On Tuesday, November 24, 2020, amid the coronavirus pandemic and poor economic conditions, the Dow Jones Industrial Average (DJIA) reached an all time high and crossed 30,000 points. It became evident that the divergence between the Main Street (businesses/ economy) and the Wall Street (stock market) got even wider. Traders and speculators fail to understand that it is the Main Street that helps determine the profitability and fundamentals of the Wall Street. At the end of the day, business fundamentals govern the stock prices, not the other way around. Said differently, a “good business” is justified to be selling at a high price, however, just because a business is selling at a high price does not make it a “good business”. In this week’s blog post, I talk about this rampant stock market speculation in detail.
As value investors, we always look at any investment opportunity from a “comparative” and an “absolute” returns perspective. In other words, if we plan to invest in the stock market, we analyze our opportunity costs; we compare the stock market’s investment opportunity to those provided by other investment classes such as commodities (gold, silver, coffee, etc), bonds (treasuries, municipal bonds, corporate bonds, foreign debt, etc), cash, etc. Furthermore, we also have to look at the stock market on an absolute basis i.e. is the stock market providing a sufficient margin of safety and an adequate return on our investment? Just because the stock market is providing the highest return amongst other asset classes does not mean that the stock market is fundamentally sound. Reviewing the company/investment on an absolute basis is crucial.
Similarly, when investing in the stock market, a value investor compares an individual company’s stock to those of its competitors, and also analyzes that stock’s fundamentals on an absolute basis. Now, if everyone invested this way, we would rarely have any bubbles. In reality, it is human nature to speculate; speculators chase the higher returns without understanding the investment from an absolute perspective. More importantly, when central banks outline that they are willing to do whatever it takes (drop interest rates and engage in quantitative easing) to revive the economy, speculators are further incentivized to “invest” in the stock market.
As central banks become accommodative (dovish outlook), the flow and circulation of money increases. Moreover, in search for higher returns, investors ditch low yielding bonds and pursue riskier stock investments. Speculators gain confidence that the central bank is on their side, and would not let large corporations fail (the central bank would inject liquidity into the failing company by buying its corporate debt/bonds). Additionally, speculators anticipate a tremendous growth in stocks in the future, and more speculators are willing to pay a premium on their investments, which pushing the prices even higher. This is essentially how bubbles are created. So, it is the central banks that fuel the speculators’ return seeking motivations, which pushed the stock market to an all time high.
Thomas Carlyle said, “Our main business is not to see what lies dimly in the distance, but to do what lies clearly at hand.” As speculators try to predict what lies dimly in the distance, they disregard the deteriorated intrinsic qualities of the business at hand. The stock market’s buying spree continues, and the stock prices of various “zombie” companies (unprofitable, debt ridden companies) rise. Lastly, speculators love to look at charts and trends, as it is a lot quicker to review charts than to perform fundamental analysis on a stock; in other words, if a speculator sees that the stock price has been rising, he will pull the trigger and invest, under the assumption that the price will keep rising in the future. Fundamental analysis includes reviewing the company’s key ratios, financial statements, annual reports, notes to financial statements, etc. As you can see, fundamental analysis is a lot more time consuming than technical (chart) analysis. After all, the last thing that speculators want to suffer from is Fear Of Missing Out (FOMO). This is precisely the reason why we are seeing many companies with sky high valuations.
This rampant stock market speculation may continue for the next few weeks, or few months, or few years. There are various stocks and sectors in the market that are in a speculative bubble, and a correction will take place at some point. Market timing is not my cup of tea, but I do believe that mean reversion, law of large numbers, and refocus on the fundamentals will eventually cause this rally to end. As Herbert Stein, an American Economist, said, “If something cannot go on forever, it will stop.”
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions. Please review the Disclaimer and Terms and Conditions.