This Bull Has (Had) Legs !

Quite a while ago, I had an interesting conversation with a smart fundie manager. We had opposing views about many things. In particular, we disagreed upon was the value of (non-price) sentiment indicators.

His argument was that when stocks get cheap enough — as reflected in their Prices, P/Es and cash flow measures — other indicators don’t matter. One can detect extreme sentiment by how under- (or over-) valued stocks are. By definition, value investors are not believers in the Efficient Market Hypothesis. Long time readers know that neither am I.

My sentiment counter arguments: At the time of our discussion in early 2007, the Home Builders and Banks had looked very cheap on P/E basis alone, while Google and Apple looked pricey on the same basis. That was a direct assault on P/E as a valuable indicator, at least as a stand alone metric. (Good thing he didn’t like the banks for other reasons).

But it was the sentiment issue that was the most interesting part of our friendly debate. I was challenged to identify a magazine cover or Page 1 newspaper story that was a contrary indicator in real time. A few weeks after that friendly wager was made, the WSJ had a page one article titled, Why Market Optimists Say This Bull Has Legs.

That was May 23, 2007, exactly one year ago today.

On that very same day, I posted this: Uh-Oh: Front Page WSJ “Why Market Optimists Say This Bull Has Legs”. Specifically, I wrote:

Today’s WSJ has a very bullish, front page article on the current Bull market lasting another decade or so. In the past, that has operated as a bit of a warning sign that an intermediate top was nearing.

That turned out to be a fairly timely warning. At the time of the WSJ article, the major indices stood as follows:

Standard & Poor’s 500-stock index 1524.12
Dow industrials 13539.95
Nasdaq Composite Index 2588.02

Markets sold off a few months later, making a low in August, rallied to new all time highs in october, and have since made new lows in January and March, prior to rallying about 10% off of those lows.

Now, one full year later, we can review each of these indices It turns out they are substantially lower: The Dow at 12625.62 is nearly 1,000 points lower; Nasdaq at 2464.58 is about 125 points lower; the S&P 500 at 1394.35 is ~130 points below.

That’s a 5-10% drop, versus a risk free 4.87% yield on the 10 year. That’s before substantial gains from bonds, which rallied in the face of aggressive Fed cuts.

While this does not conclusively prove the utility of the Cover indicator, I believe it certainly is a bit of weight in is favor.

>

Previously:
Uh-Oh: Front Page WSJ “Why Market Optimists Say This Bull Has Legs”
http://bigpicture.typepad.com/comments/2007/05/uhoh_front_page.html

Sources:
Why Market Optimists Say This Bull Has Legs
They See Decade of Gain Fed by Global Growth; Skeptics Cite Big Doubts
E.S. BROWNING
WSJ, May 23, 2007; Page A1
http://online.wsj.com/article/SB117985628323111066.htm

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Discussions found on the web:
  1. Roman commented on May 23

    Question: If markets are so inneffecient, why is it so hard to beat the market over the longterm?

  2. Barry Ritholtz commented on May 23

    Roman,

    Your question is somewhat off the main point, but let me see if this clarifies the issue for you:

    1. Markets aren’t horrifically inefficient — they are just not as perfectly efficient as academics have theorized. This means that opportunities exist.

    2. Emotions, Impatience, Human foibles and imperfections are why most people — individuals and professionals alike — underperform

    3. Because of #2 above, I have long argued that most individuals are better off dollar cost averaging into several different index funds.

  3. Philippe commented on May 23

    The financial markets are meeting with the definition of efficiency under a parody

    1 No one can be made better off..…(Actually financial markets have met with these conditions by all means and since all times) does it make them efficient under this metric? Does it make them efficient with the benefit of insight ?

    2 Should their inputs be a correct and expedient reading of financial situations their markets would never have to tank as prices would be adjusted without delay and without large losses for the system.

    3 To be read in accordance with management constraints (not relevant)

    My conclusion remains the same; the concept of efficiency (prices and profit forward looking) is quiet dubious when applied to the financial systems (their priorities are and can be driven independently of the public time factor) and is more straightforward when applied to the industries.

    Hoping that it makes sense

    ~~~

    BR: Nope

  4. Jim Haygood commented on May 23

    My theorem is that all markets are driven about half by fundamental (value) factors, and about half by sentiment (the psychology of the buyers and sellers).

    Take any set of extreme value stocks and divide them into two groups: those which have risen in the last six months, and those which have fallen over the last six months. The ones which are ALREADY rising will tend to outperform those which are still falling and haven’t turned around yet.

    It ought to be stone obvious that ALL information is important: value; sentiment; intermarket; even (occasionallly) political and cultural information. Economics (except for behavioral economics) excludes sentiment, simply because it is notoriously hard to measure. Doesn’t mean that it’s not important, though.

    To claim that only hard value numbers matter is reactionary and purblind. Such an individual is a candidate for involuntary intellectual bankruptcy, initiated by his offended peers. Take the diplomas off the wall, stack them on your desk, and back away slowly with your hands up. We’re here to help.

  5. Jay Weinstein commented on May 23

    In order to prove the value of your indicator, BR, you would need to do a study including a very large sample of covers and a rigorous method of evaluating whether they were in fact contrary indicators. I am not saying it cannot be true, but you cannot take a handful of anecdotes and extrapolate some value from it. No one ever talks about a magazine cover that gets it right.

    Much of what passes for “analysis” in this business is in fact statistically invalid crap. Anything to do with the “presidential cycle” comes to mind. In my view, technical analysis falls here too, though many on this site would disagree.

    And look how bad government statistics are–I think much of BR’s blog reputation has been built on exposing just that. I know that’s what hooked me.

    With regard to your fundamental-based friend. It has been my experience that different metrics work better for different industries. P/E tends to be poor for finance and cyclicals [i.e. homebuilders]–book value ratios tend to work much better there for example.

    Inflexibility of analysis is just asking for death in the investment business.

    Regards to all..

  6. gianluca carrera commented on May 23

    I am with you, market are not efficient. I tend to support Soro’s broader view on reflexivity. I think he as a point there, and can’t understand how lots of people haven’t figured it out. It doesn’t apply 100% of times, and it is not a science, but I think as a framework, it has legs ;-)

  7. Gavin commented on May 23

    I would say that markets are efficient at the micro-level but not efficient at the macro-level.

    It is very unlikely that GM stock is priced incorrectly when compared with Ford. Arbitrageurs can easily short one car marker and buy shares of the other car marker and be market neutral.

    However if stocks are overpriced when compared with bonds sophisticated investors cannot push values back to their fundamentals

  8. Toro commented on May 23

    The problems with using specific sentiment indicators in the popular press is that there are often many other preceding indicators that were not the top. There were all sorts of anecdotes before the housing bubble and the tech bubbles crashed two and three years before their ultimate blow-off tops.

    I also think the valuation v sentiment debate depends on the time frame. Valuation will always bail you out in the long-run (assuming the asset is truly undervalued and not a value trap) but valuation means almost nothing in the short-term. In the near-term, sentiment matters most. In the long-term, economics matters most.

    T.

  9. heather commented on May 23

    The cover of Sports Illustrated is also presumed to be a contraty indicator, or in common parlance, a “curse”. The curse is accepted widely enought to merit a Wikipedia entry, which proffers a (non-sports-specific) explanation: regression to the mean.

    http://en.wikipedia.org/wiki/Sports_Illustrated_Cover_Jinx

  10. tranchefoot commented on May 23

    I don’t know, Barry, still sounds like the confirmation bias in action.

  11. W P Gardner commented on May 23

    I think that E. S. Browning at the WSJ has a long track record of bad calls. I work in the tech industry and in early 2000 I only owned tech stocks. I was looking for something to diversify into. In February or early March 2000 E. S. Browning had a big article on how Warren Buffett had totally missed the tech boom and Berkshire Hathaway was doing badly. I bought Berkshire Hathaway as a result of this article (which I thought was dumb). Six months later it was the only thing I had a gain on. Browning’s article came within a month or two of the tech crash in late March 2000. I have the article at home somewhere and I can get the precise citation for you if you want. E. S. Browning has since then become a kind of joke to me. I am not even sure E. S. Browning is a real person; he/she may be a group pseudonym, like Nicolas Bourbaki.

  12. DL commented on May 23

    Don’t overlook the February 19, 2007 Edition of Business week. The cover story was:

    “It’s A Low, Low, Low, Low-Rate World”

    Consider what’s happened to the price and availability of credit since then.

    . . . .

    The question du jour would be, at what point does all the obsession in the media about oil prices signal a top in the oil market? (I don’t know, but I don’t think we’re there yet).

    ~~~

    Overlook it? We discussed it extensively!

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