At the end of last year, we predicted that 2015 would be another successful year for equity investors, but cautioned that gains would be hard-fought and accompanied by significant turbulence along the way. We thought that investor patience would be tested by the onset of higher interest rates in the U.S. and continued economic struggles among the world’s other major economies. While the story for the year remains to be told, the turbulence has returned as expected.
“U.S. Stocks Fall Amid Concerns About the Deepening Greek Debt Standoff” was the headline in last Monday’s Wall Street Journal. Sounds pretty scary. The very next day, the Journal’s market recap was titled “U.S., Europe Shares Rise with Greek Bonds on Signs of a Debt Deal.” These head-snapping changes in seemingly important stories are enough to give investors nausea, and are certainly contributing to this year’s stock market roller coaster ride.
With market-moving events seemingly changing by the hour and no shortage of media attention on even the most trivial events, what is truly worthy of investor attention?
We believe that financial asset prices are driven by three main factors: fundamentals, valuation, and psychology. When it comes to stock prices, fundamentals refer to the future earnings growth of a company, and are dependent upon many factors – both internal (e.g. business strategy and execution) and external (e.g. macroeconomic) to the company’s operating environment. Valuation is a process that attempts to identify whether an asset is overvalued or undervalued relative to its future earning power, past history, or other companies in similar businesses. Psychology is the short-term “noise” that tends to create mispricing opportunities when investors overreact to the market-moving news of the day, and is heavily influenced by investor mood, or sentiment. In our view, investors should gauge the impact of daily headlines on each of these three factors.
One could construct a scenario in Europe that involves Greece defaulting on its debt, exiting the Eurozone, and opening the door for other larger countries to follow suit. This would have a devastating effect on European fundamentals and would undoubtedly impact other equity markets outside of the Eurozone. We assign an extremely low probability to this outcome, and therefore view most of the headlines coming from Greece to be impacting psychology more than anything.
We continue to view both market fundamentals and valuation levels as reasonable and supportive of higher stock prices. While the precise timing of the Fed’s first rate increase is the subject of endless speculation in the financial press, is it likely to matter in three years whether the first rate hike was in June or September of 2015? More important is the pace at which the Fed raises rates, and its impact on the global economy. That is likely to have a far greater effect on fundamentals and valuation than the timing of the decision.
Successful investing involves distinguishing the signal from the noise. Our advice is to focus on events that are likely to shape long-term trends, and to avoid being consumed by the shifting news of the day.
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