Bear as I am, the case is there for this bull market to charge on
Perhaps the most unhelpful of the psychological flaws we are prone to as investors is confirmation bias. Our desire to seek out information that reinforces our existing beliefs and to reject anything that undermines our prejudices is powerful and dangerous. As Warren Buffett said: “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”
We all do it, in all areas of our lives. Climate change, homeopathy, the stock market, Brexit – we all mistake the desire to be right (the commendable search for truth) with the desire to have been right, which is often simply the pride that comes before a fall. We cling on to our beliefs because to entertain the opposing argument is cognitively painful.
Investors are particularly vulnerable to mental shortcuts. They are easy and require little energy. This is pretty much essential in an activity like investment in which the amount of information that could be relevant to our decisions is infinite. We obviously have to be selective in the ideas we use; but we don’t have to, and shouldn’t, prioritise the data that simply allows us to come to the conclusions we want to reach.
If this were the extent of confirmation bias’s corrosive influence on our decision-making it would be bad enough. But, in fact, our desire to stick to our prejudices is even more powerful. Studies have shown that presenting counter factual evidence to a person can actually reinforce their beliefs. They will emerge not only unshaken by doubt but even more convinced by their version of reality and, in some cases, even more evangelical about convincing others of their point of view.
As an investor, one of the things I try to do is to read things that challenge my world view. Even better is to try to make the case for something I don’t really believe. So, having spent the past few months shoring up my mental defences against the ongoing bull market, I have this week gone out in search of reasons to be cheerful. My default view is “glass half empty”; I’m looking for why it might actually be half full.
This is the context in which I read the most recent of Goldman Sachs’s excellent Top of Mind series of reports. The latest has an interview with Steve Einhorn, a former head of research at Goldman and now at New York adviser Omega. He thinks the equity bull market has months, if not years, still to run – perfect fodder for a reluctant bull.
Einhorn’s main assertion is that this economic cycle really is different. Having expanded for 101 months, the US economic upswing is way longer than the 60 months average upturn in the post-war era. It is the secondlongest rally to date and could well end up being the longest. But long in the tooth does not mean past its sell-by.
The list of reasons to expect the economy to continue growing is long. Despite historically low unemployment, wage growth is tepid. At the end of the cycle it would be overheating. Economic output remains below its long-run potential and is rising; typically, ahead of a recession it is above potential and falling. Leading economic indicators usually warn of problems ahead in the months leading up to a recession but today they are pointing in the opposite direction.
Ahead of a downturn, the Fed Funds interest rate is usually above the neutral rate at which it neither stimulates nor depresses the economy but today it is half as high. The bond yield curve points down in the late stage of the economic cycle, suggesting fears about future growth; today it is still positive. Yes, this is a long economic cycle, but it has also been a notably subdued one. GDP growth has been well below average in the past eight years. Inflation is unusually muted.
The link between this prolonged economic cycle and the equity market is, of course, the Federal Reserve. The subdued recovery has demanded an exceptional response and the central bank has delivered extraordinary stimulus and near zero interest rates, and it remains accommodating. This matters because, as the adage says, bull markets do not die of old age, they are murdered by the Fed. Supportive monetary policy is one of the key reasons to expect the party to continue.
Einhorn identifies five bear market signals that are a prerequisite for a prolonged downturn in share prices as opposed to a short-term correction (which we may well see). None of the five, he believes, are ringing alarm bells.
First, there is no wage inflation. The kind of earnings increases that would prompt a response from the Fed will probably not be evident before the end of 2019 or 2020. This means the second bear signal, a hostile Fed, is also unlikely for at least a couple of years even if, as expected, Janet Yellen is replaced. Third, recession is unlikely before 2020. Fourth, sentiment remains subdued. Finally, valuations are not demanding in an environment of persistently low bond yields.
So, there we are. Despite the cognitive dissonance, even we temperamental bears can make the case for sticking with the market. If you believe the argument then you can also believe the associated case for share prices rising in line with earnings (say 5pc-7pc) with another 2pc on top from dividends (closer to 4pc in the UK). The eye sees only what the mind is prepared to comprehend so it’s worth opening up to the possibility that we might be wrong.