BULLS, BEARS, AND BRAINS: THE RELENTLESS PURSUIT OF THE FOOL’S ERRAND OF CALLING THE MARKETS

8/29/14

The geopolitical situation has rarely been worse, short of all out war: 

• Russia is apparently conducting a not all that surreptitious invasion of Ukraine.
• ISIS is sweeping across Syria and Iraq, seizing territory and oil and conducting acts of brutality that are appalling even by Middle Eastern standards.
• A de facto military coup has taken place in Pakistan.
• Ebola continues to spread through western Africa and threatens to burst out of its present geographic constraints to threaten Congo, other African regions, and perhaps the entire world.
• The UK just put on a terror alert that borders on hysteria.
• The western Pacific continues to be a hotbed of sparring between regional and global powers, with the latest developments being an ongoing game of chicken between Chinese fighter planes and American surveillance planes spying on Chinese nuclear submarines.
• Cyber-attacks, on major financial institutions, power providers, retailers, and agencies of government seem to be a weekly, or daily, occurrence.
• The French government was reshuffled for the second time in months.
• It looks like David Cameron’s center-right coalition in the UK is encountering turbulence as euroskeptics start to jump ship.
• The usual nonsense and gimcrackery prevails in Washington, D.C.

Smart market observers are warning of complacency, not only about geopolitical turbulence but about everything; nothing seems to make the stock markets, or, lately, the bond markets, go down.

Equally smart observers point out that there have been many times when people thought the geopolitical situation has rarely been worse, but the world didn’t end and the markets weren’t fazed, largely because the markets seem to operate independently of geopolitics.  The markets have grown used to, and prospered despite, the obtuseness, or worse, of the politicians.  Further, these observers argue that the very fact that smart people are warning of complacency shows that not everybody is complacent.

These bright bulls point out that it is earnings that drive the markets, and earnings, for the most part, are just fine.  Equally bright bears point out that it is future earnings that drive markets, which are perhaps nature’s most efficient and effective discounting mechanism.  A still debt laden economy, weak consumer spending, tepid consumer confidence, and confusing, but largely bearish, economic news out of China don’t bode well for future earnings  These bears point out that the still lukewarm economy, combined with the aforementioned geopolitics, does not present a scenario in which we should be experiencing near record highs in the major stock averages.  Bulls scoff, arguing that record highs are just numbers.  With the S&P trading in the neighborhood of 16-17 times projected earnings, the markets are at best only mildly expensive.  Bears trot out measures like the CAPE ratio, which adjusts earnings for the business cycle and smooths them over the last ten years, is trading at 25, a level that has been reached only in 1929, 2000, and 2007.

The bears argue that, with the 10 year treasury at 2.33% and the 30 year at a calendar year low of 3.07%, bonds are ridiculously expensive and that it is these low rates that provide the helium that inflates our stock markets.   Bulls argue that with the German and Japanese 10 year government bonds at 0.87% and 0.49% respectively, treasuries don’t look rich at all; in fact, they might be cheap.   On the other side of the equation, some observant bulls are pointing out that with U.S. corporate spreads still very tight, treasuries might be cheap not only relative to foreign government bonds but also relative to credit sensitive U.S. paper.   So not only may treasuries be a better value than is commonly supposed but continuing low, and maybe falling, rates will further sustain the stock market.

So what is the point?  Do I delight in confusing my readers?  The latter is certainly not true.

One side of this argument will turn out to be right; the markets, both bond and stock, will either go up or go down.  (They could trade sidewise, in which case both sides will claim victory, but I digress.)   But given the strength of arguments on both sides, those who emerge correct will do so by nearly sheer luck.   Predicting markets is little more than a game of chance, a fool’s errand.  

The two most salient conclusions one can draw from the serendipitous nature of market prognostication are

·        We waste a lot of time and brainpower, in this country and throughout the world, trying to do the impossible—call the markets.  Very smart people are paid very handsomely to do things they can’t do (i.e., call the markets) because people understandably place a very high value on their hard-earned money and still believe that they can get a jump on the markets by listening to the smart guys.  What if those wonderful brains on Wall Street and in the City of London spent their time curing diseases, finding new forms of energy, or working out the logistical and infrastructure problems that look to be a profound source of economic difficulty in the future?  Not only would it be a better world, but everyone would make more money.  The two, by the way, are not at all mutually exclusive; quite the contrary.  But I digress…again.

·        The best course of action for the investor is not to chase the pied piper of market beating returns.  Instead, the investor should, as best as s/he can, determine how much risk s/he is willing to take and set up, alone or with the help of a genuine financial advisor, a balanced portfolio of index or index like products that conforms to that risk profile.  And then rebalance religiously.  See INDEX INVESTING:  COULD ITS SUCCESS BE ITS UNDOING?, 8/23/14 and INDEX INVESTING:  “YOU (DON’T)GOTTA HAVE HEART…”, 8/21/14