Hope vs Worry

In February I wrote: “During periods of high volatility, and even in the middle of very tough economic times, markets can go up a lot.” This continues to be a true and important statement. Since the March 9 “bottom” stocks are up a lot. Is it time to throw caution to the wind? I think not.

Markets are created by buyers who have hope and sellers who have worry. Times of change are characterized by the tension of two competing fears: The Fear of Loss vs. the Fear of Missing Out.

Markets in the short term are driven by these emotions and sentiment. Hence, logic is almost useless as a predictive tool in the short run. In the long term however, markets are priced by the profitability of companies, which is driven by economic activity and increases in productivity over the long run. Logic can be very useful as a predictive tool in the long run.

From it’s peak of nearly $65 trillion in 2007, World Stock Market Capitalization fell below $30 trillion in March 2009. This type of decline has no explanation other than a global panic driven by a level of emotion (fear) and a fall in housing prices that I have not seen in my lifetime. Since this “bottom” in March, it has risen dramatically. In April alone, it rose $4.2 trillion. The only logical explanation is the recent rally is simply a realization that the previous decline was overdone.

You will hear the “worry” crowd pontificating that markets cannot recover until the economy improves. There are many signs that the world economy is still in a great deal of trouble. Unemployment is rising. House prices may fall further. People are spending less. The “hope” crowd however will point out that there are many “green shoots” or signs that things are on the mend: Consumer Sentiment is up; Housing has never been so affordable; Governments worldwide are proactive and are implementing unprecedented pro-growth initiatives; There is a great deal of cash sitting on the sidelines, earning little interest income and poised to enter the stock market. Both crowds are correct. But, most importantly, markets tend to turn upward ahead of the economy.

Within the “worry” crowd is a group who fear that our best times are behind us. They not only fear another decline in the short term but also a long term reduction in enterprise profitability and hence value. Within the “hope” crowd is a group that figures the worst is over and that good times will soon return. Both groups are probably incorrect.

The point here is that good times will return. The unknown is only really how soon and how fast. World stock markets were probably overvalued at $65 trillion in 2007. (Knowing what we now know about excess borrowing and debt.) They were undoubtedly undervalued at $30 trillion in 2009. A case can be made that their “fair” value is between $40-50 trillion. Markets therefore have room to rise. But, their rise is likely to be a roller coaster ride of ups and downs: Hope vs. Worry.

So, investors with a long term outlook should stay invested with a cautious outlook and cash should be deployed cautiously. Continued recession and a recovery with inflation are both very possible outcomes. What you invest in will be very important. Good advice has never been more valuable.