Supply & Demand | Psychology Matters
How much is the company Gamestop worth? The stock, symbol GME, traded as low as $4 a share in the Summer of 2020. Then, inexplicably, the stock soared to over $350 a share in January of this year. Since that time, it has traded as low as 40 and as high as 264.^ Has the value of the company really changed that much? The short answer is no. The long answer requires more analysis.
Although The Intelligent Investor, Benjamin Graham’s seminal work on fundamental analysis, argues that companies are worth their discounted future cash flow stocks today seem to trade on other variables. What is going on? Why would anyone pay more than the fundamental value of a company? Why would anyone sell a stock for less than the fundamental value of a company? The answer is the economic law of supply and demand. Although you can argue that markets are efficient, as Robert Malkiel did is his work “a Random Walk down Wall street”, clearly there are times where the value of an individual stock seems to defy reason. Why is that?
I like to say that although in the long run the stock market reflects the fundamentals of the economy, in the short run it reflects the psychology of investors. Nowhere can this be seen to a greater extent that in the momentum style of trading. Momentum traders simply look for stocks that are moving, on heavy volume, and look to buy them. The thinking of this strategy is that big money is trying to get into a stock so, by purchasing it, you can ride the price up. Valuations don’t matter if the stock has a nice looking chart.
It would seem as though an easy way to make money would be to “short”* these stocks when valuations get stretched. Many hedge funds and institutions tried this strategy with Tesla, and Netflix. How can a car company be worth that much? Or who would pay that much for a movie streaming company? Well, as I’ve learned in this business, it’s what you don’t know that can really hurt you. Investors in those stocks don’t consider Tesla a car company, but instead a technology company that makes cars. Netflix investors aren’t focused on the profits from the streaming service as much as they are the massive data that Netflix gathers on their subscribers. Easy money on wall street? In my experience there is no such thing.
Common sense, diversification and investing for the long run are all time tested strategies that we believe in and use for our clients. Chasing new investment strategies, no matter how promising they look, can lead to disastrous results.
*shorting a stock entails selling it, even though you don’t own it, with the promise you will buy it back later; presumably at a lower price.