Editor’s Note: Your editor is feeling a bit under the weather today…
So we’re featuring this essay from last month.
Not much has changed, except the markets are burning even hotter… which makes it a good time to bring this one back on your radar.
It’s a reminder that when it feels like everything is soaring to new all-time highs, it’s smart to take a step back and proceed with caution.
Remember, the higher the market goes… the more conservative we become.
It’s all in today’s Cut…
Right now, nothing can keep this market down.
Good news, bad news.
It doesn’t matter… it doesn’t matter much.
Except for a hiccup here and there.
But even then, one bad day, and sure enough, two days later the market is back where it was…
At a new all-time record high.
So what does that mean for our previous guidance about taking things a little conservatively?
Should we tear that up and just go along with all this bullishness?
Well, we’re just as optimistic about the future as the next man (though it depends on who the “next man” is, right?). And we’d never “bet against America” when it comes to entrepreneurialism, opportunity, and capitalism.
But even so, we have a rule that says, “The higher the market goes, the more conservative I become.”
We’ll explain what we mean with that homespun yarn below.
Beware of “FOMO”
It’s a simple rule that most investors seem to forget.
They get so tied up with FOMO (fear of missing out) that they get less conservative the higher the market goes.
We guess we can understand their thinking. They regret not buying a stock at $10… So they try to make up for it by buying twice as much as they normally would when it’s at $20.
Or they get so swept up by FOMO… they become so convinced the time is right… they go all in just when they should be getting out, cutting back market exposure, or buying into “necessities” and “habits” stocks.
Now, just to be clear. We’re not saying those stocks can’t go down during rough times. We’ve mentioned Darden Restaurants (DRI) before. We referred to it as one of our “habit” stocks.
People like eating out at relatively affordable prices. Maybe it’s not a daily habit, but people like the habit of eating out once a week. Maybe that’s a Friday or Saturday night. Or a Saturday or Sunday afternoon.
Those kinds of habits can be hard to break. Just like folks whose habit is a coffee every morning on the way to work… or a smoking habit… or other kinds of habits!
The point is, people tend to keep up these habits even during bad times. Check out the chart below for Darden. You can see the stock plummeted in 2020 with Covid:
Don’t Lose Your Mind
But by the end of 2020, it was already back to its pre-crash price.
Investors who bought near the 2020 low could have bagged a 253% return before the year was out. Even if you bought mid-year after the initial rebound surge, you still could have clocked a 70% gain.
And even after it cut the dividend for two quarters in 2020, by March 2021 the dividend was back to where it was pre-crash. And by June 2021, the dividend was 25% higher.
Taking it from a pre-crash 88 cents to a post-crash $1.10.
Pretty good.
Bottom line, these are sustainable and profitable businesses. They are “habit” stocks with a loyal customer base. As long as they don’t screw up that relationship (we won’t mention Anheuser-Busch InBev (BUD) here), they’ll likely do fine.
On the other hand, it’s not hard to find examples of investors losing their minds. A perfect example is those who have been flocking to Lyft Inc. (LYFT).
It’s a competitor to Uber Technologies (UBER).
Perhaps you remember the news about Lyft’s earnings call after the market closed on February 13.
We’ll let Bloomberg explain:
It was, without a doubt, a strong earnings report.
Lyft Inc. projected adjusted earnings as much as 11% higher than analysts’ estimates and reported bookings ahead of expectations. And then there was the outlook for profitability: Margins, the ride-hailing provider said in an initial press release Tuesday, were set to expand this year by an eye-watering 500 basis points. Shares surged, jumping 67% in after-hours trading.
But the projection was off. Way off.
Less than an hour after issuing the statement, Lyft Chief Financial Officer Erin Brewer joined a call with analysts and said the company is actually expecting adjusted earnings margins, calculated as a percentage of bookings, to expand by 50 basis points — not 500 — acknowledging, when asked by an analyst, that the press release was incorrect.
It was, apparently, a “clerical error.” Some error.
How did the market react? As you’d expect. When the company said margins were going leap by a full five percentage points (500 basis points), investors bought up big time.
The stock gained 67%.
And what happened when the company revealed the “clerical error?” The stock came crashing back down to Earth, right? Er, not quite.
By the end of the week, it was still up nearly 57% compared to Tuesday’s closing price.
In other words, even though Lyft’s financial results were barely 10% of what the erroneous press release claimed, the stock kept pretty much all the gains for days after.
Now, as we gather, there is a short-selling story in there. That is, a fund had short-sold the stock expecting bad earnings and a falling stock price. So when it released “good” earnings, the fund likely had to buy the stock in the market.
That buying, which is typically illiquid in after-hours trading, only served to help push the stock price higher… and result in bigger losses for the fund.
Regardless, the fund wouldn’t have been the only buyer in the market. Other investors… even though they should’ve known the initial information was wrong… were still buying it in the aftermath.
To us, this shows the craziness and irrationality that can strike investors. They can lose all sense of reality, and just pile into a “hot” story, regardless of the fundamentals.
So, our lesson here is this: just because the market is up doesn’t necessarily mean it’s at the top. Don’t fall into the trap of trying to pick the next crash.
But do exercise restraint. Think about what company earnings are really telling you. Look at the bigger macro picture. And look at the price charts.
Don’t panic and sell everything. But as the market creeps higher (if it does continue to creep higher), think about becoming more and more conservative the higher it goes.
Do that, and we figure you won’t go far wrong.
Cheers,
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Kris Sayce
Editor, The Daily Cut