Sometimes Things Go Right

10/31/2016


It may seem hard to believe after years of worse-than-forecast economic growth and worse-than-ever-imagined U.S. political discourse, but betting on things going better than expected is usually a 50-50 proposition.

In the market, stocks close every trading session at a price that balances supply and demand for the shares. Even when a "bad" quarterly report is widely expected the next morning, some investors buy because they think the price already reflects the bad news — or because they expect the news to be less bad than expected. That's why stocks rally when losses come in smaller than feared — and drop on profit surges that fall short of consensus forecasts.

Keep this expectations game in mind as third-quarter earnings roll in. When a stock dips on a seemingly strong report, it may mean optimism was simply running too high ahead of the report — and not that the report brought disappointing news.

Even when looking beyond earnings and economics, keeping expectations in mind is crucial. Some examples:

The election. Using polling data through Oct. 23, the prediction model of The New York Times says Hillary Clinton has a 92% chance of winning the presidency, while FiveThirtyEight pegs it at 87%. PredictWise, based on betting markets, puts the odds at 90%.

In other words, a Trump victory has become a tail risk — something unlikely to happen that could have major consequences if it does happen. On the other side, a Democratic sweep of the White House and both chambers of Congress also represents a tail risk, since Republicans are expected to hold onto the House of Representatives.

Wall Street fears a Trump victory, but it's also scared of Clinton having a free hand to push her agenda. If Clinton wins and Republicans retain their majority in the House, stocks will likely benefit from a relief rally. But because investors expect a split result, don't expect a major surge if they get one.

Post-election government. Asked about the general direction of the country, 64% of Americans say it is on the wrong track, according to a RealClear Politics average of six polls done in mid-October. A similar Gallup poll says less than 30% are satisfied with the way things are going — at the low end of the range since 1979.

Considering recent healthy job and wage growth, some of the pessimism probably reflects political gridlock in Washington. Confidence in our system of government has seldom been lower. However, with voter discontent at extreme levels, both parties may feel pressure to get something done. Wall Street would likely applaud a tax break for the repatriation of corporate cash held overseas or a deal on infrastructure spending.

Stock-market action. Stocks not only react to events; they also spark human responses tied to fear and greed. When investor sentiment is relatively pessimistic, a breakout to new highs in the averages can trigger a fear of missing out. The Dow Industrials remain within 3% of the Aug. 15 all-time closing high of 18,636.05, while the S&P 500 Index is 2.4% from its all-time high of 2,190.15.

According to the American Association of Individual Investors survey, bullish sentiment in October reached 23.7%, the lowest level since June — lower than all but 7% of the weekly readings in the survey's 29-year history. Among newsletters, bullish sentiment is near the middle of a three-year range. And among portfolio managers, cash levels have not been higher since 2001, according to Bank of America.

Conclusion

Skepticism is a valuable trait when investing; congenital pessimism is not. Don't let the news get you so down that you look past opportunities to buy quality stocks at attractive prices. For now, our buy lists have 83% to 88% in stocks, with the remainder in a short-term bond fund.


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