THE STOCK MARKET IS NOT RATIONAL

But You Can Profit from the Volatility

SUMMARY:

The Rational Stock Market theory states that the market always looks forward and that future economic results are already priced into the market. It is all based on data.

But the economy never grows by 50% and it never shrinks by 50% in short periods of time. So why does the stock market exhibit wild swings of this magnitude?

It is human emotion and human behavior that moves markets in periods of excessive volatility.

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. 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 2-times in 2000 to a market that was undervalued by half 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.

Buy & Hold is certainly better than what many people often do, which is to sell stocks after they decline significantly and buy more when stocks are riding high. Fear causes people to sell at the bottom and greed causes people to buy at the top. So, for the average investor, sticking to a disciplined approach like Buy & Hold helps people avoid some big investing mistakes. So, clearly Buy & Hold is better than the worst investing approaches. But why should we settle for a strategy that is “better than the worst”? Is it possible there is a better way to invest in the stock market during those awful Bear markets when stocks drop by 40% or more?

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 shown in the previous chart 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. We created Beyond Buy & Hold to show you how.

Be well,

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.