A Lesson From an Investing Legend Tells Us Why One Headline Could Send the Markets Tumbling

Sometimes, it's good to put things in perspective...

When I was growing up, one of the things I most enjoyed doing was collecting and looking at maps. It wasn't just about knowing where my family was heading on vacations... it was about understanding the scale of the world. 

When you dive into geography, the most eye-opening things are the direct comparisons that can give you a sense of scale. For instance, Lake Baikal in Siberia may not look large relative to other lakes. It's less than half the surface area of Lake Superior. And in the midst of the map of Siberia in Russia, it can look tiny.

Yet because of how deep it is, Lake Baikal's water volume is equal to all five of the Great Lakes combined. It's the second-largest lake by water volume in the world, only behind the Caspian Sea. 

That type of context is useful not just in geography... It's also relevant when looking at stocks.

Big names like Apple (AAPL) or Microsoft (MSFT) swinging 2% might seem to be nothing to blink at when the broad market is rallying or selling off. But because of the staggering wealth now concentrated in a handful of mega-cap stocks, it means the market is expecting creative destruction on a massive scale.

When shares of trillion-dollar companies like Apple or Microsoft drop 2%, that's $30 billion of market cap wiped out. That's HCA Healthcare (HCA) – the largest public hospital company in the U.S. – vanishing... or retailer Ross Stores (ROST) going out of business. And that's roughly the equivalent of both Delta Air Lines' (DAL) and Southwest Airlines' (LUV) market caps being wiped out.

While investors may initially focus on that move as small as a percentage of Apple and Microsoft's stock prices, what it means in terms of changing expectations for cash flows is staggering. And it helps bring into context why smaller companies can offer such significant upside potential. 

As investors, we don't blink at $30 billion swings in Apple or Microsoft's market value.

But if Gartner (IT) – a consulting, research, and data company that's widely respected by corporations across the globe – saw a $30 billion increase in value, that would mean its stock was up 300%.

If the widely used referral platform Yelp (YELP) saw its market cap rise by $30 billion, that would mean 2,000% upside for the company's stock. 

Regular Altimetry Daily Authority readers know that we often talk about companies that aren't already massive. Our Altimetry's High Alpha paid newsletter focuses on smaller firms with big upside potential as well... and we're exploring a future offering with an even smaller market cap size.

This perspective helps highlight why. By focusing on businesses beyond the mega-caps, we can find the ones that need to do a lot less – relative to market expectations – for them to have significant upside potential. But for a company like Apple, it has to do a lot – such as create $30 billion in value – just to move its stock 2%.

There's an age-old saying about the markets...

It all started in legendary value investor Ben Graham's coveted 1934 book, Security Analysis.

In it, he explains that the stock market "is not a weighing machine," but rather it's a "voting machine." 

According to Graham, since investors use both logic and emotion to make decisions, the market itself acts more like a popularity contest or a voting mechanism than it does like a calibrated, scientifically accurate scale. 

Many years later, Graham's star student Warren Buffett took this concept and adapted it to the form you've probably heard today. 

Starting in the 1970s, Buffett has often touted the saying that "in the short run, the market is a voting machine... but in the long run, the market is a weighing machine." 

Though he attributes the sentiment to Graham, Buffett's explanation is slightly more refined based on the quotes we have today.

That said, Graham's original statement laid out a fundamental debate within finance that still holds true today.

At its basis, the stock market is just that – a market.

It's a mix of buyers and sellers bartering over stocks, bidding and asking for prices until they can complete a transaction.

Like most markets, it's driven by supply and demand... which can fluctuate in the short term.

On any given day, for any number of hours, an imbalance of buyers or sellers can send a particular stock – or the market as a whole – up or down.

It's a lot like a popularity vote in the short term.

Over longer periods of time – weeks, months, and years – the effect of any short-term "voter bias" tends to be washed away.

A stock could have a few buyer-friendly days one week and seller-friendly days the next... but over time, these tend to trend towards the underlying company's intrinsic value. This is why the market turns into a weighing machine over long periods.

Buyers and sellers generally have a perception of the value of the companies they want to buy or already own... hence why the further out your perspective, valuations and company fundamentals tend to shine through. 

While we would argue that the long-term perspective tends to be more valuable – especially for value investors – it's still important to understand how the market works in the short term.

Short-term swings can cause great market dislocations that savvy investors can take advantage of. 

If you have a stock that's dirt-cheap and getting cheaper, it's often not just valuation or fundamentals that are causing the stock or market to drop – it's also growing bearish sentiment.

If investor attitudes are pushing the stock or market too far – if it's cheap relative to its fundamentals – that can mean it's a great time to buy shares. Once the market finally starts acting like a weighing machine again, that can make the stock's rally even more dramatic. 

The same thing works in reverse... Buyers sometimes become euphoric when they see a stock rising quickly, even if it's already overvalued. This eventually can set up a dramatic price correction. 

These swings happen because eventually the incremental buyers start to dry up... Everybody who wants to buy the stock at that price already owns it, and nobody can find a trading partner.

The same phenomenon is also true for the broad market.

As we highlighted in the June 29 Altimetry Daily Authority, the market is currently being priced at an all-time high when you look at our Uniform value-to-asset (V/A) metric, currently sitting at 2.9 times.

At these levels, the market is priced for perfection. Investors are expecting a full recovery to pre-pandemic economic activity without a hitch. Overall, sentiment is on the higher end of the spectrum... especially compared to the last few months. 

While positive sentiment is generally good, as we mentioned, it sets up the risk for a quick, headline-driven sell-off when marginal buyers dry up.

We've discussed in previous Daily Authority issues that we could see troubling headlines in the coming months for several different reasons. It could be the "Big Bath," another spike in coronavirus cases, or political drama.

In any case, as an investor, you should recognize that it's part of the short-term voting mechanism that Graham described almost 90 years ago... and it's not necessarily reflective of the long-term value of the stock market.

Regards,

Rob Spivey
July 6, 2020