Market Driven By Emotions Versus Fundamentals

I write this shortly after the Dow Jones Industrial Average rockets higher by nearly 500 points, or 4+%, in just one day, I think back to the concerns raised in recent interactions with some investors expressing concern about the market’s volatility. In August and September, 40% of the trading days in the S&P 500 Index saw daily price swings of plus or minus 2%. This level of volatility was last seen in the early 1930’s. Increasingly, the market seems to be trading more on emotion than on company fundamentals. The rally at the end of November was fueled by the announcement that central banks around the globe would provide a liquidity back stop for the European debt issues. The European crisis is contributing to investors trading on short-term emotion while they worry about a repeat of the negative performance seen in 2008 and 2009. One can certainly see similarities; however, we believe there are more recognizable and important differences.

Liz Ann Sonders, Chief Investment Strategist at Charles Schwab noted in a recent report,

“the problems in the eurozone are nothing new: too much debt from eurozone member countries to over-leveraged European financial institutions. Adding to the woes is the lack of global competitiveness among many of the zone's members, thanks to the tying of 17 vastly different economies and policies to one (too-strong) currency. The lack of a single fiscal authority within the eurozone that's capable of enforcement or supervision has allowed the problems to fester and the can to be continually kicked down the road (emphasis added).”

There are many differences in Europe’s problems now and the subprime crisis in the U.S. in 2008. On the positive side, much was learned from the crisis in the U.S. and one outcome is the banks in the U.S. are much better capitalized today. Additionally, the crisis in Europe is one of a top down crisis versus the U.S. crisis which started at the bottom with Lehman Brothers, etc. In short then, European governments have a little more time in crafting a solution.

For investors, we recommend focusing on the fundamentals both economically and at the company level. Economically in the U.S., the data continues to come in better than expected. The November ISM manufacturing index report was stronger than expected (52.7 vs. 51.8) and joins a growing list of indicators that suggest moderate economic growth in the fourth quarter of around 3%. Retail sales on Black Friday exceeded expectations and cyber Monday sales were up a better than expected 24%. The labor market continues to show improvement as can be seen in the below charts: ADP’s Private Employment change for November continues to show improvement and announced corporate layoffs continue to decline.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

At the company level, valuations for U.S. equities continue to look more attractive. The below chart represents a broader market P/E measure. The NIPA P/E ratio measures earnings from the GDP calculation and divides it into the S&P 500 Index. Using this measure, valuations are at levels last seen in the early 1980’s. In addition to attractive P/E valuations, corporate balance sheets have record levels of cash. This cash is being returned to shareholders in the form of higher dividend payments and stock buybacks.

From The Blog of HORAN Capital Advisors

In conclusion, the economic data continues to come in better than expected and stock valuations are attractive. Certainly, the news coming out of Europe is going to be market moving and volatility will likely remain high. However, in the longer term, company fundamentals will be the ultimate guiding force for future equity valuations and fundamentals look strong.