We had another crazy week in the markets, with a lot of excitement over the Federal Reserve’s dot plots and maybe, just maybe, the end of inflation. Indices jumped, stocks jumped, and the phrase ‘we are so back’ rang out on reddit boards and financial social media. Is that excitement right? And what to do about market rallies like these?

Handling Market Rallies

My usual stance in the market is a skeptical optimist. I believe things will work and that the economy will grow. But I also believe things might get worse, and that I might be wrong. When the market goes up a lot, and fast, my reflex is to duck, crouch and wait for a fall. I also try not to think too much about the market as a whole. My goal is to find stocks where there is a disconnect between what it’s worth and what it is selling for. I notice when the number of those stocks is large or small, but that is not directly affected by “the market” level.

Today I want to cover that market level though, for a second, and I want to do it from a different angle. So much of value investing is based on the market being wrong about a company. This post poses the question, what if the market is right?

Market Rallies move fast

Here’s what sets me on edge. The S&P 500 is up 23% this year before dividends. The Nasdaq is up 41.5%. The Russell 2000 is up 21% in 7 weeks. When things go fast in one direction, and when we weren’t necessarily at a cheap point before then, I get worried. And as those indices are made up of stocks, yes, it does make it a little harder to find my disconnects.

But let’s step back from price and look at value. The S&P 500 is trading at 21.6 times its trailing earnings, and 21.25 its future earnings, per the Wall Street Journal. Macrotrends has it at 24.3, which is on the higher end of the range over the past 10 years, but not far off from where it was in 2016 or 2017, for example. The S&P, to use a stand in, seems fair to fully valued, but it’s been worse.

But there may be reasons

Then there’s the economic picture. I’m not a macroeconomist, I just studied as one in college. But GDP grew 5.2% in Q3, and has been solidly positive for the past few quarters. We are ahead of our pre-pandemic trendline.

Inflation, the big threat and trigger of the 2022 sell-off – beyond very expensive valuations and covid hangovers, anyway – is starting to decrease. It is still higher than it had been for most of this millennium, but when you dig beneath the surface, the picture looks better. There are lagging indicators, there is progress in the last 6 months, most commodity prices look to have shed a lot of their Covid spike, and even retailers like Costco are starting to see deflation.

The Federal reserve’s hiking of interest rates likely played a part in inflation slowing down, and the Fed appears to think the finish line is near. Its most recent projections, which came out on Wednesday and send the market soaring, are to cut rates three times in 2024. This would track the projected fall of inflation.

And through all this, we did not suffer any major job losses. In the U.S., non-farm payrolls have grown every month since January 2021, at an average of 417K jobs per month. That rate is slowing – only 186K a month the last 6 months – but it defies the conventional wisdom that to bring inflation down, you have to cause a recession.

Weighing in (or at least keeping one’s head straight)

This is, on the surface, all good. That the stock market has basically recovered from its 2022 plummet would arguably make sense, then. From a vibes perspective, the market is much saner than the late 2021 market – less crypto excitement, fewer SPACs, less extrapolation of pandemic trends into the infinite future.

Earnings are what matters, and if we stop modeling a near-term recession, and if the economy and companies continue to grow, the current valuations may get more reasonable. And if the cost of capital goes down, and the risk-free rate drops, that should support valuations.

Do I believe all this? I don’t know. My entire experience in investing is post financial crisis, a low rates, low inflation, and eventually high valuation environment. If we have bridged to a stable economy at, let’s say, 4.5% interest rates after the eventual cuts, this seems like an achievement of some sort. What it does to stocks is less obvious to me. But, after shaking off anchoring bias from what prices were a week ago, I think there should still be opportunities out there.

Which brings me to the more important point: what to do about all this?

Investing in fast moving markets

There are two Buffett sayings or concepts I like more than any other, really. One is to imagine, when you invest in a company, that you will buy shares and then the stock market will be closed for 10 years. The other is to wait for your fat pitch, to only swing at obvious opportunities.

They’re connected, of course. And I don’t follow them to the letter. I don’t trust myself to analyze what’s going to happen beyond the next 2-3 years. And I am not patient enough to only swing at the most obvious opportunities.

But I try to remember the concepts. We don’t have to chase after stocks. And the news of the day doesn’t have to shake us. When a week like last week happens, or even better when a bad news event happens, I try to imagine that I’m on a remote vacation, hiking in mountains, with no access to the internet or the quotes. What if I were? I wouldn’t do anything. Which eases the anxiety to act.

Burning Energy

I didn’t sit on my hands last week. In part, I’ve been excited to start Middle Coast Investing, so I’ve spent a lot of time looking for stocks anyway. When the prices move, I get cranky. “Why aren’t you waiting for me to finish researching!” And the skeptical side of me thinks, “I better sell some of the stocks I own now, who know when I’ll get these prices again! Things are getting risky!”

My action wasn’t crazy. I sold shares in a couple of my biggest positions which have become fully priced or more. I sold shares in another company that had recovered from a big fall and that I was less bullish on. And I bought shares in a new company that I researched last week, and another newer position that I decided to buy some of so I wouldn’t miss out on a move, before the spikes at the end of the week. It amounted to selling about 1.5% worth of my total portfolio, and buying a little bit less than 1% back.

I still had the feel of trying to keep up with the crowd. We get that FOMO, it’s a normal thing. I think it’s healthy to set aside a part of the portfolio for FOMO or play positions, 5% or less. Burn that energy, so you can stick in the stocks you need to hold long term.

The Most Important Thing (during Rallies and otherwise)

The economy and the market moving is important, in a background way. But it shouldn’t change the fundamental – I am looking for disconnects between stock price and company value. If there is that opportunity last week, with an adequate margin of safety, I should buy. If that opportunity appears at the end of October, when small-caps are in a bear market, I should buy then. And if the disconnect disappears, sitting and waiting, or selling, are both reasonable actions.

Peter Lynch famously said, if you spend 13 minutes a year on economics, you’ve wasted 10 minutes. He goes on to say that he means trying to forecast the market or interest rates. Knowing what’s happening in the economy is still useful as it pertains to your stocks.

Mostly what I’m talking about here is how the economy has sent the price of stocks much higher. There are potentially good reasons for that to have happened last week. And while I didn’t spend time on the bear case, one can certainly argue that this is a false hope, that things will deteriorate. They could!

The important thing, though, is to focus on the companies you are interested in. And if you don’t find them, it’s ok to wait. To go back to Buffett, Berkshire Hathaway has been a net seller of stocks throughout this year, after being a net buyer last year. I can’t say whether the company is right or wrong to have done that. But they are demonstrating that if you don’t see a stock you like to buy, you don’t have to buy any stock at all. That will give you the ability to swing when it’s really time.

Interested in more from Middle Coast Investing? Or in talking to us? Get in touch.

Disclosure: I and Middle Coast Investing clients own positions in Berkshire Hathaway. Nothing in this post is investment advice.