Retail stocks are getting destroyed this week as market participants come around to the fact that the U.S. consumer hasn’t fully recovered from the Great Recession. Since its April peak the Retail Holders Index has been crushed -15%. Market pundits are furiously downgrading retail names and talking about “persistent weakness” in the U.S. consumer. That was not the case just two months ago when just about everyone was convinced that the consumer was back and healthy as ever.
On April 16th I posted a relatively controversial piece claiming that the market had become disconnected from reality. Exhibit A was the retail index which had executed an astounding v-shaped recovery despite almost no evidence that the U.S. consumer was healed. I wrote:
“But where do we sit now? We are beginning to see some glaring disconnects between the market and reality. There are very real improvements versus where we were just one year ago. The recovery is here and it has been stronger than I expected. But there are also signs of irrationality on the fray. This is nowhere more apparent than it is in the consumer sector. The retail holders index is one of the few indices that has experienced a full-blown v-shaped recovery. Just how wide is the disconnect between the consumer and retail stocks. Let’s compare and contrast 2007 and 2010:
We have lost 7.8 million jobs since then. The unemployment rate is 9.7% versus 4.5%. Total unemployed workers are now 15.7 million versus 6.5 million. Real personal income less government transfers is lower by 6.5%, or $624 billion. Real retail sales have rebounded just 4% from their lows and are still down 9% from the 2007 peak. Consumer credit for February showed another sharp retrenchment of -5.6B. Consumer bankruptcies for March were the highest level since 2005. There is a glaring $1.5 TRILLION hole in the consumer balance sheet. Home foreclosures surged 19% last month and are at their highest level since 2005. The consumer’s largest asset (housing) is down 33% since 2007.
Meanwhile, the retail holders index (RTH) is back at its pre-recession highs. Granted, the market is a discounting mechanism and this index has benefited greatly from retail expansion and improved corporate efficiency, but operating income at the index’s top 25 holdings is down 4.5% from 2007 and that’s including new stores! This doesn’t rhyme with a near all-time high in the retail index. This price action is acting as if the consumer is (or will become) whole again – which I believe is undeniably false. Is the consumer on the mend and willing to spend again? Most certainly. Whether this is a good thing is a whole different debate, but as of now there are still few signs that the consumer is back to full strength or even close despite the market acting as though Goldilocks is here and ready to party.”
I do not point this out to toot my own horn, but rather, to show a real-time case of an extreme disconnect between reality and price. Careers have been built on the idea that the market is an efficient system. That it is a perfect discounting mechanism that is never wrong. I wholeheartedly disagree.
Any market is simply the summation of its participant’s decisions. Humans, by nature, are irrational creatures. The summation of irrational decisions by no means makes them all rational. This irrationality results in inefficiencies which creates opportunity for those who are able to look beyond the current price action and intelligently understand the underlying forces that are driving it. As simple as this story might sound, the rejection of the efficient market hypothesis might very well be the most important thing you ever do in achieving investment success.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.