Logic Pays Off in the Stock Market
Peter Hodson Jul 22, 2011 – 12:27 PM ET
There is a saying amongst investors that the stock market is irrational. Certainly, at market peaks and troughs, the average investor might behave in a manner that is, um, not conducive to their overall financial health. Both the 2000 and 2008 extremes prove this point. In 2000, the average investor paid 70 times revenue for some dot-com stocks. Then, in 2008, the average investor was willing to sell many companies (more than 1,200, in fact, according to S&P data) for less than their net cash holdings. Because of this, the average investor never gets rich (it is a mathematical default that not everyone can be rich, anyway).
So, while investors can at times behave irrationally, there is a similar, but lesser-known saying amongst investors that says you should never bet against a rational conclusion. In other words, if there is a rational conclusion or explanation to whatever it is you are examining, you would be unwise to bet against such a rational conclusion, especially in the long term.
What do we mean by such a statement? Well, let’s take a look at some pressing issues facing investors today, and examine them in a rational manner. You might be surprised at the investment themes that can come out of a rational examination of the facts surrounding an issue.
The U.S. debt crisis: The United States owes a lot of money, and is spending far beyond its means. If you become irrational and panic, it might look like the end of the line for the country, the markets, and the world in general if the United States doesn’t raise the debt ceiling and/or defaults on its debt. But a rational approach reveals this: The debt ceiling has been raised 40 times in the past, there is an election next year (so there are more politicians jaw-boning the issue), and a U.S. default would more-than-likely send it spiraling into a depression. Plus, a default would mean China and others would never want to invest in the U.S. again.
Think of China as the loan-shark of the United States. If you owe money to a loan shark, you make sure they get paid first; otherwise, you might be in some serious trouble. A rational examination of the facts suggests that the United States will—after much debate—raise the debt ceiling again and use their printing presses to get out of this problem. It would be risky to invest against this, at the very least.
The European debt crisis: Software programs have predicted that Greece will default on its debt. At the very least, it has been impressive how fast Greece blew through the US$100 billion in aid it received last year.
The irrational investors are trying to figure out how to best profit from a Greek default, and how to gain from the domino effect as other countries in the European Union topple one after another. It’s true that the Greek problem is bigger than the U.S., because Greece does not have a printing press to create paper money to work their way out of their crisis.
That being said, a rational investor might look at what happened last time—Germany came to the rescue, to avoid a complete collapse of the system. There’s no guarantee, of course, but, given the alternative, it’s likely Greece will get a rescue, if only to buy more the European Union more time to consider the crisis. Like last time, markets would likely rally on this.
Interest rates: Everyone says interest rates can only go up. Considering rates are more or less at 0% that might be a logical conclusion. However, the bond market is clearly saying otherwise, driving yields on Treasuries to historical lows day after day.
Is the bond market irrational? Should we all start panicking about deflation again? Who knows? But if we rationally look at the U.S. situation again, the logical conclusion is that rates are not going up any time soon. The U.S., in addition to 9.2% unemployment, simply cannot afford to pay higher interest rates. With US$14 trillion in debt, any rate increase would seriously undermine the tenuous recovery. Logic would say rates are staying where they are for a long time. If you listen to the bond market and/or Ben Bernanke, you would have to agree with this statement.
Earnings: Investors, as usual, are fretting about earnings. How can earnings growth continue in this environment, they say? How can debt-laden consumers and governments keep buying? The irrational investor panics and watches quarterly earnings like a hawk. The rational investor tries to ignore this noise. Investors ALWAYS fret about earnings. This worry is—usually—already reflected in both earnings estimates and stock market valuations.
So, while it is a challenging environment for corporations, it has yet to be reflected in earnings. This week, in fact, showed more stellar numbers on the corporate front, with Google and IBM being prime examples. Rational investors might look at low employment costs (because nobody is hiring), low interest rates and huge cash balances (11% of market capitalization now for S&P 500 non-financial companies) and conclude that, at least for companies—things are not so bad right now.
The next time, then, you are reading a nasty headline, and decide to, um, freak out, try and be like Spock—logical. You are most likely to find logic works way better in the stock market than irrationality.