By: Frank Armstrong, CFP, AIF
As we sit here surveying the wreckage in the recent markets we should review a few basics. If we can keep some fundamental economic theory in mind next time we go through a speculative frenzy, it might save us all some grief:
- There is a direct link between risk and reward. Finance does not offer us a free lunch. When everybody around you becomes convinced that prices can only go up, you can pretty much take for granted that bad things are about to happen.
- Only profits matter. Stock values are directly linked to profits. Clicks, eyeballs, sales, growth of sales, market share, and all the other possible valuation measures (or metrics in street talk) are useless. Never, never, never believe that anything but profits drive stock prices.
- Markets are efficient, but not perfect. That means that while it’s hard to outguess markets, they are not always “right”. In fact, markets are always doing something weird. But, markets are a self-correcting, self-regulating mechanism. Unfortunately, the longer the markets persist in weird behavior, the harder it becomes for individual investors to keep from doing something self-destructive. Markets always correct sooner or later. Only the timing is in doubt. That they will correct is certain.
- Buying a start-up dot.com on a multiple of losses is a strategy for disaster. Stocks with high P/L ratios (price/loss) far outperformed companies with actual profits during 1999. However, 2000 convincingly demonstrated the fallacy of that particular delusion.
- You can pay too much for even a great company’s stock. Lucent, Cisco, and Microsoft are all great companies. But, investors that paid far too much for them are sitting on staggering losses. Profits are very difficult to forecast. When investors assume profits that are not sustainable, the first hint of trouble sends them rushing for the door.
- Momentum investing is the highest risk, lowest return investment model. Momentum investors believe that if a stock went up yesterday, it will continue to go up. It works until it doesn’t work, and then it falls apart with stunning (read that frightening) force. Because momentum investing relies on the appearance of a greater fool at just the right time rather than any underlying fundamental value, it sows the seeds of its own destruction.
- No company or industry can grow indefinitely faster than the surrounding economy. If they did, before very long, they would consume all the world’s available capital and resources. Profits, and markets are mean reverting. There is ample economic theory and real world experience to document this. If a company or industry exhibits unusual growth, so much new capital flows to it that pretty soon returns on that capital revert to long term averages.
Unfortunately, not much is new. All of these lessons have been learned many times before. Investors ignored them at their peril. Both the bubble and the crash resulted from forgetting the basics. When something has never worked before, you should be very suspicious of any argument that: “This time it is different.”