From Contrary Investor
Discounting The Obvious Or The Oblivious?...But, as you know, discounting the future is what the equity market is all about. We thought it high time to take a little look back at the lessons of history in terms of market efficiency in the discounting process. As what may seem a somewhat haphazard generic statement, we are sincere believers that in most instances, the market "gets it right" in beginning to discount the future well in advance of that future reality actually playing out. Hence our affinity for the "contrary" in Contrary Investor. What follows is a pictorial look at market movements during various periods of earnings upheaval and perceptual change. This is also an instance where there is probably more "art" in interpretation of the charts and numbers than science. Let's have a go at it, shall we?
(NOTE: In the first three charts we plot the actual S&P 500 against the quarterly moving average of S&P earnings percentage change. The earnings data came from the Bob Shiller work. It was monthly data from which we created the moving average percentage change. In the final chart of the present market, we only had access to quarterly S&P earnings data. Quarterly percentage change in recent numbers is so great that we could not meaningfully smooth the data. Therefore we present the S&P earnings data in the final chart as actually reported. Mixing apples and oranges? Yes. But it is the relationship of market movement around earnings movement that we are trying to capture. The discounting process. Whether it is smoothed percentage change or actual reported numbers trends, we hope it captures the coincidental "relationship" movement. Just trying to be honest in describing what you will see.)
The first period under consideration is the 1970 through 1978 period. The oil crisis, recession, an extraordinary pickup in inflationary pressures, earnings pressures, a nifty-fifty mini or selective mania. What more could you ask for in terms of change with regard to which the market had to attempt to discount?
From what we see in the above chart, we'd have to give the market some pretty high marks for discounting efficiency relative to changes in corporate earnings as represented by the S&P 500. The market bottomed and turned up in late 1970/early 1971 prior to the upward turn in earnings. Subsequent peaks and troughs in earnings through the recession in 1974 were also anticipated pretty darn well. It is really only 1977 and 1978 where movements between earnings change and the market look a bit coincidental. Prior to that, the market seemed ahead of earnings change by a good six months. We'd have to describe this period has pretty highly efficient within the context of some very significant cyclical change.
What about the recessions of the early 1980's? You remember, back to back academic recessions at the point that really marked the launching pad for the current bull market (if that is still what we are experiencing, that is). The point where stock valuations were quite low. The point where the Fed was determined to break the back of inflationary expectations with whatever medicine was required. Reaganomics. Another period of substantial fundamental and perceptual change.
Once again, as you can see, between 1980 through 1985, the directional change in the market led the subsequent direction change in earnings by a good lead time. A period of significant fundamental change? You bet. A period also where the market did a pretty good job of anticipating that change in advance. A time when the words "Don't fight the tape" came in pretty handy.
And Now For Something Completely Different...To call the mid 1970's and early 1980's normal may not exactly be a correct characterization. For investors and society as a whole, it felt like anything but normal at the time. With clearly broad interpretation on our part, the efficiency with which the equity market discounted earnings change was normal. Close to right on the money in looking at the patterns of direction change above. It is our contention that during periods of extraordinary market activity, activity that can be considered extreme from a historical perspective, markets lose their ability to predict and anticipate with such efficiency as was seen in these examples. As you know, the 70's and 80's may have been considered extreme at the time, but for the most part valuations and historical market yardsticks were within the confines of what had been experienced up until those points. The definition of extreme is clearly in the eye of the beholder. Examples would be extremes in public participation, extremes in volatility, trading volume relative to absolute monetary factors such as GDP, etc. By their very nature, extremes are rare occurrences. A good number of standard deviations away from what would be considered acceptable under the proverbial bell curve of human experience.
Certainly the 1920's and 1930's US experience and the bubble environment from which we are currently trying to descend have been the two periods of extremes witnessed in financial history of the past century. Extremes in valuation, sentiment, volume, participation, volatility, you name it. So what about the efficiency of market discounting during these periods? Again with the acknowledgement of this being interpretive art as opposed to science, we believe the efficiency breaks down:
The peak in the quarterly moving average rate of change in earnings came well before the final market peak in 1929. Likewise, the bottom in earnings deceleration came well before the final stock market price bottom. Years ahead, in fact. During this period, it seems the discounting efficiency of the macro market was turned on its head. Change in the direction of earnings led change in market price. Most pronounced, of course, after the mania peak.
Will it be so again today? Of course the story remains to be told ahead, but we would attribute the experience of earnings leading the stock market in the post bubble 1920/30 period as being the result of the process of confidence destruction necessary for the ultimate reconciliation of mania or bubble financial and economic conditions. The evolution in short term human decision making from blind greed to blind fear.
As we mentioned earlier, the following graph is a bit different from the representations above as you will see actual reported S&P quarterly earnings plotted against the index price level itself.
As you can see in the above, from 1995 to late 1998, the year over year rate of change in S&P quarterly earnings was essentially flat. S&P earnings came in within a a very tight absolute band over those years. As you know, the index itself doubled over that time. Sheer multiple expansion. As monetary accommodation really hit full stride in late 1989, both the stock market and the real economy (S&P earnings) were the beneficiaries of liquid intoxication. Earnings growth accelerated as tech driven capital spending took off. In like manner, the S&P index was on its way higher as well, anticipating the upswing in corporate profitability supported by the liquidity so generously supplied to the financial system. It is at the top in early 2000 where coincidental movement begins to reveal itself. The market may be looking ahead, but it has not seen the earnings downturn to come within twelve short months. A flattening in earnings growth and a flattening in equity prices. In coincident fashion, it is once the earnings deceleration becomes apparent that stock prices begin to significantly react to the information.
The experience of the S&P may be different than that of the NASDAQ. We just could not come up with the quarterly NASDAQ data to plot the figure. Moreover, NASDAQ earnings would have been heavily negatively influenced by many non-profitable dotcom and tech/telecom companies.
As we have mentioned, how the final act plays out in the current drama remains to be seen. From the lows of March/April of this year, the bullish battle cry has been that the market is anticipating a earnings turn to come. So far, we have no justification in the current numbers to believe that the turn will come any time soon. The economy and corporate earnings continue to decelerate as we speak. In the same breath, we have to be mindful of what the market is saying at all times. As you know, as we have mentioned ad infinitum, we need to remain multidisciplinary in our approach to the financial markets. The fundamentals married with the charts. Weighing and integrating the messages of each. What we personally conclude about the current environment is that much like the 1920/30 period, any near term discounting efficiency of the financial markets in terms of predicting an economic turn must be viewed with a good deal of skepticism and questioning of the facts. Strictly because of the bubble or mania environment from which we have just emerged. Bear markets are characteristically punctuated by significant rallies that can be mistaken for the act of discounting or anticipation. Eventually a rally will be correct. But, in the meantime, blindly assuming any rally represents correct discounting or anticipation can be an extremely expensive pastime. Our humble suggestion: Marry the numbers to the pictures. "Don't Fight The Fed" and "Don't Fight The Tape" are usually sound pieces of advice...except outside of the warmth and comfort of the normal bell curve distribution of financial history. Don't stay disciplined, stay multi-disciplined. |
