The Dow Jones Industrial Average (DJIA) has moved up to 25,605 points as of June 12, 2020. This is a 37.7% increase in DJIA since the March low of 18,591 points. Similarly, S&P 500 has moved up from March low of 2237 points to 3041 points as of June 12, 2020; S&P 500 has climbed about 36% in less than 3 months. This rally is fueled by the government and the Fed’s stimulus money, and not by fundamentals. The Federal Reserve has been pumping liquidity into the economy by buying back assets, and the US government has spent about $2 trillion, which included the one-time cash payment of up to $1,200 for Americans with Social Security numbers. The United States is in a recession, there is a rise in recent corona virus related hospitalization rates and the possibility of a second wave/shutdown, there is ongoing civil unrest associated with the Black Lives Matter protests, and the US unemployment rate is at 13.3% (as of May 2020). Yet, we have the US stock market that has discounted all these facts, and stock prices just keeps going up and up. In this week’s blog post, I will talk about the market speculation and volatility.
What is speculation? Since last month, Delta Airlines has been up more than 57%, United Airlines has been up more than 94%, and American Airline has been up more than 45%. If you do a little bit of research, you’ll find out that Airlines have a high operating leverage. As per this article on Operating Leverage and Business risk, “The airline industry exhibits high operating leverage. Their fixed costs include aircraft leases and wages for staff for their routes. These high fixed costs make profit (or loss) extremely sensitive to sales volume. Aside from operating leverage, competition within the industry is very intense. These factors make air travel a tough business that suffers periods chronic losses and sometimes drives airline companies into bankruptcy.” With the travel restrictions and disruptions caused by this COVID-19 pandemic, we can be certain that airlines are going to see a drop in their sales volume for a long period of time. We are also certain that, in that time frame, airlines are going to bleed through cash to pay for those fixed operating costs. Additionally, since sales has dropped and cash is not coming in from operating revenue, airlines will need to take on more debt to finance their operations. So, fundamentally, airlines are becoming top heavy (debt ridden). As value investors, we do not touch such debt ridden companies, even with a 10-foot pole. Warren Buffett says, “It’s not debt per say that overwhelms an individual corporation or country. Rather it is a continuous increase in debt in relation to income that causes trouble.” Airlines are the perfect definition of trouble; With no idea of when the original sales volumes (income) will return, airlines will keep on taking more debt to finance their fixed costs obligations. Now, going back to the original question – what is speculation? All these rallies in airline stocks have been due to speculation. In other words, you are said to be speculating if you buy an asset (stock) without being certain that your principal is safe in that investment.
Anytime there is rampant market speculation, we are bound to have market volatility. You are said to be in a volatile market when there are wide fluctuations in stock market prices. I believe that volatility will stay until fundamentals improve to justify the current stock market prices, or until the stock market prices drop to reflect the current fundamental valuations. It is important to understand that when you are buying a stock, you are becoming a part owner of a company. It is foolish to pay a premium for a company that is struggling and has no future. As Ben Graham points out – the biggest difference between a market analyst (speculator) and a security analyst (investor) is that the security analyst can protect himself by margin of safety; when speculating, there is no margin of safety. The market analyst (speculator) is either right or wrong, and, if he is wrong, then he loses money.
It is believed that, up to some extent, retail investors are responsible for driving up the recent stock market prices. The total user positions on Robinhood (app) was 16.41 million in February 2019, and that number has increased to 37.13 million positions. This clearly shows that the interest in trading has increased rapidly, especially since there are no broker commission fees associated with trades. Furthermore, there are many individuals on social media flaunting how they have recently made so much money by day-trading, and that technical trading is the future. That “quick profit” can make you feel smart and alive, but as a speculator, you are bound to be a victim of emotional and mental turmoil as soon as the bull market ends.
In conclusion, I would like to leave you with this paragraph from Chapter 51 of Security Analysis, where Ben Graham and David Dodd say, “Market Analysis [speculation] seems easier than security analysis, and its rewards may be realized much more quickly. For these very reasons, it is likely to prove more disappointing in the long run. There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.“
Hope you learned a little and found this blog post helpful. We talked about the recent market rally, the ongoing market speculation, and volatility. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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