The April jobs report came out last Friday and reflected that unemployment rose to levels we have not seen since the Great Depression. Yet, on the same day, the stock market (S&P 500) was up over 1.60%. How can this be? In today’s article I will answer that question and give you insight into how the stock market actually works and how you can leverage it to your benefit.
The jobs report reflected that over 33 million people are without jobs, which reflects an unemployment rate of 14.7%. As a result, it doesn’t logically make sense as to why the stock market was up that day. You would think that bad news of this magnitude would send the stock market into a downward spiral, but the stock market doesn’t work that way.
So, why didn’t the stock market go down?
The stock market didn’t go down because large unemployment figures were already EXPECTED! Think back to when Britain made the decision to leave EU. Everybody (including Vegas) EXPECTED that Britain would remain with the EU. And when this didn’t happen, the stock market move aggressively downward.
Or think back to the 2016 election. Hillary Clinton was a shoo-in to win. It was practically guaranteed. Yet, the UNEXPECTED happened. Immediately overnight, the stock market moved downward. Then the next morning throughout the rest of 2016, the stock market moved decisively upward.
It’s the UNEXPECTED that matters!
As you can see, the stock market generally moves based on UNEXPECTED news not EXPECTED news! This is not to say that the stock market only moves on unexpected news. When people invest their money into the stock market they do so with the expectation that there is future profits and growth from the companies they are investing in. But when unexpected events happen such as 9/11, Brexit, Housing Crisis, Presidential Elections, Coronavirus, etc., that is what really moves the markets.
How You Can Benefit!
Essentially what I am saying is that EXPECTED events are already priced in (known as the Efficient Market Theory)!
That should be a key component to your investment strategy.
Imagine that you are in the grocery store and the price of fish is $9 per lb. That price is based on supply, demand, shipping costs, and many other factors. It is based on what is currently known at that time. In other words, all those factors are already priced in! If any of those components change (or if new components emerge – i.e. coronavirus) then the price of fish will change. The stock market works exactly the same way.
The other approach….
If your investment strategy doesn’t favor an Efficient Market Theory approach, then it’s likely that you’ve built your strategy around moving into and out of the market at what you would deem opportune times. Let’s call this Market Timing Theory. I understand the appeal and the logic of this strategy. You want to be in the market when it’s doing well, but get out before it goes south.
But it’s very difficult to maximize your investment results under this approach because you have to make these decisions over, and over, and over again…. I won’t bore you with the research here, but just know that the experts on Wall Street have far more resources and funding than you do, and the studies show that they cannot continuously do this successfully.
Still not convinced?
Let’s say that you still embrace the Market Timing Theory and you believe a stock market decline is headed our way. And as a result, you decide to stay out of the stock market until that event comes and goes. Even if you are right, the rest of the world has not yet caught up to your knowledge. As a result, it might even take years for the decline to happen and you could miss out on significant returns.
Let me give you an example.
Since the 2008 recession, the stock market has performed very well (at least until the coronavirus reared its ugly head). From 2009 to 2019, the stock market returned 14.68% per year (far above its 10.00% per year average). Yet during this eleven year period, many experts were saying that the stock market was overpriced and that this performance could not continue.
While the experts were correct in theory saying that the stock market was overpriced, they couldn’t predict the timing of the crash. And furthermore, it wasn’t the overpriced nature of the stock market that caused the stock market to crash, it was the coronavirus (something no one saw coming).
I’ll take it one step further. If you embraced the Efficient Market Theory and believed that the overpriced stock market was already priced in, then you would have stayed invested and benefitted from the huge returns over that eleven year period. And I suspect that if you took the Market Timing approach and got out of the stock market, then you probably ended up with a lot of angst and frustration. Or worse yet, you may not have even realized that your situation could have been much better.
To cap off the example, a person would have been far better off embracing the Efficient Market Theory approach even with the investment losses suffered as a result of the coronavirus. From January 2009 through April 2020, you still would have returned 13.24% per year. A $500,000 investment would have grown to over $2.0 million.
However, if you would have gotten out of the market at the end of 2014 (when the P/E Ratio crept up over 20%), your return would have actually been MUCH higher at 17.22% per year. However, before you get too excited, you would have missed the positive returns in the years that followed. As such, your $500,000 investment would have only grown to $1.2 million by April 2020.
You would have missed out on $800k of growth because you were trying to avoid a loss that you “knew” was coming.
If you’ve employed the Market Timing Theory with your investments, then perhaps it’s time for a change. Perhaps it’s time to embrace the fact that certain factors are already priced into the stock market. Not doing so could significantly impact your investment growth and cause you to fall short of your goals.
An Efficient Market Theory, in my opinion, is how you best make money in the stock market!
Has this content been helpful for you? Are you ready to embrace this new model? I’d love to hear your approach to investing and the experience you’ve had. Please leave your comments below.
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