what I think stock prices are signaling

A simple, but very useful, way of looking at financial markets–particularly those in the US–is that:

–they quickly incorporate new information into prices, and

–at any given time they accurately reflect (or discount) consensus expectations about the future.

discounting the future

For bond market professionals, a breed I’m happily ignorant about, it seems to me the future is at most a few weeks away. For the stock market, where I actually do know something, the what counts as discountable depends on circumstances. In a bullish phase, which we’ve been in for about 18 months, especially so after voters booted Trump out of office, the future can mean as far ahead as three years. In a bearish phase, when things don’t look so good, the future can be as little as six months.

the consensus doesn’t mean everyone

Academic finance theory is based on the nonsensical proposition that everyone is in the same financial position, has the same risk tolerances and has identical information. The reality, I think, is that new information only gradually, sometimes even very slowly, filters into markets (meaning affects stock and bond prices). I think it’s possible to take the temperature of markets, and sense their near-term direction, by figuring out what new things they are beginning to digest.

what’s percolating in now

It’s interest rates, which is an enormous factor.

Everyone knows that when you buy, say, a 10-year government bond (it’s actually called a note–don’t ask why), you expect to get: protection against inflation; a return that’s somewhat higher than that (i.e., a real return), to compensate for tying your money up for so long; and your money back when the bond matures.

If we assume the trend rate of inflation is 2%, then the interest payment on the 10-year should be, in concept anyway, 2.5% or so, and certainly more than 2%. The actual yield as I’m writing this is 1.55%, up from 1.28% a couple of weeks ago–and from 1.19% in early August, when fears about the delta variant/anti-vax pressure from red state politicians were the highest.

Why are rates so far below where they “should” be? Partly market fears about covid, but mostly because the government has been keeping rates extra low to dampen the negative effects of the fragile economy of 2018 – present.

Anyway, the Fed has been signaling that it intends to start the process of removing extra stimulus soon–and, in fact, more quickly than both it and the consensus had thought a month or so ago. The first step in the process, which has been clear for a long time, will be to gradually remove the downward pressure it is exerting on the long bond. Next, in the middle of next year (?), it will begin to raise short-term interest rates. Two ultimate goals: to restore positive real yields, and to do so in a way that allows inflation to stabilize at 2%+.

stock market implications

Rising rates affect stocks in two negative ways:

–they cause PE multiples to contract, as fixed income becomes a more attractive alternative (my stress would be on more rather than attractive, because I can’t feel my heart pounding at the prospect of 2.5%/year), and

–even the mild headwind this will create will likely cause stock investors to shorten their investment horizon from being willing to pay for earnings, say, three years in the future, to maybe 24 months.

There is a counteracting positive: presumably the reason the Fed is picking up its stimulus removal pace is that it detects the economy has a greater head of steam than the consensus realizes. Therefore, for at least some companies, earnings will likely be surprisingly high.

Finding these winners will require at least some stock-by-stock security analysis work. The market’s immediate reaction has been what it usually does in these situations–to sell off any stock with a high PE based on current earnings. Worst hit have been names like ZM, down by 23% in a market off by around 4%, which are perceived as pandemic/stay-at-home beneficiaries. Interestingly, in contrast, another s-a-t stock, ETSY, is lower by only a tad more than the market.

At some point, however–I’d make a guess, but I’m always too optimistic in situations like this–Wall Street will shift away from this baby-and-bath-water strategy and look past the damage to PEs to find stocks with superior earnings prospects. I think it will be very interesting to see whether Wall Street or Reddit will drive the rebound. I’m genuinely unsure which it will be. One indicator may be the relative performance of the ARK funds, whose all-bat-no-glove strategy contrasts sharply with traditional money managers’ some-glove-no-bat approach.

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