In the short-term fundamentals may affect investor sentiment and behavior, but in the long term, they are a poor predictor of equity market returns.
Many traders with skin in the game have noticed a low correlation between fundamentals and equity market returns. However, some analysts believe that fundamentals determine the future course of the market. Nothing can be further from the truth.
Cem Karsan of Kai Volatility also made this point in a Resolve Riffs podcast last week:
Fundamentals are not a good predictor of equity market returns.
Yet, we have reached a point of hysteria in financial social media about trying to analyze and predict Fed moves, the impact on inflation, and the future course of the stock market.
Fundamentals are useful for economic policy planning. But due to long lags, noise, and often irrelevancy, fundamentals are poor predictors of equity market returns.
Even in a high inflation environment with rising rates, at some point, equity markets disconnect from fundamentals. Companies find ways to return to profitability even under harsh economic conditions. Some long-duration equities with high dependency on interest rates may be hit hard, but value and high dividend stocks can decouple and can even rally despite adverse fundamentals.
On the monthly S&P 500 chart below with an MoM CPI overlay, I have marked four periods of high inflation when at some point the market decoupled and rallied.
It is interesting that in three of the four cases, the rally started when inflation was at its peak. In all four cases, the rally led to new all-time highs.
Therefore, while keeping in mind that markets change and underlying drivers change, this overreliance on fundamentals as a way of forecasting market direction is not justified.
Fundamentals are easy to use in popular narratives and for this reason, there is a high level of noise and the information does not provide any edge. I do not think this time will be different.
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Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
Charting and backtesting program: Amibroker. Data provider: Norgate Data
