The markets don’t work that way. All the bad news you mentioned is already widely know, so it is built into current prices and cannot be expected to move markets.

Bad economic stats are irrelevant, unless they are worse than the general expectation. Very bad news that is only slightly less bad than expected makes markets rise. Therefore,, no good news is necessary to make markets rise – just the general expectations need to become slightly less bad.

The full effects of printed money causing inflation obviously have not been felt yet, but the fear of inflation is rampant, even though it is a minimum of a year away. The fear of inflation built into current prices is likely far more than the actual likelihood.

Unemployment is a lagging factor. In a normal recession, unemployment keeps rising even after the economy is recovering. Economists are only anticipating unemployment to rise about 2-3% – from about 7% to about 9-10%.

Meanwhile, the stock market is a leading indicator and usually rises 6-9 months before the economy bottoms. So, having the market rise for a 12-18 months before unemployment turns around is the normal expectation.

We think think the market level in early March was just stupid. The rally so far has just been sanity returning after over-shooting on the downside. I don’t know who was selling in early March, but it was obviously investors that focus on trends, and not on normalized valuations.

Ed

I still look around and see friends losing jobs. Unemployment in Canada is at 8%. Inflation is at 0.4%. Food prices are still rising. The prime lending rate is 2.25%, the lowest in Canadian history. Variable rate mortgages are at 3%. Two months ago the DOW fell faster than it did during the Great Depression, and in January investors panicked as British banks announced huge losses. The full effects of printed money have not been felt yet I believe. This must eventually result in inflation as dollars are devalued.

So why the market rally? What real-world, concrete, positive news do we have to explain this?

I’m surprised that there are no comments here yet taking notice that the markets are now up about 35% since this article was written. In retrospect, does the irrational pessimism not now seem obvious?

We talked to quite a few people in December to March that believed that they should hold off investing until “things look better”. In November to February, there were several 15-20% bounces up and right back down. Nobody felt comfortable yet with a 20% bounce.

That opinion seemed to be the general opinion of the public.

So, we told onyone trying to time the market that they would not get in until the market was up 40% or more. Why would they wait and miss 40% or more?

Now we are up nearly 40%. Is anyone feeling better yet?

Ed

We think the recovery so far is just making up for over-shooting on the downside. The market had no business falling anywhere close to as far as it did. Who was selling at those ridiculously low prices? The market fall was far more than during other recessions that were far worse.

That’s a very depressing viewpoint – but it does seem to be the general public view. I have heard your exact comments from lots of people – which is why we think these things are essentially priced into the market. Everyone knows about the housing market, too much debt, unemployment, etc., so none of these are relevant to future market direction, unless they turn out to be worse than expected.

The accounting rules have actually made things look quite a bit worse. Sarbanes Oxley has resulted in profits showing quite a bit lower for many companies, even though their operations are the same. The “mark-to-market” rule changes will have no effect on profits except in extreme crisis situations.

You can’t fear BOTH inflation and deflation. At least one of them won’t happen. In fact, both are extremely doubtful in the short term. The deflation fear appears to be history now, since the economy is showing signs of recovery. The inflation argument refers to running out of resources and Peak Oil. These may well happen, but probably not this year or next. This is a longer term issue.

Japan is a unique situation, since they have an “old boys’ network” and continually prop up bankrupt banks and real estate companies. Here, we just bankrupt them and move on. That is why their market is way down for 20 years, but our market tends to recover quickly. Almost all bear markets have recovered fully in 1-4 years. Even during the Great Depression, the recovery only took 13 years. That is why we don’t think the Japan situation will ever happen here.

Your comments about fund managers are true – but not your conclusions. Remember that most fund managers are just salaried employees of some big bank or insurance company. Their bosses restrict them in many ways, such as sector restrictions and wanting them to hold the stocks and sectors that the public is looking for (even though those are always the worst ones to own). So, why would they invest in their own fund?

They are investors, so they will pick their own stocks. Most fund managers don’t buy funds or indexes, because they believe they can do better with their own picks (which of course the average fund manager cannot).

However, the top fund managers and the average fund manager are totally different. Most of the top fund managers do invest in their own fund – often with the majority of their money. Why not, since their fund consists of exactly what they would inves in anyway?

The top fund managers usually are not employees of someone else’s company. They own their own firm, have no bosses, and their firm follows the discipline and style that they believe in.

One of our hedge fund managers requires that all employees of their company have 100% of their investments in their own funds. They say that really focuses everyone – and gives us a lot of confidence in them.

Ed

I precisely argue that exact point.

Markets keep rising despite the bad news. However this is only part of the equation. Markets keep rising despite no end of bad news and markets keep rising when the bad news is not as bad as previously thought! This is the key. I am well aware of past history and the general consensus markets tend to recover 6-9 months before the economy. My point is: housing values in the US are nowhere near stable, inventory in the housing markets are at numerous year levels (forget new starts!), unemployment keeps rising (yes, it is a lagging indicator), accounting rules are changed to make things look less bad, we have not even seen the effects of the commercial mortgage fallout (stay tuned!), the response to fixing the problem of overleveraging and too much debt is to create more debt, etc. etc. etc.

For anyone who is wondering what the future holds for the US stock market, please refer to Japan’s market crash from 1989 to present day. While checking that out also refer to Jim Rogers (go to youtube). Also, the inflation vs. deflation debate is alive and well (personally I think we will see the worst of both worlds as a result of mass unemployment coupled with eventual declines in supply of natural gas, oil, and food) either way look out.

The question is not when we have another crash but how do we protect ourselves? Gold and commodities (hard assets), go short, and calculated profit taking (the days of buy and hold are looking bleak) are my bets to survive this uncertain financial environment.

Do I think the stock markets are going to recover? Absolutely – just not permanently and just not linearly – again refer to Japan.

I have been on vacation for a few weeks and am just reading many of these comments. Ed, I respect your opinion on things however I couldn’t disagree more. The problem with fund managers is they are not managing their own money. I found it startling when I read over 50% of fund managers do not even invest in their own fund! Now, I wish I could remember where I read this, but I think it was off Globefund.com MarketBlog. I believe most fund managers take their hefty salaries from MER’s and invest in sound index funds.

I provide a lot of free info on MDJ hoping it may be helpful for readers. I try to be as open as possible, but the one piece of info I prefer not to reveal is our specific fund managers.

We do a lot of research to figure out who truly has talent. It is not as easy as looking at some stats and nobody is perfect. However, just like I believe I can figure out who the top NHL players are (They are not in Toronto.), we believe we can select the most talented fund managers.

For most of our clients, we do not charge for comprehensive planning and making sure they are doing all the right strategies to achieve the life that they want, because we make our money from the investments.

If you do not have time or desire to do all the investments research, then you should either find an advisor you trust to do this for you or stick with broad-based index funds or ETFs.

Whether you choose to work with top fund managers or ETFs, we would also suggest to avoid sector or regional choices, and avoid trying to market time them. It is best to let them do their thing. Most investors will consisently choose the wrong sectors/regions and lose most of their return with bad market timing.

Ed

The main problem with banks being shut down was not that they were not making money. It was that their reserves were too low.

The biggest issue was that they were holding subprime mortgage notes as significant portions of their reserves. The “mark-to-market” rule that forced them to value these at or bear zero since there was no market for them, even though that is obviously not a reasonable value.

The accounting standards organization has now softened the mark-to-market rule to allow a reasonable value when there is no market, which should mean that the remaining banks maintain enough reserves.

Most have been making money all along, even most of those that were shut down. So, having Citibank make money is not at all a surprise. With all the stimulous money going around and being able to borrow at essentially zero, a higher profit is also not surprising.

Ed

That is also part of the I.P. trend — fund managers. I can’t write any more about this without getting overly irate and thus incomprehensible. If you have a list of good (by all definitions) managers, I would love to get a copy of it.

As well, for the vast majority of investors, it’s not a matter of “don’t want to”, but one of “can’t”. Heavy duty, in-depth research such as you recommended is a full-time job and most investors already have a full-time job (plus more!). It’s kind of damned if we do…situation.

I await The List!

That is what investing research is about. Choose a small number of companies that you understand and do a lot of research. You can’t just take the financial statements at face value. You need to understand what they really say, read the notes carefully, compare them to competition, go to the annual meeting and meet the the management, talk to people that work for competitors or that would be their customers to understand how they see the company, and then you can figure out what the company is actually worth.

I understand your frustration over accounting practices, but most companies do not intentionally deceive with their financial statments. They just try to make it look favourable. Bank balance sheets are notoriously hard to understand, because they often have lots of off-balance sheet items, but many companies are much easier to understand.

This may sound like hard work, but that is what the top investors do. Any owner of a private business knows what it is worth. However, once companies go public, it seems that most investors have little idea what the company is worth and buy based on trend, chart formations, or simple ratios such as P/E of dividend payout.

Private business owners would never sell their company shares that way. There is a huge advantage for those investors that have done their own research and know what a company is really worth.

If you don’t want to do this reasearch and all your information is from public sources, you will probably find investing very difficult. Then it may be better to invest with fund managers that are top professionals and do a great job of doing this research.

Ed

The stock market is emotion and manipulation, the big players with money control the market and it will tank again once they decided to take their ball and go home. The current rally is just speculation that the economy is getting better. Take citi, they were given $25b to keep them alive and now they are a profitable organization? I mean come on, are people really this stupid to actually believe this? I’m starting to believe , yes.

I would vote yes on both counts (I.P. and I.O.).

An I.O. example would be all the big American banks now posting “profits” — with the help of extremely “fuzzy accounting” — and the optimists buying into (and overlooking) the irrationality of it all.

I guess, in the end, it doesn’t really matter what your mind set is because the market will never cease to be fueled by the two (always irrational) grand-daddies: Fear and Greed.

That’s great for you and your fund managers, but how is a regular off-the-street investor supposed to figure out the TRUE intrinsic value of a company when said company screws with their books and reporting to such a deep level (and for so long) that the TRUE value is almost impossible to find, perhaps even to insiders and CEO’s?

THAT is why there is irrationality, pessimism, and irrational pessimism.

There is a real value for every company in addition to the supply demand and current market price. It take a lot of fundamental research to determine what it is.

Private business owners generally have a good idea what their business is worth. But once it does public, nobody seems to care about the real value. Everyone is just focused on the trend, news, industry forecast, and how its chart looks.

If you think like a business owner and do real research, you can figure out what a company is really worth.

Most of the world’s top investors focus on fundamental research and figure out what a company would conservatively be worth if they were to buy it entirely. They call this “intrinsic value”. Then if they may invest in it if they can buy at a large discount to this price.

Our fund managers are telling us they have never in their long careers seen so many companies selling for so much below their intrinsic value as now.

Ed

Are you trying to argue that markets are overly opimistic now because the markets are rising while bad news comes out?

There is a common misperception that the stock market and the economy move together. The few studies that shed light on this show usually there is no correlation between them. Some even show a slight negative correlation, which means the market is slightly more likely to move opposite to the economy.

The reasons for this are because the stock market is based on expectations created by all available information. This is why announcements of bad economic news, such as higher unemployment, often result in markets rising, because the expectation was a larger rise.

The general expectations of how bad things will get before this recession is over are all built into the markets already, so if things keep getting worse and the economy gets as bad as expected, that should have no affect on the stock market.

In the last 3 weeks, the 20+% rise in the markets appears to result mainly from being massively oversold and because the bad economic news since then was already expected.

Ed

By my count, there have been 9 posts agreeing that we in “irrantional pessimism” and 23 posts disagreeing.

There definitely is a lot of pessimism!

Ed

For example, RBC (RY) was hovering around $50 for most of the year, before everything went off a cliff. I was willing to but RY in the high $40’s, why would I not want to buy when it’s $25-$35? I’m also not saying this won’t go lower, my biggest concern with the bank stocks is whether they might cut their dividends… not that I won’t buy them, I just rather do it after a dividend cut announcement than before.

How do you know that?! Show me the Proof! Look at all the Amerikan banks that are down 90% in the past 8 months, all due to “irrational pessimism”? Perhaps it’s their non-public internal business practices as to why they are now “half-price”. As Victor pointed out, they could all still be over-priced by half, and with good, albeit hidden, reasons.

Gates is obviously right on the money. When debt fuels two decades of your economy’s “growth”…well, something nasty is just waiting to happen! That’s also why stock prices are being cut in half, if half your “growth” and “profit” are mere debt, and that debt is being called…we’re all witness to that catastrophe.

All the “irrational pessimism” may also stem from the hoard of consumers (and business owners) finally realizing just what kind mess they are truly in, and they know it’s truly bad.