Market Volatility—What’s Happening?

By Geoffrey Moore

Author – The Infinite Staircase: What the Universe Tells Us About Life, Ethics, and Mortality

As we begin 2023, the stock market pundits are all talking about how much value all the tech stocks lost in 2022. From at least one perspective, the true answer is, none. Apple still has all its products and all its transaction businesses and its retail outlets and its great brand. Amazon Prime still has a firm hold on your paycheck, Facebook still has 3 billion users, and Uber is still driving Miss Daisy wherever she needs to go. These companies did not lose value. Rather, their value got revalued.

This is not about management, in other words. It is about investors. And that includes you and me. We revalued their stocks, not management, not the partner ecosystem, and not customers and prospects. Now as we know all too well, this has worked out badly for us, so it behooves us to ask, what were we thinking? Why did we do this? And if we didn’t do it, then who did?

To get this straight in our minds, we need to go back to first principles. A share of stock entitles its owner to a share of the future earnings of the enterprise. The value of a share of stock is based on the investor’s perception of the future prospects of that enterprise. In mature categories, inertial momentum is the best predictor of future results, so analysts inspect quarterly performance intensely in search of signals that momentum is changing, either up or down. Stocks trade at low single-digit multiples of revenue, and the focus is on earnings more than growth. Two key performance predictors are company power, calibrated by market share, and offer power, calibrated by sales of new releases, new store sales, or the like. 

Changes in mature categories unfold rather slowly, which means their valuations are not volatile. That is why in turbulent times, there is a retreat into these stocks. For example, IBM is outperforming virtually all the high-flyers in the tech sector this year. This is not because IBM has done anything particularly amazing. It is because investors at the beginning of the year did not assign high-growth expectations to it, so it had little ground to lose. For the time being, that is, it is being treated more like an industry, its valuation tracking to GDP as much as anything else.

OK, so why do all the “cool kid” stocks get such a different treatment? It’s because they are in growth categories, ones that are attracting hordes of new customers who are buying in or buying up in a big way. This means the future prospects for their earnings are potentially much higher than those in a mature category, which means owning a share of those future earnings is more valuable. How much more valuable? Well, there’s the rub. Investors are absolutely horrible at getting this right. They overshoot every single time. Why? Because all of the short-term incentives encourage them to do so.

Specifically, what they do is build increasingly improbably best-case scenarios in which category power, company power, offer power, and execution power all combine to create exceptional returns. Sooner or later, the credibility of these scenarios gets disrupted by the real world. Zuckerberg overreaches by renaming Facebook Meta. Musk overreaches with his mercurial edicts re Twitter, which also destabilizes his almost godlike credibility with respect to Tesla. Geopolitical forces impinge as well, as do financial market fluctuations, and sooner or later the bubble is bound to burst.

Ah, so then the bear investors are the best bet, right? Not on your life! Bear investing is based on knowing when to call the popping. That is, it entails shorting a stock. If you were such a thing as an indefinite short, then bear investing in bubble times would be great, but there isn’t, and if your stock’s reckoning has not come by the time your option expires, you are the one who gets reckoned with. It turns out bear investors are no better than bull investors at getting their timing right.

So, is there anything we amateurs can do to come out of this successfully?  Fortunately, the answer is yes. Two proven principles are buy-and-hold and portfolio diversification, both of which financial advisors can help us with. The strategy behind the second one is pretty obvious, but why is the first one a good practice? The idea underpinning buy-and-hold is that you are investing in fundamentals that will outlast the ups and downs of valuation volatility. Electric vehicles will displace gasoline-powered cars. Artificial intelligence will continue to make inroads into manual business processes. Video-enabled remote work will persist in one form or another. Companies that have strong positions in these categories are likely to be winners in the long run. Yes, they are likely to get overvalued in the short run, and so yes, there will be painful years like the one just ending. But in the long run, they are swimming with the tide and can be expected to come out ahead. 

That’s what I think. What do you think?

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