IN THE CLASSIC book The Wizard of Oz, the Wizard
decreed that everyone who entered the Emerald City wear
green-tinted glasses. Visitors and citizens were told that this
was to protect them from the brightness and glory.
In truth, though, the Wizard had lost his mojo and become a
run-of-the-mill charlatan. There was no brightness and glory,
just an ordinary city built out of stone and glass.
Bull markets are Emerald Cities of our own making. In a bull
market it is decreed that investors and the media shall wear
green-tinted glasses. Suddenly, all economic news and
fundamental facts turn green and glittery there is no
bad news, only shades of good.
In a bear market the mandate is different: Everyone is to
wear red-tinted glasses. The Emerald City is no more. Now all
news comes in three shades of Soviet Kremlin red: bad, ugly and
This happens because we are human. The pressure of rising
prices in bull markets or falling prices in bear markets leads
us to engage in backward analysis. Instead of first analyzing
the events and only then forming an opinion, we look at the
market reaction to the news and let it dictate what we should
In the long run, stock prices follow fundamentals like cash
flow and earnings growth. In the short run well, this
old cowboy saying tells it all: Nobody but cattle know
why they stampede, and they aint talking.
The danger of wearing glasses determined by the market is
that reality will not be suspended forever, no matter the tint
of your shades. By following the color decree, you
are effectively taking advice from the market on how to
analyze, what to pay attention to and what to buy or sell. This
is the sure road to buy-high-sell-low despair. The market is
the worst giver of advice its prone to tell you
what you should have done, not what you should do.
Before the market mandated green glasses in October,
investors were wearing blood-red shades. They were dreading
significant risks threatening the global economy. Lets
quickly run through them and see if much has changed.
European recession and debt crisis: Greece went through an
orderly default, the European Central Bank pumped liquidity
into the system, and European bond yields declined. But a
recession precipitated by governmental austerity is not off the
table, and the PIIGS (Portugal, Ireland, Italy, Greece and
Spain) still have to figure out how they will deal with their
debt and lack of economic competitiveness.
Unraveling of the Chinese overcapacity bubble and potential
hard landing: The Chinese government has guided growth down to
7.5 percent, but this may prove to be wishful thinking on its
part. Cement and steel production has fallen, car sales are
off, and Chinese manufacturing has contracted sharply for five
months in a row.
Middle East tensions: An attack by Israel or the U.S. on
Irans nuclear facilities would lead to a jump in oil
prices and instability in the region. With the latest rhetoric
from Prime Minister Benjamin Netanyahu and President Obama,
this risk has greatly increased.
Japanese debt bubble: Japan is still the most indebted
nation in the developed world and pays the lowest yields on its
debt. Its population has aged six months since October and is
that much closer to the tipping point where Japans
savings rate turns negative and internal demand for its debt
drops off a cliff. Disastrously higher interest rates, rising
inflation and other fun stuff are sure to follow.
U.S. housing market: There are a lot of positive signals
coming from this dark corner of the economy, but the question
still remains: Will the housing market recover if interest
rates inch higher from their all-time lows? Thats
unlikely, because housing is too addicted to low interest
rates. As a result, the recovery will have a lot of fits and
U.S. corporate profit margins: Theyve hit record highs
and risk declining toward their rightful place, leading to a
drop in earnings. The U.S. needs robust economic growth for the
margin problem to go away. The economy has shown improvement,
but its rate of growth is unlikely to offer much excitement
considering all the factors Ive mentioned above.
U.S. budget deficit: The U.S. still has a tremendous hole in
its budget, and nothing has been done to fix it. So far, the
Super Committee, which was created to come up with a
legislative solution, has not lived up to its name.
The danger of investing by color decree is that
you start ignoring the negatives and positives, taking on more
risk than you intended during the green phase and focusing only
on risk during the red phase. So if you find that the recent
market rally has you wearing green glasses, slip them off and
take another look, because the global economy is still facing
plenty of headwinds.