What’s Going On With The Markets?
In the past two months we’ve experienced one of the most volatile starts to a new investment year in history. Surely there must be a good reason why this is occurring. Is it a harbinger of a severe economic downturn? Recognition that stocks have been overvalued for years? A response to the fact that Donald Trump is the leading Republican candidate for the U.S. presidency?
The reality is that there are basically only two drivers of stock market performance: company fundamentals and investor sentiment. While that is simple enough to understand, it is impossibly difficult to utilize to predict future results.
Let’s start with a few facts about the economy. Retail sales rose 0.2% in January, the third consecutive month of gains. Excluding gas station sales (which dropped 3.1% due to lower oil prices), retail sales have risen seven months in a row and are up 4.5% from a year ago. In 2015, hourly earnings rose 2.7%, initial jobless claims remained below 300,000, the unemployment rate dropped to 4.9%, and full-time employment has grown by 2.5 million jobs. So it would be hard to argue that we are facing an imminent slowdown, at least in the U.S.
What about the drop in oil prices? Does that signify a slowdown in demand as a precursor to a global economic recession? Not according to researchers at Dimensional Fund Advisors, who analyzed demand and supply and concluded that “since 2010…the noticeable increase in production, only partially offset by a decrease in imports, has been the catalyst for increased crude oil inventories.”
However, as I’ve written before, there is little correlation between economic growth and stock price movements. That’s because it’s not the economy that boosts prices but rather the expectation of future company performance. And when you consider all the non-economic factors that contribute to a company’s success, logically the economic piece should not have the greatest impact.
What about the fact that stocks are currently highly valued based on historical averages? The most successful predictor of stock price growth has been shown to be company earnings growth, not current prices. The value of a stock at any given time is what the market, with its millions of buyers and sellers, decides it should be. That’s pretty hard to argue with. Of course, if the current price assumes a high degree of future earnings growth, and company performance begins to falter, its stock price will inevitably drop. But again, that’s not a function of price as much as of company fundamentals.
How are companies doing right now? With one big exception – the energy sector – earnings are relatively stable. And since energy accounts for less than 6% of GDP, why are markets so volatile? If it’s not fundamentals, it has to be the other factor: investor sentiment. And that’s even harder to predict.
What makes a herd of charging buffalo suddenly change direction? Is it one buffalo that senses danger and veers away from it? Is each buffalo looking to others for direction? Whatever the reason, investor sentiment definitely reflects a herd mentality. Take the situation right now. Low oil prices are considered bad. Fed rate hikes are considered bad. There’s a general fear throughout the investment community as reflected by surveys and by the strongest measure, price/earnings ratios. Why? The economy is doing fine, inflation is positive but within the Fed’s 2% target, U.S. monetary policy is still expansionist, there are no serious trade constraints. Trying to predict when the herd will turn and in which direction is much harder than winning the lottery.
Even though at a high level we can break down market performance into two primary contributing factors, it is impossible to predict where either one is heading. So why waste time trying? It’s better to create an investment strategy that is well-diversified and focused on achieving your own future goals. With an approach like that, you won’t need to worry about what the herd is doing.