Enjoy The Stock Market Ride, But Beware The Rising Risk

The U.S. stock market is awash with gains from jumping prices and excited investors. Although some warnings of red flag conditions exist, there is no apparent catalyst to cause a reversal – yet. Therefore, the ride continues even as risk builds.

Five drivers are creating the risk

  1. Investor sentiment – Stocks are great, and the future is bright
  2. Economy outlook – Recession pessimism has shifted to growth optimism
  3. Company fundamentals – The story is everything, and the earnings will come eventually
  4. Competitive analysis – Post-pandemic, “new age” stocks are the winners
  5. Novice investors – A stock’s rising price signifies both company success and investor wisdom

Investor sentiment – Highly bullish

Investor sentiment readings typically mirror stock market moves. However, at extremes, the readings can signal overdone sentiment. Thus, their value comes in the form of occasional contrarian signals

Proof is in the reliable “Investor’s Intelligence US Advisors’ Sentiment Report.” The current bullish reading is at the previously high level of about 65%, with a low bearish reading of about 19%. The 16% remainder is labeled, “correction.”

Likewise, the “AAII Investor Sentiment Survey” has strong bullish results.

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Economy outlook

The various economy measures show rebounds from the initial Covid-19 shutdown lows. However, they still show an economy that is underperforming. The previous worries associated with that weakness have given way to optimistic views. Two primary causes are the Covid-19 vaccine and the Federal Reserve’s easy money policy.

Company fundamentals

There are four issues that put normal fundamental analysis on the back burner:

First, the Covid-19 shutdown effects that are expected to dissipate in 2021

Second, the Fed’s near-0% interest rates that make comparative bond yields abnormally low (making normal stock price/earnings ratios and dividend yields look abnormally attractive)

Third, many companies viewed as post-pandemic winners have very low earnings or are losing money. Necessarily, then, the story takes on higher importance

Fourth, investors now include stock price performance as a backdoor “fundamental.” The assumption is that a rising stock price implies improving company fundamentals.

Competitive analysis

Competition often is presented as new versus old. For example, shopping at online websites versus at physical stores. That approach has two flaws:

First, the assumption that online companies have the winning tickets. However, will the post-pandemic world really be an extension of what we have now? Will people now be content to stay home and work, shop, learn, exercise, eat and be entertained? Or will the old, pre-pandemic ways of physical life re-exert themselves because they provide benefits superior to the new online offerings?

Second, the “new businesses for the new world” view misses the key competitive analytical truth: Not all “new” approaches will work, and not all companies working in the same space will be winners. In fact, competition will make losers of more (most?) of them.

Novice investors

This last item, “novice investors,” does not mean stupid – just inexperienced in the many faces of the stock market. Particularly troubling for the beginner is the market’s knack for suddenly upending sure things and creating pessimistic havoc just when optimism is at its brightest.

The bottom line: Stay balanced in this stock market

Nothing produces regret like an easy-money bull market. Rising stock prices create optimism as well as feelings of wisdom and superiority. If nothing major goes awry, 2021 could see a bubble top. The aftermath is when not having sold something in the runup can produce regret that, in turn, can overwhelm clear thought.

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