Don't Get Ruined by These 10 Popular Investment Myths (Part V)

Interest rates, oil prices, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, etc. -- NONE have a reliable effect on the stock market

By Elliott Wave International

You may remember that during the 2008-2009 financial crisis, many called into question traditional economic models.

Why did the traditional financial models fail? And more importantly, will they warn us of a new approaching doomsday, should there be one?

This series gives you a well-researched answer.

Here is Part V; come back soon for Part VI.

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Myth #5: "GDP drives stock prices."
By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)

Surely the stock market reflects the nation's Gross Domestic Product. The aggregate success of corporations shows up as changes in GDP. Stocks are shares in corporations. How could their prices not reflect the ebb and flow of GDP?

Suppose that you had perfect foreknowledge that over the next 3 3/4 years GDP would be positive every single quarter and that one of those quarters would surprise economists in being the strongest quarterly rise in a half-century span. Would you buy stocks?

If you had acted on such knowledge in March 1976, you would have owned stocks for four years in which the DJIA fell 22%. If at the end of Q1 1980 you figured out that the quarter would be negative and would be followed by yet another negative quarter, you would have sold out at the bottom.

Suppose you were to possess perfect knowledge that next quarter's GDP will be the strongest rising quarter for a span of 15 years, guaranteed. Would you buy stocks?

Had you anticipated precisely this event for 4Q 1987, you would have owned stocks for the biggest stock market crash since 1929. GDP was positive every quarter for 20 straight quarters before the crash and for 10 quarters thereafter. But the market crashed anyway. Three years after the start of 4Q 1987, stock prices were still below their level of that time despite 30 uninterrupted quarters of rising GDP.

Figure 10 shows these two events. It seems that there is something wrong with the idea that investors rationally value stocks according to growth or contraction in GDP.

Interest rates, oil prices, trade balances, corporate earnings and GDP: None of them seem to be important, or even relevant, to explaining stock price changes. But you need not trust your own eyes. In a study that is stunning for its boldness in actually checking basis premises, Cutler, Poterba and Summers in a paper for the Journal of Portfolio Management in 1989 investigated the effect of economic news on stock prices and concluded,

"Macroeconomic news bearing on fundamental values...explains only about one fifth of the movement in stock prices."

Even here, I would question the conclusion that such news "explains" even 1/5 of the movement in stock prices. Surely a set of football statistics could generate a 1/5 correlation to the S&P. And every correlation, to have meaning, must have a theory to account for it.

What theory accommodates the idea that macroeconomic fundamentals explain 1/5 of stock price changes? If there is no accommodating theory, then the presumed causality involved is tenuous at best.v

(Stay tuned for Part VI of this important series, where we examine another popular investment myth: Namely, that "Wars are bullish/bearish for stock prices.")

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Free Report: "The Biggest Lie in Stock Market History" Dear Reader, We believe risks and opportunities even larger than those of 2007-2009 lie ahead in a bear market of epic proportions. Only problem is, this bear market is silent right now. It's not visible to the public, because the government and the Federal Reserve inflate the credit supply and the U.S. dollar to hide its impact. But make no mistake about it: There is a Silent Crash going on right now in the stock market, and it's having a very real impact on your spending power. Read this special report now, free -- and see 15 eye-opening charts >>

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Don't Get Ruined by These 10 Popular Investment Myths (Part IV)

Interest rates, oil prices, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, etc. -- NONE have a reliable effect on the stock market

By Elliott Wave International

You may remember that during the 2008-2009 financial crisis, many called into question traditional economic models.

Why did the traditional financial models fail? And more importantly, will they warn us of a new approaching doomsday, should there be one?

This series gives you a well-researched answer.

Here is Part IV; come back soon for Part V.

---

Myth #4: "Earnings drive stock prices."
By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)

This belief powers the bulk of the research on Wall Street. Countless analysts try to forecast corporate earnings so they can forecast stock prices. The exogenous-cause [i.e., news-driven -- Ed.] basis for this research is quite clear:

Corporate earnings are the basis of the growth and the contraction of companies and dividends. Rising earnings indicate growing companies and imply rising dividends, and falling earnings suggest the opposite. Corporate growth rates and changes in dividend payout are the reasons investors buy and sell stocks.

Therefore, if you can forecast earnings, you can forecast stock prices.

Suppose you were to be guaranteed that corporate earnings would rise strongly for the next six quarters straight. Reports of such improvement would constitute one powerful "information flow." So, should you buy stocks?

Figure 9 shows that in 1973-1974, earnings per share for S&P 500 companies soared for six quarters in a row, during which time the S&P suffered its largest decline since 1937-1942.

This is not a small departure from the expected relationship; it is a history-making departure. Earnings soared, and stocks had their largest collapse for the entire period from 1938 through 2007, a 70-year span! Moreover, the S&P bottomed in early October 1974, and earnings per share then turned down for twelve straight months, just as the S&P turned up!

An investor with foreknowledge of these earnings trends would have made two perfectly incorrect decisions, buying near the top of the market and selling at the bottom.

In real life, no one knows what earnings will do, so no one would have made such bad decisions on the basis of foreknowledge. Unfortunately, the basis that investors did use -- and which is still popular today -- is worse:

They buy and sell based on estimated earnings, which incorporate analysts' emotional biases, which are usually wrongly timed.

But that is a story we will tell later. Suffice it for now to say that this glaring an exception to the idea of a causal relationship between corporate earnings and stock prices challenges bedrock theory. ...

(Stay tuned for Part V of this important series, where we examine another popular investment myth: Namely, that "GDP drives stock prices.")

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Free Report: "The Biggest Lie in Stock Market History" Dear Reader, We believe risks and opportunities even larger than those of 2007-2009 lie ahead in a bear market of epic proportions. Only problem is, this bear market is silent right now. It's not visible to the public, because the government and the Federal Reserve inflate the credit supply and the U.S. dollar to hide its impact. But make no mistake about it: There is a Silent Crash going on right now in the stock market, and it's having a very real impact on your spending power. Read this special report now, free -- and see 15 eye-opening charts >>

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Don't Get Ruined by These 10 Popular Investment Myths (Part III)

Interest rates, oil prices, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, etc. -- NONE have a reliable effect on the stock market

By Elliott Wave International

You may remember that during the 2008-2009 financial crisis, many called into question traditional economic models. Why did the traditional financial models fail?

And more importantly, will they warn us of a new approaching doomsday, should there be one?

That's a crucial question to your financial well-being. This series gives you a well-researched answer.

Here is Part III; come back soon for Part IV.

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Myth #3: "Expanding trade deficit is bad for economy -- and bearish for stocks."
By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)

Over the past 30 years, hundreds of articles -- you can find them on the web -- have featured comments from economists about the worrisome nature of the U.S. trade deficit. It seems to be a reasonable thing to worry about.

But has it been correct to assume throughout this time that an expanding trade deficit impacts the economy negatively?

Figure 8 answers this question in the negative:

In fact, had these economists reversed their statements and expressed relief whenever the trade deficit began to expand and concern whenever it began to shrink, they would have accurately negotiated the ups and downs of the stock market and the economy over the past 35 years. The relationship, if there is one, is precisely the opposite of the one they believe is there. Over the span of these data, there in fact has been a positive -- not negative -- correlation between the stock market and the trade deficit.

So the popularly presumed effect on the economy is 100% wrong. Once again, economists who have asserted the usual causal relationship neglected to check the data.

And it is no good saying, "Well, it will bring on a problem eventually." Anyone who can see the relationship shown in the data would be far more successful saying that once the trade deficit starts shrinking, it will bring on a problem.

Around 1998, articles began quoting a minority of economists who -- probably after looking at a graph such as Figure 8 -- started arguing the opposite claim. Fitting all our examples so far, they were easily able to reverse the exogenous-cause argument and have it still sound sensible. It goes like this:

In the past 30 years, when the U.S. economy has expanded, consumers have used their money and debt to purchase goods from overseas in greater quantity than foreigners were purchasing goods from U.S. producers. Prosperity brings more spending, and recession brings less. So a rising U.S. economy coincides with a rising trade deficit, and vice versa.

Sounds reasonable!

But once again there is a subtle problem. If you examine the graph closely, you will see that peaks in the trade deficit preceded recessions in every case, sometimes by years, so one cannot blame recessions for a decline in the deficit.

Something is still wrong with the conventional style of reasoning.

(Stay tuned for Part IV of this important series, where we examine another popular investment myth: Namely, that "Earnings drive stock prices.")

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Free Report: "The Biggest Lie in Stock Market History" Dear Reader, We believe risks and opportunities even larger than those of 2007-2009 lie ahead in a bear market of epic proportions. Only problem is, this bear market is silent right now. It's not visible to the public, because the government and the Federal Reserve inflate the credit supply and the U.S. dollar to hide its impact. But make no mistake about it: There is a Silent Crash going on right now in the stock market, and it's having a very real impact on your spending power. Read this special report now, free -- and see 15 eye-opening charts >>

Read more ...

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Don't Get Ruined by These 10 Popular Investment Myths (Part II)

Interest rates, oil prices, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, etc. -- NONE have a reliable effect on the stock market

By Elliott Wave International

You may remember that during the 2008-2009 financial crisis, many called into question traditional economic models. Why did the traditional financial models fail?

And more importantly, will they warn us of a new approaching doomsday, should there be one?

That's a crucial question to your financial well-being. This series gives you a well-researched answer.

Here is Part II; come back soon for Part III.

---

Testing Exogenous-Cause Relationships from Economic Events
By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)

Claim #2: "Rising oil prices are bearish for stocks."

This is a ubiquitous claim. It would take weeks to collect all the statements that economists have made to the press to the effect that recently rising oil prices are "a concern" or that an unexpected (they're always unexpected) "oil price shock" would force them to change their bullish outlook for the economy.

For many economists, the underlying assumption about causality in such statements stems from the experience of 1973-1974, when stock prices went down as oil prices went up. That particular juxtaposition appeared to fit a sensible story of causation regarding oil prices and stock prices, to wit:

Rising oil prices increase the cost of energy and therefore reduce corporate profits and consumers' spending power, thus putting drags on stock prices and the economy.

Figure 7 shows, however, that for the past 15 years there has been no consistent relationship between the trends of oil prices and stock prices.

Sometimes it is positive, and sometimes it is negative. In fact, during this period it has been positive for more time than it has been negative! And the quarters during this period when the economy contracted the most occurred during and after the oil price collapse of 2008. Thereafter oil prices doubled as the economy was reviving in 2009. None of this activity fits the accepted exogenous-cause argument.

But wait. Could rising oil prices perhaps be bullish for stocks?

Yes, once again we can argue both sides of the exogenous-cause case. Consider: As the economy begins to expand, business picks up, so stock prices rise; and as business picks up, demand for energy rises as businesses gear up and operate at higher capacity. That's why stocks and oil go up together. Makes sense, doesn't it?

But neither claim explains the data. Sometimes oil and stocks go up or down together, and sometimes they trend in opposite directions. As with stocks and interest rates we discussed in Part I of this series, we could easily isolate examples of all four pairs of coincident trends.

To conclude, we can determine no consistent relationship between the two price series, and no economist has proposed one that fits the data.

This graph negates all the comments from economists who say that an "oil shock" would hurt the stock market and the economy. It also throws into doubt the very idea that stock prices and oil prices are linked.

(Stay tuned for Part III of this important series, where we examine another popular investment myth: Namely, that "Rising U.S. trade deficit is bad for the economy stocks.")

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Free Report: "The Biggest Lie in Stock Market History" Dear Reader, We believe risks and opportunities even larger than those of 2007-2009 lie ahead in a bear market of epic proportions. Only problem is, this bear market is silent right now. It's not visible to the public, because the government and the Federal Reserve inflate the credit supply and the U.S. dollar to hide its impact. But make no mistake about it: There is a Silent Crash going on right now in the stock market, and it's having a very real impact on your spending power. Read this special report now, free -- and see 15 eye-opening charts >>

Read more ...

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Don't Get Ruined by These 10 Popular Investment Myths (Part I)

Interest rates, oil prices, earnings, GDP, wars, terrorist attacks, inflation, monetary policy, etc. -- NONE have a reliable effect on the stock market

By Elliott Wave International

You may remember that during the 2008-2009 financial crisis, many called into question traditional economic models. Why did the traditional financial models fail?

And more importantly, will they warn us of a new approaching doomsday, should there be one?

That's a crucial question to your financial well-being. This series gives you a well-researched answer. Here is Part I; come back soon for Part II.

---

The Fundamental Flaw in Conventional Financial and Macroeconomic Theory

By Robert Prechter (excerpted from the monthly Elliott Wave Theorist; published since 1979)

Every time there is a recession, observers grumble about economists' methods. The deeper the recession carries, the louder the grumbling. The reason that widespread complaints occur only in recessions is that economic forecasters as a group never, ever anticipate macroeconomic changes. Their tools don't work, but consumers of their commentary do not notice it until recessions occur, because that is the only time when everyone can see that the methods failed. The rest of the time, when expansion is the norm, no one notices or cares.

The recent/ongoing economic contraction is the deepest since the 1930s, so the complaints about economists' ideas are the most strident since that time. Figure 1 shows how one publication expressed this feeling following four quarters of negative GDP.

Figure 1

Ironically, once the economy begins expanding again, everyone forgets about their old complaints. The media resume quoting economists, despite their flawed methods, and they are once again satisfied that their ideas make perfect sense.

Conventional financial theory relies upon the seemingly sensible ideas of exogenous cause and rational reaction. Papers are packed with discussions of "exogenous shocks," "fundamentals," "input," "catalysts" and "triggers." Stunningly, as far as I can determine, no evidence supports these ideas, as the discussion below will show.

The Efficient Market Hypothesis argues that as new information enters the marketplace, investors revalue stocks accordingly. This is a simple idea and simple to test. But almost no one ever bothers to test it. According to the mindset of conventional economists, no one needs to test it; it just feels right; it must be right.

Testing Exogenous-Cause Relationships from Economic Events

Claim #1: "Interest rates drive stock prices."

This is a no-brainer, right? Economic theory holds that bonds compete with stocks for investment funds. The higher the income that investors can get from safe bonds, the less attractive is a set rate of dividend payout from stocks; conversely, the less income that investors can get from safe bonds, the more attractive is a set rate of dividend payout from stocks. This appears to be a sensible statement.

And it would be, if it were made in the field of economics. For example, "Rising prices for beef make chicken a more attractive purchase." This statement is simple and true. But in the field of finance such statements fly directly in the face of the evidence. Figure 3 shows a history of the four biggest stock market declines of the past hundred years. They display routs of 54% to 89%.

Figure 3

In all these cases, interest rates fell, and in two of those cases they went all the way to zero! In those cases, investors should have traded all their bonds for stocks. But they didn't; instead, they sold stocks and bought bonds. What is it about the value of dividends that investors fail to understand? Don't they get it?

As in most arguments from exogenous cause, one can argue just as effectively the opposite side of the claim. It is just as easy to sound rational and objective when saying this: "When an economy implodes, corporate values fall, depressing the stock market. At the same time, demand for loans falls, depressing interest rates. In other words, when the economy contracts, both of these trends move down together. Conversely, when the economy expands, both of these trends move up together. This thesis explains why interest rates and stock prices go in the same direction." See? Just as rational and sensible. On this basis, suddenly the examples in Figure 3 are explained. And so are the examples in Figure 4. Right?

Figure 4

No, they're not, because, as the first version of the claim would have it, there in fact have been plenty of times when the stock prices rose and interest rates fell. This was true, for example, from 1984 to 1987, when stock prices more than doubled. And there have been plenty of times when stock prices fell and interest rates rose, as in 1973-1974 when stock prices were cut nearly in half. Figures 5 and 6 show examples.

Figure 5

Figure 6

So you can't take the equally sensible opposite exogenous-cause argument as valid, either. And you certainly cannot accept both of them at the same time, because they are contradictory.

At this point, conventional theorists might try formulating a complex web of interrelationships to explain these changing, contradictory correlations. But I have yet to read that any such approach has given any economist an edge in forecasting interest rates, stock prices or the relationship between them.

To conclude, sensible-sounding statements about utility-maximizing behavior (per the first explanation) and about mechanical relationships in finance (per the second explanation) fail to capture what is going on. Events and conditions do not make investors behave in any particular way that can be identified. Economists who assert a relationship (1) believe in their bedrock theory and (2) never check the data.

(Stay tuned for Part II of this important series, where we examine another popular investment myth: Namely, that "rising oil prices are bearish for stocks.")

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Free Report: "The Biggest Lie in Stock Market History" Dear Reader, We believe risks and opportunities even larger than those of 2007-2009 lie ahead in a bear market of epic proportions. Only problem is, this bear market is silent right now. It's not visible to the public, because the government and the Federal Reserve inflate the credit supply and the U.S. dollar to hide its impact. But make no mistake about it: There is a Silent Crash going on right now in the stock market, and it's having a very real impact on your spending power. Read this special report now, free -- and see 15 eye-opening charts >>

Read more ...

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