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Beware of sensationalist headlines

According to the American Psychological Association (APA), 95% of American adults regularly look at the news, even though two-thirds of them recognize that the media has a tendency to exaggerate events and more than half state that the news causes them stress. According to Arthur C. Evens, CEO of the APA, it is high time for us to lower our media consumption. In my opinion, this advice is very relevant for investors who want their stock market performance to be satisfactory over the long term.

At the beginning of August, significant pressure was put on the main stock markets as a result of the crisis of confidence in Turkey’s economic policy. Market participants were afraid of contagion, as happened with the debt crisis in the euro zone in 2010. Briefly, the Turkish government faced many challenges, such as an inflation rate of 15.9%, an unemployment rate of 17% and a currency that had lost more than 50% of its value in one year against the U.S. dollar, as well as foreign currency debt of more than $200 billion, of which one-third had to be repaid by the end of the year. For the media, all the ingredients were therefore in place to feed sensationalism, which unfortunately caused a large number of investors to divest their shares or stay on the sidelines. A few days later, the main American reference indexes reached historic highs...

A tool for navigating the stock market

According to psychologist and economist Daniel Kahneman, when we make a decision we rely mainly on our judgment, experience and convictions, in a process referred to as internal evaluation. Unfortunately, the media can lead us to make errors that are detrimental to our portfolio. For that reason, Dr. Kahneman suggests that we opt instead for an external vision that fosters more thorough analysis. I would like to share with you the checklist used by Steve Einhorn, a renowned portfolio manager, to anticipate the next stock market correction . As long as these five factors do not occur simultaneously, optimism is called for, in spite of the ups and down of the stock market.

No. 1: Recession

As of August 2, 2018, according to the New York Federal Reserve, the probability of an economic recession in the United States within the next 12 months was only 13.60%.

No. 2: High stock market valuations

Based on the closing price on August 15, 2018 (2818), the S&P 500 market valuation was more than reasonable, according to Yardeni Research. In reality, it was trading at a price-to-earnings ratio of 17.4 (2818/162.23) for this year and 15.8 (2818/178.65) for next year, which is consistent with its average multiple for the past 25 years (16).

No. 3: Highly restrictive monetary policy by the Federal Reserve

On June 13, 2018, for the seventh time since 2015, the Federal Reserve increased its key interest rate by 0.25%, bringing it to 2.00%. It also reiterated its commitment to raise it two other times in 2018, which was what was expected by market participants. Bearing in mind that the unemployment rate in the United States is 3.9%, the key rate remains low from a historical point of view. In fact, the last time the unemployment rate was that low (in October 1999), the key rate was 5.25%! The Federal Reserve thus has the desired leeway to normalize its monetary policy.

No. 4: Sense of euphoria

According to Michael Harnett, Chief Investment Strategist for Bank of America Merrill Lynch, market participants were very optimistic at the beginning of the year. In response to the U.S. tax reform bill aimed at reducing the corporate tax rate, stock markets took off. As a result, during the first week of 2018, a amount of some $24 billion was invested in equities through mutual funds and exchange-traded funds. Recently, the opposite took place. In fact, investors disposed of nearly $30 billion dollars in equity funds during the last week of June, marking the second largest money outflow ever recorded.

No. 5: Inflation too high

Even though the inflation rate remains close to the target of 2%, Jerome Powell, Chairman of the Federal Reserve, is not particularly concerned about a possible acceleration of the cost of living in the United States. In fact, in June, the Federal Reserve forecast an annualized inflation rate of 2.1% for the next two years, which is an acceptable level to keep from derailing economic growth.

According to the foregoing, to avoid the trap of sensationalism, it is imperative that you rely on a series of complementary, value-added indicators such as those proposed by Mr. Einhorn. Your decision-making process will then be less influenced by behavioural biases when events similar to those that occurred in Turkey take place. In the future, I invite you to beware of sensationalist headlines!

Sources
  • Barry Ritholz. Steve Einhorn’s Bear Market Checklist, The Big Picture, August 21, 2018.
  • Christian Losson. Turquie : Erdogan dans le piège économique [Turkey: Erdogan caught in the economic trap], Libération.fr, August 13, 2018.
  • Helen Reid. Equity funds lose $30 billion as investors flee U.S. and EM stocks: BAML, Reuters, June 29, 2018.
  • Jeff Cox. Stock funds rake in $24 billion in the first week of 2018, sixth-biggest inflow ever, CNBC, January 12, 2018.
  • Reade Pickert and Christopher Condon. Fed’s Powell Says U.S. May Still Be Shy of Full Employment, Bloomberg, July 19, 2018.
  • Ryan Holiday. Why Everyone Should Watch Less News and Read More Books Instead, Medium, August 21, 2018.
  • Ted Kavadas. The Probability of a U.S. Recession – August 2018, Seeking Alpha, August 7, 2018.

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach