Market Voodoo: A Cautionary Piece about Oversimplifying

By Brad Thomason, CPA

 

Monday morning here in Birmingham, and I have been waffling for several days about whether or not to write on today’s topic.  But just now I was flipping through the issue of Barron’s that arrived over the weekend, and saw a little nugget that pushed me off the fence.

In the opening column Randall Forsyth made note of the fact that last week’s announcement by the Fed to start trimming back bond buying is being credited with driving the stock market down by $775 Billion.  That’s just Wednesday and Thursday of last week.  The Dow was down another 224 today when I checked just a second ago, and there seems to be little doubt in anyone’s mind right now that “the Fed caused this.”  What drew my attention was the way he put the matter in perspective.  The government has been buying $85B in bonds each month.  So the portion of the drop on Wednesday and Thursday is equal to about 9 months worth of bond buying activity.  Seem rather disproportionate?  To an auditor, that which is disproportionate is that which needs to be scrutinized.

One of my favorite quotes is from Einstein:  “Things should be made as simple as possible, but not simpler.”  What we are seeing in the market right now is a clinic on why Mr. Einstein’s advice is spot on.

For months now I have been listening to people remark that the run up in stock prices was due almost entirely to Fed activity.  I’m going to stick my neck out here and tell you that I do not agree with that assessment, nor have I at any time.  The sustained run up has no doubt been impacted by Fed activity.  But to assume that’s the only factor requires you to ignore things like a stabilizing and recovering economy, resurgence in consumer spending, and most importantly a continued pattern of strong corporate earnings (which Peter Lynch long ago wrote is the single most important factor in stock market performance).  Factors that no one looking for a true read on things could credibly allow themselves to ignore.  And yet…

Here’s my point:  When you allow yourself to buy into a simplistic explanation about a complex matter, you give over a degree of control to that simplified (aka false) notion.  The result?  When there is a change in the status quo of that particular variable, the effects are exaggerated.  If we mistakenly think that the only thing holding up the stock market is the Fed, then when the Fed goes away, the market collapses.

Look at the chart of the last few days.  Q.E.D.

Look at the big picture here, too.  The economy is doing better.  That’s good news.  The Fed thinks it can start stepping away from its protective stance.  More good news.  Market response?  Dives off a cliff. That’s the market’s voodoo at work.

Are there fundamental reasons why the cessation of Quantitative Easing and the possible future rise in interest rates could eventually have an impact on corporate earnings?  Yep.  But it certainly hasn’t happened as of today, nor are many of the sellers in the market bothering to work through such convolutions to try to figure out what to do today.  Instead, they heard that the Fed was going away, and since everyone knows that the Fed is the only reason that stocks have gone up in the first place, that must mean it’s time to run for the exits.  Sigh.

The irony is that there actually may be some pretty good reasons to think that stocks have a tough time going higher from May’s levels.  But just as the complexity on the run up was not widely acknowledged, so it appears will be the case on the down leg.  Rather than actually get into the meat of either case, it appears that the vocal part of the herd (those entering the buy and sell orders) are going to stick with the simplicity that brought them to the party in the first place.

Which is really why all of this matters.  The market is a place where you do not have to do anything wrong to get hurt.  Your fellows can create ample chaos all by themselves, just like an inattentive driver on a busy interstate.  If I were ever to write a manifesto on investing it would likely contain a line that more or less said “Do whatever you want to do, just know what you are getting yourself into beforehand.”

In the case of investing in the stock market that would require an understanding that simple explanations are not your friend.  But also the realization that even if you understand that to be true, you still have to watch out for what everyone else is doing.  Since logic is not a requirement for placing an order with a broker, but those orders do impact where the price goes for everyone who holds some of that asset, a failure to appreciate the power of the voodoo can lead to a lot of pain.

 

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