The Stock Market Meets the Pandemic

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The Corona Virus Pandemic has motivated many people to take a renewed interest in stock markets. Reasons for this new interest in stocks are varied. Some panicked when the stock market declined to new lows in March 2020. Others found themselves with a lot of time on their hands or simply could not be trusted to work when they had to work from home. In my case, I stopped trading stocks and commodities in 2006 after taking profits in the big run up before the Great Recession and was in seminary during much of the decline that occurred after thatthe March fire sale on stocks was simply too inviting to pass up.

It’s hard to trade stocks and commodities when you have anything else to do. The buy and hold strategy that was promoted for generations by Graham and others does not work well in the sort of bubble markets that we have seen particularly since the Great Recession, but the tech boom in 1990s had already begun to undermine fundamental analysis. This implies that you have to watch markets carefully to seek out good opportunities and cut your loss when things change. The investor who who does the most homework wins, which takes a lot of time.

The Decline of Fundamental Analysis

A buy and hold investor typically focuses on fundamental analysis of companies that can be expected to produce strong earnings over a period of years. Analysis consists of analyzing financial statements and studying industry trends.

Financial statements began to decline in usefulness in the 1990s when tech companies began issuing stock options to their executive in lieu of regular salaries. Salaries appear in income statements, but in the early 1990s stock options were a liability treated as an off-balance sheet item. After tech companies used stock options to finance their early years, other companies followed suit and executive incomes exploded even as real earnings remained flat or even declined. Outside of the inequities they created, stock options undermined the credibility of financial analysis of companies in a variety of industries. Investors that depended on their integrity basically got screwed.

Stock Index Investing

Another factor undermining the integrity of financial analysis has been the growth of stock index funds. A stock index fund typically following all the major companies in the market, like the Standard and Poors (S&P) Index of the 500 largest companies in the United States. Investors do not invest in individual stocks, but simply buy shares in an index fund that purchase shares in proportion to the values of the companies listed in the index. This is an attractive investment option because the investor remains diversified and does not need to undertake financial analysis of any kind. While attractive to individual investors, this form of trading encourages investment in companies irrespective of their financial performancemoney comes in and goes out depending only on market trends. This sort of investing encourages weak managers and discourages innovation.

Sector Rotation Opportunity

During the first two or three weeks of the market crash in March 2020, we saw individual investors dumping their index funds and going into cash. Good stocks and bad stocks alike were sold by the index managers. This created an opportunity for savvy investors to pick up good companies at a substantial discount. Some of these good companies were in traditional industries (think of well-managed oil companies and airlines) and some were good tech and social media companies that have proven profitable when people work from home. Later, some of these solidly managed companies had their stock prices double and triple. This opportunity soon disappeared as professional managers realize that they could sell index funds and rotate into industries likely to do well in a pandemic market environment. This  reallocation towards new industries is called sector rotation.

The Bubble Economy

In a normal economy, savings are encouraged and the best companies are lent money to invest. When interest rates are effectively zero and companies are large relative to their markets and government regulators, discipline in the system breaks down. Add to that large government transfer payments and you find yourself in a bubble economy.

In a bubble market, the market goes up because of the inflow of large amounts of cash, not because firms have high or rising earnings. Normally, a stock has value because the firm has strong expected earnings. If you divide the annualized earnings by the typical interest rate, you get a present value of annualized earnings. Note the word expected. Investments are made in view of future earnings, not past earnings, and future earnings are by their nature uncertain. Happy investors may drive up stock values, implying that they are willing to invest and earn a lower interest rate, because they think there is less risk. More risk lowers the stock price because investors insist on a higher interest rate on their investment.

When the Federal Reserve lowers interest rates, then stock values inflate because competing investments offer a lower interest rate. A zero interest policy therefore suggests a bull market in stocks, even if companies earn almost nothing. Obviously, fundamental analysis allows one to understand this process, but it also suggests why most people have no reason to carediscipline in the whole financial system is undermined. Rumors of policy changes or political changes are likely to have a larger influence on market behavior during such periods.

Momentum Investing

When fundamental analysis and firm earnings are less important in determining stock prices, investors are increasingly forced to rely on technical analysis of stock prices and trading volumes. The analog in politics is voting on popularity rather than issues, experience, and competence. Technical analysis, sometimes called the black art of investing, focuses on analyzing patterns in stock prices and trading volumes in determining when to invest. A good technical analyst will use fundamental and industry analysis to pick stocks to pay attention to,  but buy and sell them depending on perceived patterns in the stock prices and trading volumes.

While most people think of day traders when they think about momentum investing, it is often based on simple rules. One rule would be to buy stocks when they are below their 200 day moving average price and sell when they rise about their 200 day moving average price. Computerized trading takes very complex rules and automates the process making it hard for professional traders to use a lot of the popular rules and make money.

Stocks and Life

When I worked in finance, I viewed it as a profesional necessity to learn how risk managers and trading desk actually do business. This assumption served me well in my career. When I entered seminary, I decided that I did not want to spend my evenings studying stock charts and analyzing financial statements. From an ethical perspective, investing is not itself bad (transgression or sin), but it may distract the investor from doing good (iniquity).

Most big market crashes occur in October. If you have cash and the presence of mind to invest when others go screaming towards the exits, then serious money can be made. Only seasoned investors, like my dad, are likely to buy stocks, like Apple, when they are just a few dollars a share and hold them for twenty years.

The Stock Market Meets the Pandemic

Also see:

Water Cooler Observations, June 24, 2020

Interview about the Corona Life in English and Spanish with Stephen W. Hiemstra, April 24, 2020

Managing Change 

Believer’s Prayer

Other ways to engage online:

Author site: http://www.StephenWHiemstra.net

Publisher site: http://www.T2Pneuma.com.

Newsletter: http://bit.ly/Norm2020

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