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Lean Against the Wind

Jonathan Clements

AT THE RISK OF CAUSING readers to think too much on a Saturday morning, let me start by offering a pair of seemingly contradictory statements:

  • The financial markets are efficient, but occasionally go stark, raving mad.
  • Nobody knows what stocks are worth, but they have fundamental value.

My contention: There’s a payoff to be had from grappling with these two apparent contradictions—a payoff that takes the form of greater calm in the face of market turmoil and improved long-run portfolio performance.

Measuring up. Many HumbleDollar readers, and perhaps most, are fans of indexing, and with good reason. We all know how difficult it is to pick winning stocks and to forecast the financial markets’ short-term direction. Statistics tell us that even professional money managers struggle to outwit the markets, especially once their investment costs are factored in.

Beating the market, of course, would be far easier if we could figure out what stocks were truly worth. But as I’ve come to realize after almost four decades of writing about investing, valuation metrics like price-earnings ratios, book value and dividend yield give only a rough idea of what stocks are truly worth, and they certainly aren’t a reliable guide to short-term performance.

Why aren’t these market yardsticks more helpful? There’s a host of reasons. Stocks’ fair value rises when interest rates fall, and it falls when rates climb. Investors’ appetite for risk has grown over time, and that means typical stock valuations have also trended higher. Valuing corporations based on the assets they own has become trickier as companies focus on building intangible assets like brand names and intellectual property. Meanwhile, valuation measures that look at earnings have drifted upward as the market has come to be dominated by fast-growing technology firms.

Because it’s so difficult to figure out whether stocks are cheap or pricey, outperforming the market averages is mighty tough and few manage it over the long haul. Indeed, the most sensible assumption is that the financial markets are efficient, meaning they accurately reflect all publicly available information, and that the best strategy is to settle on a prudent stock-bond mix and then build our desired portfolio using low-cost broad market index funds.

Going nuts. Investors tend to anthropomorphize the stock market, ascribing human qualities to its unpredictable behavior. For instance, if the market rockets higher and then lower, we might call it crazy. If it moves against us, we might depict the market as punishing us. Even the great Benjamin Graham anthropomorphized the market, with his famous analogy of Mr. Market, whose erratic behavior might allow us to make money at his expense.

But in truth, the market’s action reflects not the behavior of a single, unhinged individual, but rather the decisions of millions of investors, all buying and selling based on their best judgment of what stocks are worth. While some of these folks may be acting foolishly, most investors are reasonably rational and hence stocks tend to be reasonably valued. The financial markets are indeed efficient—most of the time.

That said, it seems that, every so often, a significant number of investors go collectively nuts, causing stocks to become unmoored from their intrinsic value. I don’t want to suggest this is a common occurrence and that stocks are often wildly mispriced. Still, it’s clear that it does indeed happen.

Think back to the 2021 craziness over special purpose acquisition companies, cryptocurrencies, net fungible tokens, and meme stocks like AMC and GameStop. Or think about the pricing of dot-com companies in 1999 and early 2000. Markets may be efficient when individuals make judgments in isolation. But when large numbers of investors act as a herd, with folks egging each other on, market efficiency can break down and share prices can lose touch with reality.

Behaving yourself. What does this mean for more sensible investors? Even if you think particular stocks are at unsustainable prices, I would caution against betting that they’ll fall back to earth. Shorting stocks is a dangerous game—because the potential losses are unlimited.

So, what should sensible investors do? At a minimum, I think it’s helpful to be aware of this herd behavior, so you aren’t tempted to join in. Eventually, fundamental value will win out, dragging foolishly priced investments back to earth, and you don’t want to get caught up in the carnage.

Instead, if there’s any opportunity for sensible investors, I think it comes during broad market declines. When the news is relentlessly bad, your neighbors are talking about cashing out their 401(k) and the TV talking heads are certain the market decline has further to go, there’s a chance we’re seeing herd behavior—and this is the moment when you want to rebalance your portfolio, buying stocks so you get your holdings back up to your target portfolio percentage. At such moments of collective madness—think early 2009 or early 2020—you might even consider overweighting stocks, something I’ve done during market declines.

But even if you aren’t inclined to buy, I’d encourage you to lean against the wind, at least emotionally. We may not know the precise fundamental value for stocks. But we know they do have fundamental value, and that value changes far more slowly than share prices. When financial markets seem nuts, we should keep this fundamental value in mind—and know there’s more to stocks’ value than just the latest price quote.

Think about the past year, with all the fretting over inflation, recession, a government debt default and the dollar losing its reserve currency status. If you paid too much attention to the handwringing, it would be easy to lose your nerve and make panicky decisions. And even if you stood your ground, there’s a good chance you found yourself worrying needlessly.

My advice: Get into the habit of telling yourself it isn’t as bad as the headlines suggest and that this too shall pass. Indeed, even if we fear “it’s different this time,” it’s rational to bet otherwise. How so? An imploding world hurts everybody, no matter how they’re invested, but a recovering world only rewards those brave enough to stay the course.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X (Twitter) @ClementsMoney and on Facebook, and check out his earlier articles.

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