By Joe Chidley
Are things better than they seem, or worse? It’s an age-old question, maybe, but we don’t seem to be getting much better at agreeing on an answer. This is particularly clear when you consider stock markets. Let’s accept, for the moment, that they represent some kind of collective bet on the future: what are they telling us? The answer matters, because it’s far better to buy into under-optimistic markets than under-pessimistic ones, right?
Yet there are mixed signals everywhere. Canadian markets are in the doldrums, despite the economy going gangbusters. You could argue we Canucks are too pessimistic right now, although a fundamentalist would point to the overweighting of energy on the S&P/TSX composite index to justify its weak performance. By contrast, the more-diversified U.S. markets provide a better gauge of sentiment beyond fundamentals. Despite continuing geopolitical tensions, two very extreme weather events, an inevitable if not imminent rise in interest rates, and ongoing confusion over government policy (tax reform, infrastructure, the debt ceiling, etc.), American markets just keep chugging along.
And U.S. stocks are expensive. The cyclically adjusted price-to-earnings ratio (CAPE), developed by Yale economics professor Robert Shiller, is approaching pre-1929 levels. Yet all three major U.S. indices — the S&P 500, the Dow Jones industrial average and the Nasdaq — hit new all-time highs this week. Bulls will say that strong corporate earnings and decent economic growth support valuations; bears are probably just getting tired of pointing out the risks, afraid of looking like Debbie-downers. Meanwhile, nothing seems able to derail the American rally.
One of the more interesting phenomena of today’s stock markets is their resilience. An example is terrorist attacks: investors have largely shrugged them off, at least in recent years. But the resilience extends to other areas. Consider the post-November 2016 Trump rally, fuelled by the then-president-elect’s promises of tax reform, deregulation and infrastructure spending. With the possible exception of deregulation, those promises have largely gone nowhere, and their putative benefits to corporate performance are clearly a long way off. Yet the rally — even without the Trump bump — has only picked up steam.
Are investors discounting the downside less than they are valuing the upside? You could make the case based on recent events. The accepted storyline on Hurricane Irma, for instance, is that markets breathed a collective sigh of relief after the storm’s devastation turned out to be less than feared, helping to drive indices to new highs. In the days leading up to its making landfall in the States, however, it’s hard to see that investors were preparing for the worst. Between Sept. 5, when Irma was classified a Category 5 hurricane, and Sept. 8, the last day of trading before the storm hit the Florida Keys on Sept. 10, the S&P 500 actually gained four points. If the markets were “right” not to overreact before Irma, then the net impact post-Irma should have been zero. But markets went up. So either something else was going on to support higher valuations, or investors’ response only worked one way – to the upside.
Of course, it’s wrong to look at any single factor, such as a hurricane, or a North Korean dictator, or a bumbled government policy, or even an interest rate hike, as the determinant of market moves. But you could easily take the quantum of investor responses to potential shocks and conclude that there’s an increasingly consistent pattern: overestimating the likelihood of positive outcomes and underestimating the likelihood of negative ones. If you subscribe to the tenets of behavioural psychology, you might call that optimism bias.
But is that really the case? In a recent interview, Shiller pointed out that his valuation confidence index, which is based on questionnaires with institutional and individual investors, suggests that confidence in stocks is at its lowest since 2000, at the height of the dot-com bubble. The AAII Investor Sentiment Survey, meanwhile, suggests that bears outnumber bulls by a margin of 36 per cent to 29 per cent; bullish sentiment is running below the historical average by more than nine percentage points.
In short, investors are wary of stocks, but they keep buying stocks — suggesting a clear disconnect between what they believe and what they do. That’s not necessarily a bad thing: it’s kind of hard to argue against going along with the herd when the herd is making you money.
Until, of course, the herd goes off the cliff.