Thursday, August 4, 2011

The Faulty Logic Behind the Market Sell-off - TIME

With the debt deal concluded, you might have expected global markets to have rallied. Instead, the Dow Jones industrial average closed down 266 points yesterday, or 2.2 percent.

The reason? There is a growing consensus among the investing class that a double-dip recession is imminent and that, as a result, stocks are in for tough times — and may even be poised for a crash.

You can’t argue with the market. If stocks fall, they fall. But the current outlook on equities may be based on faulty logic, namely that corporate profits and hence stock prices will track global GDP. For the past few years, profits have been strong even as GDP in many places has been weak, and there is little reason – based on what companies are saying over the past weeks – to believe that trend is at an end.

The sell-off of the past week and a half, which has continued even as the debt deal solidified, makes a certain amount of sense on paper. It’s been fueled by a raft of less-than-stellar economic data, ranging from a poor GDP report last Friday to weak future orders and declining consumer spending. And that data comes on top of uncertainty about just how bad the European banking and credit crisis will become. The upshot is that the investing class has turned distinctly bearish on the economy and future stock earnings.

Some of the most negative prognostication I’ve seen has come from the investing newsletter circuit. Perpetual bears like Marc Faber (whose regular report is called “Gloom, Boom & Doom”) are, not surprisingly, predicting a multi-year down market. But even less pessimistic market sages, including the widely respected John Hussman, have read the tea leaves of global economic data and concluded that a new recession is likely. Hussman is especially concerned about Chinese growth, which he believes will continue long-term but falter near-term, causing ripple effects in Canada, Australia and Brazil, among other countries.

But as I’ve noted in the past, what’s strange about all this is that somehow, amid the gloom, company after company has reported both record earnings and strong revenue growth. In fact, if you exclude financial companies, which are struggling under the combined weight of bad loans, anemic trading revenues, and new capital requirements, S&P 500 companies that have reported earnings this quarter are averaging nearly 22% earnings growth and nearly 12% revenue growth.  The revenue figure is especially powerful: Earnings can be massaged by astute accounting; but revenue reflects real demand.

Usually the market pays a premium for such growth, but stocks remain remarkably cheap. The average price-to-earnings ratio of S&P500 companies is about 12, well below historical averages and even cheaper when you look at the pathetically low yield on bonds.

None of that seems capable of swaying bearish sentiment, however, which holds that results to date are less important than results going forward — and that overall macroeconomic conditions globally won’t support the level of business we have seen.

You can’t prove the prevailing wisdom is wrong (given that it’s about the future), but it’s worth remembering that the most successful investors routinely bet against the crowd. And it is my sense that investors are falling into the same trap they have been falling into for years: Namely, they are assuming that business trends closely track economic trends when in fact they are increasingly diverging. Global GDP numbers are weakening, and traders will trade on the economic data in the short-term, but it has little bearing on the long-term strength of companies. This has been a problem for years, and it remains one.

So as the drumbeat of negativity gets louder, note what is happening in Corporateland. Sure, some are doing better than others there – all is not equal among companies any more than among individuals. But using weak economic data as an indicator of stocks or company profits is a mistake. It is one that is routinely made, and occasionally makes people money. But it will surely lead to missed opportunities and to a fundamental misreading of powerful trends propelling technology companies, industrial corporations and even many retailers relentlessly forward.