Riot? What Riot?
Adam M. Grossman
THE CAPITOL WAS invaded by an angry mob 11 days ago. A week later, the House of Representatives voted to impeach the president. But if you’d been looking only at the stock market, you would have no idea.
Not only is the market higher today than it was the day before this all started, but also the VIX—the market’s “fear gauge”—is lower. From the perspective of the stock market, it’s been an ordinary few weeks.
You might wonder what’s going on. Shouldn’t the market have registered these unsettling events? I could trot out the standard explanations for the market’s resilience:
- With the COVID-19 vaccine rolling out, the economy should continue to improve.
- Many businesses are struggling, but big technology companies that dominate the market indexes are thriving.
- Low interest rates are pushing bond investors into the stock market.
- With many people remaining close to home, money that ordinarily would have been spent on vacations and entertainment has instead ended up being saved, and a portion of those savings have been invested in the stock market.
Those are the standard explanations, and they’re part of the story. They definitely help explain why the market has been flying high in recent months. But they don’t explain why the market seemed to completely ignore the events in Washington, DC. What’s really going on?
If I had to identify one explanatory factor, it would be momentum. The stock market these days is being propelled higher by investors who don’t want to miss out on what they expect will be further gains. In short, it’s FOMO—fear of missing out—that’s driving the market.
Of course, the market has been going up almost continuously for more than a decade, so why am I now singling out FOMO? While it’s true that share prices have been rising for quite a while, things seem to have taken a turn. The market today reminds me of the late 1990s, when internet stocks captured investors’ imagination. There are a number of similarities:
- Certain stocks seem unstoppable—Tesla being the most obvious example. Anyone who urges caution on a stock like that is dismissed as lacking in imagination or understanding.
- Ecommerce companies are seeing their stocks rise to unreasonable levels. Etsy’s stock is trading at a price-earnings (P/E) ratio of 68. Shopify’s stock is at a difficult-to-comprehend 297. By way of comparison, the S&P 500 is trading at around 38 times trailing 12-month reported earnings and 24 times forecasted operating earnings.
- Valuations on other fashionable companies are also off the charts. The P/E on Peloton’s stock is around 300.
- Companies with negative earnings, such as Spotify, Roku and DraftKings, are seeing their stocks double or triple.
- Investors are snapping up speculative assets like bitcoin that lack any intrinsic value.
How should you navigate an environment like this? You might fall back on Warren Buffett’s dictum to be “fearful when others are greedy.” But I’d recommend a variation on this. I don’t think you need to be fearful or run for the exits. That’s because today’s market, while high, is not as universally inflated as it was in early 2000, just before the 2000-02 bear market. Right now, you just need to be reasonable when others are being greedy and apply an extra dose of caution. Below are some recommendations:
- If any single stock represents a big part of your portfolio, start there. Even if it looks like a great company, I’d cut it back to manage risk.
- Maintain your rebalancing discipline. Even if it feels like you’re leaving the party while it’s still going, that’s okay. I wouldn’t risk losses in an effort to eke out the last few dollars of profit. J.P. Morgan once said, “I made a fortune getting out too soon.” I think that’s a good motto.
- Don’t forget the fundamentals. Yes, it’s possible to make a fortune buying an overpriced stock. Its earnings could increase or it could simply become even more overpriced. But over time and on average, traditional valuation metrics can be helpful. If the valuation on a stock looks like it’s in fantasyland, don’t ignore the numbers. Take Tesla. Wall Street analysts estimate that the company’s earnings per share will more than double over the next few years, from $2.45 to $6.72. But the stock is trading around $850. Even if Wall Street analysts are completely wrong, and 2022 earnings end up being $10 per share, instead of $6.72, that would still make the P/E ratio 85. To be sure, the stock could keep going up from here—anything can happen—but it’s important to keep your feet on the ground, no matter how great a company it is.
- If you want to make speculative bets, limit the risk. Think of it like going to a casino: Plan in advance how much you’re willing to bet and potentially lose—and then stick to that number.
Adam M. Grossman’s previous articles include Moving the Target, Those Messy Humans and What We’ve Learned. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.
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