Viewing the Market Through the Right Lens

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Daniel Kahneman, Professor Emeritus at Princeton, is an American psychologist who is well known for his work on the psychology of decision-making and behavioral economics. Together with Amos Tversky, he established a cognitive basis for common errors in judgment that occur as a result of various heuristics and biases.

Kahneman is most well-known for his work on prospect theory, for which he received the Nobel Prize in Economic Sciences in 2002. He also wrote Thinking, Fast and Slow, in 2011 which quickly went on to become a best seller. If you haven’t read his book I’d highly recommend it, for the following reason:

Kahneman’s (and Tversky’s) empirical findings challenge the implicit assumption of human rationality that prevails in modern economic theory.

In other words, Kahneman helps identify why it’s so difficult for us to make rational decisions when it comes to money and investing. Even better, he helps us identify how certain cognitive heuristics and biases can lead people to make predictably irrational decisions in large groups, which we can capitalize on in the financial markets.

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I want to briefly walk through one example from his book, which can help remind us of some of the major flaws in our own decision making. Keep in mind the following:

As you consider the next question, please assume that Steve was selected at random from a representative sample:

An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.”

Is Steve more likely to be a librarian or a farmer?

Well … which is it? If you’re like most people, your natural inclination is to select librarian. And therein lies the rub…

As Kahneman asks, “Did it occur to you that there are more than 20 male farmers for each male librarian in the US?” Did it even occur to you to think about this question from that perspective?

The lesson here is simple: Equally and perhaps more relevant statistical considerations are almost always ignored when making decisions.

In this example, our attention was drawn to a few specific details that had little relevance to the question being asked. Did you recognize that? If not, do you think it’s possible that this same “blindness” could be occurring with regard to some of your investment decisions?

This example is a classic illustration of what’s called the availability heuristic. When faced with complex decisions (such as how to invest our money), we often form opinions based on the information at hand without taking into account other – perhaps more important – considerations.

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Now, I want you to close your eyes for a moment and think about the stock market. What thoughts come to mind? Do you immediately envision major geopolitical concerns such as a confrontation with N. Korea? What about the buildup in the China sea? Or does your mind wander toward the Fed, on its interest rate hiking path? What about the demise of the dollar, which many commentators are constantly telling us is just around the corner?

If there’s one takeaway from this article it should be this: The immediate thoughts that jump into your head have a very real influence on how you invest.

If you’re emotionally charged about N. Korea, or ISIS, or the demise of the dollar, or Russian meddling, you might NOT be thinking about the continued expansion of the economy, or the strong trend in job creation, or the recovery in global markets, or the technical strength in the market, or … perhaps most importantly, the outlook for corporate profits.

As we all know, when it comes to investing there is no shortage of data points available to us. The trick, then, becomes figuring out which data points matter and which don’t.

Let me rephrase that. The real trick is identifying the right lens through which to view all the information that is constantly bombarding us. And that lens … is corporate profits.

It’s a very basic concept, but many investors seem to forget that at the end of the day, a share of stock simply represents a share in the future profits of a company. As those profits rise, or the outlook becomes rosier, the shares gain value. Conversely, as the outlook for future profits deteriorates, so does the share price.

In the short-term, markets are always going to react to daily news events and other top-of-mind concerns. But beneath the surface, and over a longer time period, they reflect changes in the outlook for corporate profits. Therefore, if we can always view developments in the economy through the lens of “How will this affect corporate profits?” we’ll know which information matters and which doesn’t.

Speaking of corporate profits, it’s worth pointing out that 2nd quarter results are coming in better than expected. As of Friday, 84% of companies in the S&P 500 had reported, and blended earnings growth for the quarter stood at 10.1%. This is stronger than the 6.4% year-over-year growth that was expected.

If the final earnings growth rate for the second quarter does come in at 10.1%, it will mark the first time the index has seen consecutive quarters of double digit (year-over-year) earnings growth since 2011.

With corporate profits at record levels, is it any wonder that stock prices are as well? That’s sort of a trick question because share prices don’t reflect the level of current earnings, they reflect the outlook for future earnings.

And when it comes to future earnings, there is a big catalyst sitting in plain view: the dollar.

According to the WSJ, the dollar is having “one of its worst stretches in years.” But what’s bad for the dollar is often good for stock prices.

The chart below shows what’s happened to the dollar index so far this year. Since the beginning of January, it’s fallen nearly 10%.

USD

This means that in aggregate, US exports are now roughly 10% cheaper to the rest of the world than they were at the start of 2017. When you consider that nearly half of S&P 500 sales come from abroad (43% as of the end of 2016), this discount amounts to a significant tailwind.

A Recent analysis by Morgan Stanley suggests that S&P 500 profits rise by 1% for every 2% decline in the dollar. Take this with a grain of salt, but it does work to highlight the basic relationship.

So while many are worried about the dollar, if we view the decline through the lens of corporate profits, it’s a defacto benefit for equity prices. It’s also a major benefit for commodity prices, which are rebounding nicely and influence global profits in a few key sectors, namely energy, and materials.

Circling back around, as Kahneman reminds us, making optimal investment decisions is all about picking out the signal from the noise. It’s about making sure that our decisions are based on the data that matters, not just on “the data.”

To that end, I’ll leave you with two suggestions. First, always view every economic and financial development through the lens of corporate profits. If you can do this successfully, it won’t guarantee that you’ll always make good short-term decisions, but you’ll find that you’re consistently on the right side of major market moves.

Second, and this goes back to the philosophy that Richard Russell always advocated: Invest in sync with the Primary Trend. Many people seem to forget that markets are incredibly efficient at discounting information. Instead of worrying about specific issues here and there that may debilitate the market, focus on how the market as a whole is doing as it absorbs and digests that information.

Right now, the outlook for corporate profits remains healthy, and the Primary Trend is definitively up … so place your bets accordingly.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.

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About Matthew Kerkhoff

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