September 4, 2012 – Why Fundamentals Are Important…Or Not.

In a BNN interview in August 2012, I was asked why I thought that the stock markets would move up. Specifically, what were the fundamentals that supported my opinion?

Fundamentals are the key numbers of a company, or a sector, or of an economy that indicates how healthy that company, sector or economy is.  Many analysts select stocks and sectors based on these numbers and these numbers commonly come from the formal financial statements of the entity being studied.

Being a Certified General Accountant coming into this industry in 1988, I was naturally attracted to this way of thinking. After all, financial statements provide good, hard facts to build an opinion upon.

A year into my investment advice career this certainty that fundamental analysis was the correct way to identify investment opportunities went right out the window.

The event that caused this shift was Chrysler reporting of record profits in 1989.

Now, many of the Baby Boomers remember that Chrysler needed to be propped up by the US government in 1979. It was on the verge of bankruptcy and the government guaranteed loans for the company. By 1988, Chrysler had more than recovered from its troubles, in large part due to the K-Car and the introduction of the first minivan as well as revolutionary changes that management made, and paid off its loans.

In 1989, Chrysler stock was close to all time highs when on the day that they announced record earnings the stock price fell dramatically.

Yes, the Chrysler’s stock fell on record earnings.

According to the fundamental approach, that is not supposed to happen. Stock prices are supposed to rise when record earnings are announced because that is the time that the fundamentals of a company look the healthiest.

Seeing my puzzlement, a senior advisor at the time asked me a simple question: How does information about a company get into the stock market?

My answer was that financial reports were the source of information for the stock market. He pointed out that the most recent financial reports are, in fact, not current. It takes about two to three months to complete financial statements for the latest quarter so these reports really show what happened three to five months ago.  The same goes for reports on unemployment, housing starts and other economic information. He advocated that formal financial reports work for regulatory purposes but not for stock market price prediction.

He professed that non financial statement sources are constantly leaking information into the stock market and this information is more current. For example, when an automobile company contacts its suppliers to tell them to put on a third shift because demand has picked up, the various investment advisors of those suppliers learn about this and bid up the company’s stock in anticipation of better earnings.

(Who do you think is the first person to get a call when a supplier hears he has to put on a third shift because auto sales are increasing? Answer: the supplier’s investment advisor.)

The reverse happens when that third shift comes off, which is what happened to Chrysler in 1989.

I have seen this pattern repeat a number of times with stocks, sectors and economies. Arguably, at the last market peak in North America in June 2008 the fundamentals of the stock markets looked great and it was only six months later, after the stock markets had fallen 40%+, that those fundamentals looked really awful. Further, in March 2009, with the markets down 45%+ the fundamentals looked even worse yet that was when the markets bottomed and started to move up. It was September 2010 before it was announced that the fundamentals indicated the US economy had come out of the recession. By then the stock markets had risen more than 50%.

So, what is the lesson?

The stock market itself and individual stocks are leading indicators of what the analysts will say six months from now and not the other way around.  Individual stocks will move higher BEFORE the fundamentals improve and will move lower BEFORE the fundamentals turn down. Ditto for sectors and economies.

I know this flies in the face of many commentators, particularly those who discuss the results of a trading day and explain market moves by quoting formal economic reports and company news. This does, however, explain why markets rise while unemployment stays high and sales stay sluggish and why markets turn down even when current fundamentals look great.

See chapter 5 of my book for a more comprehensive discussion but I think my answer to the BNN interviewer should have been “there are no CURRENT fundamentals to support a rise in stock prices but we will see the fundamentals improve AFTER the stock market has risen.”

This article was prepared solely by Larry Short who is a registered representative of HollisWealth®, a division of Industrial Alliance Securities Inc. (iA Securities), a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC).The views and opinions, including any recommendations, expressed in this article are those of Larry Short alone and not those of HollisWealth®