A good story will tempt us to forget the truth about the market

The author is the editor-in-chief of Money Weekly

One thing the stock market is very good at is storytelling. Every bubble, every shift in market sentiment, is accompanied by good news. You could even describe the market as a story competition – the best contender can provide the framework for a winning investment strategy.

Look closely at the market and you will see that the claim that stock market analysis is driven by models and mathematics is not entirely true. We heard the story of Bitcoin – how cryptocurrency will save us in an age of government overreach and fiat currency collapse – as early as a model comparing its market cap to gold seemed to justify a predicted price of $500,000 Before.

The same goes for ESG investing (focusing on environmental, social and governance issues).

The story goes that if fund managers only stepped up and focused on non-monetary issues, we could avoid another financial crisis and all make more money. The problem with this claim is that it had no real statistical basis for years – that is, before that, the growth bubble gave it some happy numbers, mainly because most stocks that fit the ESG model were also growth stocks .

So is the growth boom itself. Stories tend to come before the models that support them. I think market participants know this to be true. But turn to Nature and you’ll see that this can happen in many occupations.The journal cites a recent academic paper that examines theories about the link between consciousness and neural activity market By the way, more than you might think). The authors of the paper observed that most studies “explain their findings ex post facto rather than test critical predictions of the theory a priori”. In other words: the story comes first.

This is unfortunate in the marketplace (of course it’s fun, but unfortunately) – because not bound by the absolutism of a model-first environment, we tend to push things to the extreme and extrapolate our stories to the point of absurdity. So is the huge growth boom of the past decade.

The story started well, with the recognition that the growth potential of technology in particular was underestimated after the 2008 financial crisis. But it turned into a belief (subtly backed by academia) that finding companies with the best growth potential is all about long-term investment success, and the unnatural division of the market into growth stocks and value stocks stock.

Those who invested in the latter have been mocked as losers by the former for the past decade. And those who invest in the former are ridiculed by the latter as optimistic visionaries. As I said: interesting, but unfortunately, in the end, the difference isn’t as obvious as it might seem.

A recent article by GMO’s Ben Inker explores the pitfalls you may find yourself falling into. One of the things that growth investors like best for value investors to address is the risk that they will end up investing in a value trap — that is, looking cheap on a valuation basis but only because they’re all “disappointed” And the stock is getting cheaper with respect to trailing 12-month revenue and visibility. . . future revenue forecasts are also down.”

The criticism is absolutely right. Inker notes that each year “about 30% of stocks in the MSCI U.S. Value Index prove to be value traps, underperforming the index by an average of 9%.” That said, there is something more common than the value trap: the growth trap.

Each year, about 37% of the stocks in the MSCI U.S. Growth Index have disappointing current and forecast earnings. Their performance is an average of 13% behind. That may not have mattered in the past few years when underperformance still meant making money. But it does matter when the base case is a loss (growth stocks have had a terrible year), and when the stock market hates uncertainty more than usual.

As Inker points out, the definition of a value company is already cheap, so the pain of disappointment usually doesn’t mean a big drop in valuation. But growth stocks are valued purely on growth expectations. Without it, they are nothing – so a sharp drop can be expected. they have. The growth trap has underperformed the growth sector by 23% over the past 10 months. Before long, they’ll be value stocks — or value traps, for that matter.

There is a lesson here. Good stories make us forget an eternal truth of the market: unless you are a very rare trading genius, your returns will ultimately not be a function of the story you believe most, but a function of the price you paid in the first place. Say no There is no point in holding a value trap or more importantly not a growth trap – no one does it on purpose.

A better takeaway is to remember that when reality hits the story, reality wins. The market rebounded last week. The perfect moment to let go of definition (and ridicule), go beyond the story, and try to escape the trap.