Torture numbers, and they’ll confess to anything.
~Gregg Easterbrook
Update: This article was featured in the Carnival of Financial Planning 08-27-2010 posted at The Intelligent Speculator. Thanks!
I hadn’t planned on posting today since I’m supposed to be on vacation. But I saw an article last week that I just had to comment on, so I decided to put up a little Friday Food for Thought today. The article in question claimed to explain Why the Economy is Not Relevant to Investing.
Some of you will read that title and immediately decide that the premise is ridiculous. Still, if you’re as curious as I am, it’s just ridiculous enough to make you want to read what the author has to say. I’ve written before that economic information is like a financial weather forecast and I’ve done my best to articulate Why You Should Care about Economics. This article didn’t change my opinion on any of these issues.
My aim is not to discredit the author here. In fact, he is a CFP (Certified Financial Planner) and CFA (Certified Financial Accountant) and is therefore theoretically much more qualified than I to discuss these matters. I just want to point out the other side of the debate. After that, it is (as always) up to you to decide where you stand.
It’s the Economy, Stupid
This catch phrase from U.S. President Bill Clinton’s 1992 campaign has bubbled up in the headlines again as elections approach south of the border. Many believe that the state of the economy will determine which party is more successful this November. But does the economy have anything to do with stock market performance?
I’ll quote some of the arguments presented in the article in question and offer a brief rebuttal for each:
- “most investors buy and sell investments at the wrong times . . . because they base their decision on a mainly irrelevant factor – their outlook for the economy.”: I actually agree that many investors buy and sell at the wrong times, but I don’t think it’s because they’re using the economy as a guide. It’s usually because they are not following a robust trading system that includes a disciplined exit strategy – or because they are listening to people who tell them that buy and hold is the only intelligent investment strategy.
- Next, the author explains that “there are 2 main reasons why the economy is not really relevant to investing”:
1. “The stock market is the head and the economy is the tail.” The idea here is that “the stock market forecasts the economy, not the other way around.” On the contrary, history is replete with examples where the markets have gotten it wrong. Markets rallied hard from 2003 to 2007 even as the U.S. housing market was beginning to implode. Perhaps it could be argued that the bond market got it right, but the stock market was way off the mark. It didn’t correct until the financial system became crippled under the weight of loans supported by fantasies and fraud.
2. “Expectations of how the economy will perform are already built into the price of stocks.” Again, that may or may not be the case at any given moment, but it is not always, or even often, true. Further, “expectations” and reality often diverge quite radically as we have seen repeatedly over the course of history. Was the 2007 stock market pricing in the calamity that befell the economy in 2008?
- ‘A “double-dip recession” probably won’t happen this year. How do I know? Because the stock market went up last year!’ Setting aside the potential conflicts presented by someone who claims the economy is irrelevant making economic predictions, I can offer another reason why a double-dip recession won’t happen this year: The first recession never ended. The “recovery” that we’ve seen over the past year or two was the result of unprecedented government interventions whose effects are now fizzling. The stock market went up in 2007 too. The economy sank into a near-depression in 2008.
- “You can predict the stock market more accurately by simply always predicting it will go up!” Seriously? Here’s where the number torture comes in. The author says that “in the last 25 years, the Canadian and global stock markets have been up 76% of calendar years and the U.S. market has been up 72% of years.” The key here is to realize that he’s talking about the performance of calendar years in isolation. So any given up year may have been preceded by a year that was down enough that the market still does not recover its losses in the up year. That’s how the market can have very large moves over a decade and still end up nowhere at the end of it. (That’s called a secular bear market and that’s what we’ve got on our hands right now.)
David Rosenberg recently pointed out some of the reasons this type of thinking won’t work in today’s investing environment:
“What the bulls still refuse to see is that we are in an entirely new paradigm and that the old rules of thumb are rarely, or ever, going to be able to be relied upon, as was the case in the credit-expansion days of yore. There is simply too much debt overhanging the U.S. household balance sheet, the largest balance sheet on the planet. Despite the deleveraging efforts to date, the process of balance-sheet repair is still in its infancy”
I will grant that the stock market and the economy rarely move in lockstep. Economic information is definitely not the only information investors need to be successful, but to exclude it altogether is just foolhardy. I’ll leave it up to you to decide whether you want to trust your money to a professional adviser who tells you to ignore the economy based on arguments that are specious at best.
What’s your view? Is the economy irrelevant to your investing plans?
The economy is 100 percent irrelevant to my investing plans. The only parts of the article I read are the parts that were quoted here. From those, it does not sound like I generally agree with the article.
Economic productivity has been sufficiently strong in the United States to justify a long-term average return for stocks of 6.5 percent real for a long, long time now. The long-term return is obviously a lot less when you overpay for stocks and a lot more when you underpay. So that’s all I look at. If stocks are selling at prices that indicate a great long-term return, I go with stocks. If stocks are selling at prices that indicate a horrible long-term return (as has been the case from 1996 forward), I look for something that promises a better deal.
Looking at what is going on the economy is just a distraction, in my view. I think the author of the other article is right about that (although I think he is very mixed up in thinking that stocks always offer a strong long-term value proposition). The hard part of investing is tuning out all the distractions, all the noise. I would characterize economic developments as a distraction for investors. (they are of course important for us to follow as citizens — that’s something different).
Rob
Rob Bennett´s latest post ..Early Retirement Extreme Forum- Is Buy-and-Hold Just a Marketing Pitch
Your approach to value makes sense, but I still maintain that keeping your eye on longer term economic trends can help give you a rough idea of climates in which investors will tend to overpay for stocks.
For example, looking at the current leverage profile in the global economy it seems that equity valuations could go quite a bit lower from here. History (and common sense) show that’s what happens after a credit collapse. Investors can no longer borrow to invest, faith in the markets is shaken, and sellers outnumber buyers, at least for awhile.
[...] This post was mentioned on Twitter by 2 Cents, 2 Cents. 2 Cents said: Why the Economy Most Certainly IS Relevant to Investing http://goo.gl/fb/JzrrL [...]
The fact that there are groups of people tenaciously defending their predictions as to where we will be in the short term proves to me that no one knows! If there was a scientific way of coming out with an answer like 1+1=2, we would not see this division.
This division however is what makes up a market of buyers and sellers. So i will stick to my bet: sooner or later we will have to recover because we cannot afford not to. When speaking of recovery, I mean a return to economic growth, so obviously for me the economy matters since as buffet puts it:
“If the economy does well over a long period, markets will do well over a long period,”.
Mich@BeatingTheIndex´s latest post ..Stock Trades- Bought Delphi Energy TSE-DEE
I actually believe we will recover from all of this too. I’m just not sure I think it will happen as soon as you do. Government and central bank interventions helped cause this, and their attempts to fix it have only prolonged and exacerbated the problems.
It’s interesting that you quote Buffet as a supporter of the idea that the economy matters to stocks. The author of the article in question actually stated (in the comments section) that what makes Buffet so successful is the fact that he ignores the economy. Really? I’ve heard him speak many times about how he uses information from his retail and insurance businesses to gauge the investing climate.
I should hope the economy is of interest to anyone who buys and sells stocks. Check out the conference calls for any company you want to own. If the management team sees growth ahead, their’s is the only vote you require – not what the government wants you to think, or the economists, or even your financial advisor. Management is holding the order book. Yes, they usually tend to be more optimistic, but they don’t want to be caught lying to their investors, either. Only buy stocks for less than full value and when management is telling you they see company growth ahead. (N.B. some companies do better in poor economic conditions). One could argue it is really management’s perception of the economy and not the actual statistics that really matter, but perception stems from references about the state of the economy …
Excellent commentary Ian. Your point about investors buying and selling based on what management says was quite evident in the most recent earnings season. When CEOs were optimistic, buyers stepped in. When they weren’t, the company’s stock got clobbered. Whether their comments reflect economic conditions or cause them is a bit of a chicken/egg dilemma. I suspect they’re mutually dependent and that the stock market and the economy in general have a similar relationship.
I will take the middle ground. It certainly depends on your investment strategy. If you are a trader, I think the economy certainly can play a big role in some of your “speculations.” Things that are overvalued or undervalued affect your portfolio now. However, if you are a long-term investor and have a solid portfolio and don’t need your money soon, I think the economy typically has less to do with investing. You strategy could be the same and hopefully very profitable regardless of what the overall economy is doing IMHO.
Kind Regards,
Shawn
Great point about investing strategy. I do think that economic data can be less influential over very long periods of time, so if you are quite young, as I believe you are, it’s probably not as big a deal.
My point is simply that ignoring the economy altogether can be hazardous to your wealth – particularly at a secular turning point like the one I believe is playing out right now. The shifts from debt to savings, from risk to safety, and from a younger population to an aging one will change the investing landscape enough that those who are using the same strategies that worked in 1990 could be disappointed to find that they won’t work in this new normal.
[...] -Why the economy is most certainly related to investing @ BalanceJunkie -Money CAN buy you happiness @ GetRichSlowly -Facebook acquires Hot Potato then shuts it down @ Mashable -Location based alternatives @ TechCrunch -Intel’s McAfeee buy, an $11.5 billion waste? @ DailyFinance -School shows you how to be poor @ TheFinancialBlogger -Seeking solutions in an uncertain world @ ZeroHedge -Simplifying the financial reform blog @ TheBigPicture -How to pick your dividend stocks/funds @ TheDividendGuyBlog -8 dividend stocks delivering good news @ DividendsValue -The contango killing commodity ETF @ Wheredoesallmymoneygo [...]
I think that some investors read so much into the economic data and all of the noise from the media & economists that they end up making a broad assumption for themselves whic could lead to investing mistakes.
You mention that you believe we are at a secular turning point based on some high level macro indicators and changing world demographics.
The reality is that no one knows for sure what is going to happen in the future, for better or worse. That’s why we find comfort in looking to the past, so that we can at least try and make a reasonable decision.
For years experts preached that we need to invest in China for growth. Well, does that mean we purchase shares in a Chinese company that we’ve never heard of, just to get the foreign exposure? To me, I’d rather invest in a local company who exports to China, because I’m more likely to understand their business.
I’m not saying ignore the economy, but investors need to better understand the business and fundamentals of the companies they invest in more so than the overall direction of the economy.
Echo´s latest post ..What’s New Around The Blogosphere
The business and fundamentals of every company are inextricably linked to the economy. That’s why the entire market went down in 2008 when the macro picture turned bearish. Anyone who understood the leverage profile of the economy at the time would have lightened up on equities well ahead of time.
It’s funny how economic data is always referred to as noise as if it’s meaningless. The same could be said about fundamental company information. Ask 3 different analysts what they think the price of any stock should be and you’ll likely get 3 different opinions.
No one does know for sure what will happen, but you can look at what’s happening around you and make an educated guess. I’ll take that over an uneducated one any day.
Thanks for stopping by!
@ 2 Cents, thanks for the reply. I agree that the entire market went down in 2008 when the economy turned bearish. But then how do you explain the rally beginning in March 2009? If you continued to listen to the “noise”, you would continue to keep your money stuffed under your mattress rather than making a reasonable assumption that stocks were over-sold and under-valued. If you are waiting for the economy to improve before re-entering the market…are you still waiting?
As a dividend growth investor, I picked up many new positions back in May 2009. Even if we are in a secular bear market, and a new normal, I can feel comfortable in the fact that I entered the market during a great buying opportunity. And I will take comfort in the fact that even if the market goes sideways for ten years, I will have collected rising dividends that will most likely beat the market on yield alone. Yields which will almost certainly out-perform GIC’s and Bonds.
PS – I refer to the media and economist opinions as noise because you could have 10 experts giving 10 different opinions, so how do you filter that and form a reasonable opinion for yourself?
Echo
Echo´s latest post ..What’s New Around The Blogosphere
I would explain the rally beginning in 2009 as more of the same fluff and fumes that caused the crisis in the first place. Although the economy did improve for a few months, that improvement was based on stimulus measures backed by still more debt. It was not based on sustainable economic fundamentals. That’s why it’s now unraveling again. (See the latest jobless claims, Philly Fed, etc.)
I’m not necessarily waiting for the economy to improve to re-enter the market. What I am waiting for is a sign or two that the deleveraging process is at least past the fourth or fifth inning. If I miss a few rallies (even big ones) in the meantime, that’s OK by me.
I understand your strategy of picking stocks with rising dividends at depressed valuations and I don’t necessarily think it’s a bad one, especially if you are under 35. For my personal portfolio, I’m just more concerned about return of capital than return on capital right now.
I like the idea of blue chip dividend-payers, but I worry that if things really take a turn for the worse, they will get clobbered twice as hard if they need to cut their dividends – or even if the market thinks they might.
One more thing I might add is that position-sizing is always important. If your equity position is 70% or more of your total portfolio right now, I would call that risky. If you are younger, but as wary of the market as I am at the moment, one idea is to consider reducing your equity position to a level you are comfortable with. Better yet, use that money to pay down debt.
Not everyone will be as conservative as I am, and that’s OK. What sounds like noise for one person might be sound reasoning to another.
Thanks for sharing your thoughts. Well-presented opposing views are always welcome here!
Well, I think we can both agree that in times of uncertainty it is probably best to pay down debt than to get into anything too risky on the investment side.
Most of the corporate earnings increases have come from cost cutting and not from increased revenues, which is also cause for concern moving forward.
I’m really enjoying reading your blog.
Echo
[...] Cents presents Why the Economy Most Certainly IS Relevant to Investing posted at Balance Junkie, saying, “This article offers a rebuttal to a recent post claiming [...]