On Stock-Picking in Volatile Environments

When a security starts moving higher, it makes some market participants actually more likely to buy the stock. And while being more comfortable buying a stock at higher prices often defies economic theory (and makes value investors cringe), it is a reality. It’s a reality because it may actually be better fundamentals (than previously expected) driving the stock higher, so the move may be completely warranted and rational.  

Or – and perhaps most likely over the last few years – it may be behavioral, or even technical factors driving it higher. Could the shorts be panicking and exiting simply because the stock has reached a “stop” level. Could some of the longs be emotionally excited about making money every day, and more reluctant to sell? Has their thesis drifted from the original reasons to buy the stock? Maybe some noise traders jump on board “the Trend Train”, and maybe these noise traders are more prevalent in the market, and affecting prices than some believe? Or perhaps some traditional long onlies want to dress things up and add the name to their books before the end of the month or quarter?

From an emotional or behavioral perspective, when stocks start moving higher, could ambiguity aversion be dissipating faster than is warranted, or indeed beyond the point where some ambiguity should be priced in? In other words, do some investors lose any sense of concern or worry, when they shouldn’t?

Or perhaps the combination of confirmation bias and FOMO drive some investors to the point where they want to buy this stock so badly that he or she can’t help but do so – despite it being more expensive than it was the day, week, or month before. Message boards sure contributed to this behavior in 1998 and 1999 as the tech bubble approached its peak. And one wonders if more recently social media may have impacted – to some degree, or perhaps a great degree – the Mr. Market’s rush to join in on the meme-stocks de jour, whether it was the AI “winners”, large cap tech (esp. the Mag 7), or just a few years ago, the lockdown “winners” or the purportedly “get-rich-quick” SPACs.

And things work the other way too. Individual stocks falling steeply often breed stocks falling further – and for the polar opposite reasons offered above on the long side. Pod shops are forced out of stocks where their longs have triggered a stop loss, meanwhile noise traders sell the boring stuff short (or just ignore it completely) so that they can finance purchases of the sexier stuff that they can share on Reddit or Twitter. And ambiguity aversion can soar when you don’t know why the stock is falling, naturally creating further weakness. And meanwhile the behaviorally impacted investor will ignore any signs of fundamental improvement, will start herding around like-minded, bearish investors, and will become further anchored to their view as the price falls. In other words, the stock (to some folks) becomes a better short at lower prices.

So in either scenario, whether stocks are heading dramatically north, or disastrously south, how do you know if it is overreaction and psychology, or actual economic fundamentals driving the share price?

In other words, how do you know which is which?

There is one basic answer.

Ask yourself this: If you had a crystal ball and precisely knew what the fundamentals of the company would look like in five years, and how that compared to the market’s current expectations for those same fundamentals in five years, would your job be harder or easier?

It’s not a trick question, of course it would be easier. Borderline infinitely easier.

And, most importantly, it would be extremely difficult to lose money in any of your investments over those next five years.

That’s the answer. Know the fundamentals and interpret them without bias, and you will win.

Of course, none of us has those crystal balls, and without inside information, we’re all starting off flipping coins. But to the extent that we can gather and interpret fundamental information as objectively as possible – as other price-making investors are distracted and doing other things – then all of the sudden that coin flip starts to tilt in your favor. Can you get it out to 55% win vs. 45% lose? Can you get it to even better levels?

And can you size things so that the positive impact of your winners is greater than the negative affect of your losers? Can you think about things probabilistically so that your slugging percentage is greater than your batting average?

These are the goals.

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