The Double-Edged Sword of Market Confidence
The recent popularity of high-beta coefficient securities and the general bullish market sentiment may dictate the health of the world economy in the near future.
Keith Patrick Gill, also known as “Roaring Kitty,” reportedly turned $53,000 into nearly $50,000,000 in a span of about two years through the trading frenzy and short-squeeze situation with GameStop, AMC, Blackberry, Dogecoin, and other “Wall Street Bets”-endorsed securities. With many Redditors and new retail investors attempting to match Keith’s profits through these volatile stocks, it has become clear that the trading frenzy will not be fading anytime soon. However, one thing these novel investors should keep in mind for the coming years is the risk of overconfidence.
In light of low interest rates and the resulting attractiveness of stock trading, the possibility of investor overconfidence looms dangerously in the near future. With the addition of 10 million new retail investors in 2020 and the popularity of high-beta coefficient stocks like Tesla (2.09), NIO (2.79), and AMD (2.21), in addition to volatile Reddit-hyped stocks, a market correction may devastate the economy at large. A market correction may also lead to substantial capital losses for novice investors, as increasingly popular high-beta stocks display high price sensitivity relative to the performance of the market.
While it is impossible to accurately predict the exact timing of the next market correction, the likelihood of a correction occurring in the next two years is very high. During a market correction, high-beta stocks will sustain price changes that roughly coincide with the movements of the general stock market. In other words, stocks with a beta value of 2.0 will drop roughly twice as much as the general market drops.
To counteract such disaster, a portfolio rebalancing featuring the transition to lower beta stocks (closer to 1.0) and safer choices of blue-chip or defensive investments may assist with the next economic downturn in the business cycle. Although seemingly contrarian at the moment, the anticipation of the future correction may soften or even deter the possible downfall of our current bullish market sentiment.
However, this brings us to another dilemma. On the basis of high speculations, blind following of trading fads, and the ignoring of traditional metrics of stock analysis, it has become difficult to conclude whether or not we have actually learned from our past mistakes. It is quite unnerving that the premise describing irrational behavior in the stock market refers to, in some way or another, the current stock market situation, as well as the 1995–2000 period that followed the burst of the dotcom bubble. The current massive speculations present in SPACs, the EV industry, and the cryptocurrency market especially resemble the same speculative behaviors exhibited in internet-related companies in the late 1990s. Combined with no consideration of price-earnings ratios or beta coefficient values, much of this speculation was based solely on the potential returns that the internet sector offered to high-return investors rather than the certainty of calculated growth backed by proven earnings. Because of most investors’ overly-bullish market sentiments, many venture capitalists, hedge funds, and retail investors were willing to overlook the metrics signaling apparent overvaluation. They followed the internet stock trend with no hesitation.
According to Alan Greenspan, the former chairman of the Federal Reserve, and Robert Shiller, the Sterling Professor of Economics at Yale University, the price increase attributing to the rise of the dotcom bubble was hugely driven by “irrational exuberance” among individual investors. Irrational exuberance refers to the state of mania in the stock market, where investors are so bullish that their market optimism lacks the foundation of a sound fundamental valuation and is instead based on inflated expectations for the future. While the current stock market has not yet reached the level of “irrational exuberance” encountered in the dotcom era, an extended disregard for fundamental valuation metrics may result in a replay of the bubble buildup. In fact, one security that has come to light for “irrational exuberance” in modern times is bitcoin. It has become tremendously popular in recent years and has even reached a market capitalization of about $880B despite the lack of assets to justify the cryptocurrency’s value.
Nonetheless, there is another side to this story. “A combination of loose monetary and fiscal policies previously unleashed to tackle the COVID crisis and an expectation of increasing GDP reflected in asset prices and economic indicators stipulate an increase in demand (and therefore economic activity)” and a bright future for the economy in 2021. As for the high-beta coefficient stocks, the most popular decision to be made from a risk-reward perspective meant to obtain the highest amounts of profits rapidly in this kind of bullish market is to utilize the aforementioned high-risk securities. While a drop in the market may translate to a twofold drop for a stock with a 2.0 beta coefficient, a 10% increase in the broad market may translate to a 20% increase for that stock. For this very reason, aggressive risk-taking behavior is prevalent among many nascent investors. In fact, many investors who were brave enough to explore stocks with a high beta coefficient may have also dabbled with options and futures, and reaped tens of thousands of dollars through those high-risk strategies.
So as to not miss out on the huge potential for return in the current market climate, participating in stock trading/investing is still important. It is simply a matter of weighing the expected return given the risk of invested securities such that any investor can benefit from the market’s favorable directions without leading to significant overvaluation of assets or industries. Protecting oneself against a market overcorrection boils down to diversifying one’s investment portfolio and adjusting for the market risk that high-beta coefficient stocks, options, and other risky financial instruments have to offer.
Investors should seek to reap the benefits of our current economic climate but tread lightly. Carefully assessing systematic risks, expected returns associated with said risks, and analyzing the fundamentals of security analysis is imperative to avoiding another bubble and major crash. Who knows? Perhaps you, the reader, are capable of becoming the next Warren Buffett if you strategically take advantage of market overcorrections and market inefficiencies.
