Life inside a stock market bubble is great until someone takes out a pin


“Nothing sedates rationality like large doses of effortless money.” So wrote Warren Buffett in 2000, after the burst of the tech-infused stock market bubble of 1997-1999.

Nowadays millions of U.S. stock market players have made significant money with little effort since that March 2020 plunge at the pandemic’s onset. Amid the pandemic, a raging bull market has delivered outsized stock market gains to many people, some through index funds, others through old-fashioned stock-picking, and still others through short-term trading. 

Different fuels feed every bubble, and this one includes working from home, increased leisure time, low trading costs and abundant investing commentary to sustain one’s appetite. Warnings are now being sounded about elevated valuations but it remains hard to walk away from such riches. Many plan to exit — just before the market corrects. 

Trouble is, no one knows when that will occur or to what extent. Short-term traders are as likely to pocket their gains as to lose their shirts. Indexers will face the fate of the markets — elation amid exuberance, despair amid the crash.  

The prudent course is that of the quality shareholder, the one who does homework, selects a few strong businesses to invest in, and holds them through bull and bear markets alike.  

Read: Warren Buffett knows these are the best investors to follow with your own money

Quality shareholders are specialists, not generalists. They study a relatively small number of industries and companies where they have particular competence. They avoid straying into areas they do not understand. Buffett famously dubbed this the “circle of competence,” stressing that its size is scarcely important but that knowing its boundaries is vital.

Fundamental things apply

Within their circle of competence, quality shareholders stick to fundamentals, focusing solely on an estimate of a company’s per share intrinsic value. Use this simple goal: Buy, at a fair price, a part interest in a business you understand well, whose cash flows are almost certain to grow reliably over many years.  

Few companies will clear this hurdle. When you find one, load up on a meaningful amount of its stock in relation to your investment funds.  Then sit tight. Resist the temptation to sell when your initial estimates disappoint.  

Assemble a portfolio of a few companies meeting your criteria — a business you understand that your analysis convinces you will be a steady earner over many years.  When they do, your portfolio’s value will rise in tandem.  

High-performing companies command durable competitive advantages. These are business features — brand strength, economies of scale, network effects — that ward off rivals, upstarts and disruptions. It’s possible to identify such “moats” upfront but this can be difficult, especially in rapidly changing fields, such as cryptocurrency or robotics, or amid acutely high business uncertainty, as during the prevailing pandemic.

Don’t fear missing out on opportunities. You cannot possibly have the required competence to understand the vast majority of businesses, let alone those best positioned to withstand rapid technological innovation or abrupt systemic collapse. There are experts in everything from consumer products to real estate finance, but few with expertise in more than half a dozen of the major economic sectors. 

An investor’s greatest strength is not in claiming the broadest range of expertise across multiple sectors but in recognizing the perimeters of their competence. That way, mistakes are more likely to be both accidental and modest, rather than culpable and cataclysmic. And take comfort: there are plenty of opportunities for investment success outside the latest glamour stocks poised to change the world.

The attention such glamor stocks attract, moreover, pushes their prices up to levels that make them unattractive as investments. The price is simply too high. In fact, a similar concern can arise for large swaths of the overall stock market or specific market indexes. No one can reliably predict market or index movements tomorrow, by year-end or next year, and it’s foolhardy to try. 

With the Dow Jones Industrial Average
DJIA,
+0.28%

  and most U.S. benchmark indexes up markedly during this pandemic year, it is clear that participants are wildly optimistic about expected future returns — an optimism reinforced by the forced buying of the large indexers who buy the entire market. That is something that separates a quality shareholder from an indexer. 

But aggregate U.S. corporate profit growth is ultimately tied to GDP growth. Given the economic lockdowns of 2020 that slashed GDP, expect a bounce in GDP growth in the short run, boosting corporate profits. But beyond the pandemic recovery, can GDP growth be sustained at levels high enough to justify today’s elevated valuations?  The multiples of many glamour stocks are stratospheric, rooted more in hope than in economics. 

Overheated markets tend to be followed by realistic corrections as investor expectations become more rational. Corrections are usually acute, hitting hardest the sectors and companies where speculation was most intense. The highest flying become the hardest falling. 

If that occurs to companies within your circle of competence, additional opportunities may arise. But predicting such occurrences is foolish and it is safe to tune out commentators who explain what is “really going on” in sectors of the stock market. That is why a quality shareholder cannot also be a day trader. 

In his 2000 post-mortem on the tech bubble, Buffett concluded: “A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: . . . speculation is most dangerous when it looks easiest.”

Lawrence A. Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University.  His books include Quality ShareholdersDear Shareholder; and The Essays of Warren Buffett.  Cunningham owns stock in Berkshire Hathaway and is a shareholder, director and vice-chairman of the board of Constellation Software. 

More:Companies whose board members are also major shareholders typically outperform. Here’s how to find them

Plus: Active managers see value in these 3 company practices but indexers hate them. Who’s right?

 

 



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