Market No Longer a Discounting Mechanism-Maybe it Never Was!

By The Curmudgeon

Pundits have claimed for years, that the U.S. stock market discounts future events looking out six to 12 months ahead for corporate profits and economic growth to determine current stock prices.  They go on to say that The Efficient Market Hypothesis (EMH) is based on the theory that the stock market is a very efficient discounting mechanism.

We have doubted that axiom since at least October 1987 (many averages and mutual funds peaked on Oct 6, 1987 -less than 2 weeks before the Oct 19, 1987 crash).  Recently, we've been more convinced than ever that the market doesn't discount anything at all!

 

The Dow and S&P reached all-time highs in October, 2007, despite the fact that the economy was already heading downward and soon fell into the deepest recession since the Great Depression.   Several sub-prime lenders had gone bankrupt back in February of 2007 and two Bear Stearns hedge funds speculating in sub-prime mortgage backed CDOs had lost all of their value by mid-July and had to be shut down.  Yet in October of 2007 stock market traders paid nearly $70/share for shares of Fannie Mae (FNM) which went bankrupt and taken over by the government, resulting in a tax payer bailout of $Bs!

 

Ditto for the market's March 2009 bottom, which came less than 3 months before the recession ended, according to the National Bureau of Economic Research (we don't think "the Great Recession has ended yet).

 

Indeed, for most of the last two years the market seems to respond to each news event- either rising or falling sharply for days or weeks.  Apparently, the belief is that the economy is getting better.... or not.  It's the same story for individual stocks.  Look at the meteoric rise and sudden fall in Apple's stock (AAPL) in the last few months.

 

Market action after the recent 2012 election illustrates that the market didn't discount that an Obama victory would cause "fiscal cliff" worries which would precipitate a steep selloff. 

 

Up till Election Day, the market wasn't worried at all about the fiscal cliff, which will bring higher tax rates, higher taxes on capital gains and dividends, and drastic cuts in federal government spending (and sharply reduced GDP).  Instead, the market marched steadily higher off its June 5th low of 1,274.16 on the S&P 500, which stayed above (the psychologically important) 1400 level from Aug 8th till Election Day, when it rallied over 11 points to close at 1,428.39.

 

Betting site Intrade predicted a 73% probability of an Obama win on Nov 6th election day. Market forecasters also predicted an Obama victory (see reference below).  So one would assume that the market felt that a re-elected Obama would be able to work with Congress to avoid the fiscal cliff.  Else it would have sold off months before.   Yet the day after the election marked the start of a steep stock market decline that's remains intact.

 

It's as if all of a sudden the market woke up on Nov 7th and determined the fiscal cliff was an issue after all with Obama re-elected President.  But why not before then?  Today, only 7 trading days after the election, the S&P closed at 1,353.33.  That's 75 points lower or a straight line decline of 5.25%.

 

Zero Hedge (see reference below) and Elliott Wave International concur that the market is not and probably never was a discounting mechanism.

 

Perma-bear Robert Prechter goes back to 1928 for evidence and writes:

"Technicians assert that the reason earnings lag stock prices is that smart investors anticipate, or discount, the future, in other words, guess the future correctly...The idea that the mass of investors possess near-omniscience about the economic future is difficult to defend. It does not explain why in 1928 the market foresaw nothing but blue sky, in 1929 very suddenly foresaw depression, and in early 1930 anticipated a recovery that never happened...At the start of a bull trend, the vast majority is bearish, while at the start of a bear trend, it is bullish. Their erroneous convictions often reach an extreme... right at the worst time. Because markets are patterned, the concept of near-perfect collective forecasting must be false."

 

Wave Principle of Human Social Behavior, pp. 331-332

 

Again, we caution you:  Caveat Emptor!!!


References:

 

http://www.investopedia.com/terms/d/discounting-mechanism.asp

 

http://www.zerohedge.com/news/guest-post-trading-yesterdays-news-%E2%80%93-what-does-stock-market-really-know

 

http://blogs.marketwatch.com/election/2012/11/06/betting-sites-predicting-obama-victory/

 

http://www.thestreet.com/story/11756267/1/ithestreeti-predicts-obama-will-win-the-2012-election.html

 

Till next time,

 

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.