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It’s hard to be bullish, but even harder to be bearish

22nd July, 2020

Published in the Sunday Times on July 26th 2020

The French cult movie La Haine opens with the telling of the story of a man who falls from a 50th floor of a building. “So far, so good” the man tells himself reassuringly while passing each floor. “But”, so the story goes, “it’s not how you fall that matters, it’s how you land”. There’s an evolving story in financial markets over the past several weeks for which this story seems emblematic.

The global financial market’s sprint higher in the last quarter has created new stock market celebrities, who boast triple digit returns and are scathing of traditional approaches to money management and its famous advocates including Howard Marks and Warren Buffett.

Retail investor impact on stock markets

The self-proclaimed captain of these day traders, Dave Portnoy, in a career spanning three months, claims returns of 400 per cent. Eye-watering by any standards. But it’s equally hard to keep a dry eye at the narrative around his stock picks. One of his recent recommendations - pet food retailer Chewy - he bought because he likes dogs. And the rationale provided for his purchase of Israeli medical materials developer InspireMD, was to impress a girl. Entertaining, if nothing else.

Plenty of people with time on their hands and stimulus cheques in their pockets, want some of what Davey Day Trader (as he refers to himself) is having. A popular narrative holds that the market has rallied so much because of a flood of money from retail traders using zero-cost brokers. A report by Barclays disputes this however. The phenomenon is likely more a symptom than a cause of the market rally, though there are pockets of stock market activity that seem affected (Exhibit A: stock price of Hertz).

In any event, it’s highly likely the day traders will soon discover that random, frequently leveraged stock market speculation has a similar finale to a fall from a fifty-storey building. Very sudden and usually terminal.

The Wall Street-Main Street divide

The take-away from this tale is not so much a warning about the perils of stock market speculation, though take that as read. It relates to a broader issue for the investment industry about what drives stock market returns, which is very often misunderstood, as recent debates about retail investor impact attest.

Stock markets globally have rallied significantly off the lows from March 23rd. Against a general sense of foreboding, stocks have climbed the proverbial wall of worry looking past the economic calamity that is currently unfolding.  For those who earn a living analysing financial markets, this has been a tough time. Stocks have rallied to near all-time highs at a time of a global pandemic, civil unrest, trade wars, mass unemployment and the worst peacetime recession ever.

The notion that stock markets and economies are closely tied together is deeply held. It certainly appeals to intuition. But we have to remind ourselves, that there is scant evidence to suggest that economic growth is correlated with stock market performance.

What really drives stock markets?

In the US, of the 69 years since 1950, eight have seen real economic growth contract, essentially recession years. However, in 23 of the years (33% of the time) earnings from the S&P 500 companies experienced declines (Source: Crestmont Research). In short, there is much less to be gained from poring over current macroeconomic data than is commonly believed.

So, what can explain stock market returns? In the long run, it’s earnings (including dividends) and valuation. In the short term, it’s sentiment, and valuation (which can have a much greater impact over shorter time periods). And when we look at these two variables, what we see currently is something very positive in terms of market mood and something less so in terms of price.

From the low point of markets in March, globally, Central Banks and national Governments have stepped in with a broad array of actions to limit the economic damage.

The twin arms of Central bank support via credit and sovereign bond markets are certainly encouraging a sense of optimism. Evidence of a downturn that is slowing sends share prices soaring. In a financial system flooded with cheap money, it’s the direction of travel, rather than evidence of a sustained recovery that seems to matter.

Sentiment and valuation

Sentiment is high. People’s perception of what policymakers are capable of doing when the economy (and stock markets) decline has been catapulted higher in a significant way. Barring an eruption of turmoil in credit markets or a big shift in bond yields, lasting weakness in stock markets seems contained.

The valuation side of the equation looks less promising. Most major markets are no longer cheap, with some asset classes pricing in a very normal growth recovery rather than a constrained one.

So, it’s hard to be bullish. But against the current fiscal and monetary backdrop it’s even harder to be bearish - maybe the day traders are right.

Herein lies the dilemma for investors compelled to have to make a decision (you can’t be agnostic; a non-decision is also a decision). For the genuine long-term investor, proceed with caution, and use the inevitable pullbacks as opportunities to institute a long-term strategy. If your time horizon is measured in hours as opposed to years, I’ve nothing constructive to add, but refer you to the opening paragraph.

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