I have now been writing for well over a decade on Seeking Alpha. And, during that time, I have tried to enlighten readers as to how I see the market machinations take shape, especially as compared to the common views held by most market participants. So, there's large body of work I have compiled and written on this topic.
This week, I'm taking the opportunity to compile it all into a three-article series. So, please do bear with me as I'm going to be presenting you with a lot of information, most of which has been culled from my many articles and my recent keynote address at the Las Vegas MoneyShow convention. After I complete that presentation, I will provide you with my thoughts on an “impending recession.”
I want to begin by explaining that much of what you have been taught regarding the market is likely false. I know that's quite a bold statement to make, but I can back it up with examples, market research, and market history.
You see, just as many of you have done, I began my investing career on the fundamentals side of the market. For those who may not know my background, allow me to explain the qualifications with which I initially approached the markets. I graduated college with a dual major in both economics and accounting. I went on to pass all four parts of the CPA exam in one sitting, something that only 2% of those taking the exam are able to achieve. I then went on to complete law school in two and a half years, and graduated cum laude and in the top 5% of my class. I then went on to NYU for a Master of Law in taxation. I became a partner and national director at a major national firm at a very young age, where I worked to organize very large transactions. So, when I tell you that I understand the fundamentals of economics, business, and balance sheets, you can believe me.
Yet, when I approached investing in the market with all this background of understanding businesses, economics and balance sheets, I was no better than the average investor, and sometimes even worse. It was not until I learned more about the psychology of the market that I began to learn how to maintain on the correct side of the market the great majority of the time. In effect, I had to ignore everything I learned about economics, businesses and balance sheets, and predominantly focus upon investor psychology in order to make more sense of the general market action.
As Yoda once said, “You must unlearn what you have learned.”
And many of my money manager clients with similar backgrounds have noted the same. In fact, one of my money manager clients noted this about his CFA designation just a few days ago:
“I am actually quite happy that I did it as it has helped me in my professional career. As for making investment/trading decisions, I would have been better off without it.”
Since most of the investing world still predominantly (or even solely) uses fundamental analysis, I'm certain that most reading my articles are quite sure that economic news or stock earnings are what drive the stock market. And, the reason you believe it so strongly is because this is what you have been told for years by the “stupid box,” which was a name that one of my older relatives gave to the television when I was a young lad. As an aside, I wonder what he would have thought of social media today? But, I digress.
I apologize in advance if I'm going to push you to think beyond your black and white perceptions about the stock market, which many of you may have gleaned from that stupid box. So, to begin, allow me to further digress and provide a bit of illumination as to how your mind works, based upon the perspective of Nobel Award winning psychologist Daniel Kahneman.
Kahneman outlines that we have a puzzling limitation within our minds which is due to an “excessive confidence in what we believe we know, and our apparent inability to acknowledge the full extent of our ignorance and uncertainty of the world we live in. We are prone to overestimate how much we understand about the world . . overconfidence is fed by the illusory certainty of hindsight.”
As Arnold Wood, President and CEO of Martingale Asset Management noted:
“[p]eople tend to repeat the same errors in judgment day in and day out, and not only do they do it with predictability, they do it with confidence.”
As Amos Tversky, who worked extensively with Kahneman, once noted:
“Study after study indicates, however, that people judgments are often erroneous – and in a very predictable way. People are generally overconfident. They acquire too much confidence from the information that is available to them, and they think they are right much more often than they actually are.”
And, as Wener F.N. De Bondt, Frank Garner Professor of Investment Management at University of Wisconsin-Madison noted:
“People have an enormous capacity to rationalize facts and fit them into a pre-existing belief system.”
I think Ben Franklin also noted this many years before when he said:
”So convenient a thing it is to be a reasonable creature, since it enables one to find or to make a reason for everything one has a mind to do.”
What makes this worse is that our minds engage in an automatic search for causality for our erroneous beliefs. According to Kahneman, there's evidence that we are born prepared to make intentional attributions within what he called “positive test strategy.”
“Contrary to the rules of philosophers of science, who advise testing hypotheses by trying to refute them, people seek data that are likely to be compatible with the beliefs they currently hold. The confirmatory bias [of our minds] favors uncritical acceptance of suggestions and exaggerations of the likelihood of extreme and improbable events . . . (our minds are) not prone to doubt. It suppresses ambiguity and spontaneously constructs stories that are as coherent as possible.”
And, finally, as Daniel Crosby, the author of The Behavioral Investor noted:
“Storytelling bypasses many of the critical filters we apply to other forms of information gathering . . . For this reason, stories are the enemy of the behavioral investor.”
So, with the latest understanding of human psychology, let’s look at the common stories told to us on that “stupid box,” which most investors willing accept without questioning or doubt, and then regurgitate to others with extreme overconfidence.
The News Was “Priced In”
While everyone thinks the market makes sense when a stock price rises on a good earnings report or when it drops on a bad earnings report, let’s try to understand what happens when a stock declines on good news. When blow-out earnings about a company are announced, yet the stock immediately begins to decline, the common theme we hear on the stupid box is that the earnings news was already “priced in” to the stock price. Right?
And almost every person that listens to these reports nods in sheepish acceptance, simply because of the manner in which our minds work, according to Kahneman. But have any of you actually considered what this really means and what you have to believe in order to accept this market construct?
Albert Einstein once said that “[f]ew people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are incapable of forming such opinions." I'm now going to push you to move beyond the prejudices which you hold dear regarding how markets work.
If you believe that blow-out earnings were already priced in when a stock declines after those earnings are announced, then you must believe that the market is omniscient. It means that the market knew what the earnings would be before they were announced and pushed the stock price up with the expectation of blow-out earnings.
So, the logical question then is why are analysts so surprised by such a blow-out earnings if it was “priced in” and already expected by the market? Didn’t the market already tell them based upon its pricing that the earnings would be a blow out? Do the analysts not understand the market?
Are you seeing the circular reasoning behind this “priced in” perspective?
Well, I don’t know about you, but I think the “priced-in” premise, as well as much of what we are told by the “stupid box,” is based upon horse manure. I do not believe investors or the market are omniscient. And the “priced-in” premise is simply another way for the analysts to say “we have no clue why the market declined on good earnings news,” because they will not admit their limitations.
Let me now ask you the inverse of that question: When stocks bottomed in March of 2009 or in March 2020 and began two of the strongest rallies in history, was that due to earnings being “priced in?” (Now, I know many of you are thinking it was due to the Fed, but I will get to that in a few minutes.)
If you're being honest with yourself, then you know the answer is that earnings did not cause the market to rise off the March 2009 or March 2020 lows. In fact, the stocks bottomed at some of the worst earnings reports of their time.
And, if you also remember, we were seeing record unemployment numbers and economic shut downs all over the country in March of 2020 just as the market began one of its strongest rallies in history.
And, if you look at any major bottom in the market throughout market history, you will see the exact same fact. The earnings and economic readings at the time were near their lowest levels when the market reversed and began to rally strongly.
You also will notice that earnings significantly lagged stock price off those market bottoms. In fact, if you really look honestly at market history, you will see that stock price is often a leading indicator for earnings as the stock price always begins to rally well before earnings begin to turn higher.
Now, while you may think that it is just me that questions the reasoning presented by the stupid box, why don’t we ask insiders of some of those public companies. This comment by one of my clients, who was a CFO of several publicly traded companies, mirrors many similar comments I hear from other CEOs and CFOs of large corporations that are clients of mine:
“Having worked for many listed companies and regarded as an insider with access to company confidential information, I have sometimes struggled to understand the correlation between business results and the share price.”
And, to put a cherry on top of this earnings fallacy, I want to quote to you some interesting market history identified by the folks at Elliott Wave International:
“Since 1932, corporate profits have been down in 19 years. Did stocks fall? No: The Dow rose in 14 of those years.
Conversely, in 1973-74, earnings rose 47% -- yet, the Dow fell 46%. In fact, 12-month earnings peaked at the bear market low.
Earnings were at their highest level in June 2007. Stocks were at record highs, too. The mainstream "vision" of how earnings affect stock prices demands that strong earnings should have propelled stocks even higher. Yet, the exact opposite happened: It 2007, earnings were the strongest right before the stock market's historic top.
Then, after stocks had crashed, earnings turned negative in December 2008 (actually negative, for the first time since 1935!). That should have pushed stocks even lower. Yet, the exact opposite happened: Stocks began a huge rally shortly after earnings turned negative.”
So, while many affirmatively and confidently claim that “earnings are the mother’s milk of the stock market,” I hope you can now realize they are not at all burdened by the facts of history.
Now, for those of you who believe it's the Fed that causes the stock market to rally on bad news off the major lows, I have some bad news for you.
While there are times where the Fed seems to be controlling the market, there are many times where it's clear that the Fed has no such control. Yet, most market participants believe in an all-powerful Fed just as everyone else does because of the “stupid box.” And, they simply stick their heads in the sand during the times when the Fed is clearly not in control, as the market crashes despite the Fed’s attempts at stemming the tide, as we saw in 2008 and 2020.
As Robert Prechter noted in his seminal book “The Socionomic theory of Finance,”
“Observers’ job, as they see it, is simply to identify which external events caused whatever price changes occur. When news seems to coincide sensibly with market movement, they presume a causal relationship. When news doesn’t fit, they attempt to devise a cause-and-effect structure to make it fit. When they cannot even devise a plausible way to twist the news into justifying market action, they chalk up the market moves to “psychology,” which means that, despite a plethora of news and numerous inventive ways to interpret it, their imaginations aren’t prodigious enough to concoct a credible causal story.
Most of the time it is easy for observers to believe in news causality. Financial markets fluctuate constantly, and news comes out constantly, and sometimes the two elements coincide well enough to reinforce commentators’ mental bias toward mechanical cause and effect. When news and the market fail to coincide, they shrug and disregard the inconsistency. Those operating under the mechanics paradigm in finance never seem to see or care that these glaring anomalies exist.”
Let’s look at this a bit more closely as it relates to the Fed. The Fed is simply one of the members of what's lovingly known as the Plunge Protection Team. This team was created as a response to the 1987 crash to prevent the market from crashing anymore. Hence, its name.
If there really is such a team hard at work, with their ever-present finger on the "buy" button, then we should not have had any stock market "plunges" since 1987. Rather, the stock market should have only experienced "orderly" declines since that time, and not plunges of 10%, and certainly not over 20%, within a period of a day to a couple of weeks in the same manner as that experienced in 1987.
Yet, since 1987, I don't think that anyone can fool themselves into believing that we have not experienced periods of significant volatility. In fact, the following instances are the “plunges” experienced since the year 2000 despite the Plunge Protection Team being hard at work.
- February 2001: Equity markets declined of 22% within seven weeks;
-September 2001: Equity markets declined 17% within three weeks;
-July 2002: Equity markets declined 22% within three weeks;
- September 2008: Equity markets declined 12% within one week;
- October 2008: Equity markets declined 30% within two weeks;
- November 2008: Equity markets declined 25% within three weeks;
- February 2009: Equity markets declined 23% within three weeks.
- May 2010: Equity markets experienced a "Flash Crash” with a loss of 9% in one day, but the market did manage to close down only 3.1% in one day!
- July 2011: Equity markets declined 18% within two weeks
- August 2015: Equity markets decline 11% within one week
- January 2016: Equity markets decline 13% within three weeks
- February 2018: Equity markets decline 12% within two weeks
- October 2018: Equity markets decline 20% within eight weeks
- March 2020: Equity markets decline 45% within 5 weeks.
- January 2022: Equity markets decline 12% within three weeks
Based upon these facts, you can even argue that significant stock market "plunges" have become more common events since the advent of the Plunge Protection Team, especially since we have experienced more significant "plunges" within the 30 years after the creation of the "Team" than in the 30 year period before.
As just one example, take a look at all the effort the Fed put into stopping the market PLUNGE in March of 2020, and was completely powerless to do so.
“Eventually” the market bottomed. Yet many today are convinced that the Fed was the cause of the bottom in March of 2020. And, if you are one of them that believed that the Fed “eventually” caused the market to bottom, then I have a story for you.
When my children were much younger, and we were stopped at a red light, they used to play a little game. They would each take turns yelling out the word “NOW” as they were each trying to get the light to turn green at their command. Eventually after who knows how many attempts, one of them would come relatively close to the point where the light turned green, and a proud smile would come over their face.
Those that believe that the Fed caused the market to bottom after they made attempt after attempt until the market finally bottoms are no different than believing my children were able to cause the light to turn green by their “NOW.”
But I think this chart proves that former Fed Chairman Alan Greenspan was right when he said:
“[i]t's only when the markets are perceived to have exhausted themselves on the downside that they turn.”