Reply #11: Market Action as Information (Hussman)

[54anickel]

http://www.hussman.net/wmc/wmc050118.htm

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In general, comfort is an expensive thing to purchase in the financial markets. Still, investors do it all the time. They seek comfort by liquidating stocks – even deeply undervalued ones – after the market has experienced a long period of weakness. They seek comfort by chasing stocks – even wildly overvalued ones – after the market has experienced a long period of strength. It is very uncomfortable to actually provide other investors the comfort they seek, by standing there bidding for stock in frightening, undervalued markets, and by selling into exuberant, overvalued markets. But it's that very willingness – to trade in a way that provides scarce, useful resources to others – that is the foundation of long-term gains.

Market action as information

Price movements have at least two components. One is tied to fundamental values, and the other is tied to investors' willingness to accept market risk at any given time. The problem is that we don't get to directly observe which one is making stock prices move.

For instance, a decline in price may by a signal that future fundamentals are likely to be poor, and the fundamental value of the stock has declined. On the other hand, it might be that the stock price has declined even though the outlook for future fundamentals hasn't changed, in which case the stock is now a better value. How can you tell which is happening?

As always, context matters. Stock prices can never be analyzed properly without additional information to place their movements in context. For instance, if the price of a particular stock is plunging, but the overall market is also plunging, and all the other stocks in that industry are plunging, then we take the decline as a signal about what they share in common: overall economic conditions may be deteriorating, or investors may be broadly concerned about risk (those two possibilities could be further distinguished with additional information about the economy, valuations, credit spreads, and so forth). On the other hand, if the price of a particular stock is plunging, but the overall market and other stocks in the industry are holding up well, we take the decline as a negative signal about that specific company's prospects, or at least investor attitudes toward that specific company, and immediately look for information related to products, management and other factors idiosyncratic to that particular stock.

With the broad market, it is equally important to examine not only valuations but also market action. On the valuation front, knowing that the price/peak earnings multiple of the S&P 500 is 20.5 is already enough to anticipate that long-term returns (over the coming 7-10 years or more) are likely to be unsatisfactory. It is important to recognize that P/E multiples aren't just arbitrary objects, but are instead complex little mathematical beasts that have a long-term rate of return built into them, just as bond prices have a long-term yield to maturity built into them (for more on this, see Natural Consequences). This knowledge of valuations is a major advantage to investors who take the information seriously, because it provides an enormous amount of context in which to interpret shorter-term market action. As Charles Dow wrote a century ago, in one of the single most important observations in stock market history, “To know values is to comprehend the meaning of movements in the market.”

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