Technicals vs Fundamentals
As we are looking at what might be a mild correction I want to go over a couple of things that I have learned over the years as far as predicting market:
One, it’s next to impossible.
Two, people still insist on doing it.
I will admit the first and talk about the second.
On Wall Street, there are generally two camps out there. One, is the fundamental bunch. Men and women that look at the fundamentals of a company and come up with some loosely described prediction of where a company’s stock might be going in the short term, mid term and long term. They use fundamental analysis to come up with potential risks and plot it out with whatever mathematical formulas they have and create a company analysis that is then used by portfolio managers in devising whatever portfolio they are working on.
The last few years have been a difficult time for people that use fundamentals primarily. There have been some outsized gains in portfolios for sure but it hasn’t been easy. I am in the fundamental camp and while I have done pretty well, I think I could have done better if I left things alone and let my overall strategy play out fully. No, I got out a little too early and missed some nice moves. Oh well. Thats fundamentals for you. There is some human element involved and humans are not perfect.
On the technical side, things have also been a little tricky as well. We have been dealing with a market that has not performed precisely as technicians would have liked. There have been some very clear technical signals that did not play out as planned and technicians got smoked more times than they cared to admit. All is not lost however, there are now some pretty clear technical signals if you just know where to look.
I do not profess to be a technician. I know Bollenger Bands and double tops and double bottoms but the real nuts and bolts are not my thing. I do use technical signals to get in or get out of certain investments, but by and large it’s fundamentals and gut instincts. Oh yeah, 40 years of experience as well.
What does all this have to do with where we are in this phase of the market? Ok, well it is pretty clear that we are going to be dealing with a correction of some sort. The Russell Small Cap index is almost in bear market territory as it is down 19% from it’s high. NASDAQ 100 index is in correction territory as well, being down around 13%. It will only make sense for the S&P 500 to hit that level sometime this week. So, we will be in the correction I have been calling for, big deal you say, what does it actually mean?
This overdue correction if it follows normal technical patterns should be short and sweet. Key components of a technical correction will be met but the question is, will it be a short drop or will it actually mean something?
Fundamentally, this correction should last for a few months. Repricing securities to their historical level takes time. A company that is trading at a PE of let’s say 35, historically has traded at a PE multiple of 26, will go back to the historical mean more often than not. They don’t become historical means for no reason. The overall market has been overpriced for quite some time and even with inflation creating record sales, companies earning will not keep pace. Thats where my go to, PE Ratios, will become more and more important.
You have had an economy that has had record earnings over the last 18 months and investors in December believed that those earnings will continue forever and apparently, that won’t be the case, so stocks should retrench a little.
The world is guided by equilibrium and markets are one of the purest examples of that. Stocks will always trade back to their correct price. Short term movements are trading opportunities for those people that like to trade but overall stocks usually trade at their value. All things being equal. The rub in that statement is value. How do we determine the correct value of an equity? Most times, the value will be correctly determined by the market at that time. Sometimes the valuation will get ahead of itself (as we have seen repeatedly) but valuations will almost always correct. That is where we are now. We are correcting valuations and while it may be painful, it is much needed.
I will go out on a limb here and say that if this correction is fleeting, we are in for a much bigger more sustained correction later. We are going into an era of less Fed support and possibly rising interest rates. Psychologically, that will have an impact even if economically it won’t have much of an impact. People hate investing in a rising interest rate environment and that is why we are seeing yields skyrocket and stocks retreat. Less Fed help scares investors but the reality of the situation will be a little different this time.
Here’s why:
In past rising rate environments, corporate earning suffered somewhat. Higher borrowing costs, lower profits. Not this time. This time, if corporate borrowing costs go up, they will pass these increased costs on to consumers. Now is the time! Blame it on supply chain issues. Blame it on Covid. Blame it on anything you can because we are in an inflationary cycle and you can pretty much get away with anything now. So pass on interest rate costs on to your customers, who cares? If you think about it this way, raising interest rates will not squash inflation, it will just sustain it.
Maybe I am thinking too simplistically but as I have gotten older, I have less and less faith in corporate America. It is driven by the need to sustain shareholder value more than it is to sustain a viable and important component of American society. Corporate America and their shareholders have been enjoying a tremendous run and inflation or Covid be damned, they are going to keep getting what they want.