Why is Wall Street spooked?

Judging by the talking heads in the news media, you’d think the nascent recovery has come to a grinding halt. Despite over 80% of S&P 500 companies beating their earnings estimates, with many also showing higher sales than expected, gloom is everywhere. Consumer confidence has fallen for 2 months in a row. Forecasters are starting to ratchet down their 3rd-quarter GDP growth estimates. And the equity markets have taken back their October gains, putting us about flat for the month. This many be disappointing, but after last October, when global markets plunged –20%, a merely flat month should be something to cheer about. After all, even in a roaring bull market, stocks never go up every month. But why is this happening in the context of mostly positive news?

The obvious answer is that stock prices already incorporate the good news, while the few pieces of unexpected bad news (an earnings miss here, a surprise drop in new home sales there) are drawing everyone’s attention. During periods of economic growth, there are times when growth stalls or even backtracks. This has been the case in every recovery. Stocks tend to follow a similar pattern, with an overall uptrend punctuated by periodic setbacks. A drop in stock prices tends to reinforce the pessimism that triggered the drop in the first place. Eventually, pessimism peaks and the markets hit a near-term bottom. At this point, the uptrend can start again.

There’s clearly no way to know exactly when this will occur. If I did, I’d buy only on the days when each downtrend reversed and do all my selling just before each drop started. So although I claim no special clairvoyance (never have, never will), I sense that we’re close to a reversal back toward the upside, which could start as early as Thursday or Friday. A lot will depend on how the “flash” GDP number looks tomorrow. It it’s much better than expected, stocks could soar; if worse, they could fall some more before turning up again.

This GDP number is particularly important because it will likely represent the first quarter of economic growth in well over a year. Investors and economists are anxiously awaiting the “official” number, even though this initial estimate will be revised 2 or 3 times over the next several months, and “flash” reports are notoriously inaccurate. Even so, people will parse the details behind the aggregate number looking for clues to the future trajectory of economic growth in the US (despite the well-known fact that predicting the future by examining the past is futile).

On top of anxiety of tomorrow’s GDP report, and ongoing fears regarding bank solvency and the commercial real estate market (universally described as “the next shoe to drop”), we’ve had a couple of well-regarded investors call a near-term top to the current bull market. These include Bill Gross, chairman of PIMCO and one of the best bond managers in the word, and Jeremy Grantham, a well-known equity investor who supposedly predicted the 2008 downturn. Not surprisingly, many people take these pronouncements seriously, even though the smartest person is as likely to be wrong as right when predicting the future. And by the way, Bill Gross, despite his expertise in bonds, has a terrible track record in predicting the stock market (good thing he sticks to bonds when investing). And Jeremy Grantham not only predicted a bear market in 2008, but also in 2003, 2004, 2005, 2006 and 2007. (Nothing like being 5 years too early!) And by the way, despite being an avowed bear, Grantham still has 62% of his clients’ funds in equities. Go figure.

In sum, nothing that has happened recently has convinced me to change my intermediate- and long-term view that the economy, and along with it, risky assets such as stocks, bonds and commodities, will continue their general uptrend for quite a while. Until pervasive fear is eventually replaced by pervasive greed (something we are not likely to see for several years), every brief downturn and setback will scare the daylights out of most investors. But this sudden increase in the underlying level of fear only serves to form a base for the next leg upward, which these frightened investors will likely miss.

One last note: Americans continue to focus on their own country to the relative exclusion of the rest of the world. This is even more of a mistake today than it was in years past. The US stock market now represents only 42% of world market capitalization, and our GDP is just 25% of world production. And much of the world is growing far faster than the US. South Korea, for example, just reported a surprise 2.9% increase in GDP last quarter (equivalent to 15.4% annual growth). US economists would be giddy if we could produce an annual growth rate of just 6% in a single quarter. Thus, much of the opportunity in investing lies outside the US. This is why over 55% of our clients’ equity investments, and more than 20% of their bonds, are in non-US countries. Why not take advantage of the relative rise of the rest of the world?

Halloween should spook you; Wall Street should not.