Read This, Spike That
The Cloudy View of Stocks from 30,000 Feet
How useful are broad-based market stories? Is a P/E ratio of limited use?
By John Kimelman
June 16, 2014 6:00 p.m. ET
Broad-based articles about the stock market and the economy are usually hard to ignore.
Because of their breadth and big-picture perspective, these articles tend to get great placement in both print publications and on Website homepages. And online editors know that broad stories tend to get more clicks than pieces about individual stocks.
But how helpful are they to investors? As you may have guessed, I think they have limited value at best. That's because most of these articles are based on information that the markets already know and thus already have factored in to the prices of securities.
What moves markets is the stuff that isn't in these articles. And most of those news nuggets, the best of which are tied to individual securities, are either not publicly known or known but underappreciated.
Another problem is that most of these market stories offer a mix of opposing views; a list of market "pros" that often match up nicely with the "cons."
The pieces that tread on the softest ground are the ones that suggest where stocks may be heading.
I was reminded of the limitations of broad-based market and economy stories when I read a collection of otherwise thoughtful pieces published Monday and over the weekend.
Robert Samuelson, the veteran business columnist with the Washington Post, wrote Sunday that "Stocks and bonds are sending mixed — and conceivably contradictory — signals" on the economic outlook.
"Stocks are routinely setting records, suggesting a recovery that's on track and strengthening. Meanwhile, interest rates on bonds have dropped," he added. "One possible interpretation is that bond investors expect the economy to weaken, pulling down interest rates and inflation in the process. Both messages can't logically be correct."
Despite this seeming contradiction, Samuelson argues that the surprise flight to bonds for safety and resulting lower yields doesn't necessary preclude consistent economic growth in the coming months.
"Economic growth will average three percent or more through at least 2015, according to the median response of 47 forecasters surveyed by the National Association for Business Economics (NABE)," Samuelson writes. "Consumer spending, housing construction and business investment will expand. The unemployment rate, 6.3% in May, will drop to 5.8% by year-end 2015.
Samuelson adds that "Mark Zandi of Moody's Analytics doubts the bond market is warning of a weaker economy. Zandi instead argues that the low interest rates result from a recent proposal by the Federal Reserve requiring banks to hold more "liquid assets" as a way of defusing future financial crises.
In the end, Samuelson argues that "the stock market's optimism trumps the bond market's (possible) doubt. Or does it? Could the economy disappoint again?"
Though it raises interesting points, the story should have most investors scratching their heads.
Meanwhile, E.S. Browning, the Wall Street Journal's veteran markets writer, suggests that "money managers and analysts are beginning to talk about an idea that dates from the roaring '90s: a rapid stock gain known as a melt-up."
"Now, Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, is warning clients that the market could see 'an unhealthy, speculative increase in asset prices,' which would leave stocks and bonds both vulnerable to sharp declines," Browning writes.
But Browning concedes that such events rarely happen when people are worried about them. "It is when people forget their concerns and go for broke that markets get in trouble," he adds.
At the end of the day, what's a reader to conclude? Should one alter one's investment strategy based on the possibility of a "melt up?"
It's not having that effect on me.
I'll close this column with a critical look at the most widely used investment yardstick of fundamental analysis: the simple price-to-earnings ratio.
For decades, investors have used the relationship between a stock's price and either a year or trailing earnings, or a year of estimated "forward" earnings to help determine whether a stock is overvalued or undervalued.
But an article in the Financial Times quotes a recent study by BCA Research that makes a solid case against a simple P/E ratio.
"A company's equity is not just a claim on the next 12 months of earnings," according to the study. "It is a claim on a long stream of future cash flows. Therefore, the forward PE is a meaningful measure of value only if next year's earnings forecast – assuming it turns out correct – is a representative statistic for what investors will receive over an extended period of time. However, it rarely is a representative statistic.
"The first flaw is that the forward PE takes no account of whether the 12-month forward earnings are near the business cycle peak, and therefore unsustainable, or near the business cycle trough, and therefore likely to grow rapidly. The second flaw is that the forward PE takes no account of whether the profit margins embedded in the earnings are structurally high, and so likely to trend down, or structurally low and likely to trend up."
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