Investing

The Most Important Thing To Know About The Economy And Investing In Stocks

By September 10, 2018 No Comments

(Source: imgflip)

Note that due to reader requests, I’ve decided to break up my weekly portfolio updates into three parts: commentary, economic update, portfolio summary/stats/watch lists. This is to avoid excessively long articles and maximize the utility to my readers.

We live in a golden age of economic, financial, and company-specific information. Never before has so much quality analysis and research been available to regular investors at little to no cost. But the downside to this golden age is that in addition to quality information, we face a daily fire hose of misinformation and data presented without context that can make it harder than ever for investors to make smart long-term decisions to achieve their financial goals.

In addition to the average of 11 hours per day I spend researching and writing about investing, I spend two hours reading various sources. That’s to get a diverse and hopefully accurate idea of the global and domestic economy, the stock market, and outlook for the 200 companies I follow each year. Over many years, I’ve learned both the power and dangers that too much information can represent to investors.

So let’s take a look at the most important things investors need to know about the economy, the stock market (SPY) (QQQ) (DIA), and investing in individual companies. Specifically, how to avoid potentially costly pitfalls that could sink your long-term financial dreams, including dreams of a prosperous retirement.

Economic Models Are Simplistic So Never Fixate On Any Single Data Point

Economics was my major in college and I’m very much a macro econ nerd. That’s why I track the state of the economy, including short-term recession risk, each week. However, it’s very important to realize that economic models are just that, models. They are simplified representations of a very complex national or global economy. An economy is not a machine but an organic being made up of hundreds of millions or even billions of people and millions of businesses. Each making daily purchasing choices based on a wide assortment of needs, desires, and short, medium, and long-term goals.

And just as every individual is different, the same is true of economic models. For example, take a look at the seven most popularly followed real-time GDP trackers.

For Q3 2018, the recent growth forecast ranged from as low as 2% to as high as 4.6%. What’s more, those forecasts can be incredibly volatile, swinging wildly from week to week as new data comes in.

(Source: Atlanta Federal Reserve)

Probably the most volatile model is the Atlanta Fed’s GDP Now. That’s because of the collection of leading economic indicators it tracks and the weightings it gives to various reports. Does this mean that it’s not worth paying attention to any economic models or forecasts? Not at all. But we have to keep in mind that no single data point is the gospel truth, or probably anywhere near it.

That’s why I tend to focus on the consensus estimate of economic growth (3.2% right now for Q3), and the trend over time. The US economy is like an oil tanker, a massive, slow-moving beast that has large momentum and doesn’t change direction quickly.

This also applies to recession risk monitoring, which has become ever more popular now that the US economy is in its second longest expansion in history. The financial media has made yield curve watchers out of millions of us.

Yield Curve Inversion Date

Recession Start Date

Months To Recession Once Curve Inverts

August 1978

January 1980

17

September 1980

July 1981

10

December 1988

July 1990

19

February 2000

March 2001

13

December 2005

December 2007

24

Average

16.6

(Source: St. Louis Federal Reserve, Ben Carlson)

That’s because according to a study by the San Francisco Federal Reserve an inverted yield curve has “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”

However, it’s important to remember that what this historical track record actually shows is that if the 10-year yield falls below the 2-year yield, it means there is a 90% historical probability that a recession will begin within the next six to 24 months. Or to put another way, whether looking at economic data, growth forecasts, or recession risk models, we must remember they are all a very rough estimate based on probabilities. Thus such things lack the kind of precision needed to successfully make short-term investing decisions.

Bold Short-Term Market Predictions Are Often Wrong And Stocks Go Up Over Time

(Source: imgflip)

The financial media loves to trumpet sensationalistic headlines, especially doomsday predictions like a “once in a lifetime crash is coming within the next 3 years” or “a crash is a sure bet, it’s a guaranteed certainty”. The bolder the claims, the more digital ink tends to be devoted to it. That includes such hysterical claims as “50% unemployment, a 90% stock market crash, and 100% annual inflation.”

(Source: Marketwatch)

Every single such prediction is backed up by some plausible-sounding logic. Things like market valuations that are high by historical standards, or excessive bond buying (QE) by central banks inflating the money supply and triggering runaway inflation.

However, the track record of analyst market predictions over any 12-month period have been absolutely horrible. For example, between 1998 and 2016 analysts made 159 12-month targets about the next calendar year’s performance. 92% of the time they predicted the market would rise (a good probabilistic bet) and 92% of the time they were correct. But for what investors most care about (avoiding downturns), analysts are totally useless.

(Source: Econlife)

Over this 18-year period of time, only four analysts predicted stocks would fall in the next calendar year. Not a single one actually predicted a down year correctly. That literally means that baboons throwing darts would have been more accurate predictors of market downturns than these richly paid professionals.

Now it’s certainly true that stocks periodically suffer corrections or even bear markets outside of recession. But we need to keep in mind important historical context.

(Source: Wealth Of Common Sense)

First, that corrections are a normal and healthy part of the market cycle. They are unpredictable, but beneficial in that they tend to bring down valuations and help prevent disastrous bubbles from forming. It’s also true that bear markets (20+% decline from all-time highs) sometimes happen outside of a recession. But in the last 79 years, that has only happened five times.

(Source: Wealth Of Common Sense)

And every single time investors who used the improved valuations to add to their positions have made a fortune over the following five and 10 years. Even if you are terribly afraid of “catching a falling knife” and chose to invest 1 year after the market bottomed, you still would have ended up making great returns over time.

(Source: Morningstar)

That’s because while stocks are volatile in the short term, over the long term, they are 100% driven by fundamentals. That means corporate sales, earnings, and cash flow growth. And since the economy and earnings tend to rise over time, in any given year, the stock market has a 74% chance of going up. Over a 5-year period that probability rises to 86%. And over a 15+ year time frame?

Well since 1926, there has never, not once, been a period in which the S&P 500 has failed to generate a positive return. That includes those poor souls who bought at the 1929 peak and failed to dollar cost average during the subsequent 90% market crash (largest in US history).

Popular Stock Memes Can Get You Into Trouble

As a stock analyst who is focused on finding the best long-term income growth ideas for my readers, I face lots of questions about how one factor or another will negatively affect one of the companies I write about. But here too, it’s important to realize that popular investing memes, like “interest rates up, REITs (VNQ) down” are oversimplified and can easily lead you astray.

That’s because REIT total return correlations to long-term interest rates (10-year yield) are purely short-term phenomenon. In fact, in the last seven periods of rising interest rates, REITs actually outperformed the broader stock market.

How can that be? Because the bond market doesn’t tend to push 10-year yields higher unless it is expecting stronger long-term economic growth and inflation. And stronger growth means tenants are thriving and real estate is historically a good hedge against inflation. That’s because REITs pass on higher costs in the form of higher rents, driving stronger cash flow and dividend growth. That, in turn, causes share prices to rise.

And in case you think I’m cherry-picking just the modern era, when long-term yields were trending downward, rest assured I’m not. Here’s how REIT total returns have fared since 1972, including during a decade when 10-year yields were high, climbing, and peaked at 16% in 1981.

(Source: NAREIT, ST. Louis Federal Reserve)

What’s the long-term correlation between 10-year yields and REIT total returns? Just 0.04. That means that if over the past 45 years, you could have predicted 10-year yields with 100% accuracy, you could have guessed just 2% of actual REIT total returns. And that’s only if you assumed that rising rates were ever so slightly beneficial to total returns.

(Source: NAREIT)

That’s why REITs have been a great asset class, beating the S&P 500 over time. They have also outperformed private real estate ownership (like rental properties).

Another example of simple but popular memes steering investors astray is renewable energy, particularly solar.

(Source: PV-Tech)

Few industries have experienced such rapid growth as solar, which is expected to remain a major mega trend and see exponential growth over the coming decades. So that means that solar stocks, such as leading panel manufacturers like First Solar (OTC:FLSR) or SunPower (SPWR) represented “sure thing” investments right?

ChartFSLR Total Return Price data by YCharts

Actually no, First Solar has underperformed the market over time, while SunPower has cost investors a fortune. And keep in mind that these are two high quality solar companies that are consistently profitable and have strong balance sheets.

What about a passive approach for those who don’t have the time, expertise, or desire to pick individual stocks? Surely, you could have made a fortune cashing in on the rise of solar power by buying an ETF like the Invesco Solar ETF (TAN) right?

ChartTAN data by YCharts

Actually, you would have done even worse than just buying a 50/50 portfolio of FSLR and SPWR. What explains this terrible performance in the face of such booming demand? Because solar panel maker stock prices are a function of earnings. And earnings are a function of panel prices, which are determined by both supply and demand. Demand has been soaring, but panel supply has exploded even faster thanks to a plethora of Chinese panel companies flooding the global market.

These are just two notable examples of how simplistic but popular investing memes can lead investors to the wrong conclusion. How can you avoid making costly errors, either buying the wrong thing or avoiding buying something that is likely to make you money over time?

By realizing that the business world is more complex than bumper sticker headlines trumpeted by the financial media would have you believe. Every industry and sector faces its own challenges and growth opportunities. Over the long term, quality management teams will navigate a company through the turbulent waters and help drive cash flow and dividend growth, resulting in strong total returns.

This is why I do my best to point out good long-term income growth investing opportunities for readers. That includes highlighting both the bullish thesis and the risk profile. And of course, I never forget to discuss the valuation, which is an important component of risk management and also a key driver of long-term total returns.

Bottom Line: Investing Is About Long-Term Probabilities And Fundamentals So Don’t Fixate On Short-Term Noise

Being an informed investor is the first step to long-term financial success. That being said, it’s important to know what sources to trust when trying to learn about the state of the economy, stock market, and individual companies. And even when you have a diverse source of reliable information, it’s equally important to keep in mind three things. The first is that the world economy is not a machine, but a highly complex organic organism that models can only approximate very roughly. Thus, you should focus on the trends and not on any individual data point.

Stock markets are equally complex and impossible to predict since, in the short term, they are driven by the often irrational emotions of hundreds of millions of investors. Investors with often very different goals, time horizons, and risk tolerances.

Finally, when reading investment analysis about any individual stocks, keep in mind that no bear or bull argument must ever be taken at face value. Popular but simplistic memes like “interest rates up, REITs down,” the “retail apocalypse” or “renewable energy stocks can only go up” fail to take into account the complexities of the real world.

Above all else, remember that the global economy tends to grow over time, and stocks tend to follow corporate earnings higher over the years. This is why I only ever advocate long term, fundamental-driven investing. While the stock market can be highly irrational and unpredictable in the short term, over the long-term stock prices are 100% a function of sales, earnings, and cash flow growth.

So focus on the fundamentals, ignore short-term noise and simplistic short-term predictions, and remember that investing is about probabilities and requires good risk management. That’s because the future is uncertain, and even blue chip companies can have the wheels fall off.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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