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Voting Machine vs. Weighing Machine Revisited

There’s an old Wall Street aphorism claiming that in the long run the stock market is a weighing machine; in the short run, a voting machine. This dynamic has been playing out in spades over the past several weeks. The longstanding and still growing domestic and global debt problems are well known and well publicized. Geopolitical problems in the Middle East and Northern Africa have been long-festering and recently have burst into flames. The earthquake and tsunami tragedy in Japan with its uncertain nuclear and financial consequences is a newcomer to the list of fundamental concerns.

On the bullish side, the Federal Reserve’s fire hose of liquidity persists. In response our economy continues its recovery, and corporate profits continue to surge. Last week’s stock market rally shows that investors and traders are clearly concentrating on the bullish conditions.

Changing market patterns are complicating investment analysis. For many reasons, stock market volume remains at levels far below those of just a few years ago. And the bulk (60% estimate) of even that reduced volume is coming from recently introduced high frequency trading with time frames measured in seconds rather than hours, months or years. The dominant force in the markets today is the trading community, not the investment community.

Most equity owners consider themselves investors, not traders. When price trends continue long enough, however, most investors morph inadvertently into traders. They tend to perceive a correlation between those price trends and the most believable fundamental stories. When stocks rally for two years, as they have since early 2009, it is easy to believe the bullish explanations. Conversely, while stocks were plummeting for years in the past decade, bearish stories seemed more logical. Both positive and negative circumstances exist in both bull and bear markets. We simply allow price direction to identify those to which we pay most attention. If price patterns persevere long enough, we make the assumption that conditions justifying that directional move are the critical variables. The longer the rally or decline persists, the more investors tend to vote with the trend. Sentiment surveys show clearly that investors are most bullish at market peaks and most bearish at market bottoms. That behavior poses a potential problem for market participants today, because the unanimity of bullish opinion resembles that at the 2007 market peak.

The dominance of traders over investors in today’s markets adds a level of complexity to the investment equation. The criteria that most motivate traders, not least of which is momentum, may offer investors no insight into the most relevant fundamental conditions. In fact, price momentum tends to mislead with respect to the single most relevant long-term consideration for true investors˗˗valuation.

Training, discipline and a willingness not to be swayed by the power of price moves differentiate investors from traders. Very few traders have been successful over the long run. The majority of truly successful investors are those who pay far more attention to the weighing machine than to the voting machine.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.