Beyond The Headlines

Hot or Cold

June 1, 2022 | Bogumil Baranowski
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Have you ever used those old-school hot and cold faucets? Some older hotels may still have separate faucets, one with scorching hot water and the other with bone-chilling cold water. If you burn your fingers in one, you can at least cool them down in the other. A happy middle would be preferable, but it’s not always available. The stock market sentiment seems to have only two options, too: hot or cold, and rarely something in between. Let me explain.

Time after time, it’s fascinating to watch how the market sentiment swings from despair to euphoria and back. The last two years took investors on a real rollercoaster ride of emotions. In February 2020, I attended a conference in Florida. Companies presenting shared their peak results and looked forward to even better results ahead. Coronavirus was a distant problem far away on the other side of the globe. The bottom seemed to have fallen out only a month later, and the stock market took a 32% dive.

Doom and gloom forecasters took the stage on TV, spreading chilling predictions. The market started to recover, though. The S&P 500 rose as high as 40% above the pre-pandemic high. A very impressive feat as the world worked its way out of lockdowns and stay-at-home orders. The market euphoria fed on the consumer excitement or vice versa. Many shopped for anything from grills and pool equipment to new cars and houses. It felt like a now or never moment for both investors and buyers. We heard the mantra: you only live once, and the fear of missing out overtook many.

Quality stocks rose, but also companies with no profits or hardly any revenue. If that wasn’t enough, digital assets with neither profits nor revenue rose in price, including cryptocurrencies and NFTs (non-fungible tokens). Some of them represented as little as funny digital images of a colorful roll of toilet paper. One could find it amusing since that household staple in its physical form became quite a hot commodity in the middle of the pandemic. There was no cloud in sight, and the market reached new highs getting hotter by the minute. Yet something stopped again.

Benjamin Graham, the father of value investing, wrote about Mr. Market. This imaginary character resembles a manic depressive with extreme mood swings wanting to buy or sell. Sometimes he is optimistic, other times pessimistic, switching from hot to cold and back at a moment’s notice. Benjamin Graham explained how Mr. Market might be knocking on our door with an offer, it could be high or low, but it’s up to us to decide when and how we act on it.

The last six months might have felt like a cooling period. Stocks fell from their highs, especially those with extremely high valuations and little or no profit. Then digital assets experienced more cold shoulder treatment from earlier enthused investors. We saw some collapses and crashes in crypto markets.

It may all seem disorienting and disturbing, but all noise and temperature swings aside, what drives stock prices, in the long run, is the underlying value. The value comes from the earnings power of a business. How much money is left after all costs are covered – the profit. Outside the stock exchange, if you were to buy a business, a pizza restaurant, or local cleaners, you would look at the last five years of profit history. You’d want to know if those profits are sustainable or if they are growing. You’d be curious to know if the customer base is fairly loyal, too. Finally, the cost structure would be equally interesting to understand. What does it cost to run this business?

The daily, weekly, or even monthly price gyrations aside, the stock market follows the same logic as purchasing local cleaners. We remind ourselves of that every time an overheated market reaches new highs or an overchilled market drops to new lows. The fundamentals, the profits are all that matter.

Those fundamentals are somewhere in between the two extremes; Mr. Market might be jumping up and down, but it’s up to us to decide how and when we act on it. There are times to sell, raise cash, wait, and there are times to buy and put more capital to work. We don’t have to precisely call the markets’ tops and bottoms. We don’t believe anyone can do it. We can do what’s second best, and gradually sell toward the top and gradually buy toward the bottom while carefully watching the fundamentals rather than daily prices.

That’s exactly what we have been doing for the last two years and the previous decades. We believe that slow and steady wins the race. Mr. Market used to go from hot to cold a hundred years ago when Benjamin Graham sat in his Manhattan office, and it does today.

Graham famously wrote: “Business conditions may change, corporations and securities may change, and financial institutions and regulations may change, human nature remains essentially the same.” This was true back in 1922 when railroad era companies like American Locomotive (the leader in steam engines on wheels) still belonged to the Dow Jones Average, and it is today with Apple Inc. (one of the leaders in smartphones) in the index.

Hot or cold, optimistic or pessimistic, euphoria or despair, we keep a steady course, and we hear Graham’s words: “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”


Happy Investing!

Bogumil Baranowski

Published: 5/25/2022


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