I don’t normally tell readers to do this.
This morning, I want you to save this email. Or print it – stick it somewhere you’ll see it.
Because if there are three things you need to know to be a better investor, I believe it’s this (the last one is my favourite).
Here goes…
1. I believe the stock market is heavily influenced by short-term interest rates
Think of the stock market like a bathtub. The individual stocks are the floating rubber boats. When interest rates drop, water gets filled into the bathtub and lifts all rubber boats.
However, when interest rates go up, water in the bathtub gets drained into the drain plug. The rubber boat drops along with a falling water line.
For the last 15-20 years, interest rates stayed near zero. Easy money poured into the stock market that lifts all rubber boats. However, when the interest rate cycle changes, the stock market cycle changes.
In 2022, interest rates shot up. The water drained fast and forced the stock market to drop like a brick. The glamour stocks that had no profits, borrowed heavily plunged overnight. These stocks never made it back to the original water line.
2. The nominal price of a stock is not the same as its intrinsic value
Management determines the nominal price of a stock. Example: A $1,000 stock with a $1 billion market cap just means management decides to issue 1,000,000 shares for the company.
Market cap = total no. shares X stock price
What happens if that same company decides to issue 100 million shares? The price of that stock is now $10. Whether one stock trades at $1,000, or another stock trades at $10 doesn’t say a lot about what the business is worth.
In contrast, a business ability to generate future profits over its lifetime determines its stock’s intrinsic value. Find a business that has a strong economic moat. Because this protects and grows its future profits, making it reliable to calculate intrinsic value.
Likewise, a business that has a poor economic moat suffers from unpredictable profits. It’s much harder to calculate intrinsic value.
Most people worry about stocks fluctuating around certain prices. What they don’t know is prices are controlled by intrinsic value in the long run.
When you identify a high-quality stock, you want to buy them when its price trades below its intrinsic value.
3. Every bull market contains the embryo of the next bear market
There are three phases to a bull market.
First, Accumulation. Public sentiments are pessimistic, but institutional investors realize things aren’t as bad and start buying quietly.
Next, Euphoria. Corporate earnings report huge improvements, the economy grows and prices keep going up. The public takes notice and an upward trend happens.
Finally, Mania. This is retail mania. Stock prices shoot up like a rocket, with prices completely divorced from its fundamental value. Everyone is now an expert giving you a stock tip. No one questions the absurdity.
During the third phase, the seeds of the next bear market will germinate. Surging stock prices induce people to take on more risk, borrow more and ultimately misallocate capital. That’s where the danger lies.
What other things do most people don’t know about the stock market? Reply to this email and share with me!
Sometimes, investing can be simple.
Willie Keng, CFA
Founder, Dividend Titan
