Barry Ritholtz The Fundamentals Stink: Buy Stocks By Barry Ritholtz RealMoney.com Contributor 7/15/2005 11:56 AM EDT URL: http://www.thestreet.com/p/rmoney/barryritholtz/10232668.html

Market Commentary BULLISH The crowd that drives the market is choosing not to see troubles in the economy. Jobs and inflation data underscore pending weakness in the economy. But the market won’t reflect that until the crowd sees those woes.

"The most costly of all follies is to believe passionately in the palpably not true. It is the chief occupation of mankind." -- H. L. Mencken

Fundamentals don't matter.

Earnings are irrelevant.

Economic expansion is meaningless.

You may disagree with those statements, but consider this: How accurate are the average investors' perceptions of these issues? And how much does it really matter?

The short answer to both questions is "not very." But the longer answer is more interesting: It may not matter if the crowd is wrong -- at least, not in the short run -- because the crowd is the market. If the mass of investors believes something and acts upon it, traders shouldn't really care if the emperor has no clothes.

To be clear, there will come a time -- there always comes a time -- when the crowd's collective delusion gives way to an unpleasant reality. This often comes near market tops or bottoms, and the crowd, unfortunately, tends to realize this quite late.

Subjective vs. Objective Reality

A large part of my job involves finessing my way through myriad data points. Not taking them at face value, but drilling beneath the headlines to discover what is truly going on in the markets and the economy.

My working presumption is that markets do well in advance of and during periods of robust economic expansion. They fare less well when they anticipate an economic contraction. While the timing may often have a coinciding overlap, the biggest market gains come from anticipating major shifts early in their cycle, and catching these key macroeconomic reversals.

I've discussed variant perceptions before, and it is a very useful concept for investors. If you can recognize when the crowd misunderstands a fundamental aspect of the market, that's an edge you can take advantage of. The tricky part is the timing: When will the masses learn that their subjective reality is false, and move closer toward your understanding -- subjective though it may be -- of the economic universe?

A favorite example is oil. I became bullish on crude oil in December 2003. As it moved through the $30s and $40s, we heard every rationale why the price was unsustainable: there was a $20 terror premium, a lack of refining capacity, it was the fault of speculators. The reality was that a combination of massive government stimulus plus a huge growth spurt in China, combined with a finite supply, was pressuring prices.

But the reality didn't matter, until it suddenly did. Once the price passed $55, it became apparent the rationales were false, and that a new intellectual framework had to be adapted so the mentally inflexible could contextualize the price of oil. China and global growth were a convenient fit for those looking for an explanation for oil prices they could live with. A similar process happens with most other economic news and is going on now with jobs and inflation data.

Data Point vs. Data Series

It's important to recall that economic data -- indeed, any data series -- is not a snapshot, but a moving picture. And even a moving picture requires context.

Consider two factors in the unemployment rate: long-term unemployed and personal income.

The common (but incorrect) answer simply assumes the rate is low because many more people are getting jobs. The reality is that people have been dropping out of the labor force at an unprecedented rate. Five percent unemployment reflects a dearth of job seekers, not a plethora of new jobs.

Some talking heads have touted the drop in long-term unemployed to 17.8% from over 20% in May as a positive. How can that be bad, you may wonder? Context: Historically, an unemployment rate of 5% is typically accompanied by a long-term jobless rate of 10.7% -- not 17.8%, according to the same EPI release that was widely touted as revealing better income data.

And speaking of the improving quality of personal income data, there is now greater growth in above-average wages after four years of below-average wage expansion. Taken in isolation, this appears to be a positive development. But...

Following a mild recession and a horrific market crash, many people have been taking lower-paying jobs with fewer benefits. A combination of postbubble economics, globalization and outsourcing are the primary reasons. (The full examination is another column in itself.) After a four-year hiring spree, these lower-paying industries have most of the employees they need. It's somewhat ironic that the secondary sectors of transporting and warehousing these overseas manufactured goods -- formerly made here, now outsourced -- is a growth sector. That's hardly cause for celebration.

Then there's inflation. Despite Thursday's CPI data and Friday's PPI numbers, unless you live in a cave, you know inflation has been robust. I noted Wednesday that real wages continue to fall behind real prices, regardless of whether you look at a 20-year or a five-year time period.

Click here for larger image.

Source: Michael Panzner

The Bureau of Labored Statistics (to borrow a term from Barron's Gene Epstein) can use whatever hedonics and seasonal adjustments it desires, but it doesn't change reality one bit. Inflation is eating into consumers' limited income gains faster than their wages are rising. Unless this trend is reversed, this bodes poorly for the future standard of living of U.S. consumers.

Despite this, I am bullish for the second half of the year, not because of the economic fundamentals, but because I anticipate that the rest of the market misunderstands these fundamentals. They are bullish, so therefore, I am bullish.

If that sounds contradictory, it is because fighting the tape is futile. Your own subjective reality doesn't matter -- until it does.

All these fundamental negatives are meaningless over the short term. Investors need to understand reality as it is perceived by the masses. The important question for you as a trader isn't when will fundamentals get worse. Rather, it is a question of when the masses realize that the fundamentals have already decayed.

Let's use a more concrete example: When Henry Blodget, then a little-known Oppenheimer analyst, put a $400 price target on Amazon, the stock was about $75 (if memory serves). Merrill Lynch's (then) Internet analyst, Jonathan Cohen, scoffed. He said the stock was worth more like $30 or less. Cohen, who ultimately had the last laugh, had to sit by and watch Amazon soar to $400. Blodget eventually took his job at Merrill, while Cohen went on to co-found Wit Capital.

Although Cohen was ultimately correct about Amazon's valuation, it was Blodget who made investors money -- at least until the whole shooting match collapsed. The subjective perception that Amazon was going higher dominated the masses -- until it no longer did. Eventually, Cohen had the last laugh, as Amazon crashed and burned on its way to being a single-digit stock.

The same lesson applies to macroeconomics. Lord Keynes stated it well: The market can stay irrational -- meaning the crowd can remain delusional -- far longer than you can stay solvent.

Let the exuberantly optimistic enjoy their happy talk. The Blodgets and Grubmans of the '90s -- those compromised fundamental analysts -- have been replaced by a new class of corrupted commentators. These are the reality-challenged economic cheerleaders, who like Candide look at everything as if we live in the best of all possible worlds.

Your job as investors is to first figure out what the economic reality is, despite the blatherings of the pom-pom crowd. But that's only the first step. The really tricky part is figuring out when the crowd will discover it as well.

That means being proactive about investing. Planning an exit strategy. Continually watching for signs of a major sentiment shift. If you do not have a capital preservation strategy in place, this can be a very expensive game to play.

However, if you manage this trade well, you may just catch a big move up on what I call false premises, and the subsequent denouement. That can be the most lucrative trade of this cyclical bull market.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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