Emotion vs. Fundamentals – What Drives Stock Market Performance?

This month’s sharp selloff in technology stocks highlights how quickly investor sentiment about a given sector of the stock market can change. Technology shares dropped as investors rotated out of these higher growth names and into more value-oriented sectors of the market. While there were a few drivers behind the recent pullback, notably the data leak out of Facebook, the majority of the selloff seems to simply reflect a shift in investor sentiment. Investor sentiment can turn on a dime and in the short-run can dominate market fluctuations. However, in the long-term these emotional factors tend to cancel each other out and the underlying fundamentals of a given company really drive performance.

As the father of value investing Benjamin Graham said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”This month’s sharp selloff in technology stocks highlights how quickly investor sentiment about a given sector of the stock market can change. Technology shares dropped as investors rotated out of these higher growth names and into more value-oriented sectors of the market. While there were a few drivers behind the recent pullback, notably the data leak out of Facebook, the majority of the selloff seems to simply reflect a shift in investor sentiment. Investor sentiment can turn on a dime and in the short-run can dominate market fluctuations. However, in the long-term these emotional factors tend to cancel each other out and the underlying fundamentals of a given company really drive performance. As the father of value investing Benjamin Graham said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Chart 1

Over the past year, even after the recent pullback, the market sentiment around high-growth industries has been euphoric. The performance gap between growth and value stocks over the last year is one of the widest in history. Growth stocks are up 16.09%, while value stocks have only risen 3.95%. This outperformance has driven many investors to shovel more money into high-growth areas of the market, as they extrapolate outsized returns going forward. The difficulty with this strategy is that many of these stocks are not trading on the current fundamentals of their business, but on their “tremendous growth potential” moving forward. As the market has shown us time and time again throughout history, betting solely on a company’s potential is a risky proposition. As Allegiant’s COO Paul Cantor CFA, CFP®, AIF® wrote about in The Investment Derby, over long-time periods value stocks actually outperform growth stocks (see Figure 2). So, while value investors may be kicking themselves right now, it is wise to recall that chasing performance of certain stocks is quite dangerous, as the time when sentiment is the highest often turns out to be the peak in their share price. 

Chart 2
At Allegiant we avoid injecting emotion into our investment process and never try to chase the newest hot stocks, focusing instead on identifying quality businesses with strong underlying fundamentals. This can lead to periods of underperformance, like we experienced in the Tech Boom of the late 1990s and the massive outperformance of high growth stocks over the last year. However, when the tide turns we are reminded that the markets may have their fads, with some sectors out or underperforming, but in the long run, owning quality companies with strong financials will ultimately provide the best performance for our clients.