A good story can tempt us to forget the truth about markets

The writer is editor-in-chief of Money Week.

One thing the stock markets are extremely good at is storytelling. Every bubble, every change in market sentiment comes with a good story. You might even characterize a market as a competition of stories: the best one provides the framework for the winning investment strategy.

Look closely at the market and you’ll see that anything people say about stock market analysis being based on models and math is not entirely true. We were hearing the story of bitcoin, how cryptocurrencies will save us in an era of government overreach and fiat meltdown, long before models comparing its market capitalization to gold seemed to justify a projected price of $500,000.

The same goes for ESG investing (one that takes into account environmental, social and governance issues).

The story goes that if fund managers stepped up and focused on nonmonetary issues, we could avoid another financial crisis and we’d all make more money too. The problem with this narrative is that for years it had no real statistical basis; that is, before, the growth bubble gave him some happy numbers to work with, largely because most stocks that fit ESG models are also growth stocks.

The same goes for the growth boom itself. Stories tend to come before the models behind them. I think all market participants know this to be true. But go to the journal Nature and you’ll get a hint of how that might be the case in many professions. The magazine cites a recent academic article exploring theories about the connection between consciousness and neural activity (which, by the way, are more relevant to markets than you might think). The paper’s authors note that most studies “interpret their findings post hoc, rather than test critical predictions of theories a priori.” In other words: stories come first.

This is unfortunate in the markets (amusing, of course, but unfortunate), because without the constraints of the absolutism of a model-first environment, we tend to take things to extremes and extrapolate our stories to the point where they become absurd. And so it has been with the great growth boom of the past decade.

The story started well, with the recognition that the growth potential of technology in particular was underappreciated after the 2008 financial crisis. But it turned into the belief (neatly backed by academia) that finding the companies with the best growth potential is all that matters for long-term investment success, and an unnatural division of the market into growth stocks and value stocks.

Those who invest in the latter have spent the last decade being derided as losers by the former. And those who invested in the former have spent their time being derided as fanciful optimists for the latter. As I say: funny, but unfortunate because, in the end, the difference is less clear than it seems.

A recent note by Ben Inker at GMO discusses the pitfalls you could find yourself in with both. One of the things growth investors most like to criticize value investors for is the risk that they will end up investing in value traps—stocks that look cheap based on valuation, but keep getting cheaper. because they have so much “disappointed”. on income in the last 12 months and seen . . . the future revenue forecast will also decrease.”

The criticism is perfectly valid. Inker notes that each year “about 30 percent of stocks in the MSCI US Value Index turn out to be value traps, underperforming the index by 9 percent on average.” That said, there is something more common than a value trap: a growth trap.

Each year, about 37 percent of stocks in the MSCI US Growth Index underperform on current and projected earnings. They underperform by an average of 13 percent. This may not have mattered much in the go-go years when poor performance still meant making money. But when the base case is losing money (growth stocks have had a horrible year) and when stock markets hate uncertainty even more than usual, it does matter.

As Inker points out, value companies are already cheap by definition, so the pain of disappointment often doesn’t mean valuations drop much. But growth stocks are valued solely on the basis of growth expectation. Without that, they are nothing, so you can expect them to drop quite dramatically. that have. Over the past 10 months, growth traps have underperformed the growth universe by 23 percent. It won’t be long and they will be value stocks, or for that matter, value traps.

There is a lesson here. Good stories make us forget the one enduring truth of the markets: unless you’re a very rare trading genius, in the end your profits won’t be a function of the stories you believe the most, but rather a function of the price you paid in the first place. place. . It makes no sense to say don’t use value traps or, more importantly, growth traps: no one does it on purpose.

A better bottom line is to remember that when reality hits stories, reality wins. There was a rally underway in the markets last week. A perfect time to ditch the definitions (and the mockery), rise above the stories, and try to weasel out of the traps.

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