The U.S. unemployment rate has fallen to 3.8%, a level seen only once since 1969, when it briefly bottomed in 2000. The Atlanta Fed increased its second quarter GDP forecast to 4.8%, a figure that, if it proves accurate, will be the second highest quarterly increase in the past ten years. Corporate earnings increased nearly 23% in the first quarter. Hourly wages increased 2.7% over the past year and minutes from May 2 Federal Reserve Board meeting indicate that the governors continue to see the economy as strong.
Yet with all of this good news, the stock market is essentially flat this year. How can that be? The apparent disconnect between the economy and the stock market this year is the result of the way humans develop expectations. People tend to gravitate toward obvious and simple explanations, even when not supported by facts. This type of first-level thinking ignores less obvious and often much more meaningful explanations and opportunities.
A first-level thinker sees positive economic news and assumes that stock prices will increase. Or he sees disappointing investment returns and blames the president. Second-level thinking looks beyond the headlines. Perhaps this quarter’s strong GDP figures are compared to a weak quarter a year earlier. Manufacturing may have improved, but are consumers actually buying the increased production or are retail inventories building?
Legendary investor Howard Marks writes extensively on this topic, explaining that all a first-level thinker needs is an opinion about the future. If, in 2000, an investor believed that Walmart was a great business and bought the stock based solely on that opinion, he would have been disappointed in his investment return, even though his opinion was accurate. From 2000 to 2010, Walmart’s earnings increased 207%. In those same ten years, the price of Walmart’s stock fell from $57 to $53 a share. There is a difference between buying good stocks and buying stocks well.
The divergence between Walmart’s business results and its stock price was a result of a number of valuation issues – variables that few people consider, or know to consider, when selecting investments. Seeing those issues required both a willingness and ability to looking beyond the obvious. It required second-level thinking.
Second-level thinking is often complex and difficult, especially in areas outside of our competence. Within our personal experiences, however, second-level thinking is second nature. Few people would ask a stranger to marry them based solely on how attractive they appear across the bar or grocery aisle. Second-degree thinking would at least investigate whether the individual had a personality or had recently escaped from prison.
Anyone who doesn’t delve at least that deep when selecting a spouse probably shouldn’t select investments, either.
David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.