How to Tell the Bulls From the Bears
The same set of facts and events can be seen in very different ways.
Bloomberg, October 27, 2017
What’s driving the stock-market rally? How you answer that question determines if you are a bull or a bear.
I have been thinking about this for some time. Regular readers know I am in the bull column, and have been for some time — but only up to a point.
I credit the factors discussed below as key drivers of the bull market. I present them here in what I believe is their order of significance. You may come up with a different list of drivers, or simply a different order. If your order is the opposite of mine, then you might be more bearish than I am.
Global economic expansion: The worst financial crisis since the Great Depression is now almost a decade behind us. It has been a slow painful recovery, but we are now getting to the point where emergency policies are being removed. Monetary policy is being normalized; growth, employment and wages are mostly solid. This is the broadest context, and a great source of strength, for the gains in stocks.
Earnings: Corporate profits are a key underlying driver of stock prices. Say what you will about everything else, corporate earnings have improved in the U.S. and are recovering in emerging markets, Europe and Japan. All other things being equal, rising earnings typically lead to rising equity prices.
Sentiment: For a long time this bull market was the most hated rally in Wall Street history. That is no longer the case. Individual investors are back, mainly via indexing. This can lead to multiple expansion, or higher price-to-earnings ratios, which helps sustain a bull rally. As an example, multiple expansion accounted for about 75 percent of the bull-market gains from 1982 to 2000.
Terrible headlines and news: Whenever I am asked why markets are going higher, despite the parade of terrible news, my standard response is “News is mostly irrelevant.” Why?
- News is old. Very little is genuinely unknown or is surprising;
- Headline risk still exists, but it always exists — it’s not specific to this rally;
- You are predisposed to notice bad news — evolution has shaped your cognitive functions to look for threats to your survival. Good news is mostly ignored;
- News creates the infamous wall of worry that markets climb (i.e., creates buyers and sellers);
- Bad news is, for the most part, is already reflected in stock prices.
Note that terrible headlines do provide emotional support for bearishness.
Monetary policy: Central bank asset purchases and zero interests are ending — yet markets are still rising. This refutes the claim that the rally is exclusively the result of actions by the Federal Reserve.
Capitulation: Markets that get cut in half, as they did in 2008-09, create a reset that tees up the next secular market. It may be brutal for bulls while it’s happening, but once it has been overcome, it provides an underlying support for future gains.
Recovery from the credit crisis: I have been urging readers to stop using the usual recovery from recessions as a frame of reference. Instead, understand that recoveries from deep financial crises, as Carmen Reinhart and Ken Rogoff wrote, are quantitatively and qualitatively different. Long and slow recoveries from crises are normal, and the one we are experiencing presently is very typical.
Valuation: Markets have rallied in anticipation of those rising earnings — and then some. By most reasonable measures, U.S. stocks are either expensive or very expensive. But that doesn’t mean the market stops going higher — it only means we are borrowing some gains from the future. Thus, investors should lower their expectations for future returns but not assume the rally will stop because of valuation concerns. The 1970s taught us that cheap stocks can get cheaper; the 1990s taught us expensive stocks can get more expensive.
FAANG, bitcoin, speculative excess: In other words, Facebook Inc., Amazon.com Inc., Apple Inc., Netflix Inc. and Google (Alphabet Inc.). So much of the market’s gains are accounted for by these five stocks (along with Microsoft Inc. and Paypal Holdings Inc.), that it raises some valid concerns that speculation has run amok. My Bloomberg Gadfly colleague Stephen Gandel pointed out that dot-com stocks rose 680 percent from early 1996 to the peak in March 2000. Bitcoin has risen 825 percent in past year alone. However, the excesses seem to be confined to specific corners of the market.
Fiscal policy: Tax reform! Deregulation! Overseas profits being repatriated! This is perhaps the weakest argument for the rally. It isn’t persuasive for the simple reason that overseas markets have outperformed U.S. markets since the November 2016 election.
Let’s stop there. We could keep going, but the main idea is that you probably can find an explanation to support whatever your views are, bullish or bearish, in each of the situations above. Experience informs us that people become bullish or bearish after they make a purchase or sale. In other words, our beliefs typically are a consequence of what we just did with our investments.
What do you think is driving markets?
Originally: How to Tell the Bulls From the Bears
