Saturday, November 18th, 2017

What do we know about the current market mood?

As the title of this article indicates, my intention is to distinguish the market mood from several important facts.  The emotions of market participants is subject to change every moment of every day, causing them to change their outlook on the future value of businesses.  If people worry about the future, their appraisal of the future value of a business tends to decrease accordingly.

On September 22, for example, the news was full of statements from government officials who are worried about the poor state of government finances in many countries.   The fact is that many governments have made promises to pay amounts they do not have and likely never will have to their citizens.  Such vote-buying promises are very common and I think everyone knows it happens.  However, eventually reality assets itself and politicians must deal with the facts, not their wishes.  At that time, if there was a single voice for “financial markets” it would effectively say “you have borrowed too much from your future, you are unable to pay for your promises and so I will either not lend money to you or will charge you a higher interest rate.”  This is happening as I write: in Greece they are effectively bankrupt right now; Ireland stared at the abyss and seems to have mustered the courage to reduce spending; Spain and Italy seem to be headed in the right direction; the United States is still in discussion as the President seems unwilling to face reality just yet; Canada has huge problems in the future but is not being forced to deal with them right now.

And now back to the difference between perception and reality.  The broad public perception is that the businesses of the world are in trouble.  The fact is that it is governments that are in trouble.  Businesses live in the real world where customers vote every minute of the day by how they earn and spend their dollars, so businesses must be very quick to respond to customer demands or else they face losses and eventual business closure.  Businesses do not have the ability to borrow almost unlimited amounts and to print their own money to spend on their promises.

As one conservative money manager recently put it “As is so often is the case with equity markets, the violent swings we’ve experienced in recent days and weeks are more rooted in fear rather than  fundamentals. The fundamentals remain attractive:

  • interest rates are low,
  • inflation is low,
  • corporate profits have been rising,
  • corporate balance sheets are exceptionally strong,
  • businesses are showing confidence,
  • investing in their  markets,
  • increasing their dividends,
  • buying back stock and
  • making acquisitions.
  • Most importantly, valuations remain very attractive today both in an absolute sense and certainly relative to fixed-income alternatives.”

In the face of an apparent contradiction between perceptions and reality, which one an investor chooses to follow often determines his success in long term investing.  Since perceptions are constantly changing in unknowable ways, an investment policy driven by perception will also be constantly changing in unknowable ways.  On the other hand, an investment policy driven by facts and reality is always rooted in truth and hard knowledge, but requires one to ignore the popular perceptions and live by the judgment of one’s own mind.  This is the way all the great investment minds work and history shows it is the best way to investment success.

The fact is that the future value of a business is perfectly tied to its ability to produce net income after all expenses.  On average, this changes relatively little over even modest time periods such as three years and on average it rises by about 7% per year after accounting for inflation due to gains in technology and productivity.  In the daily news, the estimates of many so-called investors varies wildly as they alternately project doom and glory.  The truth is that a return of about 7% is all that is justified by 200 years of data and this means that if returns have been below 7% over a long period then they will be higher in the next period to return to their average.  If returns have been above average they will tend to be lower as they return to their average.  To see this does not require a crystal ball and does not sell newspapers or web-site ads- it requires a knowledge of facts, an examination of history and an understanding of the big-picture context.  It’s quite boring actually, and the investment industry would do well to adopt more of the boring facts and spend less time on the hype of the moment.  Just saying…

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