Financial Markets, Forecasting

Fake News (Finance Edition)

The purpose of fake news is not to change the mind of the audience, but rather reinforce the beliefs which the audience already has.  Today, when we hear the term “fake news” we think of politics, but fake news is also very rampant in finance.

Clients have been asking me for some time now “isn’t the market overvalued?”.  This is not the way I think about the market.  Stocks can trade at average, high, or low valuations, which alters the returns that one would expect going forward.  It is common belief that when stocks trade at high valuations, they must crash.  This is not true.

The term “overvalued” would suggest that there is a fair value to stock prices, and that the collective wisdom of market participants has valued stocks significantly higher than that.  If there was such a fair value of stocks, the formula to calculate it would be well known by now and the market prices would rarely deviate from it.

The term “overvalued” has been beaten into our brains by the financial media over and over again as to where we start to believe it is a rational thought.  However, it isn’t.

Hearing the market is overvalued catches our attention.  In the back of our minds we know how well stocks have done since the pits of The Great Recession, and we think it cannot continue much longer, so we are looking for a rational reason to sit on the sidelines.

According to different financial media outlets, stocks have been overvalued for nearly a decade.  See below:

That was fun.  Now let’s look at a chart of the S&P 500 Total Return Index during those 9 years.

Source:  Morningstar Advisor Workstation

It’s quite amazing that throughout all those scary headlines, the S&P 500 compounded at an average of 15.25% annually, for a cumulative return of 258.76% (2009 – 2017).  Maybe the “experts” do not have better insight into the fair value of the stock market than anyone else.

Legendary investor, Joel Greenblatt, recently shared a story regarding a time where he was teaching 9th graders about the stock market.  He brought a large glass jar filled with jellybeans to the classroom, then asked each student to write down their best guess on an index card as to how many jellybeans were in the jar.

Next, he went around the room and asked everyone to verbally state in front of the rest of the class their best guess, and said they could use a number different than what they wrote down.  The results were interesting.

The first guess, which the students wrote on the index card, averaged 1771 which was extremely close to the 1776 jellybeans actually in the jar.  The average of the second guess which each student stated verbally, only came to 850.  Greenblatt explained to the students that the second guess is how the stock market works.

When everyone heard the guesses from their peers, it altered their guess.  When investors in the market start reading the newspapers, listening to the radio, or watching financial programming, they have dozens of different opinions being thrown at them which influences how they feel about the future of their investments.

Believing your prediction on the fair value of stocks is superior to the wisdom of the crowd, would be similar to a student believing their note card guess on the jellybean total was more accurate than the average of the class.  It is possible, but not at all probable.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that is is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.  Any opinions are those of Mark Meredith and not necessarily those of Raymond James.  Investments mentioned may not be suitable for all investors.  Investing involves risk and you may incur a profit or loss regardless of strategy selected.  Past performance does not guarantee future results.  Inclusion of the index is for illustrative purposes only.  Keep in mind that individuals cannot invest directly in any index.  Raymond James is not affiliated with and does not endorse any of the listed articles or their respective authors.  The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.