31 Jan How to Navigate the Stock Market Madness
At the time of this writing (1/29/21 1PM EST), the stock market is in the midst of turbulence, to say the least. The S&P 500 has erased all its gains from the past month and stocks like GameStop have risen dramatically due to a social media phenomenon regarding Reddit and young retail investors more generally. I explained the phenomenon regarding these young investors and their tendencies to gravitate toward such activity here.
For those who are confused and anxious about the wild swings in stocks like GameStop and the stock market more generally, this article aims to explain the driving forces behind recent events and detail how a wise investor should navigate the market.
Meme stocks refer to the aforementioned stocks causing all the ruckus such as GameStop, AMC, Nokia, and others. The reason why they are skyrocketing in value is due to a variety of factors, none of which are likely sustainable. The immediate cause is due to the large influx of young retail investors, due to apps like Robinhood and countless people sitting at home with nothing to do because of lockdowns. Their investments into such stocks are coordinated on online message boards and are driven by factors such as humor, sentimental value, and the fact that in the stock market if enough people buy a stock, it goes up. For most of January, these investors have been driving up the price of GameStop and that eventually gained national attention this week, causing an even greater influx of investors. The proceeding controversy with Robinhood was explained here.
At the moment meme stocks are a global sensation with the WallStreetBets Reddit Channel tripling in size overnight. Celebrities have given their endorsements and this phenomenon has been framed as a populist uprising against hedge funds which many have large stakes in seeing the prices of meme stocks fall. John Tamny explains why this is a misguided crusade here.
The big question is, should you invest in these stocks? AIER president Ed Stringham explains the dangers here. At the moment the federal government is looking into this activity, which could have a significant impact on this trend. This is an extremely short-term trend and one should not expect this to continue long-term. However, based on the level of traffic and growing attention, it is likely such growth trends will continue in the immediate future. These stocks have nothing to do with fundamentals and everything to do with popular appeal. If one wishes to invest in such stocks this distinction is crucial to understanding their movement. There are a large number of driven individuals who lend a level of stability as they are in on the meme, so to speak. They’re also even more people who simply bought the stock because they saw the commotion and are not committed to seeing the stock rise as high as possible. This creates wild swings in the stock price as people buy and sell as a knee-jerk reaction. The erratic movement of GameStop shows this dynamic as it continues on an upward trend but sees double-digit percentage point fluctuations throughout the trading day.
A working paper explains how such short-term popular interest drives the movement of such obscure stocks here. Meme stocks are a real market force and should be taken seriously but invest at your own risk.
Cult Stocks and Youth-Friendly Stocks
Another phenomenon that seems to be far more sustainable is the rise of cult stocks and innovative firms more generally. Stocks relating to electric vehicles, electric charging, cannabis, cybersecurity, and other innovative ideas have seen tremendous growth despite questionable fundamentals. Cryptocurrencies also fall into this category.
All these stocks actually seem to have a real future and they are held by investors who are sure of that. Although the fundamentals may not be there quite yet, it is probable that these companies, such as Tesla, have a bright future ahead of them. CNBC’s Jim Cramer explains how young retail investors are driving the growth of these stocks here. Prior to the advent of self-directed investing, the market was dominated by older individuals whose sentiments stood with older companies. Now that the market is full of young investors, their affinity with tech firms, online shopping, cannabis, green energy, and other things popular with millennials have become a market force. Young investors such as those on Robinhood tend to also gravitate toward growth stocks with high trading volume, which explains the manner in which many of these stocks move. Volatility is high with these companies but generally speaking, their growth reflects a real long-term change in the market.
Cryptocurrencies and stocks like Tesla also fall into the category of cult stocks.A large number of people hold these stocks despite the aforementioned questionable fundamentals such as profitability or usability in the case of cryptocurrency. Those who hold these stocks believe that one day these assets will be successful, which leads to stronger than expected growth as well as stability. An example of this dynamic at play was when Tesla’s short-sellers collectively lost more than the US airline industry did as a result of travel restrictions in 2020. The short sellers believed that Tesla stock was overvalued because of its lack of profitability and the unusually large market cap. However, where they failed was understanding that people hold the stock because they believe in the future of the company, not because of its ongoing performance. Furthermore, many investors adore Tesla CEO Elon Musk and his work. All of these factors combined with real innovative potential make these cult stocks and youth-friendly stocks investments worth considering. Many of these stocks are actually sound investments but it would still be wise to research and keep an eye on current events that may affect them. Although there is certainly a real driving force behind these assets, that does not make them immune to becoming bubbles. It shouldn’t be controversial to say that some of them are.
Timeless Wise Investing Strategies
AIER has published a book titled How to Invest Wisely, which details a number of sound investment strategies that are now more relevant than ever in this turbulent market. When it comes to current events some of the most important lessons include being wary of impulse transactions. Buying stocks at market tops and selling them at lows is a common-sense way to lose money. In today’s turbulent market stocks will swing quite violently up or down. To inexperienced investors, this could be a tempting incentive to buy or sell, which could either result in losing money before a strong recovery or increasing weight for a sharp decline. A steady hand and having a long-term strategy will save investors from the perils of knee-jerk decisions.
This brings us to another very important principle for today’s volatility. That is diversification and balance. Right now it may be tempting to throw large amounts of money at high-performing stocks, be it meme stocks, cult stocks, or mainstream companies. Take companies like Amazon, and NVIDIA for example. All excellent and stable companies that saw sharp declines in September, that led to months of stagnation which continues to the time of this writing. Although they may be good in the long term, having a diverse portfolio that can zig while other stocks zag so to speak will allow for more sustainable growth. Furthermore, it is important to diversify into other industries. Although tech companies may be doing well, that could likely be due to some short-term factors such as the ongoing lockdowns. Having exposure to other industries will not only provide added stability, but it will also allow you to reap the rewards if and when those industries have their time in the spotlight.
It would also be wise to purchase assets such as Treasury bonds as well as gold that provide long-term stability and also to hold cash as even these assets could see short-term volatility. Given the ongoing rise of cryptocurrency, it may also be smart to have some limited exposure to those assets as well, but they are subject to high volatility and perhaps even eventual regulation.
Finally, to establish balance, it would be wise to routinely sell a portion of high-performing stocks so they do not take up too much of your portfolio. That way a correction will not have an outsized impact on the overall value of your holdings. Today stocks tend to rise and fall with notable volatility and a balanced portfolio will give you the best chance at a smoother trip.
New investors are flocking to the stock market in numbers like never before. If you are one of them, embracing sustainable investing practices will give you the best chance at long-term success. Even if you have been invested in the market for a while, it is important to understand that there are new forces at play. There is nothing wrong with partaking in recent fad investing trends; some of them even seem quite promising. However, just like anything else, being prepared and knowledgeable will ensure your success is long-term and not just the prelude to disaster.
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