Fluctuating Conviction

This is just a thought I have been mulling over the last couple days that relates to investing.

I read about a third of "Reminiscences of a Stock Operator" before I lost it, but even what I read had a big impact on me. The young men in the book would be in a flurry of activity and excitement. They would often ask a particular older gentleman if he thought the specific stock they were talking about would go up. His repeated response was "It's a bull market", which really annoyed the younger traders because they didn't think he was answering the question. I'll come back to this in a second.

I played golf with my brother the other day and we were talking about the markets. I mentioned that many of my recent purchases had gone up dramatically and that I was really enjoying being an investor right now. He made that comment that maybe I should just trade for myself rather than keep trying to find a job working for someone else. His suggestion forced me to verbalize something I already knew; We have been experiencing an unusually good time to be an investor and these times don't last. This rally off what I think was the bottom has been violent and very profitable if you were lucky enough to get involved at the right time. Picking doubles and triples will not be as easy once we get into a more normal bull market.

My recollections about "Reminiscences" and my conversation with my brother are the catalyst for this post. I think that as an investor, the level of conviction I have should vary over time as the circumstances of the market change. Having worked as an analyst at an investment firm, I can tell you that there is unspoken pressure to maintain a high level of conviction; all the time. How do you get a portfolio manager to buy your stock recommendation? You "pound the table"! But as the old man in the book pointed out, the back drop really matters. Will XYZ stock go up? If we are in a bull market, then it most likely will. In mid-march, my conviction level was very high that I should buy a basket of beaten-down stocks because I was convinced that those types of stocks had explosive upside potential. I mentioned the stocks I bought in the last post, but my point here is that my success in that case had less to do with the five stocks I picked than with matching my purchases to the environment I thought we were in. I'm sure there are hundreds of other stocks I could have bought that would have matched or outperformed the five I purchased.

What are the current implications? As I have been thinking about this, the key point is that I think the environment is shifting. We were in an environment where the most beaten down stock could really bounce off the bottom. I think we are entering a phase where investors are still looking for pockets of extreme pessimism to play the bounce, but in general the environment will start focusing on longer term growth and earnings power. As such my level of conviction probably needs to be reigned in to match a less extreme environment.

I occasionally catch a show on CNBC called "Fast Money" which is basically a show for traders. One of their favorite lines was "everyone is a trader now". I think they were picking up on the environment we were in. The environment was a traders market, but I really think that is changing as I write.

I have not seen the job numbers yet this morning, but the number of data points that look good continues to build. Things are getting better and money on the sidelines will start pouring back into equities driving a bull market.

Let me be presumptuous and give you my formula for prices (this applies to stocks and the market broadly). P=(IV*S)+T. Price equals the product of intrinsic value and a sentiment multiplier, plus the impact of technicals. Intrinsic value is theoretically what a financial instrument is actually worth if we could all agree on what discount rate, and growth rates to use. As you know, sentiment pushes prices around that intrinsic value. The price of a dot.com stock in 1999 was largely driven by the sentiment multiplier, not calculations of intrinsic value. I am using the term "technicals" to describe unusual imbalances of buyers or sellers, such as if the top share holder starts liquidating their position, or if pension funds in aggregate start reallocating away from US stocks and into international stocks. The distinction between sentiment and technicals can get blurry so don't over-think it. The formula is really just a mental framework, not a calculation tool.

Using that framework, I would argue that intrinsic value has not changed much, but sentiment and technicals have been overwhelmingly negative until mid March. Now that I am convinced both factors will be a tailwind, I want to own equities. "It's a bull market."