Irrational Movements in a Rational Market

We believe that over the long-term, public stock and bond markets are rational. That means that while there are advisable strategies that help investors achieve their long-term goals, there is no magic “get rich quick scheme” caused by a fundamental mispricing in the market. However, even if a market is logical over the long-term, various short-term movements need not be rational – according to the SEC, the majority of trading activity is driven by short-term traders, who by definition, do not have a long-term outlook – and we believe much of the recent day-to-day volatility exhibits such irrationality.

No one can calculate the precise value of the S&P 500 index – doing so would require an exact foresight of future growth rates, profit margins, and reinvestment rates for each of those 500 companies, as well as interest rate levels and broad investor return expectations. So when we state that the market szeems to be fairly priced, we mean simply that the S&P 500’s price-to-earnings ratio (currently around 16) is consistent with long-term averages and current broad economic conditions. So suppose on a Wednesday, the S&P 500 is 2000, and the next day it falls 2% to 1960 – we can’t say which of those values is a more accurate representation of the value of the index. For long-term investors, this minor difference has only a small impact on their return performance.

However, what we can determine is whether such a 2% movement is rational – was that 2% change driven logically by changes in market conditions? We used that approach back in 2011 to determine that a 6% decline in equity values could not have been justified by the Greek economic crisis, because the Greek GDP was such a small fraction of the world economy.

Now let’s use the same type of analysis to understand the logical impact of three often-cited causes of the recent market volatility: China, oil prices, and interest rates.

China:

China has become a more important trading partner of the U.S. But it far from dominates our economy – exports to China are about 1/5 of the amount of exports to our North American neighbors, and sales to China make up less than 1% of our overall GDP. So when we see a report that growth in China may be 1% or 2% slower than it was before, a large reaction in Chinese stocks is understandable, but a significant drop in the U.S. stock market (or a significant rise when prospects for China become more favorable) seems irrational.

Oil:

In our commentary a few weeks ago, we explained the logic of any movement in U.S. stocks caused by energy prices. But the magnitude seems out of proportion. Certainly an oil price decline of 4% will significantly affect oil and natural gas exploration companies. But those companies only make up 1.7% of the U.S. economy – nearly all of the other sectors of the U.S economy will either be positively affected or unaffected by an oil price decline. So while some movement is understandable, we regard a significant overall stock market decline as illogical.

Interest Rates:

There is always an apprehension of what the Fed will be doing with interest rates. But let’s be realistic about where we are with respect to levels of rates. Annual real GDP growth was 4.5% between 1983 and 1989, and it was 4.0% between 1992 and 1999. And yet the average Fed-Funds rate during those two eras were 8.2% and 4.7%, respectively. So it makes us wonder, would an increase in the Fed Funds rate from 0.5% to 0.75% really be the cause to slow down the U.S. economy? If not, then the rationality of such large stock price movements caused by short-term Fed policy is questionable.

We want to clarify: movement in the markets caused by these three factors is understandable. It’s the extreme magnitude of the movements, both up and down, that causes us to believe that they’re irrational overreactions. There are other factors impacting markets, such as the possibility (albeit small) of deflation or severe recession. If these are the factors causing the recent stock market reaction, then again, it’s an extreme overreaction – such a drop makes sense if a severe recession is a probability instead of a remote possibility.

The Game We Choose Not to Play

So if we believe the volatility we’ve seen recently is not driven by rational factors, how should we change our investment strategy? The answer is we shouldn’t. In the aforementioned energy prices commentary, we cited research suggesting that after the vast majority of short-term volatile periods, markets over the next five years provided good returns – i.e., rationality comes back to the markets over the long-term. The volatility we have seen in the recent market dramatically affects short-term traders. As long-term investors, that volatility will only impact our actual returns if we choose to participate. For that reason, our recommendation is to maintain your existing investing strategy.

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