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Which Stories Should Stock Market Investors Be Listening to?

By Alex Dumortier, CFA - Jan 25, 2016 at 1:25PM

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Stories drive the stock market over the short term, but long-term investors need to be able to weave stories of their own.

It's the story of 2016 so far, as the start of a new week produces more red ink, with the Dow Jones Industrial Average (^DJI -0.09%) and the S&P 500 (^GSPC -0.07%) down 0.15% and 0.31%, respectively, at 1:18 p.m. EST.

Stories drive the stock market in the short run. Which ones are you listening to?

Haven't you heard? The economy and the stock market are going to hell in a handbasket. How do I know this? It must be true, because the headlines are nearly unanimous (minus the occasional positive headline -- contrarian views attract clicks, too!); just take a look at a sample from today's Yahoo! Finance home page:

Time to say goodbye to long bull market? -- The Wall Street Journal

Goldman: These are the stocks to buy if you're worried about a U.S. recession -- Bloomberg

The price Americans pay for slow growth -- Bloomberg

Americans are trapped in a 'cycle of financial insecurity' -- MarketWatch

Has the U.S. (or global) economic environment changed that dramatically since December? No; however, investors' perception has changed markedly, and perception is the major driver of prices in the short term.

That change is triggered by new information, such as the stock market's poor performance this year, but it is amplified and/or distorted in the stories the media and investors weave in order to try to make sense of an overwhelming amount of (often contradictory) data.

Nobel prize-winning economist Robert Shiller of Yale published an illuminating piece on this process on The New York Times website on Friday, titled "How Stories Drive the Stock Market" (sign-up may be required). Shiller examines a number of the stories that have gained prominence this year and puts them in context:

Another current focus is the fact that this year set a record for poor performance of the stock market in the first week of the year. That timing has given the market-decline story wings, though there is really nothing special about such timing. After all, the date of the new year is an arbitrary social convention. There's a Western Christian New Year, an Orthodox New Year, a Jewish New Year, an Islamic New Year, a Chinese New Year and so forth. The prominence of the Western year in global calendars reflects a history of Western dominance, and that has given the new year the ability to spark stories that evoke mixed, and changing, feelings.

Part of the storytelling process is a product of the limits of our cognition (it's also, to some degree, the result of laziness or a lack of curiosity: It's easier to repeat the prevailing narrative than to produce a new one). We're not comfortable dealing with uncertainty and storytelling is one of the (imperfect) strategies we use to allay that discomfort.

In Aug. 2009, less than five months after the stock market had bottomed, billionaire investor and Berkshire Hathaway CEO Warren Buffett told Bloomberg Television:

We didn't have any visibility in 2006, we just thought we did, right? Or 2007. People say, you know, "It's too uncertain," well the future is uncertain then, they just didn't know it was uncertain. The truth is, I go to work every day feeling the future is uncertain, and I always will.

That doesn't mean I can't value a business, though, or value a farm, or value an apartment house. I look at the asset -- it's gotta be one I understand reasonably well -- and I say: "What will this produce over the next ten, or twenty or thirty years?" If I buy a farm, I don't know whether there's going to be a drought next year, but I know there's not going to be twenty straight years of drought and I know there's not going to be twenty straight years of great rainfall.

Investors with the temperament (and the liquidity) to look beyond the next financial quarter can weave their own stories. Here's one: All else equal, stocks are more attractive when prices correct 10%.

Is all else equal? In other words, are the prospects for long-term earnings growth (which is what ultimately drives stock values) exactly the same as they were in December? Perhaps not, but neither have these long-term prospects changed as much as the decline in prices would suggest.

Let me be clear: I don't think the broad market is particularly cheap, even after the recent declines. However, these drops have undoubtedly created a number of attractive opportunities for investors who can read between -- or rather, beyond -- today's headlines.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Dow Jones Industrial Average (Price Return) Stock Quote
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