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As we addressed in the Monkey and the Volcano parable, there eventually comes a time when extreme volcanic pressure releases itself all at once. Markets are no different. Extreme buying pressure over time inevitably leads to sudden eruptions that send prices falling; in many cases faster than they went up. In markets as with volcanos, energy and volatility doesn’t disappear, it simply transmutes into another form. If you’ve been paying attention to financial markets the last few weeks, you’ve probably picked up on the fact that this process seems to be playing out currently.

Netflix has been a good example of just how suddenly risk can materialize. After a steady march higher in recent years, very much in sync with the broader stock market bubble, fortunes for shareholders abruptly changed. In a matter of weeks Netflix stock was down as much as -50%, bringing the share price all the way back to where it was in early 2018. That’s almost four years of gains gone in 10 weeks. This is observation number one. When it happens, it can happen fast.

Observation number two is thinking about the psychology that’s now in play and the options shareholders are faced with. Option 1 would be to sell the stock, take recent losses, and move on. Of course, this would make sense if the investor felt there was more downside ahead and wanted to avoid further losses. Option 2 would be to hold the shares and hope for a recovery in price. This of course would make sense if the investor felt the business prospects were still good for Netflix, the share price was fair, and the recent volatility was short-lived.

Although these options seem pretty straightforward and simple, getting there isn’t quite so easy. First, it’s extremely difficult to stay calm and collected in the face of a -50% decline. Investors can have a very hard time making sound long-term decisions in the face of scary short-term volatility. Emotion tends to trump logic which leads many to sell good investments at very inopportune times (The same emotional response that leads most to buy them at less-than-ideal times). For others, selling what they recently bought because it went down in price is synonymous with admitting they were wrong. As we know, this can be challenging for some, which causes them to hold onto declining investments for much longer than they otherwise should. Again, if the investment made good sense when it was made and prospects continue to look good, then this might not necessarily be detrimental to long-term success. The problem arises when this isn’t the case. Investors can have a very difficult time changing their mind in the face of changing facts and circumstances.

Finally, a mistake we see investors making repeatedly is thinking that a company’s fortunes are always reflected in and correlated with the company’s share price. They are not. In the case of Netflix, it’s possible that the company continues growing and dominating the streaming market for years to come, but the stock can still go down over a comparable period of time. How, you ask? Because the price of a stock can get ahead of itself and detach entirely from the fundamentals of the company during euphoria-filled bull markets. Coming back into sync with those fundamentals (revenue and earnings, etc.) means that the share price has to come down even as the company’s fundamentals continue to improve. This is exactly what happened with technology powerhouses Microsoft and Intel from 2000 through 2013. Although they continued to grow revenue at 5-10% per year throughout that period, their share prices were under water the whole time. It took 13 years for the over-inflated share price to get back in alignment with fundamentals, despite the fundamentals continuing to do just fine. Imagine if fundamentals actually deteriorated over that same period of time. The losses and outcome would have been much worse. Consider Microsoft and Intel a best-case scenario when a pent-up volcano finally erupts. The takeaway? The company might be fine, but that doesn’t mean the stock will be. It’s all about the price you paid when it comes to long-term return prospects.

So, what are investors in Netflix and stocks in general supposed to do? Well, the only option for those taking heavy losses at the moment is to do the best you can to override our natural wiring as human beings by keeping emotions in check and engaging in cognitive, rational thought. If the investment is still sound (not the same as the company), then it may be best to hold that struggling investment. If not, then don’t be afraid to take the loss and limit the potential for further damage. The most impactful action one can take in this moment, however, is to work through this same process to pre-empt these sudden and extreme losses. See to it that what you’re holding makes good medium and long-term sense. We’ve discussed the appeal of precious metals and other commodity categories in this regard. By contrast, the U.S. stock market indexes and those companies that play the largest role in comprising them, in our opinion, do not make good medium or long-term investment sense. That’s where the bubble is focused; the epicenter, if you will.

Regardless of how sound an investment is over the medium to long term, it can still experience scary volatility over short periods of time. A good way to think about short-term market volatility within the context of our volcano parable is sound investments may also get hit when the volcano erupts. The difference, however, is that while stocks (and other extremely overpriced assets) get hit with the lava, sound, fairly-priced investments get dusted with a little ash. We can survive a little dust from a lower, cooler, vantage point and be back on our feet in relatively short time; so long as we don’t panic, run frantically away from the mountain, and trip over a rock.

There are many more Netflix’s out there; most at risk of getting hit with lava. On the other hand, there are plenty of investments that offer a better opportunity for survival, and once the dust settles, for success. Stay prudent, then stay patient; in that order.

Editor’s Note: This article was originally published in the February 2022 edition of our “Cadence Clips” newsletter.

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This blog is provided for informational purposes and is not to be considered investment advice or a solicitation to buy or sell securities. Cadence Wealth Management, LLC, a registered investment advisor, may only provide advice after entering into an advisory agreement and obtaining all relevant information from a client. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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