Your Investments: Why should the stock market drop?

My question to all these doomsayers is why? Was it “rational” 18 months ago when the market had lost 60 percent of its value?

By AARON KATSMAN
October 27, 2010 23:02
3 minute read.
Aaron Katsman

Aaron Katsman 58. (photo credit: Courtesy)

 
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Maybe it’s just an ego problem
Problem is I’ve been fooled before
By fair-weathered friends
and faint-hearted lovers
And every time it happens
It just convinces me more
– Dr. Hook in When You’re in Love with a Beautiful Woman

We are continuously told that the stock market is overvalued and due for a huge fall. “Economic fundamentals stink,” “The stock market is irrational,” “The US dollar is worthless,” “The mortgage-foreclosure scandal is the next shoe to drop.” Basically, “It’s the end of the world as we know it.”

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We hear “experts” spouting these mantras all the time, and yet the market moves up? My question to all these doomsayers is why? Why does the stock market need to crash? Was it “rational” 18 months ago when the market had lost 60 percent of its value? Why should that be the correct level for the stock market?

The disconnect

While many investors believe that stocks price act in unison with economic performance, in many instances there is little relation between the two. According to the highly regarded CXO Advisory Group: “Evidence from simple tests offers little support for a belief that monthly or quarterly changes in US employment usefully predict intermediate-term US stock-market returns. Over longer intervals, the relationship appears to be inverse.”

The recent global recession, while painful for the average Joe, was a wakeup call for corporations worldwide. To stay afloat, many companies resorted to cutting costs and trimming unnecessary organizational fat. Anticipating a prolonged business slowdown, they were faced with the option of either massively lowering costs (which entailed huge layoffs) and trying to weather the storm, or continuing to be bloated and face massive losses and eventual bankruptcy.

For investors looking to invest in companies maximizing profits, now may be a potentially great time to invest. Regardless of what the “experts” say, the stock market is a gauge of current and expected corporate profits. It is not a litmus test for economic performance. Corporations have succeeded in significantly cutting expenses and are now very lean.



That means not only are they more agile and able to quickly adapt to changes in the marketplace, but when the overall economy starts improving, they are poised to post very strong profit growth. In fact, in the midst of quarterly earnings reports, we are witnessing company after company handily beating their earnings forecasts, and the companies themselves are becoming more optimistic on their own business prospects going forward. For investors looking to make money, this is the bottom line.

The end of the world

Maybe fear-mongering sells, but for investors it’s important to stay focused. Stocks are actually cheaply valued on a historical basis. Besides anticipated earnings growth, many analysts maintain that stocks are undervalued considering the huge amount of cash investors have been hoarding, with $9.5 trillion still on the sidelines, down by just $550 billion, or 5.5%, from a year earlier.

David Kelly, chief market strategist at J.P. Morgan Funds, believes “investors are missing the best part of the day,” comparing them to teenagers who sleep in until mid-afternoon. While there are lots of problems the economy still has to solve, “the biggest thing that’s out of whack is investor attitudes.”

According to Bill Nygren, manager of the Oakmark Fund, “The most likely candidate to derail the stock market would be Washington. There’s the risk that ballooning government spending will eventually lead to significant inflation, and that there’s much more of an anti-business tone to the rhetoric that we’ve had in Washington than anything since the Carter administration.” But he doesn’t see it as a big enough problem to make investors avoid owning equities for now.

In fact, the way it’s looking, next week’s US elections will be a total rebuke of the current economic policies of Washington. A reversion to more-moderate policies could be a big catalyst for further stock-market gains.

aaron@lighthousecapital.co.il

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people open investment accounts in the US.

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