Economy Robust Enough

Markets have countless moving parts, which means trying to figure out why the market does what it does, is difficult at best. Investors always look for clean explanations of why markets move up or down. The simple truth is markets often move in head-scratching ways. For example, we would expect that a worse than expected labor report, arriving during a period of Fed tapering, would result in lower stock prices. That is not what happened Friday.

From Bloomberg:

U.S. stocks rose, with the Standard & Poor's 500 Index capping its best two-day rally since October, amid optimism economic growth is robust enough to weather stimulus cuts even as data showed weaker-than-forecast hiring. "The broader data beyond just this one jobs report tells us the economic recovery is intact and the economy's growth rate is continuing to strengthen," Darrell Cronk, the New York-based regional chief investment officer at Wells Fargo Private Bank said by phone. "I just don't think the market is looking at it and saying that this one number changes the overall trajectory of what the Fed is trying to do."

Aggregate Tolerance For Risk Improving

In an October 2013 article, we provided a hypothetical example of how the market values securities. Since it can help us understand Friday's head-scratching gains in stocks, we will revisit it now. Let's assume we run a controlled market experiment where:

1. We give 1,000 investors an annual report to read for company XYZ.
2. All 1,000 are asked to read the report and then value the stock.
3. Stock XYZ can only be traded or owned by these 1,000 investors.

The Market Does Not Care What We Think

If I am one of the 1,000 investors in the experiment, how relevant is my personal opinion in terms of how the price of stock XYZ is set in the marketplace? In simplified terms, my personal take on the value of XYZ impacts the price by roughly 0.10% (1/1000). Stated in a politically correct manner, 99.9% of the factors impacting the price of XYZ have nothing to do with my personal analysis, forecast, or opinion about XYZ, or the global macro environment for that matter. Said in a more direct manner, the market does not care what "I think" about where XYZ is headed or what it is worth. It sounds harsh, but that is the way markets work. Does that mean fundamentals don't matter? Absolutely positively not; the concept simply defines how fundamentals impact asset prices.

If we expand the XYZ analogy to the real world, it gets even more humbling. Facebook (FB) trades 65,000,000 shares on a typical day. It closed Friday at $64.32. If we assume the average FB trade is for $10,000 worth of stock, that means the average number of shares traded per individual transaction is 155 (10,000/64.32). A back of the napkin estimate of the number of people that trade Facebook every day comes to 419,354 (65M shares per day / 155 shares per individual transaction). Therefore, if I am trading Facebook, the impact of my personal opinion/research/forecast on the price of the stock is 1 divided by 419,354 or 0.00023%. The admittedly crude analysis tells us 99.977% of Facebook's value is impacted by external factors that are in no way impacted by what "I think" or "what I think will happen next".

We Don't Have To Agree With The Markets To Profit

The takeaway from the example above is that the aggregate opinion of all investors sets asset prices, and our personal opinion has little-to-no impact. This means the way to balance risk and reward is to monitor the aggregate opinion of future outcomes related to the economy, Fed policy, earnings, etc. When the aggregate opinion is bullish, the odds favor higher stock prices. When the aggregate opinion is bearish, the odds favor lower stock prices. We can monitor the aggregate opinion using stock charts.

A Still Mixed, But Improving Picture For Stocks

What are the markets telling us after Friday's labor report? The daily chart of the S&P 500 below looks complex, but the concepts are easy to follow if you look at each letter in isolation:

1. Point A: The blue and red moving averages are trying to flatten out and turn up as they did in the early stages of the October 2013 rally in stocks (compare A and B).
2. Point C: Investor conviction was strong enough after the employment report to push the S&P 500 above two areas of possible resistance (1,775 & 1,781).
3. Point E: If the S&P 500 can clear 1,808 and the green 50-day moving average next week, it will provide more evidence of an improving perception of the economy and growth-oriented assets.
4. Point D: The pink 200-day moving average is used to monitor the market's long-term trend. The slope remains positive, which continues to favor higher stock prices.

Investment Implications

Before we discuss how the chart above impacted our allocation, it may be helpful to review the four tenets of investment success we covered on October 18:

1. Think in probabilities
2. Develop an IF, THEN system
3. Monitor the big picture
4. Remain highly flexible

The charts above tell us (a) the probability of a bear market kicking off from a risk-tolerance profile similar to what we have today is relatively low, (b) the odds of further downside in stocks are dropping, and (c) the odds of additional upside in stocks are improving. A relatively low bear market probability does not mean a zero probability. Therefore, if the chart above continues to improve, we will continue to incrementally increase our exposure to stocks (SPY) and decrease our exposure to cash. Before the close Friday, we added to our position in technology stocks (QQQ). The incremental increase in stock exposure brought our portfolios back in line with the market's current profile. Since hurdles remain (50-day and 1,808 on S&P 500), we still have some bonds (TLT) in the mix.

Fed's Low Rate Pledge Still Backs Equities

The worse than expected non-farm payrolls report also helped improve perceptions that the Fed will continue to provide low rates. From Bloomberg:

Policymakers are in the midst of phasing out their massive bond-buying program, but worry that the U.S. economic recovery could stall if financial conditions tighten too soon. To ensure that stimulus still flows, they plan to lean ever more heavily on their promise to investors that a rate hike is far in the future.

The buckets below speak to opportunity costs for our limited investment capital. If we monitor the market's pricing mechanism with an open mind, we can greatly increase our odds of allocating in a reasonable manner. The market's pricing mechanism called for a shift toward the stock bucket Friday. We will see what next week brings.