Have you ever noticed how your expectations going into an event can have a dramatic impact on your enjoyment of that event?
For example, several years ago I almost left the theater during Lost in Translation, an incredibly depressing movie in which one of the funniest men on the planet, Bill Murray, shows his serious side. The movie couldn’t have been as bad as I remember because it won lots of awards, and lots of people I know said it was great…but I really think that is the problem: I went into the theater expecting a great movie, and I was disappointed.
Conversely, I remember the first time I went to Poland for work. My employer at the time had purchased a pension operation there and the portfolio was underperforming badly. I was told to “go fix it.” I am ashamed to admit I had very low expectations going to Poland for the first time – I was dreading spending three weeks in a dark, cold, depressing place with sad people and bad food. Yet everything about Poland came as a pleasant surprise to me. Don’t get me wrong – if you have never been to Europe and you have the opportunity to go to either Warsaw or Paris, go to Paris. The point is that low expectations can be a beautiful thing.
Expectations are the issue in the market right now. For nearly a year we have been climbing out of a hole based on performance that has been not that great, but has been much better than expected. Economists were talking about a “new normal” of slow growth and high unemployment here to stay. While there are still several in that camp, more and more economists are becoming born-again optimists. GDP growth in 2010 is now expected to be about 3%, and corporate earnings are expected to be up 25%. Those are the official expectations. More and more market watchers are expecting firms to beat expectations, which simply means real expectations are higher than the experts are willing to put in writing.
Why the sudden shift to the positive? First, we are Americans. We are an optimistic bunch. This crisis has been a big blow, but eventually our true nature will triumph. Secondly, it is becoming increasingly apparent that we may dodge the worst of the anti-growth policies now that the political winds have shifted dramatically. It is always dangerous to bring up politics, I know, but let me make this clear: it was Pimco’s CEO, Dr. Mohamed El-Erian, who coined the phrase “new normal.” He was, and I would assume still is, a very public supporter of the current administration. However, not being a politician, he understands that there is an economic cost to a European-style social safety net. The policies which Dr. El-Erian supports are a big part of his “new normal” theory, and he is completely honest about such.
The danger now lies in an overly optimistic view. Intel posted record profits, had a rosy outlook, and the stock still traded down 2% on the day they reported. Nucor blew earnings estimates away just this morning and still opened down. It is becoming increasingly possible that we could see good economic growth and still have stock prices go nowhere because expectations were too high. Remember, the market does not move based on economic news; it moves based on surprises.
We must remember the lesson that Benjamin Graham passed down to his star student, Warren Buffett: Be greedy when others are fearful and fearful when others are greedy. I’m not sure I would go so far as to say these rose-colored outlooks are greedy, but they are certainly less than fearful, which leads us to be cautious.
Chuck Osborne, CFA
Managing Director, Iron Capital Advisors