“Davidson” submits:

“Can you tell how many, what type and where fish are in the oceans by looking at the waves?”

This is a question I ask students when I am a guest speaker at college business programs. Can you guess the answer?

Below is the price history of the S&P 500 and the NASDAQ Composite(Over-the-Counter) from December 1977 till today. The calls for a market crash have been frequent lately as the NASDAQ(BLUE LINE) ($QQQ) approaches the highest levels ever reached in early 2000 when the Internet Bubble peaked. We had similar calls as the S&P 500 (BLACK LINE) reached 2000 and 2007 peaks. Now that the S&P 500 has gone well beyond its previous highs, those who predicted disaster based on price have been muted. The NASDAQ being 30pts from its all time intra-day high has revived some of these dire predictions. But, then in Barron’s this week a column on Technical Analysis stated: “With new highs spread across sectors and capitalizations, the rising trend remains in place until real evidence emerges to refute it.”

S&P 500 vs Nasdaq Composite

[drizzle]Hmm…some of the ‘best’ minds advise buying markets because they see an uptrend and then tell you that they will change their minds when the trend changes? Is this serious research? Just as ocean waves tell you nothing about fish, equity price trends tell you very little about business trends. I know of only a single academic program where price trends are not taken as the basis for understanding business trends. The accredited syllabus in business schools globally is and has been price trend based since the 1950s, i.e. Modern Portfolio Theory and Efficient Markets. Although some will beg to differ, there is scant attention given to valuation analysis and when push comes to shove it is the accepted consensus that in the final analysis the ‘market knows best’. This means that when valuation fails to explain prices that the market knows something more than the best investors do. It is for this reason that so many follow trends, apply algorithms and when the current price near a historic mark make assumptions about the future which only in hindsight are seen as unreliable. Of course we never hear of the many who produced forecasts which did not work out. What we do hear is that one or two people got it right and they are the smart ones. Unfortunately for investors, those forecasters who the media has dubbed ‘gurus’ seldom repeat being correct more than once. This is media cherry picking and makes good entertainment, but is not helpful to investors.

Prices in any market are a reflection of what people think things are worth. Considering the wide range of perceptions and the belief that the market operates by some “Invisible Hand” correct pricing model, the logical outcome which is supported by observation of thousands of wild disparities in prices vs. business fundamentals, prices are pure psychology. This is why market prices do not represent business values ever!!

If one steps back and recognizes that prices are set by market psychology and if you have a math/science background (as I do), you can recognize that what moves markets can be broken down into to types of investors, i.e. Value and Momentum Investors. I have discussed this many times before and will continue to do so. The recession lows in markets are made by Value Investors who know how to value future earnings streams with respect to our Gross Domestic Product .The S&P 500 Intrinsic Value Index ($SPY) was created with respect to this concept. Any differences between the S&P 500 and its Intrinsic Value Index is due to market psychology. In the simplest terms the market is correctly priced only 2x in each cycle, at the lows of the economic cycle , once at the beginning and once at the end.

To invest across the full economic cycle, one needs to understand both Value and Momentum Investing and understand their separate price drivers. As long as economic activity is expanding, equity prices historically rise. Investors find every reason to justify higher stock prices when the economic expansion surprises them. The reverse is true when economic news surprises on the downside. When one is an investor one’s focus should be at all times monitoring the drivers of investor perceptions and how they translate into market prices. This is why I monitor economic activity. If you can see economic trends are different from investor psychology and market pricing, then you have investment opportunity.

At the moment and for the next couple of years, equity prices like the economy look headed higher. Possibly much higher! But , market psychology as the major driver, I cannot provide precision or timing except that my guess is a higher market for the next 5yrs-7yrs. Calls for correction by looking back at previous highs with which we are peppered daily are like a sieve, they do not hold water.