Photo: Marcin Chady. Source: Wikimedia
One reason is because markets are adaptive. They adjust to expectations. Sometimes we get concerned about a market melt-up. That’s where prices adjust so quickly to expected good news that there isn’t time to take advantage of the improved outlook. Then, the overpriced market sows the seeds of its own correction: new deals are put together that don’t make any economic sense. Eventually, these shares fall, pulling the rest of the market down.
Adaptive markets mean that what works one day doesn’t work down the line. This makes investing fundamentally different from other math-intensive disciplines. A civil engineer works with the laws of nature: a bridge built to bear a load will always bear that load, until its materials degrade. The bridge’s capacity doesn’t change just because everyone believes in it. But an undervalued stock doesn’t stay undervalued once everyone realizes it’s undervalued and buys it.
What works today will be sub-par later. Right now, growth is in vogue. Secular growth is hard to come by in a slow-growth economy. But after everyone buys growth stocks, their expected returns become miniscule. There’s no margin for error, and other sectors become more attractive. And circumstance in the future may not favor growth. A few years ago, dividends were the darlings. People couldn’t get enough of their transparent cash flow engines. But now, they’re out of favor. People look at dividends as if they were dinosaurs – yesterday’s dominant species.
Photo: Allie Caufield. Source: Wikimedia
Times change. Investors need to stay nimble, and watch out for asteroids.
Douglas R. Tengdin, CFA