The Most Expensive 10% You Might Ever Earn with Stocks
[Author’s Note: This is not investment advice but merely educational content. Consult a professional for investment policy recommendations]
DURING the whole of a dull, dark, and soundless day in the autumn of the year, when the clouds hung oppressively low in the heavens, I had been passing alone, on horseback, through a singularly dreary tract of country; and at length found myself, as the shades of the evening drew on, within view of the melancholy House of Usher. . . Perhaps the eye of a scrutinising observer might have discovered a barely perceptible fissure, which, extending from the roof of the building in front, made its way down the wall in a zigzag direction, until it became lost in the sullen waters of the tarn.
—Edgar Allen Poe, The Fall of the House of Usher
The current S&P chart pattern and recent crashes in Facebook and Netflix (two of the celebrated FANG stocks) suggest that the US market is heading into a very turbulent Fall season. Though the market finally turned positive for the year, more damage was done than meets the eye.
But investing is about whether the return justifies the risk. Just because you made the money doesn’t mean you were wise in your decision, it only means that you got away with a poor risk/reward decision.
Stocks could drive higher simply based on the fact that for the last eight years, investors in stocks (as with many investors in real estate) have been rewarded for holding on: people are less likely to sell while they are ahead and so the trend is self-reinforcing in and of itself. My friend Dean H. said it better “People capitalize their most recent experience.” But investing is about whether the return justifies the risk. Just because you made the money doesn’t mean you were wise in your decision, it only means that you got away with a poor risk/reward decision.
Let’s use the examples of Facebook and Netflix. Prior to the recent earnings announcements a week ago, most investors had been rewarded for holding on to their shares of these two high-growth technology companies.
Then the shares of both companies lost twenty percent in one day!
The idea that severe adjustments could take place in such stalwart names is example enough that risk is lurking. And I could rant on about all the possible sources of stock-market calamity, but the truth is that despite what appear to be solid economic readings , markets fall when perception changes. My reaction to the twin crashes in two of the investment darlings of the last ten years was that that they represented a crack in the dam. Overnight, it seemed, the market lost its appetite for risk.
The chart from BigCharts.com compare the riskier Nasdaq ETF (QQQ–black line) to the less risky SP500 ETF (SPY–tan line). Note how only a couple months ago, the QQQ set a new high while the SPY faltered. Last week, the roles were reversed.
Take heed! In markets, risk leads the way: it leads the way up during bull markets and it leads the way down in bear markets.
The market may rise into yearend and shrug off this temporary divergence, but that won’t make investing in stocks a good risk/reward choice. We had a 50% correction that started in 2000. We saw another 50% correction start in 2009 (note: nine years later).
This kind of perspective is mostly technical analysis–looking at patterns of price action over time to evaluate the supply/demand characteristics of the market. Fundamental analysis looks at the prospects for corporate earnings growth in the context of economic conditions–they are not the same thing, though some argue that technical analysis should lead the way because markets are discounting mechanisms: they base today’s prices on the future–not the past, and changes in the estimates of earnings for the future would show up first in changes in price.