An Irrational Stock Market?

“Don’t let your ego get too close to your position, so if your position gets shot down, your ego doesn’t go with it.” – Colin Powell.

There are many reasons why managing your own investments is a daunting task. The biggest challenge isn’t the lack of expertise or time…those can be attained. The ultimate challenge is removing your emotions from your money and investments. If you associate success, self-worth, security and future well-being with the balance in your bank account, then you need to be aware of the emotional roller coaster you are on. That’s not even the worst of it all. If you make decisions influenced by these emotions, that’s when you get hurt. Your ego gets in the way and sometimes, what your ego asks you to do in the short term, isn’t necessarily in your best interest in the long run. Your ego should carefully be excluded from your critical thinking. Makes perfect sense and sounds easy to do, but even step one – identifying your ego – is a long process, let alone excluding it from important decision. So what can we put our trust in? Objective data. To find the right answers, one has to ask the right questions.

What are the most important and main macro drivers of capital markets? * Inflation (or deflation) * Economic growth or lack of it * Demographics (aging population) * Policy (FED – monetary and Congress – fiscal) * Trend (momentum) and prices * Sentiment (consumer and investor) * Debt burden (or lack of it) * Credit conditions * All of the above factors in international markets and geo-political conditions

Now clearly, getting into the details of all the above would be beyond the scope of this newsletter, but we can at least talk about the crème de la crème factors and decide for ourselves, whether or not there is more room for growth in stock values given we are at all-time highs. Ladies and gents, allow me to introduce: Inflation, the FED, credit conditions and the economy.

Inflation:

Research shows that, there is indeed a sweet spot for a market friendly inflation rate, which is somewhere between 1.5% and 2.5%.

Below 1.5%, the economy shows the signs of weakness and the risk of deflation becomes a reality. Here, probably the supply-demand balance is supply heavy. Above 2.5%, the economy starts heating up, borrowing rates start to climb, as a result the FED is pressured to raise rates to fight inflation and cool off the economy.

So in case of low inflation, excess supply slows down stock price appreciation. With high inflation, rising costs become the nemesis. A growing but not overly heated economy is where you want to be.

Current year over year inflation rate, (Consumer Price Index issued by the Bureaus of Labor Statistics) is 1.6%. Judging by weather related economic slow-down (more on this later) and its effects on inflation, high inflation is a low probability event for 2014, so you can add this as a plus.

Last note on inflation: low inflation also means low interest rates; low interest rates mean cheap money; cheap money means an investor friendly environment and relatively low fixed income (bonds) returns. When savings accounts and fixed income investors feel they are wasting time with low returns, they are forced to allocate a higher percentage to stocks. Even if these investors chose large dividend paying companies, this pushes valuation of these stocks higher, making growth stocks relatively cheaper and a preferable habitat for growth stocks as well.

The FED:

In a free market capitalist economy, there are two masters pulling the strings at the macro level: central banks (the FED) and law makers (the Congress). The FED controls monetary policies while Congress oversees fiscal policies. Together, they aim to provide just the right amount of incentives and limits to foster a healthy environment for economic growth and prosperity of all citizens.

The FED has more influence over the market in the short term. Easy monetary policies make it cheaper to borrow and invest, start or grow a business, refinance existing loans and stimulate the economy. Tighter monetary policies would reduce liquidity, raise interest rates and aim to cool off the economy.

Current FED policies are market friendly and accommodating (even with tapering = cutting bond purchases). Yes, the FED cut the amount of sugar but the candy jar is still out there kids. Just because it’s not all you can eat, doesn’t mean you are on a no-chocolate diet, so yes, add this on your list of pluses as well.

Credit/Lending Conditions:

Remember, we are going through the crème de la crème factors, so credit conditions are equally important and surprise: inter-related to the inflation rate and FED policies. Ever since societies evolved from a barter economy to transacting with the means of an exchange that today we call money, along came banks and credit. In a healthy and well-functioning economic system, banks serve as institutions that funnel savings into investments and support economic growth. Almost no business today can operate without the help of credit. How many people do you know who bought a house with no mortgage? This is all good and dandy but like most things, human greed and lack of regulations to control that, brought us to an abused and over used borrowing conditions, which popped in 2008. When the lending bubble burst, it created a below-the-means response, which meant that we went from extremely loose lending conditions, to an extremely tight lending zone. Tight lending conditions in a debt driven economy brings compressed economic growth. It is like having one foot on the gas pedal, one foot on the break. If I had more space, I would share with you charts showing the direct relation between lending conditions and market performance.

Today, we are back to less restrictive lending. We are nowhere near pre-2008 levels, but we don’t need to be. As I have noted earlier, we are in a low inflation, low interest rate environment and that’s a great place to start.

Businesses are awash with cash, which eventually would translate in to capital spending and hiring. One side note: one of the strong tailwinds of the stock market performance has been stock buybacks and mergers and acquisitions activity. So there isn’t much demand for business loans compared to previous recoveries, thanks to technological improvements and related efficiencies but that will change and when it does, we will find ourselves in an increasing demand for loans and banks eager to answer that call. If you were wondering, where the next waive for higher earnings will come from; this one will be a big help.

The Economy:

And last but not the least; the economy has to be in growth mode for stocks to appreciate. The only exception is when the economy is coming out of a recession as stocks are a discounting mechanism. In fact, this is when you get your best returns. Since we are almost five years past that point, without the economic growth, there is no tunnel or light. The most recent real economic growth rate is 2.4% during the last quarter of 2013. This is slow compared to 50 year averages of 3.5%. Add the weather related slow down, this quarter result will probably disappoint. Then why do stocks celebrate? The expectation is a strong recovery in the second half of the year. I wouldn’t be surprised with a 4% growth during the second half of the year, since we have started seeing over 4% growth rates, like 4.1% during third quarter 2013.

Now there is a lot that can go wrong. The market at an all-time high is challenging to maneuver as it is hard for investors to find bargains when there are so many eager sellers to cash in their gains. Secondly, geopolitical threats can throw a serious punch. Russia, luckily alone in the Ukraine crisis, is contained for now but there is no limit to what Putin can and will do once he takes his shirt off and gets on his high horse. Iran is on the back burner right now but Syria is still a boiling pot. Thirdly, European economies can surprise us to the downside. Current expectation for previously troubled economies is to start or speed up with their recovery and this expectation is priced in. What if they don’t deliver? Or conversely, what if the EURO over appreciates and creates headwinds?

IMF recently has issued a warning/recommendation to the European Central Bank President Draghi, to print more money. If they do, that would be a market positive move; if not, hard to tell at this point.

Coming off of a very strong year, being a second year in presidential cycle, right at all-time highs, corrections can be fast and furious, case in point the 6-8% waterfall decline that started on Jan 21st. The challenge this year and task at hand is to handle these corrections with your risk appetite and investment objectives in mind.

Summary:

In a low interest rate, low inflation, easy FED, loose credit and with growing economy, stock values tend to move towards the right top corner of your charts. Risks are plenty and corrections are expected but for the cool and collected longer term investor, this year may bring positive returns. Summary of summary: Markets are driven by fear and greed. Do you see more fear or greed out there? I see greed.

Disclosure The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.