Sentiment Speaks: What If They Held A Recession And No One Showed Up? - Part III

The first two articles in this series can be read here:

Sentiment Speaks: What If They Held A Recession And No One Showed Up? - Part I

Sentiment Speaks: What If They Held A Recession And No One Showed Up? - Part II

Market Causality Chain In The Real World

Now, let me attempt to explain how the causality chain works in the real world based upon market psychology.

I don’t think it would come as a surprise to any of you when I repeat something that is relatively of common knowledge. A market tops on euphoria and it bottoms on pessimism.

Note that this phrase mentions nothing about earnings or the Fed. Yet, the simplicity of this statement is more accurate than most even realize. Let’s explore it a bit.

I think many recognize that when investors are “all-in” to the market, there's no one left to buy, therefore there's only one direction the market can go. This is how major tops are created. But I think exploring the psychology of bottoming is much more instructive for our purposes today.

During a negative sentiment trend, clearly the market declines, and the news seems to get worse and worse. But, once the negative sentiment has run its course after reaching an extreme level, everyone that has wanted to sell has done so, as I cited Mr. Greenspan’s quote earlier, “[i]t's only when the markets are perceived to have exhausted themselves on the downside that they turn.”

So, once we reach that negative extreme in sentiment, it's time for sentiment to change direction. The main reason is simply that there's no more room for negative sentiment, and the general public then begins to subconsciously turn towards optimism. You see, once you hit a wall, it becomes clear that it is time to look in the opposite direction. Many of you will question how sentiment simply turns on its own at an extreme, and I will explain to you that many recent scientific studies have been published to explain how it occurs naturally within the limbic system within our brains.

When people begin to subconsciously turn toward optimism about their future - again, which is a subconscious – and not conscious – reaction within their limbic system, they are again willing to take risks. Now, consider for a moment what the most immediate way that the public can act on this return to optimism? The easiest and most immediate way is to buy stocks. This, my friends, is the main reason why we see the stock market lead in the opposite direction before the economy and fundamentals have turned.

In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.

But let’s explore what the same turn to optimism does to the fundamentals and the economics of the market.

When the general public subconsciously turns towards optimism, this is the point at which they are willing to take on more risks. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, and those take time to secure.

They then put the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public and, ultimately, profits and earnings begin to grow - after more time has passed.

When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals is evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.

Clearly, there's a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change.

This is why I claim that market fundamentals and economics are lagging indicators relative to market sentiment. This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of a business-growth cycle.

It's also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns. I have taken the following quotes from The Behavioral Investor, written by Daniel Crosby to outline this point:

“[C]ontrarian investor David Dreman found that most (59%) of Wall Street consensus forecasts miss their targets by gaps so large as to make the results unusable – either undershooting or overshooting the actual number by more than 15%. Further analysis by Dreman found that from 1973-1993, the nearly 80,000 estimates he looked at had a mere 1 in 170 chance of being within 5% of the actual number.

James Montier sheds some light on the difficulty of forecasting in his “Little Book of Behavioral Investing.” In 2000, the average target price of stocks was 37% above market price and they ended up 16%. In 2008, the average forecast was a 28% increase and the market fell 40%. Between 2000 and 2008, analysts failed to even get the direction right in four out of the nine years.

Finally, Michael Sandretto of Harvard and Sudhir Milkrishnamurthi of MIT looked at the one-year forecasts of 1000 companies covered most widely by analysts. They found that analysts were consistently inconsistent, missing the market by an annual rate of 31.3% on average.”

By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time, and the forecasters do not even realize it. That's why they fail so miserably at the turns. And this is also why economists fail as well – the social mood has shifted well before they see evidence of it in their "indicators."

Economic Theory Fails To Explain Stock Market Moves

Even though the market rallied strongly off the March 2020 lows, economists had us classified as being in a recession until the market had almost doubled off those lows. That means the valuation of the stock market doubled before economists viewed us as having come out of a recession.

And this was not the first time we have seen such failure. After the analyst community failed to foresee the market swoon off the 2000 market top, on October 6, 2002, Paul Samuelson, a co-founder of modern economics, admitted “[w]e are at a loss for words. If nothing else, this baffling economy has defeated the vocabulary of economics.”

As an aside, it's interesting to note that Samuelson’s admission came within several days before the market bottomed and began a multi-year rally into 2007. His exasperated admission - wherein he effectively threw his hands up in the air in submission - marked a multi-year bottom at an extreme in negative market sentiment. He was being driven by market sentiment and likely did not even realize it.

But the failures of 2000 have not stood alone. There were many admissions of failure after the analyst community’s inability to also recognize the impending market meltdown which began in 2007.

In February of 2009, Paul Volker, former Fed Chairman, said regarding the economy:

“It’s broken down in the face of almost all expectation and prediction. Even the experts don’t quite know what’s going on.”

In May 2009, the Wharton Business School noted regarding the analyst community that “[i]t’s not just that they missed it, they positively denied that it would happen.”

And, finally, what will blow your mind is that in January of 2010, Eugene Fama, the father of the Efficient Market Hypothesis, told the New Yorker:

“I’d love to know more about what causes business cycles. I used to do macro-economics, but I gave up long ago. Economics is not very good at explaining swings in economic activity. We don’t know what causes recessions. We’ve never known.”

Yes, my friends, feel free to read that again. The father of EMH came out and told us that it does not work, and he gave it up long ago. Yet, it's still taught as the basis of economic theory in most colleges today.

Mr. Prechter went further in his book The Socionomic Theory of Finance as he then outlined the reasons why such analysis has been an absolute failure. Whereas the law of “supply and demand operates among rational valuers to produce equilibrium in the marketplace for utilitarian goods and services . . . [i]n finance, uncertainty about valuations by other homogenous agents induces unconscious, non-rational herding, which follows endogenously regulated fluctuations in social mood, which in turn determine financial fluctuations. This dynamic produces non-mean reverting dynamism in financial markets, not equilibrium.”

Moreover, since the efficient market hypothesis (the basis for fundamental analysis in financial markets) is an outgrowth from the world of economics, it has become quite commonly viewed as an unworkable paradigm for financial markets (as noted above) for various reasons. Understanding that an underlying assumption within economics is ceteris paribus, and an underlying assumption in the efficient market hypothesis is that all investors act rationally and with the same knowledge, you can easily understand why it is simply unworkable in financial markets.

In fact, Benoit Mandelbrot outright stated that one cannot reasonably apply an economic model to the financial markets:

“From the availability of the multifractal alternative, it follows that, today, economics and finance must be sharply distinguished . . .”

From an empirical standpoint, consider that, within economic theory, rising prices result in dropping demand, whereas rising prices in a financial market leads to rising demand. Yet, most continue to incorrectly apply the same analysis paradigm to both environments.

So, I will repeat my premise. As most of you, I started my investing career with fundamental analysis. Yet, I have abandoned it when analyzing the overall market because analyzing market sentiment has been a much more accurate lens through which to view the machinations of the stock market. And those who have followed me through the years can attest to this fact.

As Werner F.M DeBondt, Frank Garner Professor of Investment Management at the University of Wisconsin-Madison noted:

“. . . the sad but honest truth is that, despite its many insights, modern finance offers only a set of asset-pricing theories for which no empirical support exists and a set of empirical facts for which no theory exists.”

With all this being said, I want to now explain why I view fundamentals as important. Remember that market sentiment is the primary driver when we are dealing with investment products wherein mass sentiment is evident. However, this is not an absolute perspective. Rather, it's based upon a continuum of sentiment.

You see, while the SPY is an example of an investment product that presents us with the ultimate in mass sentiment, a microcap biotechnology company may be on the opposite end of that continuum of sentiment. Within the example of the microcap, sentiment can be a factor, but the fundamentals of the company are going to be the primary driver of this stock. And all products run somewhere within that continuum. The greater the mass sentiment being evident within the buying and selling of that product, the greater probability that sentiment will be the driver of price. And the reverse is true.

So, in conclusion, my ultimate goal is to push investors to do your own independent and intellectually honest assessment of everything you hear or read, while you pass it through a prism of logic and truth. Much of what you currently read in the investing world is based upon fallacious, but commonly accepted, perspectives about how the market really works. And it does not look like anything will change anytime soon. The most common reason I have heard as to why they cling to their failed methods is simply because they are unable to come up with a better model. Yes, that's the truth.

In the January 6, 2011, issue of Oxford Analytica, they explained that “[a]though the crisis has exposed serious weaknesses in the neoclassical synthesis, no alternative paradigm is likely to eclipse it in the short term. Moreover, there are strong intellectual and social pressures that work to hold the paradigm in place. . . While it may be possible to suggest revisions to this paradigm at the margins, there is little evidence that an alternative paradigm to understand the economic world is gaining widespread credibility among mainstream economists.”

When Is The Next Recession?

This brings me to the question in the title of the article – what is my perspective on the next recession?

Well, let’s start with the premise that a “recession” is a construct of economists. Therefore, we're attempting to impose an economic theory on our expectations of the stock market. And, if you did not figure this out from the discussion above, this is a failed construct if your goal is to remain profitable in the stock market.

Now, after I just presented you evidence as to why an economic perspective is ultimately meaningless to how one should approach the stock market, do you think you really have to worry about when the economists are going to determine we are in a “recession?” In fact, the market will likely have been down for several months before the economists will see evidence of a recession in their indicators.

So, of late, all we have been hearing about is the inverted yield curve and how it precedes a recession. Resultingly, I'm reading so many posts in articles that are terribly concerned that we have begun a major recession already.

They say that a little information is a dangerous thing. So, let’s try to offer a bit more information so that you are not a danger to yourself as an investor. First, there's no guarantee that an inverted yield curve will lead us into a recession. Second, consider what happened the last time we went into a recession. If I may remind you, the stock market rallied from 2200-3500 while we were in a “recession” in early 2020. And, third, a recession is only seen between 12-18 months after the curve inverts.

Avi Gilburt is founder of ElliottWaveTrader.net.