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Posted by Derek Benedet on Jan 31st, 2022

Bubbles, Biases, and Broken Dreams

So far, we’ve had quite the rollercoaster of emotions for investors this year, with many markets on the verge or even dipping their toe into correction territory. The recent large intra-day swings may make it seem like we’re nearer to the elusive capitulation day that often marks a bottom, but history would suggest such days are basically impossible to know in real time.

With volatility elevated, the risk of being wrong seems more punishing than at any point over the past 20 months. Conviction is important when investing, but conviction in and of itself means nothing if it’s not founded on rational decision making. Investors have short memories and are most captive to recent experiences. Buy the dip—wash, rinse, and repeat. The habit has been simple, reinforcing, and rewarding, most notably for a swath of new investors.

Bursting Bubbles

Looking back, it’s now clear that most high-growth/non-profitable tech stocks were in a big bubble. Well, the bubble has most definitely popped. This isn’t just a routine correction for this segment of the market. Oddly enough, we’re approaching the one-year anniversary of peak meme stock mania. Last January GameStop (GME), AMC Entertainment (AMC), Blackberry (BB), and other names rose on the back of blog posts on Reddit and other platforms, cementing the term ‘meme stock.’

Companies rose based on how they could change the world. Since then, the road has been anything but paved with gold and filled with Lambos. Sure, some fortunes were made, Deep F’n Value had a memorable time in front of Congress, but the drawdowns for the highest flyers have been horrendous. The meme stock craze is done. For some time, investors clamored to own the worst companies—that delusional market idea appears to be dead.

Chart showing meme stocks

Over the past decade, there have been a number of localized bubbles that have burst, but none have the broad market risk of contagion quite like the potential of a mega-cap growth stocks going out of favour. Easy money, cash on the sidelines, and low interest rates have always been there for the rescue, but with rates rising and financial conditions becoming less accommodative, the path of least resistance appears now to be lower.

We’re not saying investors shouldn’t stay largely invested, because the risk of being out of the market if this is just a normal correction can be just as painful. But we would argue for the return of reason, investors should once again pay attention to valuations, scale back exposure to high-growth industries with overly optimistic growth assumptions, and instead refocus on portfolio allocation with balance in mind. The predicament many investors are finding themselves in is that they are still overpaying for growth. This is rooted in a couple of behavioural biases.

Overconfidence – Sometimes called the superiority illusion. It’s a tendency for most people to believe that they are above average—whether  for their intelligence, sense of humour, driving ability, or investment skill—despite it being mathematically impossible for the majority to be above average. In investing, the overconfidence induces investors to take riskier bets. When markets have rewarded this type of risk-seeking behaviour, it only magnifies the optimism.

Overoptimism – Over-optimistic people will have an unrealistic expectation of how often they’ll get a good result versus a bad result. Strong recent performance makes it easier to feel optimistic about the future. Unsatisfied with just average market returns, these behavioural biases entice investors to increase exposure to risker investments.

Overoptimism can encourage excessive risk taking

These biases also cause increased trading activity. The gamification of many of today’s online trading apps/sites is meant to further increase transaction volumes. Lowering transaction costs usually is presumed to increase investor welfare; however, reducing the marginal costs associated with trading stocks may have the perverse and counterintuitive effect of decreasing investor welfare.

High earnings multiples are often a manifestation of high confidence, not necessarily strong earnings prospects. 2021 was a year with exceptionally high earnings growth and stock returns. Looking back into the past, this growth will be hard to follow up. The change is proving to be the undoing of growth investors reminded that high growth is the exception, not the rule.

S&P 500 EPS growth and price performance

When returns are easy to come by, it’s all too easy to be convinced of your own abilities. These hardwired biases are hard to eradicate especially when good performance only reinforces them. Often the best course of action is to follow simple advice: diversify and rebalance when necessary.

Prices matter, but a cheap price is not the same as value

The battle between Value and Growth will likely be drawn out for some time. There is a lot of room to make up and we would not be surprised to see higher market volatility as the two factors battle it out. Obviously, we have no idea if the bottom is in, but the excesses seen over the past couple of years are being let out and it’s a process that can take plenty of time. Interestingly, Canadian inflows into dividend-focused equity ETFs, which heavily tilt towards value continue to be strong, with the category adding over $240 million last week after adding over $110 million the week prior. All it takes is a change in investor appetite to cause one factor to fall out of favour.

Canadian Equity ETF flows by type

Valuations have begun to matter, but there is a big difference between what is truly cheap and what is actually just down. This may not be the same thing. Rather than just looking at what stocks have fallen the most, focus on areas of the market that have enduring and sustainable growth. It’s good practice to have price targets where if hit, you should be acting. Targets and stop losses are simple ways to help take the emotion out of investment decisions and help mitigate behavioural mistakes.

— Derek Benedet is a Portfolio Manager at Purpose Investments

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Sources: Charts are sourced to Bloomberg L.P.

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Derek Benedet

Derek is a Portfolio Manager at Purpose Investments. He has worked for the past sixteen years in the investment industry with experience at CIBC Wood Gundy, GMP Securities as well as Richardson Wealth. He is a Chartered Market Technician (CMT), a designation obtained through expertise in technical analyses and is granted by the Market Technicians Association. His unique investment approach combines technical analysis, quantitative finance and fundamental analysis.