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Legendary investor Peter Lynch once said that if you spend 13 minutes per year on economics, you’ve wasted 10 minutes.
Although I spend more than three minutes per year looking at economic data, I do tend to look a lot less than others in the industry. Many years ago, I saw a study that showed that the connection between gross domestic product (GDP) and stock market returns were lowly correlated, which is odd because you would think that the two would be highly connected.
Yesterday, I came back from lunch and found the most recent Bloomberg Business Week on my keyboard so that I couldn’t possibly miss it. The cover features a confused and slightly incredulous Bill Gross, the Chief Investment Officer (CIO) of PIMCO and general bond king with the headline, ‘Am I really Such a Jerk?’
Portfolio Insights went to print last week. You can see the latest issue by clicking on the image to the right.
High hopes for faster economic growth this year were disappointed in the first quarter as the harsh winter weather depressed spending and production across much of the country. Add in the $20 billion reduction in household disposable income due to expiring emergency unemployment benefits and slower inventory accumulation, and it is understandable that economic growth came in below trend. However, all of these headwinds are temporary and we expect the U.S. economy to pick up speed.
There are two trends that boost our confidence for the balance of the year. First, the Congressional Budget Office expects federal spending to rise for the first time since 2011 after contracting 4.7% last year. In addition, improvement in state and local level finances should lift public-sector spending and employment. Second, the labor market is improving, which positions consumer spending to accelerate as real income growth picks up – last year’s tax hikes limited real personal disposable income growth to 0.7%, which is a low bar to clear this year.
The improvement in the labor market has given the Federal Reserve enough confidence to continue tapering bond purchases so that their quantitative easing (QE) program ends this year. Much to the surprise of market observers, Federal Reserve Chair Janet Yellen suggested the first interest rate hike could come six months after QE winds down. However, she later reassured markets that the Fed would raise rates more gradually than previous tightening cycles. The primary reason for this is that the Fed sees “considerable slack” in the labor market that will require easy monetary policy for “some time.”
There is a growing debate about the amount of slack in the labor market. Labor market slack simply means that employment can rise without causing inflation to pick up. As the labor market tightens, the Fed must worry about inflation and consider tightening monetary policy to promote price stability.
Although the unemployment rate has been steadily declining, Yellen has repeatedly identified four measures of labor market health that have her concerned: (1) high levels of partly unemployed workers who would like a full time job, (2) stagnant wages, (3) large number of long-term unemployed, (4) low labor participation rate.
The recent underperformance of small cap stocks has me wondering whether the outperformance that small cap stocks has enjoyed over the last decade could be coming to a close.
Over the last ten years, the S&P 500 has gained 7.16 percent and the S&P 600 Small Cap Index has earned 9.81 percent a year, an outperformance of 2.65 percent per year.
The 2004 book, The Wisdom of Crowds, by James Surowiecki, starts with a vignette about the famous British scientist Francis Galton set in 1906.
In the story, Galton travels to the county fair and finds a weight judging competition, where the crowd could wager on how much a fat ox weighed. For a sixpence, people could write down their wager and the closest person one a prize (but not the slaughtered ox).
More than 775 people placed a wager, some were farmers and butchers who could make reasoned estimates and some were everyday people hoping to get lucky.
Galton wanted to know what the average guess was since his scientific contributions were statistical in nature. He is credited with creating the concept of correlation and was an early supporter of the mean-reversion concept. (He also came up with the phrase ‘nature versus nurture.’)
He reasoned that the collection of guesses would form a bell curve and that the average would end up being a reasonable estimate. It turns out that he was right: the average guess was 1,197 and the ox ended up weighing 1,198.
Galton expected that all of the guesses by the non-butchers and farmers (the uninformed) would ruin the results of those in the know. When he saw the results, he decided that there was wisdom in the crowd.
The application for markets is simple: no one knows exactly what company is worth.
Theoretically, we believe that it’s worth the present value of its future cash flows. The problem is that we don’t know what those cash flows will be and what discount rate we should apply to bring them into today’s dollars.
We know that a stock, and therefore the whole stock market, has an intrinsic value, but it’s unobservable, we don’t know what the intrinsic value is.
Efficient market advocates argue that the price is the best signal of the value based on the wisdom of the crowd. Investors all over the world look at a stock, evaluate their prospects, make some estimates and assumptions and come up with an intrinsic value.
The efficient market folks say that their intrinsic value estimates, on average, are probably a very close proxy for the actual value, just like the crowds guess of the ox’s weight was only one pound away from the actual weight.
For the most part, I tend to agree with the efficient market theorists and, therefore, the crowd.
The problem, however, is that the crowd is made up of human beings that can be rational at times and completely crazy at times.
It’s not hard to find examples of the madness of crowds, I can’t help think of the recent ‘victory’ riots on the UConn campus after their NCAA win.
I realize that these are drunken college kids, but there are plenty of other examples like the Tech Bubble, housing bubble, Tulip-mania and Bit Coin prices (okay, that last one is probably drunk college kids again).
The strict efficient market people are right that prices contain all available information, rational and otherwise. Fortunately, over time, markets end up getting it right even if the gyrations can get as wild as a UConn after party.
My favorite author, Michael Lewis, appeared on 60 Minutes last Sunday and started out by saying, ‘The stock market is rigged. The United States stock market, most iconic market in global capitalism, is rigged.’
A few second later, when anchor Steve Kroft asked who the victims were, Lewis said, ‘Everybody who has an investment in the stock market.’
Wow – that’s scary!
Stocks were sharply higher yesterday on comments from Fed Chair Janet Yellen, who offered new assurances that the Fed intends to keep interest rates low to support a weak job market. Yellen’s speech was unusual was that her delivery offered unusually personal stories about three people who are trying to find work.
In some ways, it was not different than when a politician talks about someone he met and uses their name to make it seem like they were listening, but since the Fed Chair is an appointed office and not an elected one, it was an interesting surprise. From my personal perspective, unlike the politicians, it also seemed genuine.
Markets were higher on Friday, although they had been much stronger in the morning than they were at the close.
Emerging Markets stocks, which had been down nearly eight percent this year, gained nearly five percent this year so that they year-to-date performance of the FTSE Emerging Market stock index through Friday is now -1.1 percent.
That’s almost on part with the FTSE index for developed markets, which is down -0.15 percent so far this year.
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