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Plenty of myths regularly circulate in the stock market, and many of them threaten to separate you from your money. Here are five of the biggest myths nowadays, with a look at why investors shouldn’t believe them.
1. Trump’s failures will hurt stocks
Donald Trump made lots of promises to bring immediate reforms to improve the economy, health care, infrastructure and the tax system. So far? Nada. The bear case here is that further Trump failure will hurt stocks.
But what if Trump has little to do with the recent stock market strength? This isn’t as farfetched as you might think. “The data suggest that improving global conditions are the true catalyst,” says RBC Capital Markets strategist Jonathan Golub.
He cites the following. Purchasing managers’ indices (PMI), a key forward-looking indicator, are strong around the globe. The rebound in Europe and China has been particularly notable. All of the larger developed economies are delivering PMIs greater than 52, a level that suggests these economies are in expansion mode. The U.S. is at 57.2, while Europe is at 56.2.
“We do need more certainty on taxes and reform,” says Eric Green, director of research at Penn Capital. But the Trump administration is far more pro-business than the prior one. Accordingly, Green says, “the likelihood of getting slammed with some regulatory burden is lower,” meaning that even without significant reform, Trump can continue to be bullish for the economy.
2. Investors are too bullish
To beat the market, watch investor sentiment. Buy when there’s “blood in the streets.” Tilt to cash and be careful when the crowd is cheering. Many analysts now see excessive optimism as a reason to move to cash. They cite bullishness in investor surveys from the American Association of Individual Investors and the Investors Intelligence Bull Bear ratio.
But watch what people do, not what they say. By this yardstick, investors don’t look so bullish. In April, investors returned to shifting assets away from equities, points out Baird investment strategist William Delwiche. This reversed the big inflows of the first quarter. True, investors recently flipped back to putting a little money in stocks again. But inflow is not excessive levels.
Besides, market internals including measures of momentum and breadth that gauge participation levels continue to be bullish, which outweighs red flags over sentiment, says Doug Ramsey, who manages the Leuthold Core Investment Fund LCORX, +0.00% . This is one reason he’s bullish on stocks right now. Ramsey’s fund has a strong record, beating rivals by 2.5 percentage points, annualized, over the past three years, according to investment researcher Morningstar, and 3.3 and 1.2 percentage points, respectively, over the past five- and ten years.
Investors also should pay attention to the financial media, which is a great contrarian indicator. Nowadays the media remain cautious on the markets and the economy.
3. The bond market is forecasting economic doom
Many market pundits consider bond investors the “smart money” relative to stock investors. So when bond investors ramp up their exposure to the perceived safety of bonds, these pundits suspect bond investors see problems on the horizon with the economy. We know bond investors have moved into bonds because the 10-year U.S. Treasury yield recently fell to 2.3% from 2.6%. Bond buying drives up bond prices, which pushes down yields.
But this move in yields may not actually signal problems ahead for the economy, for a few reasons.
First, there’s a mixed signal from the bond market overall, in the sense that corporate bond yields haven’t fallen, points out Green at Penn Capital.
“Corporate bonds are screaming that the economy is great,” Green says. By this he means their yields have held up, in contrast to Treasury yields. Even energy company bond yields have stayed strong, despite recent sharp declines in oil prices.
Green and his colleagues at Penn Capital follow the corporate bond market closely, as managers of the PENN Capital Opportunistic High Yield Fund PHYNX, +0.09% , which beats competing funds by 3.3 percentage points over the past year, according to Morningstar.
Green says government bonds may have strengthened more because of recent worries about the European elections, Trump administration reform delays, and some weak economic data out of China.
But reasonably solid 2.5% second quarter U.S. economic growth will ultimately outweigh those issues, leading to a bond sell-off which could drive 10-year Treasury TMUBMUSD10Y, -0.85% yields towards 3%, he says.
Certainly there are good reasons to expect a second-quarter rebound. Employment strength and wage growth continue to be solid. That should benefit consumer spending. Surveys of business leaders continue to show lots of bullishness. One worry is that “soft” survey data haven’t translated into capital spending and sales that boost “hard” economic data. But history shows this typically happens sooner or later even if there’s a lag, notes Golub, the RBC Capital Markets strategist.
Plus the recent strength in bonds may just be a signal that inflation is dead, adds strategist Ed Yardeni, of Yardeni Research, which would be good news. “That’s telling us there is not going to be a Fed policy engineered recession for a long time.”
4. Weak commodity prices suggest the economy may soften
Since January, the Thomson Reuters Core Commodity CRB Index has been in a steady decline. This can signal economic weakness ahead. It suggest companies are buying fewer raw materials because they see a slowdown in demand. It also raises some doubts about the “reflation trade” that has driven stocks higher, or the belief that the economy and therefore inflation are heating up after so much worry about deflation.
You can see the declines in commodities by looking at the charts of commodity exchange traded funds such as WisdomTree Continuous Commodity Index Fund GCC, +0.38% , PowerShares DB Commodity Index Tracking Fund DBC, +0.41% and iShares S&P GSCI Commodity-Indexed Trust GSG, +0.49% .
“This does get my attention,” observes Yardeni, who is otherwise mostly bullish about the economy. “It is something I watch.” However, the decline may be more due to recent attempts by the government in China to trim credit in the shadow banking sector and clamp down on speculators, Yardeni observes.
Green, the director of research at Penn Capital, says the decline in commodity prices may just be a natural pullback following a big rally last year. And Ramsey, at Leuthold Core Investment Fund, points out the decline may have more to do with weakness in grains and energy than industrial commodities.
5. U.S. economic surprises have hit the skids
Market insiders love to track the Citigroup’s Economic Surprise Index (CESI) as an economic signal. Recently it has declined sharply and moved into negative territory. This could be bad news for stock investors because CESI can correlate with S&P500 SPX, -0.22% sell-offs, say analysts at JP Morgan. They think the recent decline points to a possible 10% downside for stocks.
This sounds scary, but CESI might not be the guidepost it is cracked up to be. While CESI’s crossover into negative territory “has preceded some nasty setbacks, the batting average is fairly random,” says Ramsey, at The Leuthold Group. So he discounts the signal.
How to position your stock portfolio now
If market myths are holding others back from buying stocks — but the economy is likely to fool them and continue to grow more than they think — one way to position for this is to simply stay long broad market indices like the S&P 500 and Nasdaq COMP, -0.22% .
But there are better ways to outperform at a time of reacceleration in growth, says Golub, the RBC Capital Markets strategist.
* Favor value because cheaper stocks tend to outperform more expensive stocks when growth rebounds.
* Go with smaller companies since they outperform larger companies during times of accelerating growth because they run leaner. This means more of the additional revenue drops to the bottom line.
* Favor stocks in developed economies abroad, such as Europe, which haven’t rebounded as much as U.S. stocks. So they should perform better on signs of continued global strength. Consider a fund tracking the MSCI EAFE Index, which should get an additional boost because it is overweight economically-sensitive sectors including financials, industrials and materials. “To the extent we are experiencing a global re-acceleration, these biases should lead to the outperformance,” says Golub. One way to get exposure here is through iShares MSCI EAFE ETF EFA, -0.25%
* Rising rates tend to be harsh on the low-volatility stocks that investors had recently flocked to for safety. Avoid them.
But shouldn’t you “sell in May?”
One market “myth” that could hurt investors is to “sell in May and go away.” This is a folksy take on market seasonality, which actually can be good advice. Since 1950, the market has posted a mean return of 1.4% from May through October, compared to 7% for November to April, Delwiche says.
It’s interesting to note that this pattern has not been arbitraged away, even though it has been so widely noted that it has hit adage status. The same pattern has held up, on average, since 2010, says Baird’s Delwiche. While there are exceptions, “sell in May” is one market myth that might not be such a yarn. But since we probably aren’t going to get a bull-killing recession soon, it will be best to just ride out any volatility that does happen.
Michael Brush is publisher of the stock newsletter Brush Up on Stocks. At the time of publication, Michael Brush had no positions in any stocks mentioned in this column.