THE IRRATIONAL STOCK MARKET

The Rational Stock Market theory states that the experts have already incorporated all the relevant information into stock market prices.  If there is going to be a recession next year, they are already including that impact in their market values.  If inflation is going up and down, they have that covered.  If the global economy is slowing down, that too is reflected in the current prices for stocks. 

If the market makers are really that good, why does the stock market move up or down by 5% on a given day when an economic report comes out only to be followed by a drop of 4% the following day?  If corporate profits grow by an average of 8% per year, why does the market drop by 40% in a matter of months only to reverse course upwards by 50% or more over the following years? 

All you have to do is look at charts of stock prices to see that emotions and the herd mentality move the market in the short term, not reason.  For centuries, the stock market has been the best place to invest your money compared to just about every other investment.  But it can be painful to invest in the stock market.  The stock market is not rational in the short term.  Investing in the stock market can be maddening but the volatility of the irrational market presents a big opportunity to make higher returns. 

In the chart below, we compare the actual performance of the S&P 500 for the period between 1995 and 2021 to what a “rational” market would look like. For the rational market, we smoothed out the chart by using the average annual return of 8% that the S&P produced over this time.  The orange line represents a market that produces steady returns.  The blue line is the actual stock market performance. Over the long term, the S&P consistently produces average annual returns between 7% and 8% excluding dividends.  This period was no different.  When the blue line is significantly above the orange line, the market is irrationally bullish.  When the blue line is significantly below the orange line, the market is irrationally bearish.  This illustrates perfectly how people are constantly over-reacting to news and events.  Corporate profits grow by 8.7% per year over time which is consistent with the growth of the stock market over long periods of time.  So, in the long term, the stock market is rational. But in the short term, the market is anything but rational.

Look at how overvalued the market was in the late 1990’s and early 2000’s.  A rational market would have valued the S&P 500 at $709 in March of 2000, but the irrational investors valued the S&P at more than double that amount - $1,499 at that time.  This was during the height of the dot-com bubble when everyone was saying things were “different” this time.  The collapse of the housing and mortgage markets in 2008 sent the S&P well below a rational valuation.  A rational market at the beginning of February 2009 would have valued the S&P 500 at $1,437 yet rampant fear created an actual value of the S&P that was half that level - $739.  We moved from a market that was overvalued by 100% in 2000 to a market that was undervalued by 50% in 2009.  Even though the market experienced strong gains between 2009 and 2021, the blue line stayed below the orange line until the end of 2020.  A chart like this one gives you an indication of whether investors are overvaluing or undervaluing the market.  

So, we are left with this awful Catch 22.  We have the stock market that is a great place to invest (annual returns of 9% to 10% with dividends reinvested) and we have the stock market that can drop by 50% or 60% in a matter of months and stay in negative territory for six years or more. If the market were truly rational with market values closely following the orange line in the previous chart, using a Buy & Hold investing strategy would be just about all one could do.  Investing would be easy and painless.  But because the market is irrational, a Buy & Hold strategy is painful.

The next chart compares the price of the S&P 500 to a “fair market value” or rational market value from the middle of 2021 thru November 2024.  Notice how the market was significantly overvalued in January of 2022 and that the bear market of 2022 brought the market to under-valued territory in October of 2022.  You’ll also see that the large stock market gains since October of 2022 until now have created an overvalued situation.  The stock market has not been this overvalued since 1999 during the dot-com bubble.  When looking at these charts, does stock market pricing look rational to you? Are your investments protected against big losses if the market drops significantly from it's current overvalued level? Hopefully, this information helps you understand why you need an investing strategy that deals with the irrational financial markets.

There is a better way. We don’t think it makes sense to watch your investments get cut in half during one of these downturns that happen every six to seven years and then wait four or five years for your investments to get back to even.  The wild swings in stock values present an opportunity to make more money in the stock market.  It is emotional human behavior that creates these wild swings, and that irrational human behavior is something that is very predictable. 

We figured out a way to exploit the volatility.  You can reap the rewards when the market appreciates excessively, and you can sidestep the irrational bear market collapses.  In a truly rational market that steadily climbs by 8%, you could only make 8% per year.  Because the market is not rational, you can make much more than 8% per year.  The trick is to ride the wave of the long, high growth bull markets and to avoid most of the pain of the bear market collapses.  If you believe in market cycles and you are worried about how your investments will get crushed in. the next bear market, you need to get Market Signals. We created our Market Signals newsletter to show you how get the high growth of the stock market and to avoid the bear markets.  You can subscribe by clicking here.

Stay Disciplined My Friends,

Phil

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Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.

Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.