The Power of the Recency Effect
Year End Predictions
Let me ask you a question. How did your fund perform in December 2022? The Nasdaq 100 was down 10.3% for the month. Can I remind you of the market narrative at the time? The inflation readings were showing a welcome weakening month-to-month while the jobs reports remained strong. Jerome Powell was talking about 2023 seeing much weaker GDP growth, while Moody’s Analytics forecasted 2023 GDP growth of around 1%. The Fed Funds target rate was 4.0%. As always, individual stock news was light in December between reporting periods. The AAII bull-bear survey showed a very low 24.7% bulls, 41.8% bears and 33.5% neutral, quite a coincident indicator. The Recency Effect describes how people tend to recall most accurately the most recent information they receive. As a result, you could find few perked ears in the investing world that wanted to hear a prediction of a market bottoming or an economy that would stay resilient heading into 2023. The antithesis of the recency effect is Warren Buffett who famously said: “it's wise for investors to be fearful when others are greedy and to be greedy only when others are fearful.”
By the close on Friday October 27th, the market was down almost 4% for the month with nearly every important index-moving company having reported, aside from Apple. We wrote on October 28th a substack titled: “The Silent Bell has Rang?” where we effectively challenged the recency effect littered with strong negative market narratives by examining price exhaustion via the Demark technical indicators. All three major indices QQQ, SPY and IWM signaled price exhaustion buy signals that Friday.
Taking a step back, fundamental analysis is critical in identifying market expectations, business trends, possible inflections, and valuations. This is the main tool in our tool belt. Equally important though, price exhaustion analysis uses a version of technicals to find when the last seller has sold and the last buyer has bought to identify market turns. It’s level of precision should be viewed as trying to identify what inning of a nine-inning baseball game are we currently playing. If we are in the bottom of the eighth in a sell-off, it pays to cover shorts and start looking for longs, correct? The same is true during rallies.
I would argue price exhaustion analysis can be a far more potent tool investors can use compared to deciding, with “precision”, whether Microsoft should trade at 25, 30 or 35-times earnings and what year are we even using to apply the multiple. After all, what is the difference between 25 and 35-times earnings based on 2024 estimates? The price range would be $294-411 versus the closing price of $369.67 on Friday. If you do not like that range for your position, just use the same range on 2025 estimates! As most of you know, this is the game often played by the sell-side analysts to justify their price targets. A good friend at a major global macro fund recently pointed out a function on Bloomberg I had not ever used before: DDM (presumably stands for the dividend discount model). The major inputs are EPS for the next 3 years, dividends, a growth rate long term and drum roll please, interest rates (cost of capital). Clearly, income producing securities such as real estate must use this tool in order to determine the fair market value of the assets they own or plan to purchase or sell. Agreed? Your investment value gets turned upside-down fast when your borrowing costs change in comparison to your cash flows. A therapist friend of mine recently told me he is now seeing multiple real estate investors in his practice who own New York City properties that are worth 25% of their carrying value.
Well, in the equities markets, few bother with the DDM to determine fair value. The daily liquidity allows for quick changes of heart usually based on whether you are making or losing money and less about your sense of “ownership” of the cash flows. We have been vocally positive on Microsoft during its ascent on Azure, AI, Co-Pilot and its growth trajectory being recurring revenue. However, let’s take a look at “fair value” based on DDM (Bloomberg function).
Hmmm. A theoretical price of $179.991. You might say let’s cross this DDM function off our list for stock picking right now! Patience please, keep reading. If we change the interest rate to 3%, the theoretical value jumps to $300. While that is better, you can see that the price of Microsoft has a lot more to do with investor supply and demand than it does the value of the cash flows the company produces. This is why price exhaustion matters! What inning are we in is the question you should always be asking. Ask me and I will tell you! Now, is it any mystery why the XBI 0.00%↑ has been the absolute worst performer since the rate hiking cycle started? The usual positive catalysts such as big pharma buyouts have been present as well as some major new drug trial successes. Yet, higher interest rates have overwhelmed it all.
Let’s summarize our thoughts and get to our market conclusion for the rest of 2023.