Understanding this quote holds the key to investing in stocks in 2022.
What does ‘voting machine’ and ‘weighting machine’ mean?
By weighing machine, Ben Graham meant stock prices will move based on fundamentals alone…in the long run.
By voting machine. he meant stock prices, in the short run, are driven by people’s emotions: Greed and fear.
This raises the question, what drives the emotions of greed and fear in the stock market?
Here’s the answer…
Narrative is the fuel for greed.
Uncertainly is the fuel for fear.
We have seen narratives in all their glory in 2020 and 2021. Narratives i.e. stories were spread far and wide about the economic recovery and why you should put all your money in stocks.
People believed the stories. Investors and traders alike thought the market could only go up.
But 2022 has seen uncertainty take hold.
After bottoming out in March 2020, the stock market has been on a relentless rally. From a level of 7,600, the Nifty soared to 18,500 by October 2021. A gain of nearly 2.5 times in a little over 1.5 years.
It was truly a spectacular rally. Never has the stock market gone up so fast, so much, for so long, without a meaningful correction.
But things have changed now. The market is behaving very differently. It’s no longer being driven by the emotion of greed.
Fear, driven by uncertainty, is now in charge.
And accepting this reality is the key to investing in 2022.
A Demanding Stock Market
If fear is the dominant emotion, doesn’t that mean stocks will go down?
And if so, shouldn’t you sell and stay on the side lines? Or even better, short the market?
Alas, it’s not as simple as that.
People like to think in binaries. 1 or 0. Yes or no. Good or bad. Right or wrong. Up or down.
This kind of binary thinking certainly helps to simplify our decision making. It’s fast. It frees the brain from additional hard work.
It’s also useful in many situations in life when deep thinking is not needed.
This is true in the stock market too. Often, Mr Market will offer you a great deal like it did in March 2020. In such situations, your decision buy or sell is very easy.
But most of the time, the stock market does not offer you such simple buy/sell opportunities. Most of the time, you will have to put in a lot of thinking effort to make sense of what’s going on.
And that is not everyone’s cup of tea.
This is what you face in 2022. The year of 2022 will likely go down in history as the year of uncertainty.
And that means, the stock market today demands higher-level thinking. Simple statements like, ‘The market will crash’, or ‘The market will go up’, are unhelpful.
The volatility in the market is so high that it’s impossible to predict stock prices with any certainty.
Anything could happen.
The market might stop falling tomorrow.
The market might stay flat instead of going up or down.
The market might fall some more but just when the bulls have given up, it could reverse and start to rise again.
Or the bears might finally win and the market could crash.
Which of these scenarios is most likely?
No one in the market, not even the so called ‘experts’ you see on TV every day, can answer this question. The market is in a situation now where any number of possibilities are on the table.
And all this is just for the short term. If you were to think about the long term, then there are even more possibilities.
What’s the Solution?
Ever since the crash in 2020, the bulls have not faced even single serious market correction. Even the second covid wave didn’t result in a crash.
The market has relentlessly transferred money from the bears to the bulls for a year and a half. As a result, the bulls are sitting on enormous amounts of money…and they don’t want to lose it.
This is perfectly natural. The richer one becomes, the more one worries about losing it all.
And that explains the recent nervousness in the market.
Sure, there are other reasons too – inflation, rising interest rates, many geopolitical worries (Ukraine, Middle-East, Taiwan), another covid variant, GDP growth falling short of expectations, and more.
But most important of all is the fear of losing all the gains made since March 2020. Investors have made so much money, so fast, they’re unsure what they to do now that the market isn’t going up.
What Should You Do?
There are two parts to the answer. It all depends on what you want to do in the market.
Do you want to trade or do you want to invest?
If you want to trade, the answer is to develop a good trading system and constantly evaluate it.
You also need a rock-solid risk management process to prevent losses.
Your trading system will tell you how worried you should be. If it’s screaming warning signals at you, then you should take your money out of the market. If not, you can hold on to your trades.
But you must have a stop loss in place, no matter what.
If you want to invest, you will need to follow a good investing system. Your system must consider your investing objectives, risk appetite, and time horizon.
Here are some pointers…
Be prepared to buy high quality stocks in 2022. If the market suffers a crash, even the fundamentally strong stocks will crash.
And that will be a great opportunity to buy high-quality stocks at a reasonable price.
You can find stocks like these in the Equitymaster Stock Screener. It’s very user friendly and you can create your own customised watch lists.
Also, you need to stay away from fundamentally weak stocks. Don’t invest in any company that’s making losses.
Equitymaster’s co-head of research, Rahul Shah, has prepared a list of what he calls toxic stocks of 2022. You should avoid all of them.
Watch Rahul’s video for more…
Avoid high debt companies. Corporate India is in a debt re-payment phase. If the companies you’ve invested in still have too much debt, then it’s time to re-think your portfolio.
And here’s something important. Be very selective with smallcaps.
If you’ve made money in smallcaps in this bull market, and want to continue investing in them, we have some words of caution.
Your task will be difficult in 2022. The easy money in smallcaps has been made. The low hanging fruit has been plucked in 2021.
If there is a crash, smallcaps will be ones to fall the hardest. Keep that in mind. Remember, your hard-earned money is at stake.
Having said that, there are still some great buying opportunities in the market. It’s just that you will need to be very selective with smallcaps in 2022.
Change Your Strategy
The bulls made so much money, they become overconfident. Some investors believed the market would keep going up in 2022 and beyond. And any correction will be small.
The market has already proven them wrong.
And that’s why we recommend a change in strategy.
In the bull market, almost every stock you bought went up. But that won’t be the case anymore.
The market has woken up to the reality that many stocks, even fundamentally strong bluechips, are very overvalued…and they cannot sustain their high PE ratios.
But it’s just about specific stocks. The entire market is at risk of a serious correction. Not the 5-10% variety we’ve become used to…but a meaningful one.
We recommend you become very strict with your investment process. You must have very clear pre-defined rules for buying and selling any stock in 2022.
Your pre-defined rule for buying could be investing in a growing, fundamentally solid company at decent valuations. This rule will be very useful in a correction.
Your pre-defined rule for selling could be to exit when the fundamentals take a turn for the worse or there is an adverse, structural shift in growth.
These two rules, along with the pointers above, should help you not only avoid bad stocks but also buy high-quality stocks in case of a market crash.
Investing in 2022 won’t be the same as 2021.
It won’t be year of investing blindly in the stock market. Your chances of losing money are higher compared to last year.
Thus, you will need to be more cautious. Pay more attention to fundamentals…and to valuations.
Be prepared to handle a lot of uncertainty.
And finally, don’t forget the right asset allocation. This is what Equitymaster recommends.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
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