Why Looking For Value in The Market Doesn’t Matter…Until it Does

Yesterday I discussed why you’re better off ignoring all the opinions about the market that are flying around right now. While most might be well meaning, chances are they can inadvertently get you into trouble.

The best advice I can give you right now is that it’s fine to have an opinion, just don’t cling to it too tightly. Be open minded. Be willing to change your mind if the circumstances change.

The easiest way to do this is to accept the reality that global financial markets are so complex that you cannot possibly understand them. Accept that you’re ignorant of what’s happening. When you do this, you’re much less likely to cling to a view (bullish or bearish).

One way to do this is to look at what the charts are saying in an unbiased manner. We did this in yesterday’s essay, and had a look at the NASDAQ, the S&P 500 and gold. The conclusion was that both the NASDAQ and the S&P 500 remain in a bullish upward trend (for now) while gold remains in a bearish downward trend (for now).

However, as a part of the analytical process I employ with my investment advisory, Crisis & Opportunity, it’s important to consider the fundamental factors that influence markets.

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Sometimes the market ignores the fundamentals, and the driving force is investor emotion. Arguably that’s been the case in the US for some time now. As an example, check out the divergence between the S&P 500 and an ETF of the emerging markets.

Since early April, these major asset markets have gone their separate ways:

MoneyMorning 16-10-18

Source: Optuma
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Clearly, this was around the time when markets realised that Trump’s trade policy wasn’t just bluster. And, somewhat correctly, the market interpreted this move as being good for the US and bad for the emerging economies that have previously benefited from US debt-fuelled consumption.

But that divergence was just too wide. Either emerging markets were going to play catch up, or the US was going to come back to Earth. It appears as though the latter scenario is playing out now.

If I had to inject my opinion into it, my guess at this point is that this scenario is still in its early stages. That’s because fundamentally, US stocks are stretched in terms of valuations. 

Valuating the market

The thing about valuations is that they don’t matter until they do. What do I mean by that? In the midst of a bull market, investors ignore valuations in the belief that earnings will rise in the future and therefore justify today’s higher values.

This is where emotion comes in and plays its part. Optimism allows investors to believe that things will always get better. Optimism pushes prices way beyond fair value. There is still plenty of optimism around in US markets. This attitude will need to shift before you see prices continue to fall.

Let me explain…

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I pointed out to readers in last month’s issue of Crisis & Opportunity that US stocks didn’t appear expensive based on current measures of profitability. However, they were certainty stretched based on the long term measures:

US stocks are extremely overvalued based on longer term measures of profitability. While many investors know this, they simply don’t care. They are investing for the here and now. They will sell only when a catalyst occurs to signal that corporate profitability growth may be coming to an end.

The way I propose dealing with this is to continue focusing on what I call ‘counter-cyclical’ opportunities. That is, stocks that operate in their own cycle, rather than the cycle of the broader market (and one that could turn for the worse at any moment).

What was the catalyst that caused the market to hit the sell button last week?

It was probably the realisation that growth is about as good as it gets in the US, and the Fed is going to continue to raise rates into 2019. Not that this was a revelation to anyone. It’s just that the market decided to all of a sudden acknowledge it.

The fact that 10-year US government bond yields popped higher last week, to levels last seen in April 2011, was probably the actual catalyst that sparked the selling. The chart below shows the move. Since August, you’ve seen a 45 basis point jump in bond yields.

It was a 50 basis point move that sparked the sell-off earlier this year.

MoneyMorning 16-10-18

Source: Optuma
[Click to open new window]

Clearly, markets are reacting to increasingly tight monetary policy. While 3.2% doesn’t seem like a high level of interest for a ‘risk-free’ rate, the global economy is much more indebted than it was in 2011, when rates were last at this point.

That means the global economy is much more susceptible to global monetary tightening. The Fed plans to continue to raise rates, while the European Central Bank plans to end its quantitative easing program by the end of the year.

If bond yields can move lower from here it may stabilise markets for now. But the message is that as interest rates increase, the risks to stretched asset prices increases too.

While US stocks at least have the benefit of a strong economic tailwind, Australia doesn’t. The ASX 200 fell another hefty 60 points in yesterday’s trade, or nearly 1%. Thanks to a lacklustre performance from the US overnight, it doesn’t look like we’ll get much of a bounce today.

The Aussie market never went up as much as the US, yet we are now falling just as hard. In tomorrow’s essay, I’ll explore the reasons behind the Aussie market’s abysmal performance.

Until next week,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia