The ability for short-term stock market movements to confound the experts has rarely been more evident than over the last two weeks. Despite a spate of disappointing U.S. economic data, continued weakness in China, and a marked slowdown in German industrial production, global stock markets have been on a tear.
Since the low on September 29, the S&P 500 has rallied more than 8% as of last Friday. The MSCI EAFE Index of developed international economies has risen 6.7% in October and the beleaguered MSCI Emerging Markets Index has leapt more than 9% (USD). If stock prices are driven by economic growth (and its subsequent effect on profits), what accounts for the seemingly irrational behavior of equity investors?
While long-term stock prices are theoretically derived by the future earnings power of companies discounted to the present, in the short run other factors such as investor psychology and sentiment are much more important. As we recently noted, the market correction that began in late August rekindled fears of a more significant decline akin to the 2008 to 2009 market collapse. Measures of investor bearishness returned to levels not seen since the third quarter of 2011, when the U.S. threatened to default on its debt. When investor sentiment gets this bad, it is often viewed as a contrary indicator: if everyone is bearish, who is left to sell? In these situations, even a modest change in the direction of the data can cause a quick reversal in prices.
In this case, the change in momentum was apparently driven by the notion that the weaker U.S. economic data would cause the Fed to further delay its plans to raise interest rates. If that is truly the reason, we can expect the effect to be relatively short-lived. Instead, we would hope that the market’s recent rally is foreshadowing an upturn in future economic activity. Stock prices tend to react to expectations about the future long before the economic data actually confirm them.
In a recent study of the last eleven U.S. bear markets (prices down more than 20%), we found several characteristics that were common to each. Most typical was a looming economic recession, which occurred in eight of the eleven instances. Other factors often present were a sharp spike in commodity prices, aggressive Fed tightening, and extreme valuation levels. In our view, none of these conditions are present today, which gives us confidence that a severe bear market is not on the horizon.
The lack of direction from the economic data, the confusing and often conflicting messages from the Fed Governors, and the uncertainty surrounding China’s growth rate are likely to lead to continued volatility in asset prices. While further downside is always possible, we believe we have the seen the lows from this downturn.
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The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The MSCI EAFE Index is an equity index which captures large and mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Developed markets countries in the MSCI EAFE Index include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.