Morgan Housel, in a 2014 WSJ article, shared some wise words to help demystify the stock market.
Companies earn a profit. When investors are in a good mood, they pay up for that profit. When they are in a bad mood, they pay less. Future stock returns will equal profit growth, plus or minus the change in investor attitudes.
That really is all that is going on in the stock market. But we complicate it, scrutinizing every market detail for evidence of what is coming next.
At their core, market forecasts are an attempt to predict investor’s emotions—say, how happy people will be in 2024. An there is just no reliable way to do that.
A sensible way to invest is to assume companies will earn a profit, and assume the amount investors will be willing to pay for that profit will fluctuate sporadically. Those emotional swings will balance out over time, and over the long run the profits companies earned will accrue to investor’s pockets.
Everything else—what stocks might do next quarter, or when the next crash might come—can be needlessly complicating. Investors should learn to take the simple route.
Housel’s description of how the stock market works is spot on. However, investors still have to decide what to do with this information. Perhaps, they will choose buy and hold index investments. Perhaps, they will choose to employ active investment strategies in an attempt to improve the risk/return profile of a passive investment. If they choose the latter, even for a portion of their overall allocation, they would be well served to choose active investment strategies that take into account the reality that stock prices are determined by a combination of factors that include corporate profits AND investor emotions.
Key to the rationale for momentum investing is that one never knows, nor does one necessarily care, the exact motivation of buyers and sellers in the marketplace. For momentum investors, it is enough to see the net effect of all buying and selling pressure for stocks and then to rank a universe of securities by their momentum, buying the securities with the strongest momentum and holding them for as long as they remain strong.
What should investors avoid? As Housel points out, forecasting is an exercise in futility. Furthermore, expecting the stock market to be a simple math problem related to corporate profits is another way for investors to set themselves up for disappointment.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.