My eyes were wide open even before my cup of coffee on Monday. And I’m sure I wasn’t alone.
First thing in the morning, I saw them: warnings from every major news source to watch out for big losses in global stock markets.
The quickly spreading coronavirus was to blame, according to the headlines. The number of cases is growing in South Korea and, even more surprisingly, in Italy.
Of course, those fears are well-placed. South Korea is a crucial global manufacturing center. Italy is part of the European Union, and its borders with its neighbors are completely open.
The emerging epidemics in those places up the ante considerably.
But the coronavirus is just a catalyst. The real cause of Monday’s drop is more mundane: The U.S. stock market is overvalued and has been looking for any excuse to correct.
A Chinese viral epidemic turning into a global pandemic has given investors just the excuse they need.
As we head into what will surely be a rough patch ahead, here’s what you need to know … and do.
Irrational Exuberance
You need to be smart and tough to survive in the market these days.
Part of the problem is that there’s been a recent influx of investors who are neither of these things.
That’s not their fault. In fact, these investors are fulfilling a classic role in the bull market cycle. Take a look at the three states of any bull market to see what I mean:
- Stage 1: Accumulation. This is a period of recovery from a previous bear market. Smart investors begin to buy stocks at bargain-basement prices. Our current bull market experienced this in 2009 to 2016.
- Stage 2: The Big Move. In this phase, investors gradually buy back into the market, quickening over time. Eventually, it becomes a self-sustaining cycle of increasing confidence and market gains. The period from late 2016 to the end of last year was a Big Move phase.
- Stage 3: Irrational Exuberance. This is when unsophisticated investors begin to experience “FOMO,” or fear of missing out. In this stage, experienced investors often pull back from the market, leading to lower trading volumes. But new retail investors pile in to chase gains, leading to rapid price increases — but also high volatility. We touched on this at the beginning of 2018, followed by a sharp correction. We entered the phase again in January.
I knew we were in the Irrational Exuberance phase when I learned that virtual brokerage Robinhood saw tens of thousands of new investors creating accounts just so they could buy hot stocks such as Tesla Inc. (Nasdaq: TSLA). This, in turn, drove up their prices to unsustainable levels.
But those new investors are like a flock of birds — likely to change direction at any moment, leading to rapid reversals like the one we saw on Monday:
Time to Be Smart and Tough
To get through this, you need to use your brain and your heart. You need to be clever and brave.
To do that, you have to really look at why a company’s stock may tumble in the next few days. Here are the three potential contributing factors:
- The company’s exposure to the impact of the pandemic. Look at the company’s supply chains and the impact on its customers. Companies directly exposed to these risks will suffer deeper and longer declines in stock price. Examples include airlines and oil companies, and also companies with factories in Asia, such as semiconductors and consumer electronics.
- The extent to which recent demand for the company’s stock has been driven by novice retail investors. As I noted above, there’s been a big jump in buying activity from individual investors — many new to the stock market — taking advantage of no-fee trading to speculate on “hot” stocks such as Tesla and Virgin Galactic Holdings Inc. (NYSE: SPCE). These investors are likely to flee from these stocks just as quickly as they bought them. Virgin Galactic, for example, was down almost 11% as I wrote this. Tesla was down over 6%.
Tesla & Virgin Galactic vs. the S&P 500 Index
- The company’s long-term prospects. This is the one to focus on. In an interview on CNBC over the weekend, Warren Buffett told investors to ask: “‘Has the 10-year or 20-year outlook for American businesses changed in the last 24 or 48 hours?” If not, he said that the coronavirus “gives you a chance to buy something you like and you can buy it even cheaper — then it’s your good luck.” For companies with great long-term prospects, we can expect bargain-hunting to push their prices back up after the initial drop.
Review your portfolio carefully. Ask yourself how these three factors have influenced the price of the stocks you own.
For example, if you own a stock currently exposed to coronavirus-related impacts (factor No. 1), but it has great long-term prospects (factor No. 3), buy more, as Warren Buffett advises. Those companies will recover eventually, and buying now sets you up for extra profits.
On the other hand, if you’ve bought a stock with a massively inflated share price and no clear direction to profitability (factor No. 2), sell early to preserve your gains or cut your losses. Stocks like those are going to lose value fast and hard. They may or may not recover.
For stocks that aren’t directly exposed to the virus’s impact and that haven’t been irrationally boosted recently (factor No. 2), proceed as you normally would. They may experience a short-term decline along with the rest of the market. Treat this as a buying opportunity if the company looks like a winner. If you’re not sure, hang in there, but don’t sell.
Those three approaches all occur in the head.
To make them happen, however, you need something in your heart: the toughness to believe in what you doing, and the commitment to keep doing it.
Kind regards,
Editor, The Bauman Letter