False Fears of a False Dawn

Stocks have surged since mid-February, mostly reversing early 2016's sharp decline. But sentiment hasn't much improved. Many are skeptical of the rally. Some say it's a false dawn, built on sand, and will last just long enough to fool all the suckers before stocks fall anew and hit new lows. Pundits warn nothing has fundamentally changed, and stocks are rising on short covering^[i] and corporate buybacks alone. Others say Treasury yields' failure to reverse their own early-year volatility shows "safe havens" remain in demand, another sign stocks' good times can't last. We'll give them this: No one can say definitively the correction's bottom is now in. That is only ever clear in hindsight, once stocks regain their prior high. Nor does this correction's official end preclude another in the coming months, rare as that might be. But while volatility could always return, we think the narrative around this being a false rally is mistaken. The correction-a short, sharp, fear-driven drop-was the "fake" part. Fundamentals are positive, suggesting the bull market has further room to run regardless of any potential short-term wiggles. The skepticism about this rebound is basically the norm when corrections end. It's a reason to be optimistic, not a reason to be fearful.

Though the rally-is-fake arguments vary, they have the same underlying premise: People believe the correction was a rational response to deteriorating fundamentals, and they worry those conditions haven't improved. With retail fund flows still negative, earnings falling, P/E ratios high, China still China, economic data a bit mixed, oil prices still low and politics a circus, many investors have a hard time seeing anything right with the world. So if stocks are rising, of course it must be a figment of "fake" buying like buybacks and short covering, and not "real" buying, where investors bid up stocks in rational anticipation of a brighter future.

Not to be harsh, but that is the very definition of myopia. Stocks rarely move on what the financial press chatters about daily. For markets, today's noise is just that-noise. Stocks typically look past yesterday and today and weigh what's likeliest over the next 12-18 months or so. There are many positives for markets to weigh over that span. Forward-looking economic indicators, like The Conference Board's Leading Economic Indexes (LEI) and the new orders components of most service and manufacturing surveys, suggest global economic growth will continue over the foreseeable future. LEIs in the US, UK and the eurozone are all in long uptrends. These regions, combined, account for about half of global output. With growing economies comes growing demand, powering profits for firms globally. For all the China fear, its economy continues growing at enviable rates, elevating more and more consumers into the middle class. China is a big end market for many Consumer, Technology and Health Care firms, and there, too, demand is surging. Other Emerging Markets also continue growing nicely-particularly those like India and South Korea, which don't make their living exporting commodities. Deep recessions in Brazil and Russia might hog more headlines, but they are outliers. Most everywhere else, underappreciated growth is the norm and should continue.

That political circus is also more good than bad, hard as it might be to believe. Whether due to election-year inactivity and squabbling (America), government infighting (the UK), the rise of anti-establishment parties (Germany) or inconclusive elections (Spain and Ireland), most developed-world governments are ever-more gridlocked. On the surface, this means elected politicians don't do much beyond grandstanding and arguing, but for stocks, this is good. Gridlocked governments are highly unlikely to pass broad, sweeping legislation that creates winners and losers and potentially spooks investors. When inactive governments don't change the rules, they create far less uncertainty. That makes it far easier for businesses to plan and take risk-and their risk-taking is what ultimately drives investment and growth.

Investors also miss some things about the correction itself. Chiefly: The things that drove the volatility aren't huge negatives sneaking up on us. Folks have dreaded a Chinese hard landing since 2011. People collectively decided to fear negative interest rates in February, but negative rates have existed since 2012. The eurozone has had them since 2014. Oil? Oil started falling about 22 months ago. The US election? It has been on the calendar for centuries, and anti-establishment candidates have hogged the spotlight (and polls) for nearly a year now. The Brexit vote? In the cards since 2013. Earnings? Negative since Q2 2015, but positive once you exclude the Energy sector (through Q4). Again, stocks look forward, not backward, and they discount all widely known information. This doesn't preclude more volatility, but as these have been widely discussed for considerable periods, they are highly likely to already be factored into stock prices. Surprises move markets most, not what everyone already knows. With fear baked in, the surprise potential is of the positive kind, not the negative kind.

Perhaps that seems hard to believe? Take heart: Skepticism is normal after big volatility. If it weren't, investors would make loads of money timing corrections perfectly-they'd know exactly when to get in and wouldn't be afraid to take the leap. But that isn't how it works. Volatility influences sentiment. Humans forever react to what just happened, and in stocks, that instinct gets compounded by loss aversion-our innate tendency to feel the pain of losses far more than we feel the joy of an equivalent gain. Corrections are painful, and we're hard-wired not to want to feel more of that pain. When we're scarred from volatility, any subsequent bounce is bound to feel more like a temporary reprieve-another chance to get out before the storm returns-than something that could actually last. That makes people exceedingly vulnerable to all the "this isn't real!" headlines. But it doesn't make those headlines right-beware confirmation bias. We saw similar headlines after the corrections in 2009, 2010, 2011 and 2012. Heeding their advice would have been costly.

One of the hardest things for an investor to do is to tune out fear. Those who will reach their goals, over time, are those who can discern between media bogeymen and actual risks. Today, we have bogeymen, or monsters under the bed if you prefer-pundits justifying their pessimism with nonsense that presumes no one is bullishly buying, one market predicts another, or past performance predicts future returns. See through this fog, see what others miss, and you'll see this bull market likely has further room to run.