Hot News!

Stock Markets are Like a Pendulum

Stock markets are like a pendulum.  They are always swinging one way, and then the other, looking for the perfect "sweet spot".  Like a pendulum, markets continue to overshoot their mark on the up-side and then on the downside, as they search for the right price.

How does an investor make sense of this? Investors view markets on a minute to minute basis; an hourly basis; daily; weekly; monthly; yearly, and then on a three, five, ten, fifteen, and twenty year basis and some investors look at even longer periods of time to evaluate the trends. The news media likes to focus on the hourly, daily, and weekly movements in the markets. I refer to this as "noise". There is an infinite amount of information that goes into the minute by minute movements of markets. The internet, and twenty four hour a day business channels add to the proliferation of information of news that affect stock markets. Factors like weather, political comments, economic comments, corporate reporting, consumer buying reports, inflation updates, wars, assignations, terrorist attacks, and human emotions all go into the minute by minute changes in the market. Each new piece of information affects millions of individual decisions that cause markets to move. Why do I call it "noise"? This is because the daily movements have minimal impact on the long term. They act as a reference point for the next day’s markets, but one new report can change the direction of markets all over the world another way.

The longer term investor looks at the monthly numbers, the annual numbers, and most importantly the three, five, and ten year rates of returns. The longer term investor wants to block out the "noise " and look at longer term trends. Most importantly, the longer term investor wants to sell when prices are high, and buy when prices are low. This seems so obvious that it does not have to be stated. The fact is that many investors get this simple maxim wrong. Investors, particularly amateur or emotional investors, tend to buy high and sell low more times than not. Many professional investors are actually "closet indexers. " This means that they buy what everyone else is buying and sell what everyone else is selling. They are afraid to veer from the pack and bring their own point of view to investing. The results are that when markets are good, the closet indexer does very well. When markets turn down, the closet indexer is hurt more than a professional should.

The best example to look at right now is energy. It is a topic that is on everyone’s mind. Energy prices are affected by many factors. In 1973-74, it was the oil cartel that squeezed supply and drove up prices and brought world economies to their knees. Stock markets suffered decreases of up to 50% as the oil price shock drove economies into recession. Thankfully, supply expanded again, economies recovered, and so did stock markets.

It is hard to believe that in 1999 oil fell in price to almost $10.00 a barrel. Everyone wanted to own technology stocks, and the oil supply was plentiful. Profits on oil companies were falling, as oil prices reached prices lower than the cost to take oil out of the ground in many oil producing countries. Therefore oil stocks were not in favor. This fall, oil has risen to $69.00 a barrel. Growing economies, industrialization of China and India, and hurricanes have all contributed to supply shortages causing prices to rise. All oil companies are extremely profitable at these higher oil prices, and everyone wants to own the oil companies, as well as those companies that supply the oil industry.

It is interesting to follow the trends of value investors. In 1999 value investors were selling technology, and buying oil stocks. Value investors did not believe that oil prices would stay as low as $10.00 a barrel, and that the pendulum would swing up. Rising demand for oil, and diminishing supply would eventually lead to higher oil prices. Last summer value investors were selling oil stocks, and buying industrial, consumer, and some technology stocks. Value investors believe it is better to sell early before the market peaks, then to sell late and get hurt by market sell-offs. This is a good example of the pendulum swinging. In 1999, cheap energy looked like it would stay inexpensive for the foreseeable future. Commentators were using expressions like "a new paradigm " which would keep technology stock prices rising for the foreseeable future. In retrospect, technology stocks no longer had value, and were way overpriced. The pendulum swung too far to the up-side on a majority of stocks. This meant that as "red hot " investor sentiment cooled, markets dropped too far to the downside to correct the excesses in the technology sector. 9/11, the war in Iraq, Y2K, accounting fraud, and over exuberance all contributed to the 2000-2002 downturn in stock markets. It has taken five years for the technology swings to find their equilibrium and start a slow, but steady rise up.

Energy is now the "darling " of stock investors. Professionals know that we are close to a market top in any sector of the markets when you hear the phrase, "This time it is different ". In my twenty year career I have seen major corrections in the bond markets and Latin American markets in 1994; the Far East and emerging markets in 1998; and technology stocks in the 2000 to 2002 period. This doesn’t mean that energy is not a great place to invest in the longer term it just means that the higher it goes in the short term, and the more frenzied the investor sentiment becomes, the more the pendulum will swing to the downside to correct investor excesses.

Ultimately, every stock is valued on its profits. All the other factors I previously discussed contribute to the price of a stock that investors are willing to pay, but in the final analysis, the higher the profits, the higher the stock price. If corporate profits are increasing, higher stock prices will follow. If corporate profits are falling, stock prices will eventually drop as well. To make this discussion a little more interesting, if interest rates are falling, stock price multiples will probably increase, and if interest rates are rising, stock price multiples will probably contract. Stock price multiples can be defined by the price earnings ratio. In other words, how much investors are willing to pay for a dollar of earnings. If they are willing to pay fifteen times the amount of earnings, or $15.00 for a dollar of earnings, the price earnings ratio will be fifteen.

The average price earnings ratio over the last fifty years is about fifteen. In retrospect, there was a problem in 1999 when markets like the S and P 500 in the United States were trading at twenty eight times earnings. Interest rates had dramatically fallen in the 1990’s and the majority of investors believed that there was "a new paradigm ". This justified the expansion of the P/E ratio to absurdly high numbers, and since the pendulum had swung so far to the high side, it took a very large correction, and a very large swing of the pendulum to the low side and many smaller swings to finally have markets arrive at the "sweet spot " again.

Many investors believe in the theory of "reversion to the means ". This means that no one sector of the market will continually outperform every other sector for an indefinite period of time. It also means that the higher one sector goes, the more it will fall to get back to the average long term rate of return. This is one of the biggest pitfalls that amateur investors make. Many want to buy last year’s winners.

In the 1990’s American markets were the best in the world for the decade. Though the Canadian and U.S. economies are closely interconnected, U.S. markets were dramatically outperforming Canadian markets for the entire decade. Canadian investors wanted to move their investments from Canadian markets to US markets. The problem was that there were foreign content constraints on RRSP and pension fund investments for Canadians. By the end of the decade, investors found ways to get around the foreign content rules by using clone funds, and derivatives. What has happened this decade?

Canadian markets are dramatically outperforming US markets. This is what we refer to as reverting to the means. Though U.S. markets are much larger than Canadian markets, history has shown that the out performance that US markets enjoyed in the 1990’s would not continue forever, and in fact this is what has happened.

In simple terms, the U.S. stock market is much more diversified then the Canadian market. In the 1990’s technology, consumer and industrial companies were being rewarded by stock markets investors, The Canadian markets are primarily natural resource and financial. In the 1990’s investors wanted what the U.S. markets were strong in. This decade, there is a worldwide shortage of resources, and therefore Canadian markets are being rewarded.

What are Canadian investors doing now? They are selling their foreign holdings and buying Canadian energy and natural resource stock, and income trusts. What are many of the professional Canadian money managers doing? They are selling their energy and natural resources stocks and income trusts. They feel that the pendulum will swing again, and they see value outside of Canada. They would rather sell high, and buy low. Does this mean that the price of energy and energy stocks can’t go higher? Nobody can predict natural disasters, terrorist attacks, political decisions, and demand from growing economies. The value investor would rather be out early and miss some of the profits, then be out late and lose the profits. Markets, and specific sectors of the markets, go down faster then they go up. The reverse is also true. Value investors would rather be buying early in another sector where nobody is buying with enthusiasm, then take the risk and buy into a sector after everyone else has already discovered the sector and the easy money has already been made.

What should an investor do? Canada makes up only 3% of the world markets. An investor should try to tune out the hourly, daily and weekly "noise ". Asset allocation is the key. A proper weighting of bonds, stocks, cash and real estate will spread out the risk for the investor. The next decision is what percentage of the stock component should be allocated to foreign, and to Canadian investments. The long term investor should continually review their asset allocation, and re-balance to their target weightings. This means taking profits from one sector when prices dramatically rise, and buying into other sectors when the prices drop in value. Most importantly, buy stocks that are good businesses, and have good long term potential for increasing profits. For many investors, the real estate component of their portfolio is their personal residence. Though a personal residence will not generate revenue for you, it does give an investor a sense of security when real estate prices are rising, as they have in this decade.

The following advice is 500 years old. It comes from one of the original value investors. Surprisingly the advice is as relevant today, as it was 500 years ago.

"Divide your fortune into four equal parts: stocks, real estate, bonds and gold coins. Be prepared to lose on one of them most of the time. During inflation, you will lose on bonds and win on gold and real estate: during deflation, you lose on real estate and win on bonds, while your stocks will see you through both periods, though in a mixed fashion. Whenever performance differences cause a major imbalance, rebalance your fortunes back to the four equal parts. " Jacob Fugger the Rich, 1459-1525

Remember, the pendulum always swings. If things seem too good to be true, they probably are. If markets seem depressed, and the news media is predicting doom and gloom, a turn for the better is probably not that far away. My personal belief is that the free market system is more elastic than most people believe. The system has a way of correcting excesses, and lifting markets. One example is energy. Many believe that the higher the energy prices, the more people will find ways to conserve, and find alternative sources of energy, which will force prices down in the short term. The word elasticity and pendulum are interconnected. The pendulum always swings, and as long as innovation continues, and productivity increases, markets will rise over the long term.

Richard H. Kizell, BA, RFP, CLU, CFP

Independent Planning Group- Kingston

This is not an official publication of Independent Planning Group Inc and the views expressed in this article are not necessarily those of Independent Planning Group Inc. This article is intended as an information service with the understanding that it does not render any legal, market predictions, tax or other professional advice. It is recommended that readers consult their professional advisers regarding any matter addressed in this article. The information and opinions contained in this article are obtained from various sources and believed to be reliable, but their accuracy cannot be guaranteed. Readers are urged to obtain professional advice before acting on the basis of material contained in this article.