any early-2010 weakness, should that occur, to be more akin to a correction, or profit-taking pause (following ’09) than a major bear market.
Now, let’s critique the trend line I drew.
Obviously, bears can find reasons to claim there’s too much upward slope. Bear in mind, though, that it can also be argued that it’s too conservative.
I had assumed that what we saw from stock prices in the late-1990s was an aberration having nothing at all to do with the underlying mega-trends. Suppose, though, that this is too harsh an assessment. There’s no law that says the trend line needs to be straight or constant. The latter part of the last century, starting especially in the 1980s and really picking up steam as the 1990s progressed, was marked by some very important changes: a spectacular advance in information technology with the average household coming to own and operate more technology than that which powered Fortune 500 companies just a few decades earlier, and a major geopolitical paradigm shift characterized by the spread and eventual dominance of market-based economics and among major nations, a continuing push toward democratization of political institutions. Neither development, especially the politics, has progressed as far yet as it may. But might it be argued that such changes as we were able to see justify an upward tilt to the more recent portion of my trend-line?
Let’s now give due consideration to some of the more important negatives. Clearly, it’s easy to delineate a list of reasons why the present is a terrible time to own stocks. The financial crisis is yet to be fully solved. International tensions persist with terrorism having supplanted super-power warfare as the main source of violence. We face huge environmental challenges. Global wealth distribution remains remarkably unequal. Etc., etc., etc.
I’m not going to try to refute such concerns. I couldn’t. They’re real and they’re serious. But, do they really indicate one should not own stocks now?
Let’s consider some historical context.
How about the financial crisis? Yes, it’s still worrisome. But is it worse than financial crises we already survived? How many families have had their life savings wiped out recently when they thought they were being prudent? I’m not talking about those who reached for performance by investing in exotic things. I’m talking about Joe Average who wanted nothing to do with financial risk and put everything in FDIC-insured bank products. They weren’t burned at all. But that wasn’t always the case. In fact, until the 1940s, bank failures and financial wipeouts not just for sophisticated performance seekers but even for Joe Average were quite normal. So as bad as things have been lately, we must still be doing something right in a big picture sense.
How about the environment? Yes, we have challenges. But how often do we, in the developed world, look at weather trends and say “Oh, oh, we may not have enough food for the winter. Will we survive?” Contrary to once-dire Malthusian predictions, we have enough food for everyone. Problems today reflect economic organization, which still needs repair in many parts of the world. But at least we’re making progress from the time, covering most of human history, when starvation simply reflected the absence of enough food. Ditto energy. We may be doing a lot of things wrong today, but this shouldn’t blind us to the fact that we’re also doing a lot of things right and are at least progressing in the right direction.
What about war? Is it generally assumed this is a bad thing? Of course. But that’s a very recent sentiment. For most of human history, violence among nations, tribes, or whatever, was considered normal at worst and often downright positive. We’re not where we ultimately want to be. But at least we’re moving in the right direction, and it’s only recently that we even bothered to figure out what the right direction is.
I could go on but this is not meant to be an orgy of bright-eyed rhetoric. Instead, it’s meant to shed light on the question: Is this a good time to invest?
Perhaps it isn’t. But then, when has there ever been a good time to invest? Can you name a single date at any time from the initial emergence of civilization through the present day when conditions truly were “right” for investing in economic ventures? I can’t. The nature of the problems change, but one way or another, they’re always there. (Go back to the late-1990s “positive” stock-price aberration. Do you remember what was happening then? The Clinton scandals, the Third-World meltdown; Long Term Capital Management; it was no picnic back then.)
When we really think about the big picture, we see there has never been a good time to invest. Yet somehow or other, economic progress persisted and presumably brought good things to those who invested or were able to invest in the economy, in whatever form that took in various places at various times. So the question of whether today is a good time to own stocks is, actually, irrelevant because the answer is no different than it’s ever been. Instead, we need to ask: Is the present a significantly worse time to own stocks than in the past. On this basis, the present may actually be OK or better.
Disclosure: No positions