The Message of the Markets: Wrong at Turning Points

I have said in the past to "Beware the Economist who is seeking guidance from the stock market as to the state of the economy. These creatures make lousy economists and worse money managers."

Jim Welch takes this a step further, explaining the "message of the markets:"

Over the many years I have been following and learning about the economy and financial markets, I have heard comments used repeatedly by presumably knowledgeable experts as they discuss various markets. People will say the markets are a discounting mechanism, and that markets anticipate events, as when stocks bottom before an economic recovery. Some people will go so far as saying that a particular market is telling us a specific outcome is coming based on how that market is trading.

After listening to these comments when I was younger, I too believed that “markets” were indeed imbued with a special instinct about the future. If I could just learn to listen to them, I would learn something I wouldn’t get out of a financial newspaper or research report. One of the CNBC anchors has even published a book entitled “The Message of the Markets”. Of course, the message is always clearer with the benefit of hindsight. I know I would have done better in school, if I could have just taken all those tests, after having already taken them once!

In 1982, the stock market had spent 16 years going nowhere, which prompted Business Week to publish a cover story entitled “The Death of Equities.” Somehow they didn’t get the market’s message that a 1,200% increase in 18 years was about to commence. When the stock market crashed 22% in one day in 1987, almost double the decline on Black Tuesday in 1929, was the market telegraphing a coming depression? And when the Nasdaq zoomed past 5000 in 2000, was it proclaiming that we had arrived in a “New Paradigm” Paradise? A list of examples showing that markets are always wrong at important turning points could be a very long list.

Needless to say, I don’t subscribe to the notion that markets ‘know’ much about the future. Markets are a reflection of recent trends and what a majority of investors have come to believe at that moment, in response to the recent trend. And, when a majority of investors are fairly certain of an outcome, the probabilities rise that something other than what is expected is likely to occur.

(emphasis added)

-E. James Welsh

We have said this previously, but it bears repeating: The crowd is right much of the time. However, the crowd can easily become an unthinking mob. They tend to be wrong at the worst possible moment, most especially at turning points.

Good stuff. Thanks, Jim.

Comments

[NO DooDahs:]

How about "beware the advice of an economist when you're trying to trade profitably?"

2007 Jan 25 10:06 AM

[Walter Morton:]

So where does that leave you? All I can think to do is invest in companies that are making a profit, whose business is growing, and who have good management and hope that eventually the value will be reflected in price. What more can you really do?

2007 Jan 25 12:52 PM

[NO DooDahs:]

This post has a partially complete list of known stock market "anomalies."

www.billakanodoodahs.c.../

You are correct that profit growth is "a" key, but it is not the "only" one. Earnings quality, relative valuations, relative price strength, mean reversion, margin growth, and trading characteristics like low float and high short days to cover can all be used to find good stocks to hold, even for long periods. Several of those traits, like earnings quality and margin/profit growth, are really the only way the retail investor has to evaluate management. Let's face it, they're not gonna sit down for you & I to inverview them.

Back to economists - name a wealthy one (other than one that worked for the Fed and is now on the speaker circuit). Now name a bullish one. One can find times when the general market indices followed the economy and one can find times when the general market indices led the economy, but EVEN WHEN THE ECONOMY WAS "BAD" one could always find some stocks worth buying.

Check this out:
aaii.com/stockscreens/...
Literally dozens of long-only stock screening strategies, almost all of which outperformed the general market indices over the last nine years. You'll find that Graham's "Enterprising Investor" strategy would have doubled your money during the recent Bear years, while the indices were getting chopped off at the knees and some economists were, well, let's just say they weren't bullish on equities.

Cheers!

2007 Jan 25 01:56 PM

[Panskeptic:]

Actually John Meynard Keynes did very well, with both other people's money and his own.

Sorry.

2007 Jan 25 07:13 PM

[Panskeptic:]

<i>This is from Wikipedia, whose spellchecker works better than mine.</i>

John Maynard Keynes' brilliant record as a stock investor is demonstrated by the publicly available data of a fund he managed on behalf of King's College, Cambridge.

From 1928 to 1945, despite taking a massive hit during the Stock Market Crash of 1929, Keynes' fund produced a very strong average increase of 13.2% compared with the general market in the United Kingdom declining by an average 0.5% per annum.

The approach generally adopted by Keynes with his investments he summarized accordingly:

1. A careful selection of a few investments having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
2. A steadfast holding of these fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchases on a mistake, and;
3. A balanced investment position, i.e. a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g. a holding of gold shares among other equities, since they are likely to move in opposite directions when there are general fluctuations).

Keynes argued that "It is a mistake to think one limits one's risks by spreading too much between enterprises about which one knows little and has no reason for special confidence ... One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself to put full confidence."

Keynes' advice on speculation, some might say, is timeless:

"[Investment is] intolerably boring and over-exacting to any one who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll."

When reviewing an important early work on equities investments, Keynes argued that "Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest operating in favor of a sound industrial investment."

2007 Jan 25 10:34 PM