Is the market rebound justified?
November 17, 2009
The short answer is yes. The rebound is ‘justified’ because of the way that the market prices securities – not because I know any more than you about the future direction of the economy in the short term. Let me explain…
“The financial market works as a conduit for demand and supply of (primarily) long-term debt and equity capital.”1 In other words, stock and bond prices are determined when the demand from those seeking capital meets the supply that we as savers are willing to invest. You surely remember the fascinating line charts in economics class identifying the low price of a widget at the intersection of healthy widget supply and slumping widget demand. Stock and bond prices work the same way – and I’m delighted to inform you that it’s this simple.
The foundation of our capital market started to crack in September of 2008 and what ensued was a flight of investor demand from all things risky. Stock and corporate bond prices plummeted to a level not seen since early 1997. Treasury bond prices soared. The rebound we’ve enjoyed since March has been the simple, direct response of increased investor demand brought on by the confidence that our capital market system is no longer on the brink of collapse.
So when some say that the market has gotten it wrong – it’s being suggesting that either the supply side or the demand side is incorrectly forecasting future economic growth today. One or both sides will surely get it wrong from time to time but the bottom line is that supply and demand (the market) has set the price today and that’s the best indication of the level of growth to come. News will break tomorrow that alters both sides of the equation and prices will change – quickly. Until then, the price is right!
Clearly the question is posed with the hope that I, or someone, will foresee the next downturn and help you avoid suffering another setback. I have no doubt that fear will once again shake investor confidence and drive prices lower. The challenge is that it is impossible to know when this may occur. It’s impossible because it depends on knowledge of events that have not yet occurred.
The following quotes demonstrate the challenge with trying to predict future market prices:
"Without a sustained improvement in the credit market — the
seat of the crisis—it seems irrational to expect a durable move higher
in equities."
—Richard Barley, "Bond Markets Don't Buy the Rally," Wall
Street Journal, March 26, 2009.
"New research shows corporate bonds have been far better at predicting
where the economy is headed than anyone thought. Unfortunately, that suggests
the economy is going to get much worse."
—Justin
Lahart, "A Warning from the Bond Market," Wall Street Journal,
April 9, 2009.
"The March stock market rally that fuelled hopes of a broader
economic recovery was deceptive because 'real money' investors remained on
the sidelines."
—Anuj Gangahr and Chrystia Freeland, "Head of NYSE Cautious over
Rally in March," Financial Times, April 16, 2009.
"April saw the lowest level of insider buying ever recorded
by research group TrimTabs, with insider selling fourteen times as
high. Likewise, companies sold 64% more shares than they bought in
April."
— Spencer
Jakab, "Beware the Seductive Appeal of the Suckers Rally," Financial
Times, May 9, 2009.
"Markets need volume to sustain bull runs, but unfortunately this
run does not have it. In fact, trading volume on the New York Stock Exchange
has been trending lower all month."
— Michael
Kahn, "This Bear Should Stay Well Fed," Barron's, May
20, 2009.
"We are still a long way from a viable, solvent banking
system that intermediates credit independently."
—George
Magnus, "Reasons Why Bear Market Rally Will Stall and Reverse," Financial
Times, May 21, 2009.
Since March 9, 2009 the S&P 500 stock index has rebound by over 60%3 - indicating the potential cost of relying on market predictions.
I encourage you to avoid getting caught up in identifying the degree to which the market is ‘right’, or ‘justified’, in how it is pricing securities. These are interesting discussions (mildly) but not at all practical in building and sustaining long term wealth.
The important question is how we should invest in an environment in which the future is uncertain. The answer is by eliminating unnecessary risks and expenses and balancing competing priorities based on cash flow requirements and time frames. In other words, focus on the things that you can control. Successful long term investors don’t seek to avoid setbacks - they invest in a manner that allows them to endure setbacks and enjoy the recoveries that inevitably follow
