Weekly Wrap from Pythagoras Investing: market reactions to bad news

Stock markets do not reflect the general economy, therefore, stock prices vary from general economic conditions. This is are due to a few key dislocations between the stock market and the general economy.  Firstly, the stock market index doesn’t represent the underlying economy – eg agriculture and small businesses are underrepresented. Secondly, large companies dominate the ASX 200 index.  Banks make up 26% of the ASX200 index.  Mining stocks are 19% and healthcare is 13%. Indeed the biggest company in Australia right now is Commonwealth Serum Laboratories (CSL) and it represents 10% of the ASX200 and 70% of the healthcare weighting.  In fact, there is no attempt or need to correlate the index with the economy.

Why stock markets look through bad news

When it comes to pricing stocks – only a few things really matter to equity markets.  Firstly, future earnings and secondly interest rates, with the latter being used to value the former.  There is a lot of information implicit in both factors. Let’s focus on earnings as interest rates have played out and can’t move much from here.  Therefore, when stock markets react, they anticipate future developments which effect earnings.  If they can’t see the “other side” they tend to fall like there is no tomorrow.  But once a situation is understood and dimensioned they predict the outcomes and “look through” a situation.

Whereas people tend to dwell on current affairs.

Stocks have risen strongly, even as the economic news has deteriorated.  The human behaviour of overreacting is key in understanding this. 

Just as overly ebullient greedy markets opt for maximum optimism, fear-based markets opt for maximum panic and downside.  The initial fall in March was anticipating a loss of future earnings and pricing for that.  This is what is referred to as “down by the elevator” – showing the panic.  Once we could see the other side of the crisis stock markets began to make an assessment of what will future earnings look like. This is what is referred to as “up by the stairs” – showing the cautious optimism until overconfidence returns.

When I wrote “The lunatics have taken control of the asylum” on 15 March 2020 the ASX200 was at 5000.  We were at the stage of the spreading of fear and uncertainty.  When I wrote “Irrationality be gone” on 23 March the ASX200 was 4650.  Fear was at its maximum. It was apparent in our indexes we were at the worst and that with rational thinking share prices could rise.

We have to remember the stock market isn’t full of rational thinkers, but many fearful and greedy. When they act in unison they sway the market one way or the other.  We always see extremes of human behaviour – so to in stock markets.  Its tricky for most people to cut through the noise – which we do through maths.

Stock selection and its underlying situation becomes paramount in every sector – which is why we have been working to reduce sectors and stocks which are problematic in the current market. 

For example, tough times for banks inevitably lead to investor misery – especially when your big 4 banks are such a large part of the Australian market. When the banking regulator APRA (Australian Prudential Regulation Authority) strongly “encouraged” banks to cut dividends to conserve capital and the Government lent on them to be “generous” to those who couldn’t pay their mortgage we have a difficult industry outlook.  What ensued was a slashing of banking profits and cutting or eliminating dividends.  The outcome would not suit most investors who hold banks for dividends and doesn’t bode well for the future growth of bank stocks.

We have looked at the mathematical indicators and adjusted which stocks we would offer to clients.  For the banking sector it is slim pickings.   For other sectors it is similar –  it’s time to be very careful which stocks you invest in and how.

If you would like a discussion please  contact  Michael Dee at michael@pythagorasinvesting.com