Signals and Noise.

January 22, 2013

Success in investing, according to Bill Smead, boils down to history, psychology and math.
To achieve any modicum of long-term success, an investor must have historical perspective. An understanding of how the market traditionally responds to events and circumstances.
Additionally, investors must be aware that success often involves activities that run counter to everything with which an investor is comfortable. We are not hardwired to be effective investors. So, one must learn the traits inherent to becoming one.
Finally, one must be able to crunch a few numbers in order to determine the validity of one's thesis.
After that, it's all signal and noise.
Historically, two contrarian indicators have provided reliable signs as to when investors should buy and sell stocks. These are Wall Street and Main Street.
The equity strategists of the major Wall Street brokerage firms have been as accurate as the Mayan Calendar when it comes to asset class forecasts. When they were at their most bullish, telling investors that stocks were positioned for future returns in 2000 and 2007, the market cremated anyone who listened.
In 1997 and 2009, when equities were primed to begin huge run ups, Wall Street's strategists were markedly bearish, counseling clients to overweight bonds. Once again, dead wrong. Equities defied them and those who allocated capital into the markets were paid handsomely.
Which brings us to today. As of January 2013, Wall Street's equity strategists are extremely bearish, cautioning against equities, preferring allocations weighted towards fixed income.
Bank of America Merrill Lynch regularly reports on Wall Street's consensus equity allocation. It is near historic lows. So, even as stocks continue to melt upwards, Wall Street remains hyper-bearish.
And yet, Main Street does not concur.
Traditionally, Main Street has been almost as inaccurate as Wall Street when it comes to forecasting the stock market. When the stock market is shooting upwards, mutual fund flow data shows investors pouring into bonds. When the market is gearing up for a correction, fund flow data shows investors pouring into stocks.
These last four years, the S&P 500 has rebounded off the March 2009 lows like John Travolta's career post-Pulp Fiction. America loves a comeback. Yet, American investors did not love this one, as they continued to allocate capital to bonds, even as the market continued climbing.
Recently, something changed. Electrical engineers call what transpired a "signal." Something that conveys information to those seeking it.
As of last week, Main Street, in defiance of Wall Street, turned bullish. Nearly $19 billion flowed into stock funds. That's the biggest one-week increase since 2008 and the largest inflows since May 2001. That's the signal. Gulp.
Electrical engineers, in their attempt to find the signal, endeavor to tune out "the noise," those unwanted, non-meaningful, random distractions that can pose as signals, but are not.
The election? The Fiscal Cliff? Europe's sovereign debt crisis? Iran? Noise.
Typically, Main Street's enthusiasm might scare us, as we would no sooner invest with Main Street that we might attend a movie with Pee Wee Herman.
But being contrarian does not always involve being bearish.
So, let's look at the two existing camps.
One insists that the market's positive performance is overextended, unjustified, and dues for a correction.
The other says that the last four years was an unorganized, garbage rally in which the average investor did not even participate. So, as Main Street begins to laggardly buy into the rally, and if corporate profits remain decent, this market has room to run.
Such investor confidence would typically make us squeamish. But, some perspective is called for.
This rally these last few years has been a herky-jerky rise dominated by crisis conditions, fear and apathy. Since 2008, everyone has detested stocks, preferring bonds and even zero-yield money markets.
Which is exactly why last week's signal is so interesting. For the first time in years, investors appear to be flocking towards risk. Even as Wall Street's finest caution against it.
At 1485, the S&P 500 sits at five-year highs, less than 100 points beneath its all-time high. Still hates equities. Main Street is putting massive amounts of capital to work. The Fed and other central banks continue to support markets with record-low interest rates and easy liquidity. Corporate profits continue to positively surprise.
Growth rates for employment, retail sales, durable goods and service orders all accelerated during the final months of 2012. The homebuilding revival continues, with the National Associate of Homebuilders index at its highest level since 2006.
True, manufacturing remains weak. Recent tax increases will degrade household incomes, and likely lower GDP growth by roughly 0.5%. But, GDP growth should accelerate as the year goes on. Especially if the eurozone debt crisis stays quiet.
The wonderful aspect to our system of free-market capitalism is that ambitious, determined individuals, toiling in their self-interest, can propagate their visions upon the world stage. If consumers like what they see, then these forces of nature can create comfort, enjoyment and wealth for all. Regardless of the increasing amounts of government intervention and politically manufactured volatility, energetic visionaries will always create opportunity.
Focus on the signals. Forget about the noise. Equities could provide continuing upside surprises.

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