Market No Longer a
Discounting Mechanism-Maybe it Never Was!
By The Curmudgeon
Pundits have claimed for years, that the U.S. stock market
discounts future events looking out six to 12 months ahead for corporate
profits and economic growth to determine current stock prices. They go on
to say that The Efficient Market Hypothesis (EMH) is based on the
theory that the stock market is a very efficient discounting mechanism.
We have doubted that axiom since at least October 1987 (many averages and
mutual funds peaked on Oct 6, 1987 -less than 2 weeks before the Oct 19, 1987
crash). Recently, we've been more convinced than ever that the
market doesn't discount anything at all!
The Dow and S&P reached all-time highs in
October, 2007, despite the fact that the economy was already heading
downward and soon fell into the deepest recession since the Great
Depression. Several sub-prime lenders had gone bankrupt back in
February of 2007 and two Bear Stearns hedge funds speculating in sub-prime
mortgage backed CDOs had lost all of their value by mid-July and had to be shut
down. Yet in October of 2007 stock market traders paid nearly $70/share
for shares of Fannie Mae (FNM) which went bankrupt and taken over by the
government, resulting in a tax payer bailout of $Bs!
Ditto for the market's March 2009 bottom, which
came less than 3 months before the recession ended, according to
the National Bureau of Economic Research (we don't think "the Great
Recession has ended yet).
Indeed, for most of the last two years the market seems to
respond to each news event- either rising or falling sharply for days or
weeks. Apparently, the belief is that the economy is getting better....
or not. It's the same story for individual stocks. Look at the
meteoric rise and sudden fall in Apple's stock (AAPL) in the last few months.
Market action after the recent 2012 election illustrates that
the market didn't discount that an Obama victory would cause "fiscal
cliff" worries which would precipitate a steep selloff.
Up till Election Day, the market wasn't worried at all
about the fiscal cliff, which will bring higher tax rates, higher taxes on
capital gains and dividends, and drastic cuts in federal government spending
(and sharply reduced GDP). Instead, the market marched steadily
higher off its June 5th low of 1,274.16 on the S&P 500, which stayed above (the psychologically
important) 1400 level from Aug 8th till Election Day, when it rallied
over 11 points to close at 1,428.39.
Betting site Intrade
predicted a 73% probability of an Obama win on Nov 6th election day. Market
forecasters also predicted an Obama victory (see reference below). So one would assume that the market felt that a re-elected Obama
would be able to work with Congress to avoid the fiscal cliff.
Else it would have sold off months before. Yet the day after the
election marked the start of a steep stock market decline that's
remains intact.
It's as if all of a sudden the market woke up on Nov 7th and
determined the fiscal cliff was an issue after all with Obama re-elected
President. But why not before then?
Today, only 7 trading days after the election, the S&P
closed at 1,353.33. That's 75 points lower or a straight line decline of
5.25%.
Zero Hedge (see reference below) and Elliott Wave
International concur that the market is not and probably never was a
discounting mechanism.
Perma-bear Robert Prechter
goes back to 1928 for evidence and writes:
"Technicians assert that the reason earnings lag stock
prices is that smart investors anticipate, or “discount,” the future, in
other words, guess the future correctly...The idea that the mass of investors
possess near-omniscience about the economic future is difficult to defend. It
does not explain why in 1928 the market foresaw nothing but blue sky, in 1929
very suddenly foresaw depression, and in early 1930 anticipated a recovery that
never happened...At the start of a bull trend, the vast majority is bearish,
while at the start of a bear trend, it is bullish. Their erroneous convictions
often reach an extreme... right at the worst time. Because markets are
patterned, the concept of near-perfect collective forecasting must be
false."
Wave Principle of Human Social Behavior, pp.
331-332
Again, we caution you: Caveat Emptor!!!
References:
http://www.investopedia.com/terms/d/discounting-mechanism.asp
http://blogs.marketwatch.com/election/2012/11/06/betting-sites-predicting-obama-victory/
http://www.thestreet.com/story/11756267/1/ithestreeti-predicts-obama-will-win-the-2012-election.html
Till next time,
The Curmudgeon
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.