Sentiment is the New Fundamentals

One of my favorite analogies about the difference between the economy and the stock market centers around a man and his dog, walking through the park. The man’s course is steady, for the most part, as he strolls from one end of the park to the other. His hand clutches a leash which is attached to a dog, whose course is anything but steady. The dog darts left and right, hither and yon – lunging at a pigeon, scurrying backward in fear of a speeding bicycle, leaping up at his master spontaneously and stopping repeatedly to pee, bark or scratch himself.

The man continues forward, altering his pace from time to time and occasionally stopping to check his watch. The dog is frantic, careening back and forth, even if he ultimately ends up heading in the same direction as the man holding the leash. Most people are watching the dog, because the man is boring.

You can guess which of our characters represents the economy and which represents the market. You could use the same analogy to describe the difference between fundamentals and sentiment. A company probably doesn’t lose or gain nearly as much value day to day as the stock market says it does.

Barron’s reported that half the respondents of its Big Money Poll – all professional money managers – were neutral on equities right now. Normally, I scoff at consensus readings that high, but at the current moment, I’d say that a neutral sentiment is the only sane stance one could take.

GDP growth around the world is flatlining and the earnings of US companies are no longer growing. But prices – which are sentiment-driven in shorter timeframes like “year-to-date” are saying something else. We’re approaching all-time record highs in the S&P 500 price index while the total return index has already gotten there. The recent rally has been led by explosive moves in the energy and materials sectors, where a glance at the fundamentals renders the stock price recovery utterly unfounded.

And as a result of this dichotomy, investors are left with nothing to watch but the sentiment of their fellow participants. This is what Keynes referred to as judging the judges of the beauty pageant as opposed to judging the contestants themselves.

Fundamentals are stagnant and not giving anyone much of a clue as far as the current trend. It’s not better or worse, it’s heading nowhere for the time being. In the absence of a trend, sentiment becomes the new fundamental – are they buying or are they selling on flat growth and earnings? And bon chance when trying to predict sentiment shifts, multiple expansion, etc when you can’t even predict fundamentals. It’s like a delusion of a delusion.

James Mackintosh at WSJ nails the current zeitgeist:

These wild swings in investor emotion took place while the world economy showed no more than mild fluctuations, and corporate profits took a hammering.

Understanding how this could be is essential for those trying to work out whether the rally has run its course. It also illustrates once again one of the great truths of investing: Those in the market spend a lot more time watching each other than they do watching the fundamentals.

There is a laundry list of items that could account for the bottoming-out of oil and other commodity prices – things that have very little to do with the overall economy. Some say production dropping off has been sufficient to create a floor. Others note the entrance into commodity and futures trading by the Chinese retail investing public, where it wouldn’t take much money to create wild moves. Any of these things may be true, or, it’s possible that prices are anticipating actual economic improvement that simply hasn’t manifested itself in the data yet.

It’s more sane to be neutral right now, from a sentiment standpoint. Your other choices are doubting the possibility that things could improve or, worse, getting all fired up near record highs- highs that we’ve failed at multiple times before. It’s okay to say the jury’s still out. The rewards for guessing right probably do not outweigh the penalties for betting aggressively while wrong.

Yes, we’ll resolve in one direction or the other. Eventually.