Markets often get the little things right while missing the big picture, something we call local efficiency. The last thirty months has been a period where those with the greatest influence over the marginal invested dollar have paid little attention to improving fundamentals. In 2004 I wrote a paper describing it as the opposite of the 2000 technology bubble. This week Gary D. Smith, author of the excellent Long/Short Trader column on Street Insight, compiled a list of sentiment indicators and called the current environment a "negativity bubble." Good term! (I wish I had thought of it, because that is certainly the concept. I'll credit Gary in my book). Scott Rothbort in his novel and useful definition of bull and bear markets cites the same negativity. Jim Cramer sounded this theme, once again, on his CNBC program today.
The purpose here is to show in some detail how an idea can gain a foothold with many of those actively trading, swinging billions of dollars with very little in the way of evidence. Transport stocks play a central role. (For the record, my individual clients do not have positions in transports-- yet -- but my funds have some moderate option positions).
The chart shows the flow of effects for this example. In this post, I'll describe the chart as briefly as possible to introduce the idea. I am hoping to elaborate on the theoretical basis for what happened in this case in future posts.
The chart starts (1) with the combination of some questionable research that purported to show that markets decline after a Fed hiking cycle. Anyone with a little experience in thinking about causation and data can look at the compilation and see the obvious problems. Despite the dubious nature of the conclusions, the findings were widely promoted and got a lot of publicity in mainstream press and among bloggers.
Another factor is (10) the daily need to explain that is the job of the financial journalist. When the Fed announced a pause in the interest rate tightening cycle, many expected the market to rally. This certainly included most average non-traders. When it did not, there was a need to explain. All of a sudden the research on "After the Fed" got another media life-cycle.
It is important to realize that most market participants parse a lot of information every day. They take a simple view, a mile wide and an inch deep. They probably never saw the actual studies. They did not know about the ancient data and partial analysis. They probably would not know how to do a critique of the work, unless they remember their old college methods courses. There is no peer review, and little criticism on Wall Street. The only thing everyone remembers is that an end to the tightening cycle will not help.
This over-simplified conclusion is absorbed (2) by financial analysts. Some of them have quit trying to analyze the companies they follow and become pundits on the market and the economy. In two specific examples (3) we have documented where a UPS executive reported what he had read in the newspaper and it was viewed as some fantastic leading indicator by the market. This happened in spite of his insistence that what he sees is a concurrent indicator and it looked fine. In a second example a prominent analyst downgraded a stock because he expected its PE multiple to contract after the Fed cycle.
While these are only two examples, they are typical of what I am seeing in analyst reports and conference calls dealing with cyclical stocks. The result is the central theme of the chart, the decline of transport stocks (4) and the Dow Transportation Index.
Now we get the trading effects. Momentum traders (5) bail out, if they have not already left. Technical traders see a less attractive chart and they also sell. This confirms the "message of the market" as we listen to repeated commentaries from CNBC anchors explaining how this decline (6) presages economic weakness.
The entire dogma sticks with traders, as reported (7) by the man who knows, Art Cashin. Here is what the traders think they know:
- Stocks will probably go down after the end of the tightening cycle;
- UPS sees a bad economy;
- FedEx is getting downgraded, and that tells you that a big-time analyst sees a bad economy;
- The Transportation Index is down, so the market is telling us about economic weakness.
This proceeds to drag the entire market (8) down with it. Journalists, needing to explain the market decline in the face of (yet another) great earnings season and good economic data, point to the Transport Index and back to the dubious resesarch (1).
If one understands the factors behind The Cycle of Negativity, there are opportunities both for traders and investors.