discounting at work today
My previous post was about what the equity discounting mechanism is. Today I want to give my take on how discounting is working in today’s US stock market.
The US market has been rising since June, despite the evidence of widespread global slowdown. How can this be?
economic slowdown, but uptrending market??
Several macro reasons:
- After five years of decline, the US housing market has been giving strong signs of bottoming for some months and is recently beginning to rise. Housing is important in the US, not only for the construction jobs it brings, but because it’s the largest source of wealth (or potential wealth) for most Americans.
- Around mid-year the leadership of the EU seems to have stopped living in denial about the Eurozone’s structural problems and begun to take positive action to address them. Yes, resolution may take a half-decade. Yes, Greece may get tossed out and the UK may voluntarily withdraw. But the basic direction of government policy appears to have changed.
- Beijing has already taken a number of measures to reinvigorate its economy. Yes, any dramatic steps will probably await the installation of new top leadership in the Communist Party there. But, again, the basic stance of government economic policy appears to be reversing itself from contractionary to expansionary.
- The US Fed has announced that it intends to keep the current extraordinarily-low level of short-term interest rates in place for at least the next 2 ½ years. Ultimately, rising interest rates will be a threat to world bond, and to a lesser extent, stock markets. But that’s not likely to be anytime soon.
two discounting judgments
Two qualitative discounting judgments are involved in the upward move of global indices over the past five months:
–the first is that there’s no longer any percentage in betting that conditions will continue to deteriorate. That’s already been fully, or very close to fully, discounted by the prior price declines.
–the second is that the three macro forces listed above are powerful enough for investors to begin discounting potential future good news into today’s stock prices.
In my view, there’s nothing unusual about this. It’s the standard macro-based anticipatory discounting that has occurred at business cycle turning points over the thirty years or so that I’ve been involved in global stock markets.
To my mind, what is unusual, though, is the apparent disconnect between the macro discounting judgment that the worst is behind us and the very violent micro discounting being done as companies report 3Q12 earnings results.
two separate judgments
In theory, these are two separate kinds of judgments–how benign or hostile the overall economic environment is likely to be vs. what earnings prospects are for individual companies. But in practice, investors, in my experience, tend to ignore poor company results during a transition period between macro trends. The bad numbers are usually dismissed as “old news,” the last artifacts of a trend that has already been relegated to the scrap heap (or, if you prefer, the recycling center).
Not this time, though. Companies that disappoint are being aggressively sold off.
Why should this be?
More important, should this strong micro-related discounting undermine confidence that the macro trend has indeed reversed?
I can think of a couple of reasons macro and micro discounting could be following different paths:
–the most likely, in my view, is the current valuations of business cycle-sensitive stocks. Typical market turning points in the past have been 2009-like affairs. Not as ugly, but conceptually similar. Those bottoms occur at the end of extended bear markets, when overpowering fear is rampant and all stocks have been sold down to levels which—in hindsight—will appear ludicrously low. The most cyclically sensitive will often be crushed, priced as if they’re going out of business.
In the quarters immediately following these market turns, the negative effect of earnings disappointment on individual stock prices is offset by the positive of extremely low valuations.
That’s not the case today. We’re more than three years past the 2009 bottom, and about 100% higher than the absolute lows. So disappointing stocks don’t have the valuation cushion they normally do.
If I’m correct, the selloffs of cyclical stocks on bad earnings doesn’t undermine the macro case that the overall market trend has changed in a favorable way. It just means this upcycle is different and will be more muted than the standard pattern.
–it may also be that both buy-side and sell-side firms are no longer integrated, having both macro and micro researchers, as they have been in the past. In the integrated model, either the chief investment officer or a committee of senior staff would set an overall investment policy. To a significant extent, the overall investment stance, bullish or bearish, would be coordinated with, and reflected in, recommendations about individual stocks.. In an up market, portfolios wouldn’t sell cyclical stocks; disappointing earnings would be ignored. On the sell side, cyclical stocks would continue to be recommended, not downgraded.
In today’s world, in contrast, brokerage firms have dismantled their research departments. Many hedge funds specialize in macro research only. Others run highly concentrated portfolios that hold only a handful of names. There are many more short-sellers, as well.
So it may be that the market for individual stocks is becoming much less uniform in its thinking—and thereby much more volatile–than it has historically been.
–there are other possibilities, but less probable and not worth mentioning here.