▶ Full Post Text
I'm sure many of you already know this, but if not, it might help provide a little context around huge market swings and drawdowns. There have been plenty of them over the past year and there are a lot of people here that take a high level view of value investing as "buying the big dips, with a P/E + historical fundamentals check." I've made this mistake and I definitely will again...
The market is a different animal today than it was even 10 years ago and incredibly different than it was 20 or 30 years ago. This is mostly from three big changes: **passive investors,** and investing strategies made possible from technological advancements, **quantitative/algorithmic trading** (DE Shaw, Two Sigma, AQR etc.) **and multi-manager "pod shop" hedge funds** (Citadel/Millenium/Balyasny etc.).
These strategies have an incredible amount of capital and utilize significant leverage to enhance that capital meaning they command a huge portion of the daily trading volume and effectively set prices for stocks, especially after news/catalyst events and quarterly earnings. **In general they have extremely short time horizons. They cannot hold through volatility or uncertainty. It's a shoot first ask questions later philosophy.**
A PM at Citadel or Millenium will get their capital stopped out and fired if they have even a 10% drawdown for 3 months. That risk limit is usually algorithmically driven, no chance to say this is an overreaction in my sector, it will turn around, they're just fired. Many of them actually trade on short term fundamentals, but **they cannot wait for a turnaround that's longer than their career risk of 3 months.**
So a company doesn't report the earnings that these pod shops expected with all their data, they immediately sell out indiscriminately. Stock goes down 20%, any trading strategies that sell based on technicals and volatility sell out too, amplifying the move. The stock is now deeply in the red.
The passive strategies don't necessarily have to sell, but the stock is now a smaller part of the index so it's passive flow tailwind is smaller.
The closet indexers sell out next because they don't want to be holding the dog of the S&P, they never had differentiated conviction anyway and now that the stocks down maybe it's not as strong as they thought.
Any growth investors don't like declining growth, any quality investors question the quality of the business. The 1-3 year hold HFs might just wait for another bite out of the apple at a lower price. **All those fundamental investors might not have questioned as much if the initial move was less violent absent leveraged pod shops and quant trading**. **I've heard countless investors that have 30 years of experience talk about the violent volatility following earnings over the past couple years, they're all mindful of this new structure in either the way they invest/size positions or their focus on behavior and how they react to volatility.**
Those selling parties all have significantly more capital than truly long term fundamental value investors that are willing to stomach volatility. Those investors cannot possibly outweigh the simple supply and demand dynamics between those that want out of the stock and aren't thinking about it's fundamental value over the next 3-5 years.
So you can either try to play the volatile trading game or expand out your time horizon over a multi-year timeframe. If you're not comfortable with a longer holding period you might want to alter the types of companies you invest in or research them deeper.
**Basically, I would not be surprised with any stock going through negative revisions, an evolving narrative, or even just uncertainty to have deeper drawdowns than you would expect and to take longer to rebound than you would expect/hope.** Obviously, the value traps will have the same initial pattern as great opportunities, but even the great opportunities can get much, much cheaper before things turn around. I don't want everyone to get conviction in shit companies that deserve to be down right now and could grind lower for years, but I also think there are a lot of commenters here or elsewhere that immediately label something as a value trap just because it keeps falling. There's some weird level of pride people feel in not investing in what's getting crushed even if they've done very limited research, they're validated by their 2 minute "value trap" assessment. Who cares. Stop the "I told you so" posts.
**My suggestions, take 'em or leave 'em, I'm not some value/fundamental investing guru:**
1. Expand your time horizon, time horizon and behavior are basically the only advantages a retail investor can have. Either be a ruthless trader, or don't buy a stock you're not comfortable holding for multiple years and have a real thesis on it. The average investor does something like 10 minutes of research before buying a stock...
2. Don't buy a company **just** because it's down 20%, even if the fundamentals look good to you.
3. With any stock, know it can drop another 50% or more, maybe don't go all in after the first drop. You don't have to feel bad/FOMO in the instances where price snaps back quickly. So what you made less money, don't expect that every time. If it drops and you really have deep conviction you can average down, but you have that flexibility bc you didn't go all in. Even the best value investors I've ever heard speak mention they're often early, it's almost impossible to perfectly time the bottom with one large swing.
4. You can also buy stocks that have gone up recently... even if they're at all time highs they may reflect a good value on a 5 year timeline. Don't limit your search to daily/yearly losers. Look for value in different places.
5. If you think you've found a great opportunity that you own, continue to research it and poke holes in your thesis and be open to being wrong but people yelling it's a terrible stock don't necessarily have any knowledge of the business/value. Look for the most compelling bull and bear cases and make your decision. If you really know a business you should be able to provide a very detailed bear case.
6. There's no way anyone is going to read even half of this shit. So, if you're still here, buy Duolingo. Just kidding. Or maybe not. Just do real research on whatever company you like and be long term.