HUMMONEY - A Basic Misunderstanding (Perspective)

- By Greg Lewin

A common mistake made by most investors is to associate the movement of a market or a stock with a particular piece of information that has just made its way to the public consciousness.  Let’s assume some latest and greatest piece of economic news was just released by the government and the market reacts violently. The first mistake an investor could make is to assume a cause and effect. It is my opinion that the majority of the time the market is not reacting to the news but rather is responding to its state of under or over valuation in a period that may be subject to change.

You may logically ask how I could possibly make such a broad and bold statement.  This is easy. Think about it, in our worldwide interconnected economy is it at all possible that any 1 piece of information, in 1 country, at 1 single point in time could arguably alter the sustainable economic prospects of ours and other linked economies by the hypothetical 2-3% change reflected in the stock market on that given day? If we were capable of measuring the aggregate change in worldwide market values versus the economic weight of this single news item we would soon see the limits of this connection.

I would argue that an attachment to individual information is a very poor predictor of market behavior. But don’t tell this to the abundance of media sources arrayed to pontificate on the news of the day, regardless of how limited in overall value it may be. Rather an awareness of market valuation is a far more reliable method for managing daily market news flow. The issue is rarely an individual piece of news.  Rather, it is the margin of safety built into the market to handle the news.

It is not coincidence that great market declines follow extended periods of market appreciation when expectations are high creating excessive valuations for stocks. For it is at these moments that the market is least capable of adjusting to bad news. Just as we see markets become increasingly resilient to bad news at market bottoms. The question is rarely the news because in and of itself it is illogical to believe that any 1 piece of news could alter market valuations as much as they do. More importantly and more sustainable it is market valuation itself that ultimately will determine market reaction and behavior because the sustaining question is, has the market built in a set of shock-absorbers to digest unexpected news.

Your bigger problem as an investor is that when you incorrectly correlate market behavior with the news of the day you will instinctively look for that pattern again and in my opinion base your investment decisions on faulty logic which could lead to a pattern of mistakes.

My advice is train your thoughts on durable values, such as fundamental market valuation, rather than disposable information, like the news of the day to properly adjust the probability of risk and reward when making an investment decision.      

- The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.