Published August 24, 2009

Is the market always right?

By R SIVANITHY
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IT'S always an interesting and useful exercise to question conventional wisdom in the stock market, either when the mood is overtly bullish or bearish. Of course, many observers would point to a time-honoured maxim that 'the market is always right' which if true, suggests that it is an exercise in futility to try and probe for hidden truths beyond what the markets are saying at any one time - just accept the message being conveyed and react accordingly.

Stimulus packages may cause more damage as they delay the downturn and prevent economies from healing themselves.

As a general rule, this approach would be correct; you'd have to assume that the market is usually right and certainly, if you had stood still over the past five months and done nothing, you'd have missed out on a rebound that has, on average, added 40 per cent to equities round the world.

However, all rules have exceptions and this could well be one such instance when markets are, shall we say, less than correct. We say this because current wisdom, going by the large upward thrust in equities since March, says that because the US economy has turned a corner and is supposedly improving, then the outlook has to be rosy and thus stocks are cheap. This much most investors would be familiar with, the mantra from the broking community and investment banks that markets have more upside, that there are more earnings upgrades to bank on and that economic growth has only one direction - up.

But you'd have to ask, why is there still such widespread scepticism among an appreciable number of learned observers? In BT's Aug 20 Roundtable for example, the recovery was described as 'phony' by financial consultant Ernest Kepper. He said that 'a turn-up in the economy is not the same as the economy recovering lost ground'. Japanese professor and former finance vice-minister for international affairs Eisuke Sakakibara said that he was mystified because there is no good reason why stock prices are so high, either in Japan, the US or even in China, where he believes a major bubble is inflating.

Plenty to ponder

All of these concerns might be dismissed as simple, misplaced over-conservatism if stock prices are really cheap relative to future prospects, but here we find plenty to ponder.

In US financial weekly Barron's Aug 3 issue for example, former Merrill Lynch strategist David Rosenberg is quoted as being still doubtful that Wall Street's March low was a real market bottom. This is because, according to his reckoning, on March 6 US stocks were trading at two times book value, 13 times forward earnings and 18 times trailing earnings which were supported by a paltry 3 per cent dividend yield - all numbers which don't qualify as a true market low.

Worse, the dividend yield today has dropped to 2 per cent while the trailing price/earnings has climbed to 24, leading to the suggestion that 'the marginal buyer of equities today may well be the same person who was loading up on real estate during the summer of 2006'.

And what of US growth? Even here, questions can be asked. Thus far, the latest figures - which incidentally brought cheer to Wall Street when they were released - showed that the slide in US consumption is levelling off, but this was most likely due to tax cuts and the stimulus taking effect, both of which can only provide temporary relief. With no real improvement in employment and only 0.2 per cent private sector wage growth, it's not likely that US consumers can do their part to spend the economy out of trouble in the months ahead.

As some critics have correctly pointed out, stimulus packages may ultimately cause more damage than good because they delay the inevitable downturn and prevent economies from healing themselves. One editorial described stimulus packages as akin to juggling flaming torches - impressive while it lasts, but doomed to succumb eventually to the law of gravity. If and when the US's 'bailout bubble' bursts - or when the stimulus is withdrawn - Wall Street could be in serious trouble.

Liquidity driven momentum

So where does this leave the investor who is wondering where equities might head in the months ahead? First, it's best to acknowledge that a large part of Wall Street's rally since March was liquidity driven, possibly even fuelled by money from US bailout packages that was quietly channelled to investment banks. If the liquidity dries up, so will the momentum.

Second, government spending and stimulus can help ease some of the pain some of the time, but not all of the pain all of the time - especially when both are funded by government borrowing. This is because artificial growth of the sort being engineered in the US comes at a price, and this could take the form of higher inflation and higher taxes as many have forecast.

Third and perhaps most important though, is not to get too carried away by the pronouncements from the broking community that the worst is over and that it's all happy days ahead because there is plenty of room for scepticism.

Put differently, it's best not to place too much faith in the dictum that the market is always right because sometimes, it isn't.