Stock prices don’t reflect P/E ratios or revenue growth.
Stock prices represent only one thing, the last price at which a willing buyer and a willing seller conducted a transaction. Their decisions are a function of millions of variables. Some investors use fundamental analysis. Others, including trading algorithms, use technical analysis. Many people dollar-cost average in or out of the market ignoring stock-specific information. No one can know what buyers and sellers are thinking when they make their investment decisions. The one thing and only one thing we can know is the price of the trade. When we see those prices on a chart, we know the trend. That’s where we look to make money.
Professionals on Wall Street know “The trend is your friend.”
Much like the disbelief that existed in 2009, the market trend reversed into a new bull market. The summer of 2020 was de ja vu. The “shock and awe” of a 34% S&P-500 decline in less than two months was a bear market. (A 20% or greater decline is a bear market). The rise in prices of the major indices has surprised even professional investors.
When markets decline, investors renew focus on risk management policies that are already in place. Typical asset class diversification risk management is simply reducing stock market allocation. Portfolios usually increase asset allocation to bonds. The allocation is based on Modern Portfolio Theory which applies long-term average market returns to each asset class.
Why? It simplifies sales and client reporting. It seems logical. It generates pretty charts.
- You aren’t buying long-term average returns with your investment dollars. You are buying unknown future returns.
- Current market prices seldom match average long-term prices. You can’t invest in any prior decade with today’s dollars.
- Market risk is dynamic and probably does not match the average used to construct your portfolio.
- Economic conditions today are likely not average.
- Cash is not important when using Modern Portfolio Theory.
Whether making an investment today or maintaining a portfolio, today’s market generated information has priority in building and adjusting our portfolios. Specifically, our models treat cash as a separate and important asset class. Using current market data, cash becomes a primary portfolio position when market risk rises.
Anyone who mentions they were “out of the market before the big drop” has probably heard the response: “You will be too scared to get back in.” The fear is a natural human emotion for investors. Eventually it becomes “fear of missing out” or FOMO. It happens because most investors are ruled by emotions.
Process and discipline can be used to override emotions. Market generated information creates the foundation for our models and client portfolios.