The Randomness of the Stock Market in the Short Term, and Jason's Gloomy Prediction

Jeff’s Random Words

When Jason and I decided to do the Smattering Portfolio contest back in December it was a thing we thought would be fun and could raise some money for some charities. It also allowed us to build in some opportunities to talk about stocks. We like to talk about stocks, but that’s not what the podcast is about—so having that scheduled reason to do it felt right.

What I wasn’t expecting was how much it would serve to illustrate how irrational the market can be in the short term. Nothing I’ve seen this year in the portfolio was surprising, but having such clear examples was helpful in solidifying my thinking around concepts I already understood.

Here are 3 takeaways I have about the Smattering portfolio after the first 9 months of the year:

3 quarters, 3 winners

We award a winner each quarter. That’s the portfolio with the best return (including dividends) for those 3 months. We’ve had a different winner each time. Additionally, the winner in Q3 was a portfolio with a return of negative 7.7%. A lot can happen in 3 months, and none of it could make sense.

Lots can happen with no news

One of the worst-performing stocks in the entire portfolio is one of my picks, Outset Medical (OM). Stocks moving after earnings makes sense, and that certainly happened to Outset after it reported its Q2 results. The stock dropped 10% the next day mostly on news that the company was halting the sale of one version of its product in order to submit it to the FDA for additional clearance. This wasn’t required but was something the company chose to do.

That all makes sense, but here’s what doesn’t. Since the market close on August 3 (the day after the results), the stock is down an additional 42%! There’s been no news from the company since then. Is Outset a 42% worse company now than it was on August 3? Unlikely. Time will tell where this goes, but the takeaway for me is how much can happen in such a short amount of time with no business news.

Understanding volatility

One of Jason’s picks, Lemonade (LMND) has had a wild ride this year. It was down 21% at the end of April and then up 65% at the end of July. On the other end of the spectrum is MercadoLibre (MELI), which has hovered between a gain of 40% and 62% throughout the first three quarters.

To some degree, this makes sense. Lemonade was admittedly Jason’s “moonshot” pick. So the range of outcomes was expected to be wide. I’m a little surprised MercadoLibre has been as consistent as it has been.

The point is that it’s generally a good idea to have an understanding of how volatile a stock is, especially if you’re sensitive to volatility. If large drops freak you out, you should know the likelihood of large drops for the stocks you own. One simple if imperfect way is to look at a stock’s beta. I own Lemonade and it helps me to know that wide price fluctuations are to be expected so that I’m less prone to react irrationally to a sudden drop (or rise) in share price.

Again, none of what I wrote here is new or especially insightful. I was just struck by how effective the Smattering Portfolio has been in demonstrating some simple ideas we all know. What about you? Are there any insights this portfolio contest has made obvious or visible to you? Let us know via comments on this newsletter, email, or The-Platform-I-Refuse-To-Call-X.

Jeff

Jason’s Random Words

Nick Santoro might be my favorite person on earth. He basically put Jeff in a position where he had no choice but to buy shares of Tesla (TSLA), a company Jeff has said he would basically never invest in when the stock price was half what it is now. If you’re not sure who I’m talking about, listen to this week’s podcast, Episode 73. It’s at the end, and pretty great.

I’ve been thinking a lot about interest rates lately. And honestly I don’t think enough investors really are. Cost of capital is a real thing, and most companies borrow money, pay a dividend, or both.

For the companies that pay a dividend, many have benefitted from multiple expansion (the stock’s valuation being above historical averages) over the past decade, because equities became the only game in town to capture a decent yield. 2020 and 2021 were extreme examples, but the decade before the pandemic were incredibly cheap-money years, too. So companies saw their stock prices get bid higher as more money moved out of debt and into stocks.

Other companies — sometimes the same companies — benefitted from cheap interest rates to borrow money to grow quickly. The rub: Corporate debt is almost always interest-only. Remember, bond issuers have to repay borrowers their money at maturity. As a result a lot of companies are facing a big increase in debt expenses in the coming 3-10 years; frankly most of them won’t be able to repay the debt and will have to roll it back out, at a much higher interest rate.

Companies will have to come up with the money to bridge the gap. Profit margins will shrink; cash flows will take a hit. In some cases, dividend growth will take the back seat. In other cases, dividends will start getting cut or even eliminated.

No matter what happens, I fear that many stocks will see the higher premium they got over the past 12-14 years start to disappear, too.

Don’t get me wrong: I’m not calling for a big market crash. But I do think investors in stocks have underestimated they’ve profited from low interest rates, and may be similarly underestimating how higher interest rates could impact their stock returns.

What am I getting at? Figure out what you need to have at the end of your financial journey, and then be conservative with growth rates and stock market returns when figuring out how much you need to contribute. I still hear people expecting to earn 12%+ annualized returns going forward. That’s not impossible, but coming out of such a wonderful decade-plus, and losing some very favorable tailwinds that are turning into headwinds, I think now isn’t the time to expect above-average returns for stocks over the next 5 years or more. I hope I’m wrong, but I’m also planning to increase how much I am investing, just in case I’m right.

Jason