Investing in a Volatile Stock Market

What is going on in the stock market right now? Just like your wedding night, there’s plenty of ups and downs. It seems like every day there’s a new all-time record followed swiftly by a big drop. Unlike your wedding night, it seems like this is going to last a while. When you rely on headlines, investing in the stock market with massive volatility can be next to impossible. Big swings make people worried, and worried people make rash decisions. When you rely on the fundamentals and ride the waves, volatility is your chance to make it big.

What Drives the Stock Market

Down 700 points one day, up 700 the next. Regardless of what’s going on in the news, only two things make stock prices change: buying and selling. The question is, what drives people to buy or sell? Largely, this is based on emotion.

When people in the stock market feel exuberant, people get greedy and buy. Buying drives up stock prices, leading people to feel more exuberant and buy more stock. The FOMO sets in and people start doing anything they can to make money in stocks. On and on this trend continues until it stops and puts the car in reverse.

Once this downhill escalation starts, it’s very difficult to stop. People forget what they learn about buying and holding, and their emotions take over. Panic sets in. People fear they will lose their retirement money, they begin selling stock, and stock prices drop. Seeing the stock market drop causes more panic and more people follow suit in selling out. The same momentum works on the way down as it does on the way up. The only difference is the drops happen much faster than the gains. As they say, the stock market goes up like an escalator, and down like an elevator.

Market momentum can either make you or break you, but there’s a better way. Instead of relying on emotions, think rationally. Using the stock market’s number one rule comes into play here: buy low, sell high. Let’s take a trip back in time to see how this might’ve worked in the past.

Imagine You’re in the Year 1995

Gangta’s Paradise was on the radio, Alicia Silverstone and Clueless were taking over the world, and the S&P 500 started the year at $465. As if! In addition to being the year Michael Jordan un-retired (the first time), 1995 is also recognized as the start of the “dotcom boom.” The internet was the biggest thing since sliced bread, and it was going to revolutionize how we do business. For the most part, they were right. The internet has changed our lives and businesses drastically. They were right about the efficiencies the internet would bring to food delivery, media, and basically any other business out there. The market was so exuberant, the S&P 500 experienced a 228% increase from January 1, 1995 to March 24, 2000.

They were wrong, however, in estimating the degree of these impacts. While the stock market tripled, the businesses in the stock market did not. The hopes and dreams of a new world drove stock prices to unattainable levels until the day of reckoning appeared. This reckoning started on March 24. In the next 2.5 years, the S&P 500 would drop 49% (many tech stocks would drop more than that), and the “dotcom boom” would come to an abrupt end.

What Happened, and What Can You Do?

This crash happened because the stock market was supporting a value that the businesses themselves couldn’t match. Yahoo stock, at one point, was selling for over 500x its projected earnings. If you bought the entire Yahoo company in 2000, you’d have to hold that company past the year 2500 just to break even! Even at half that price, not a good investment. Trading at nearly 80x earnings at its peak, Microsoft was another stock that was extremely overpriced at the peak. This was the perfect opportunity to sell high.

Say, however, it’s now the year 2001. The stock market is bottoming out, and Microsoft is now a third of the price it was in 2000. What do you do? Let’s take a look at its fundamentals.

Source: ycharts.com
Source: ycharts.com

After over a year of bouncing between a PE Ratio of 60 and 80, the crash drives PE ratios into a normal range. In some cases, this drop could signal a drop in earnings that would justify a drop in stock price. This is not one of those cases. While the stock price dropped, earnings increased without the need for any debt.

Source: ycharts.com

Lowest PE ratio in over 3 years, check. No debt, check. Increasing net income, check. You know what this means: time to buy low. At the beginning of 2001, Microsoft was trading at $21. As of July 7, 2020, Microsoft stock is $208. That’s nearly 10x return in under 20 years.

I know what you’re thinking. Anyone can look at history and fabricate a story around it. True, but the principles of buying low and selling high span across time. Stocks move around all the time. One just has to sit and wait for the right opportunity.

“You don’t make money when you buy and you don’t make money when you sell. You make money when you wait.”

Charlie Munger

Investing in Today’s Stock Market

Even with the market drops in March and April 2020, the market now is still overvalued. The Fed has and will continue to invest in the public markets, and may start buying stocks soon. They’ll continue propping up the stock market until it doesn’t. That’s when the market will flip.

Above you will find my personal tracker for momentum and trends of the S&P 500. At the end of June 2020, the S&P 500 index was 3% above its trailing 12 month average. A mere 3 months prior, the S&P 500 was 13% below its trailing 12 month average. It would be easy to say that the stock market overreacted to COVID-19 when the protective measures began. I would argue that the drops in March & April weren’t enough.

Here we have the famous “Buffett Indicator.” This economic indicator is the favorite macro-economic tool of the world’s best investor. Per The Oracle himself, the stock market is in risk of being overvalued when the Wilshire 5000 is roughly 80% of the U.S. GDP, or a 0.8 on the index. At the end of Q1 2020, we find ourselves at a whopping 1.79! And that doesn’t even take into account the drop in GDP we have experienced in Q2 2020.

Q2 2020 GDP came in 9.5% lower than the previous year. That puts the Wilshire 500/GDP at 1.9. The stock market as a whole is nearly twice as much as the annual GDP of the United States. Yikes! With rising asset prices and a continually falling economy, this could very well get worse from here. If you ask me, this seems like a “sell high” type of market.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Benjamin Graham

Conclusion

This market is out of hand and sooner or later, liquidity is going to dry up. The question is when that will happen. As long as the Fed continues to keep interest rates at record lows and buy up all assets in sight, the stock market can continue its rise. When the rates start to rise and the Fed stops buying, cash will be king and cheap stocks will be on the market again.

DISCLAIMER: Investing is an inherently risky operation. Past performance is not a guarantee of future returns. All information presented is for educational purposes only and should not be taken as investing advice.

Featured photo source: Aditya Vyas on Unsplash

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