Tuning out the Market Noise
The level of headline noise surrounding financial markets is nearing deafening levels. On top of the flood of economic data and corporate earnings reports that market participants sift through daily, the Federal Reserve has ramped up its communication efforts on monetary policy this year to guide investors through this period of economic uncertainty. White House communications are elevated as well, as President Trump tweeted 172 times in reference to trade, the markets, and the economy, in the first three quarters of 2019, according to Bloomberg.
In general, financial markets, particularly in the U.S., are highly adept at evaluating new information and pricing stocks according to changes in future earnings growth potential. Every data point, whether a tweet on trade or a new jobs report from the Bureau of Labor Statistics, is immediately digested by a broad swath of market participants—including individuals, institutions, and automated algorithms—and incorporated into the supply and demand for securities, thus informing changes in market prices.
However, the markets are not always as adept at distinguishing between quality information and distracting noise. Right now, we’re seeing investors make decisions based on daily headlines that describe trade talks as either “constructive” or “entrenched” – but don’t actually discuss the progress on the fundamental issues at the heart of the negotiations. Investor sentiment has become so sensitive to this issue that even a mere hint of optimism or pessimism will send the market whipsawing.
Distracting noise can also come from companies themselves. Although more public disclosure is generally positive, it can have some negative side effects. Information overload can cause market participants to react impulsively, thus narrowing their investment perspectives to only thinking about the next few days, weeks, or quarters instead of the next several years or decades as a business owner would. And the trend toward lower trading commissions and transaction costs can prove to be a double-edged sword as trading on gut-reactions and short-term outlooks has never been easier.
In fact, according to analysis by Ned Davis Research on stocks trading on the New York Stock Exchange, the average stock holding period has fallen from over 5 years in the pre-1960s era to just over 8 months today. And this is mainly thanks to falling barriers to trading and rising access to information. Eight months is certainly not enough time to enjoy the benefits from compounding equity ownership in a strong and stable business, and it risks higher tax and transaction costs in addition to exposing investors to the negative impacts of short-term noise and behavioral baggage.
Benjamin Graham, widely viewed as the father of value investing and a teacher to renowned investors like Warren Buffett, once wrote that "in the short run, the market is a voting machine, but in the long run, it is a weighing machine." In other words, in the short run, security prices may be carried away from their true values, to the upside or the downside, by the effects of noise and investor herding behaviors and inertia; but in the long run, noise and investor behavioral impacts are filtered out and security market prices converge to fundamental value. The market price of a stock may swing second-by-second, but the true value of a business does not.
It is this understanding that allows patient, fundamentally focused investors to use periods of market dislocations – like the sell-off at the end of 2018 – as opportunities to purchase the stocks and bonds of high-quality companies selling at a discount to their true values.
But where does that leave us today now that equity markets are surpassing all-time highs, interest rates are dropping fast, and corporate earnings growth seems to have plateaued? Furthermore, the U.S. manufacturing sector is in contraction territory right now, according to the most recent survey from the Institute for Supply Management (ISM), with a reading of 48.3 in October (below 50 indicates contraction and above indicates expansion). That is only slightly better than September when the index dropped to its lowest level since 2009 with a reading of 47.8. Does this change the fundamental outlook and call for a change in portfolio risk exposure?
To answer that question, we must put that data into context. Although the ISM manufacturing survey has been an important leading indicator of economic strength, it also has fallen into contraction territory several times during this expansion, in 2013 and again in 2016. Thus, making investment decisions on this data point in isolation could have been detrimental. In terms of impact on the overall U.S. economy, the manufacturing sector only directly makes up a little over 11% of U.S. GDP and just 8.5% of total employment today, as the U.S. has become increasingly service-oriented. The much larger service sector remains in expansion territory according to the ISM non-manufacturing index with a 54.7 reading in October, although that is off index highs of over 60 a year prior. Additionally, the impact of the current General Motors strike, which was recently resolved, likely weighed notably on the manufacturing index over the last few months.
That is not to say that this indicator should be ignored. It does show that slowing international economies are reducing demand for U.S. exports. It also demonstrates that the tight job market is putting pressure on labor costs and that the ongoing trade conflicts are damaging business sentiment, which hurts capital investment and job growth. And the manufacturing sector has a much larger impact when you consider the services involved in getting those goods to market, including transportation and retailing. With these other components, the final output of goods as a percentage of GDP is more significant at about 30%. This means that viewing one data point in isolation, even a valid indicator, creates its own noise that can cause harmful investor actions without sufficient knowledge of context.
The ISM manufacturing index in combination with other economic and market factors, confirms that economic growth is slowing, which we have written and discussed with clients for some time now. However, we still don’t foresee slowing economic growth turning into recession in the near-term, as long as the U.S. consumer, who drives almost 70% of U.S. GDP growth, remains on stable footing. This outlook still holds true, supported by an unemployment rate of 3.6% that is just off its 50-year low, rising wages above the rate of inflation, and high consumer confidence. Items that may shift our outlook include continuing downside in manufacturing and any knock on effects that it may have for the service sector and employment, thus impacting the U.S. consumer.
In many cases, investors who make reactionary investment decisions based on a short-term outlook are turning their greatest advantage of constant liquidity and daily market pricing into their greatest disadvantage. At First Merchants Private Wealth Advisors, we strive to help clients avoid this pitfall by tuning out the short-term noise and remaining focused on the long-term, fundamental picture. As always, we will continue to monitor the economic and market outlook and keep you apprised of our thoughts and actions. Please don’t hesitate to contact us with questions.
David Pfeiffer
First Merchants Private Wealth Advisors products are not FDIC insured, are not deposits of First Merchants Bank, are not guaranteed by any federal government agency, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency. This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.
