On market swings and the behaviour of crowds
While taking in a recent NHL hockey game, wegot to thinking about the peculiarities of humannature and how group dynamics might bemaking an outsized contribution to the recentplunge in stock prices. During a stoppage in playmidway through the first period, the team mascotmade one of its frequent appearances in thelower bowl, this time wielding an air-poweredbazooka designed to fling tightly wrapped t-shirtballs across the arena and into the hands of luckyfans. Though we’ve never had the fortune tosnare one of these garment bombs – and mustconfess to never having seen one in its unfurledform – we’re reasonably confident that the shirtsbeing given away many times each night aren’tcrafted of fine pima cotton or painstakingly hand-embroidered with the team’s crest. Still, when the barrel’s pointed their way, patrons with themeans to sit in the rink’s best seats are suddenlyovercome with desire for a memento that theywouldn’t likely think twice about in any othercircumstance. The hopeful feed off each other’senergy, shedding restraint as they wave arms,whistle, holler, and jump up and down, tryingdesperately to catch the eye of the gun-totingstuffy.
Around the same time that we were watching therelatively well-heeled jostle for attention in a t-shirt toss, a run-of-the-mill equity marketcorrection was rapidly taking on a more bearishtone. In the space of just a few weeks, thecollective perception of stock valuations andunderlying business conditions was upended andmeasures of investor sentiment shot from mildlypositive to deeply pessimistic. As recently as latesummer, investors worried that the economicbackdrop was too good and that central bankerswould be forced to raise interest rates severaltimes to get ahead of potential inflation; now,though, the market convulsed when a mere 25basis point hike by the US Federal Reserve wasaccompanied by comments which wereperceived as not quite sufficiently dovish.
Because the drop in equity prices was relativelysudden and hasn’t coincided with a corporateearnings slump or a significant deterioration inreported commercial activity, we’re inclined tobelieve that the swoon represents more of amarket event than an economic one. Severalmarkers from the front lines of the US economysupport this view:
Costco reported same-store sales growthsignificantly ahead of analyst expectations,including a jump of more than 32% in e-commerce;
Target enjoyed a similar lift in recentmonths, with the CEO commenting thatthe present “consumer environment isperhaps the strongest I’ve ever seen”;
In early December, Darden restaurants(parent of Olive Garden, LonghornSteakhouse, and others) said that not onlyhave sales been strong, but customers arepurchasing add-ons and upgrades tostandard meals at a record clip;
At the depths ofthe market plunge, DM holding Nike reported blow- out earnings, with management commenting that it “wasn’t seeing any impact from friction on trade between the US andChina” and that it’s “incredibly energizedabout 2019”;
According to Mastercard SpendingPulse,the jump in retail sales from November 1stto Christmas Eve made this the bestholiday shopping season in six years.
None of these suggest a failing economy or capitulating consumer, yet several commentators have suddenly piled onto the idea that we’re set for a meaningful slowdown – maybe even a recession – in the coming year. Even from a broader view, though, it’s difficult to find much in the way of deceleration. In December, the US economy created 312,000 jobs, blowing past expectations of 180,000 additions, while the chart below shows that trucking tonnage in the US has remained robust right up to its latest reading (we could substitute trucking volumes with rail data, air freight, or aggregate industrial production and the chart would look about the same).
Source: American Trucking Assn., Bloomberg
As you can see, the amount of goods shipped bytruck south of the border and the performance ofthe S&P 500 have borne a close correlation over the past 15 years.While stocksplunged by asmuch as 20% inthe fourthquarter of 2018,however,trucking volumeswere climbing toan all-time high,resulting in a rare divergence of trend and opening up a significantgap between activity in the real economy and thebehaviour of equity prices.
When stocks decline as sharply as they have inrecent weeks, talking heads are quick to declarethat “the market is telling us something”, as if thecollected wisdom of the share trading crowdnecessarily carries some economic clairvoyance.We put less faith in the foresight of the broadinvesting public, however, and much as fans at ahockey game will behave less rationally thanotherwise when swept up by the fervour of thosearound them, it’s almost certain that marketplayers are just as likely to discard their betterjudgement when excitement or anxiety arerunning high. In fact, disproof of the market’spredictive power can be found in the circled area of the trucking chart. When volumes flat lined in2007, stocks ignored this tangible omen andclimbed steadily to mark new highs, unfortunatelyoblivious to the economic and market nose divethat would begin just a few months later.Sometimes, in fact, the market is wrong.
As wild price swings and incendiary headlineschallenge confidence, there are at least a fewthings worth remembering. First, no matter howpersuasively commentators, journalists, andstrategists present their predictions andprescriptions, the fact is that none of them reallyknows. As the saying goes, if they truly had suchprized knowledge, they wouldn’t be writing ablog, or talking on TV, or working for a bank. Acouple of years ago, a consulting firm (CXOAdvisory) decided to test the forecasting ability ofWall Street’s best-known investment gurus bycollecting data on more than 6500 predictions bythese financial luminaries and grading each for itsaccuracy. The result? Only 47% of forecasts werecorrect ... a score that would have been beatenby a coin toss.
Second, despite what the market is purportedlytelling us, the world’s most important economy(and a significant contributor to Canada’seconomic well-being) is doing just fine. Yes, therehave been pockets of difficulty – Apple had a bigstumble in China, but it’s unclear how much thisshortfall had to do with trade troubles or haltinggrowth, and how much just reflects the fact thatthe country is still far from wealthy on a percapita basis and only has so much capacity topurchase or upgrade $1000 luxury items. Back on our shores, companies are hiring, consumers areconfident and behaving that way, and recentcommentary from most corporate managementteams has been decidedly positive. Earningsgrowth in the US almost certainly won’t be ashigh in 2019 as it was last year when a massivetax cut provided a tangible boost, but it shouldbe relatively strong nonetheless. At the sametime, equity market valuations are now below 60-year averages, even though interest rates aresignificantly lower now than in virtually every yearof that six-decade span. Against this backdrop, it’sdifficult to envision the current market setbackswelling into a prolonged, grinding downturn.
Finally, quarters like the one just passed areunfortunately the price of admission to theupside of equity ownership. The risk beingrealized at the moment is merely the flip side ofthe same coin that generates the long-termcompound growth that most of us require to stayahead of inflation and meet our investment goals.Without fear of periodic decline, however, stockswould be bid up to the point that they offeredthe same meagre returns as other risk-free assets,such as treasury bills and government bonds.
The fourth quarter of 2018 was unquestionably abad one and, absent a post-Christmas rally, itwould have ranked amongst the worst since thebeginning of the Second World War. Two pointsshould be noted about horrible market intervals,though: first, they scare a lot of people out of themarket and, second, in doing so they often setthe stage for a big comeback for those who remained committed to their investment plans(see table below).
We can’t say whether 2019 will bring a recoverysimilar to those listed here, but given a reasonable level of equity valuations, interest rates that remain historically low, and an economy which continues to create jobs andsupport consumption growth, such a resultwouldn’t be surprising in the least.