How to trade the news?

The Dow Recently notched its 5th straight week of losses as the Russia-Ukraine conflict drags on.

YTD graph of DOW Jones

The question investors often grapple with during times like these is: 

Given the market turmoil, where should we invest our money?

What are the best things to buy? Oil? Gold? Growth? Value?

To answer the question of how to trade the news, I’m going to share a few observations that have informed my judgment…

John Maynard Keynes was an influential English economist whose ideas fundamentally changed the economic policies of governments, especially in the first half of the 20th century.

He observed that shares of ice companies were higher in the summer months when sales were higher. This fact is surprising because, in an efficient market, stock prices should reflect the long-term value of a company. 

Why did the predictably higher sales of ice in the summer, cause the stocks of ice companies to trade for more in the summer? Shouldn’t Ice company stock prices reflect the average sales these companies are expected to experience and not the sales they’ve experienced recently which are influenced by what season we are in? 

However, it seems this is exactly what happens in the public markets.

Companies with seasonal businesses have higher prices in seasons when their earnings are higher

Why is this?

It’s likely because investors suffer from something called Availability Bias which, according to psychologists, says we subconsciously base our decision-making on what is easily available to recall in our minds, which are often not the most probable events but the most recent ones. This means that what we’ve recently seen and heard in the news and social media tends to have an unjustifiably large influence on our outlooks for the future. Because of availability bias, we think that what we are hearing and seeing now is a permanent trend that is not likely to go away anytime soon. 

Recall in 2020 at the outset of the pandemic when the price of oil went negative and now, only 2 years later, it is nearing all-time highs.

5 Year price chart of Crude Oil

During this period, the price action of oil corresponded with the price action of oil companies. If you look at the S&P Global Oil Index, this index measures the performance of 120 of the largest, publicly-traded companies engaged in oil & gas exploration and extraction and production from around the world.  The price of this index crashed after the pandemic, but now it’s back to pre-pandemic levels.

1 Year chart of S&P Global Oil Index

In retrospect, this seems like quite an easy trade that one could have made but few actually took advantage of this opportunity. Why?

Because people have availability bias.

Allah swt says in the Holy Quran…

خُلِقَ الْإِنسَانُ مِنْ عَجَلٍ

Humankind is made of haste

Quran

We tend to put more value on what we think is going to happen soon or what has happened recently and often unfairly discount that which is probable in the long run and requires us to wait. The truth of the matter is, over time, the most probable prediction for prices after a dramatic change is that these prices will revert to their average. 

Not always, but probably.

The book “Misbehaving” by Richard Thaler refers to a study done where the best-performing stocks on the New York Stock Exchange were labeled “winners” and the worst-performing stocks were labeled “Losers”. 

They took a group of the biggest winners and losers (say the most extreme 35 stocks) and compared their performance going forward. Over the next 5 years, the stocks labeled losers outperformed the market by 30% whereas the stocks labeled winners underperformed the market by 10%. So a difference in the performance of 40% between the stocks labeled as winners and losers based on past performance in favor of the stocks labeled as losers. As long as the period looked back on to label stocks as winners and losers was long enough, say three years, the “losers” portfolio did better than the “winners” portfolio.

Now I’m not saying go out and buy shares of Blockbuster, the video rental company. Some companies are in industries that are dead or are dying. 

What I am saying is: Often, in the stock market, it pays to be a contrarian.

That is, it pays to not follow the crowd. 

When companies that are in growing industries, have low levels of debt and are clearly not going to go bankrupt, experience dramatic drops in price because of some news event or they’re simply not in style right now, going against the crowd can be very profitable.

When people are bullish on energy and bearish on tech, it’s often much more profitable in the long run to be bullish on tech and bearish on energy. 

This is why most of my portfolio right now is growth tech stocks.

For this trade to work, you need to invest with money you are not going to need anytime soon.  Don’t invest with borrowed money, that’s always a horrible idea, and you have to have a stomach for volatility. If you’re investing in a stock that is down a lot, chances are you haven’t timed the bottom perfectly and it will likely go down even more. 

So in summary, the way to trade the news profitably is often to do the exact opposite of what the crowd is doing.

Disclaimer: this is how I think about investing, it’s not personalized investment advice. Be sure to do your own due diligence.

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