The good news, is that I continue to see regular (less frequent that 2 years ago for sure) predictions that the financial world is about to go into a meltdown along with Japanese nuclear reactors. Good news because if everyone were seeing the global economy through rose coloured glasses, the end would be nigh.
I’ve been arguing (borderline ‘nagging’) that investors shouldn’t equate volatility with market anxiety (as the press will do) but would be wise to consider sector rotation, portfolio rebalancing or whatever you want to call it as the primary cause of the ups and downs of late. Read some of my prior commentaries to get a sense of what I’m driving at. Yes we are inundated with risk, but I’ll get to that in a moment.
I spent some time in my new book “A Maverick Investor’s Guidebook” on supply and demand. Laymen don’t think about what really drives stock prices. A company’s stock doesn’t go up because it’s making tons of money, although this may factor into people’s thinking about why to buy. All prices (of anything) go up because someone wants to buy it enough to pay more. If there are more sellers than buyers, prices go down. I dug up this graph to illustrate this point. It’s mutual fund sales (Canadian data but works in U.S. too) over a period of time.
Even after the data is adjusted for seasonality, the rather obvious spikes occur during March to May every year. More money (big fund company & bank campaigns to encourage saving) is flowing into markets and hence the adage ‘sell in May and go away;’ often preached but seldom practiced. Demand rises for securities (money flows into funds and into stocks and bonds) and since supply is pretty much constant then prices generally rise every time, and the same time every year. So, there are two major things to think about.
1) Getting horny about investing in the stock market (or getting more aggressive) at this time of year means you’re betting against this seasonal pattern. Don’t get angry at yourself. Everyone does it and it takes many years of practice to NOT do it. Perhaps much wiser to be less aggressive.
2) This is a short term periodic phenomenon (a few months is not a long time). What about the bigger picture?
Concerning number 2, didn’t we (again, consult my previous commentaries) already have the global meltdown? Some folks are just slow to catch on. A long term (say at least another 3 to 5 years) period of prosperity has only just begun. Despite this fact there are always disruptions to financial markets whether caused by natural disasters (earthquakes) or temporary financial hurdles (Portugal etc.) It takes only a modicum of understanding about seasonality and business cycles to know markets don’t go in a straight line. Whether one does nothing when opportunities present themselves, or act is what differentiates good investment results or disappointing (even negative) returns.
There is uncertainty of course. Many weeks ago I suggested the very BIG unknown that cannot be forecast is whether enough or too much liquidity (low interest rates, other central bank tactics to get money into corporate and consumer hands and get it moving around) has been pumped into the global financial network.
The graph illustrates that a number of ‘normal’ relationships changed at the turn of the century. During the tech boom, the markets kept going higher (and the ‘earnings yield’ lower – earnings by companies in the market index divided by the rising price) even though interest rates went up and should have discouraged investors (irrational exhuberance according to Alan Greenspan at that time – or a ‘bubble’). Right now, the earnings yield for the S&P seems way too high (stocks aren’t expensive compared to what you can get in bonds) and no doubt it could be argued that interest rates are still way too low – especially if all that liquidity pumped into the global economy sparks inflation.
So far there’s no inflation – but who cares? It’s only future inflation (the unknown) that actually matters. Nevertheless, politicians will use current inflation (and unemployment) to argue that there is not too much liquidity. Economists will argue that monetary policy should look forward and at least begin raising rates to head off inflation. The economists may be right, but the truth is, politicians won’t react to data but would rather wait for a consensus.
So there’s a whole bunch of things then to consider:
– Sector rotation (rebalancing) might take the wind out of the sails of the Canadian ‘resource’ market which is a bit long in the tooth. Last week the TSX was net sloppy, while the broader NY Dow Jones industrial average and Nasdaq edged higher.
-Summer is coming, and the ‘demand’ from investors tends to be soft seasonally during the summer months.
-North America and Europe may be loathe to ‘tighten’ with benign inflation statistics but with China’s consumer inflation running at 5.4% (and rising) it could be China that gets that ball rolling and others will just have to play along. For the most part, the odds are elections will dampen the enthusiasm of governments to fight inflation for awhile yet.
To summarize, it’s pretty ordinary over the next few months to expect ‘a pause for the cause’ from the stock market. My own prediction (worth about as much as you’re paying for it) is that bond markets may ‘anticipate’ higher rates and sell off some, but history tells us central bankers will ignore the attempt by bond managers to coerce the banks into taking rates higher. Central banks will fight them and refuse to use monetary policy to slow the economy down. After the pause, it’s likely that an undervalued stock market (continued rising corporate earnings) will deliver good returns late summer and into the fall.