I often wonder, what is the person on the other end of this transaction thinking? One of the best investment books of the last decade isFooled by Randomness, by Nassim N. Taleb. Taleb, an options trader by profession, does an excellent job of explaining how humans are hard-coded to find patterns, even when patterns don’t actually exist. Part of this is a need to know why. For example, why was the market down yesterday? The news will always give you a reason, and as Taleb points out, the reason they give is usually wrong and often just complete nonsense.
For the last several weeks the reason for negativity was the debt ceiling debate. Based on market activity over the last few days, I think a few people perhaps missed the memo: that crisis is over, Congress struck a deal. While some seem to be unaware of that development, the financial media is not among them – they have moved on, first to the bad U.S. economic data and then to Europe. I am not buying it.
I think the explanation for recent market fall is far simpler: over the last week or so there have been more sellers than buyers. That is it. Sellers outnumber buyers, thus, prices are going down. This leads to two questions: first, why aren’t there more buyers? In the midst of all the gloom and doom we have seemed to lose track of the fact that 77 percent of S&P 500 companies have outperformed on their earnings, and the S&P 500 is selling at approximately 13X earnings, which is very attractive. When you start breaking it down further there are bargains everywhere. Yesterday I read a headline that says that Berkshire Hathaway is selling for less than 2X the earnings of its operating companies. These are ludicrous valuations.
There are only two reasons I can think of for the lack of buyers. First, it is summer and who wants to buy stocks when it is this blazing hot. I am only half joking here. This is prime summer vacation time, and investors go on vacation just like everyone else. Second and more importantly, there seems to be a greater deal of uncertainty than usual for what the future is going to hold, illustrated by the drastically changing economic forecast. While we at Iron Capital have stayed fairly steady with a two percent forecast for GDP growth, we have been the exception. Most forecasts have gone from overly optimistic to overly pessimistic and back more rapidly than I can remember at any time in my career. The truth is reality does not change as rapidly as market prices and economists’ moods.
Although we remain cautiously optimistic on the equity markets, I do understand why more investors are not buying right at this moment. However, that leads us to the other side of the equation and our second question: who in the world is selling on a day like yesterday and what are they thinking? Based on information that we have thus far, the selling is not as heavy as the headline drops in the market may suggest. The few sellers are just selling into a vacuum. With no buyers out there to speak of, the sellers are selling no matter the price and making the market move lower than it really should. The only reason I can think of to do such a foolish thing is panic. Of course panic is by definition not a rational emotion, but I still have to ask, why are they panicked?
Sure, there is a long laundry list of things that are wrong with the world, but please point out one of those items which has not been on that list for months now, if not years. The financial condition or value of a company does not change much from day to day, and neither does the economic health of a nation or the world. Moods change quickly and market prices change quickly, but reality changes very slowly. There is nothing wrong with the world today that wasn’t wrong with it two months ago, when market prices were higher.
This environment creates opportunity for those who stay focused on reality and avoid the mood du jour. That is what we try our best to do at Iron Capital. Nothing changed from last week that would suggest this is anything other than a short-term market correction, and timing corrections is not a winning strategy.
Chuck Osborne, CFA