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There’s a growing gap between what we know and what we feel. We know that avoiding panic and staying in place is the best strategy during turbulent markets. History shows that patient investors are always rewarded, and market timing is a futile exercise.
Yet our emotions tell us it’s time to do something. This excellent article by Jason Zweig explains why. This gap creates an internal struggle for advisors and clients alike.
Facts can only do so much to resolve this struggle. Before facts matter, both advisors and clients need to work through the emotional turmoil caused by events like the corona crisis.
Those of you on the front line bear the brunt of dealing with the stresses and anxieties your clients are experiencing. But we are here to support and encourage you in any way we can.
We thought the following explanation of what’s driving the current market volatility might be of assistance in calming your clients during this difficult time.
What’s Happening in the Stock Market and What to Do About It
Legendary investor, Benjamin Graham, explained the stock market in the following way. “In the short run, the market is a voting machine, but in the long run, it’s a weighing machine.”
What he meant was, the day-to-day price movements of stocks are greatly influenced by the event of the day, trends, the popularity of certain stocks or industries, and the emotions of market participants. But in the long term, stock prices are determined by the prospects of the firms whose stocks are traded. A firm’s prospects are measured primarily by its future expected earnings.
Since the emergence of COVID-19 the stock market has been acting both as a voting machine and as a weighing machine. Many people are voting by expressing negative emotions and fears through the undisciplined selling of stocks. On the very next day, others vote by expressing their optimism and hopefulness through their buying activity.
The main cause of the volatility is that the weighing machine is temporarily out of order. Market participants know the future expected earnings of many firms have been adversely impacted. They also know the future expected earnings of a smaller number of firms have improved. The problem is, they can’t accurately quantify the impact that COVID-19 will have on the earnings of any of those firms. There’s simply not yet enough information available.
Because stock prices are being determined based on incomplete data, those prices are unstable. As new information emerges, the weighing machine incorporates it into its pricing calculation even though the total picture is still far from clear. This can create spikes in stock prices—both up and down—as the weighing machine seeks the “right” price for every stock.
This situation is likely to persist until the weighing machine has enough reliable data to perform its long-term function—providing accurate and reliable prices for the stocks that are traded. In the absence of such information there will be uncertainty. Markets do not like uncertainty. Uncertainty creates anxiety, which, in turn, negatively stimulates the voting machine.
Eventually sufficient data will be available, the uncertainty will dissipate, and the weighing machine will restore order and stability to the markets. There is always some level of uncertainty and the weighing machine is always making adjustments based on new information. But the magnitude of market movements will return to “normal” range, until the next new cycle of major repricing takes place.
This process is not new. Market disruptions, either in the form of bear markets (declines of 20% or more) or corrections (declines of 10% or more), come along frequently. Each has its particular cause and its own unique character. This one was caused by a disease. The last two bear markets were caused by the financial crisis and the tech bubble. They all pass eventually.
Times like this are very stressful for long-term investors, but history teaches us exactly how we should react in these situations. Remain as calm as possible. Avoid selling into a volatile market, especially one that has already dropped as much as this one has.
At some point the markets will regain their positive upward trend. The weighing machine is always measuring future expected earnings, so the market usually begins to trend upward long before the events that caused its decline are fully behind us.
The individual firms whose stocks have been punished in this market are already working to turn things around. They’re taking action to minimize the damage, while positioning themselves to thrive once the crisis has passed. Some will be successful, some will not. Overall, the stock market will regain its positive momentum. Patient investors will be rewarded.