Four engines of the market

Often investment professionals get asked to provide forecasts about the markets. I’m not always sure why since I do not have the ability to predict the future. However, I do understand that to have an even remote chance of being right, you have to understand what causes markets to move.

My airplane analogy

Last week I talked about markets and weather, this week I’ll talk about airplanes and the market. By the end of all this, I’m sure that some of you will wonder if I’m coming out with some other crazy analogy next week. When people ask me about the markets, I often use an airplane analogy. Here is my version today.

If we think of the market as an airplane with four engines, we need all four engines to be working in order to take off the ground, climb in altitude and stay in the air. Markets, too need all four engines to recover from a bear market into a bull, have an appreciation, and prevent another downturn from coming. If none of the engines are working, then whether it is an airplane or the markets, we have depreciation in values or decent or worse yet, a major crash!

Engine 1 = economics

Currently, the economic environment is in transition and transition for the better. The low-interest-rate environment has helped the economy turn around from recession to growth. Many of the economic signs are suggesting growth (albeit not robust growth). Economic indicators like Gross Domestic Product (GDP); inventories and manufacturing are pointing to economic growth. This engine is working for us at this time.

Engine 2 = fundamentals

When analysts look at fundamentals, they typically are analyzing the fundamental characteristics of companies (like valuations, earnings, efficiencies, debt, cash flow, etc.) to see if they have the potential for future growth and profits. The key factor in looking at corporations is corporate earnings. The Market has been very sensitive to corporate earnings information. Arguably, corporate earnings have had a significant role in causing the recent demise of the technology sector. The fact is that while corporate earnings are improving, there are still many companies posting disappointing earnings figures. Add in what happened with Enron and the accounting fiasco, and there is a lot of concern over how earnings are reported and what they really mean. While the economic engine is working for us, the corporate earnings are still not working to capacity. This engine is working at low to moderate levels. Much of the volatility in April is a result of disappointing corporate earnings.

Engine 3 = statistics

While past performance is not a real indicator of future performance, we use historical statistics to help us to understand market movements. The statistical engine is definitely on our side. Bull markets always follow bear markets and they tend to last four times as long as a bear market. The bear market we have just gone through was one of the worst Bear markets ever experienced. While emotionally, that leads us to extrapolate bad news and think that things will get worse, statistically, it means that the probability of a bull market increases every day that passes. I feel this engine is definitely working at high capacity.

Engine 4 = sentiment

The fourth engine is more of a behavioral component. After all, it has been said that investments do not drive the markets but rather the behavior of investors drives the market. Investor sentiment or confidence is low. This engine is struggling right now. Investor confidence can be measured by the amount of cash that is held. Today cash levels are extreme highs. This cash is earning about 2% and many of these investors are waiting to get this money invested back into the markets but not until their confidence improves.

My two cents

To summarize, we probably have two engines working out of four. This is probably why markets have been a little choppy this year. January and February were off to a slow start but March has really picked up. We need continued improvements to corporate earnings to get investor confidence back up. We hope that by the second or third quarter of this year, all four engines will be working in our favor and markets will start to produce some better news.

This analogy is once again oversimplified. Remember there are many markets in the world and each one can be described differently with this model. My real advice is simple. Don’t time the markets. Keep your seat belts buckled we have bound for takeoff again. Just sit tight and be patient. Good luck.

Leave a reply

Your email address will not be published. Required fields are marked*