Even in the US the supposed causal relationship between stock prices and earnings appear headed for irrelevance. That’s especially a conundrum for experts whom are fixated with “fundamentals” and seem at a loss on how market cycles occur.
Writes Vitaliy Katsenelson in A Sideways View of the World [via John Mauldin]
(bold highlights mine)
The stock market seems to suffer from some sort of multiple personality disorder. One personality is in a chronic state of extreme happiness, and the other suffers from severe depression. Rarely do the two come to the surface at once. Usually one dominates the other for long periods of time. Over time, these personalities cancel each other out, so on average the stock market is a rational fellow. But rarely does the stock market behave in an average manner.
Among the most important concepts in investing is mean reversion, and unfortunately it is often misunderstood. The mean is the average of a series of low and high numbers – fairly simple stuff. The confusion arises in the application of reversion to the mean concept. Investors often assume that when mean reversion takes place the figures in question settle at the mean, but it just ain't so.
Although P/Es may settle at the mean, that is not what the concept of mean reversion implies; rather, it suggests tendency (direction) of a movement towards the mean. Add human emotion into the mix and P/Es turn into a pendulum – swinging from one extreme to the other (just as investors' emotions do) while spending very little time in the center. Thus, it is rational to expect that a period of above-average P/Es should be followed by a period of below-average P/Es and vice versa.
People’s random-like personalities can’t create excessively wild swings in the stock market if the stock market is solely funded by the scarcity of savings.
In other words, greed and fear is no less than a symptom of a structural underlying cause—“circulation” credit inflation.
Mr. Katsenelson adds,
In sideways markets P/E ratios decline. They say that payback is a bitch, and that is what sideways markets are all about: investors pay back in declining P/Es for the excess returns of the preceding bull market.
We say no more that this represents a manifestation of a credit driven boom-bust cycle where investors overpay during a credit driven boom cycle and vice versa.
More from Mr. Katsenelson
Mean reversion is the Rodney Dangerfield of investing: it gets no respect. Mean reversion is as important to investing as the law of gravity is to physics. As long as humans come equipped with the standard emotional equipment package, market cycles will persist and the pendulum will continue to swing from one extreme to the other.
Mean reversion is simply the product of unsustainable booms.
This reminds us of Fritz Machlup who once wrote,
-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.
-Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.
-An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.
In short, the Austrian Business Trade cycle explains more the workings of the dynamics of stock market prices than mainstream’s “corporate fundamentals”. Even celebrity "former grizzly bear" guru Jeremy Grantham observed of this phenomenon but had a difficult time explaining it.
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