Has the Market Lost Its Mind?

Welcome to StockUp, the investing newsletter that tries to ensure all its exuberance is strictly rational. --------------------------------------------------------------------------------------------------

View this email in your browser Welcome to StockUp, the investing newsletter that tries to ensure all its exuberance is strictly rational. This week, uh, did we maybe break the stock market? Here’s why we’re not too worried about recent headline-making bursts of irrationality. Plus, five reasons, reassuring or otherwise, why the stock market’s gotten historically expensive. And after we discuss how the market’s gotten so seemingly scary, we’ll give you three reasons why you shouldn’t be afraid to invest anyway. Finally: Have you seen our new ad on TV? Let us know what you think! — Nathan Alderman, StockUp Editor IT WAS LIKE THAT WHEN WE FOUND IT, HONEST Why the Stock Market May Not Be as Broken as It Looks Mr. Market? Buddy? Can we talk? Look, we know you’re prone to mood swings -- no judgment here! You do you! -- but we’re starting to worry about you all the same. In the long run, your ups and downs are supposed to even out and make sense. But some of your recent behavior … well, we’re having trouble understanding it.  Let’s just focus on GameStop (NYSE: GME) for a second, OK? The struggling video game retailer faces a tough challenge, between COVID-19 crimping retail sales and more video game publishers shifting from discs, cartridges, and other physical media -- the kind GameStop makes moolah by buying and selling -- to purely digital purchases.   Citron Research, a periodically profitable perennial party pooper, promised to unveil a report showing why GameStop’s then-recent and modest gains would soon evaporate. (Find out more about short-selling -- the possible reason why Citron’s trying to sour these shares -- in our Jargon Decoder segment below.) By rights, this kind of bad news could make GameStop shares sink.  Instead, Mr. Market, you basically just went, “Nuh uh!”  Individual investors rallied on Reddit and other message boards and bought the stock en masse. Their apparent aim: Beat the tall-dollar hedge funds that had placed massive -- and, if they fail, potentially ruinous -- bets that GameStop shares would fall. A little more than two weeks ago, shares traded around $20. As of Jan. 28, they were hovering around $150, having recently peaked near $480. Some online brokerages had even halted trading in GameStop, drawing criticism and allegations that they were doing so expressly to protect billion-dollar hedge funds at individual investors' expense. Whichever side you take in this standoff, remember that GameStop’s fundamentals haven’t changed. It hasn’t announced higher profits or successful new strategies. The company itself has provided no underlying reason for these massive fluctuations. Individual investors may succeed in forcing hedge funds to blow all their cash reserves and go belly-up covering their failed bet on GameStop’s decline. But by paying more and more for the shares of a company with potentially dim future prospects, these everyday investors are putting their own money at long-term risk in the process. GameStop’s not the only stock to seemingly come unmoored from the facts in the past few weeks. Look, Mr. Market, people are worried. They’re bemoaning the possible death of the “efficient market hypothesis” -- the idea that ultimately, you and all the investors you work with know what you’re doing. So help us out here, Mr. Market. Please let us know you haven’t lost your marbles.  Oh, I see you’re getting out a history book. And now you’re drawing up some charts. Huh. OK! That’s actually pretty persuasive. I guess we can forgive you your occasional flights of fancy, given long-term trends like that.   Fool Dan Caplinger can help you learn more about why the market’s may still be bound by the laws of, you know, reality when you read the rest.  Already subscribed to a premium service? Click here to view your subscriptions. Not a member yet? Click here to sign up! JARGON DECODER When Your Shorts Get Squeezed They don’t call it “Wall Street” for nothing; the big banks there build bigger barriers of baffling terminology to keep regular Fools like you intimidated, underconfident, and ready to fork over your cash to a broker. Each week, Jargon Decoder translates one of those worrisome words or phrases into plain English, helping you get a leg up on the Wall Street Wise.  This week’s term: Shorting. When you dislike a stock and want to bet that it will fall in value, you sell it short in hopes of profiting from its impending plunge.  Most investors can easily grasp regular stock purchases and sales. If you like a stock and you think it’ll rise in value, you buy it. If you own a stock and think its future looks bleak, you sell. If you’re wrong, you can’t lose any more money than you’ve already put into the investment. But if you’re right, and the stock keeps rising, you can earn back many times your initial purchase price.  But what if you loathe a particular stock that you don’t already own? And what if you want to turn your share-price schadenfreude into cold, hard cash?   To short a stock, you borrow shares through your brokerage from someone else who actually owns them. You promise to return those shares to the owner no later than some future date. Then you immediately sell the shares you’ve borrowed, and pocket the cash. You’re betting that shares will drop enough for you to buy them back on the cheap before you have to give them back.  For example: You borrow shares of Curly Joe’s Wing Hut at $30 a pop and sell them right away. A month later, the FDA releases a report stating that Curly Joe’s highly dubious wings are sourced entirely from “free-range” pigeons -- not, as advertised, chickens -- and the share price plunges to $5. You buy back the same number of shares at this vastly lower price, return them to their dismayed and possibly queasy owner, and pocket a cool $25 per share in pure profit.  Sounds great! What could possibly go wrong? Well, if you guess wrong about a stock, and the price goes up, you lose money. You’ll have to spend more to buy back the shares than you earned by selling them. Shorting flips the risk-reward proposition of regular investing; at most, you can earn 100% of the share’s price in profits -- but your potential losses are theoretically unlimited.  Indeed, when lots of people bet against a stock this way -- creating what the market calls high short interest -- and the stock just keeps rising, it may set off a short squeeze. More and more short-sellers will start to sweat their dwindling profits and/or rising losses as their target’s price drifts suddenly higher. They’ll start to buy back shares to cover what they owe and cut their risk. But when more people clamor to buy a company’s stock, they further increase its share price -- putting greater pressure on any investors still stubbornly shorting the stock.   Short-selling can be a healthy way to counterbalance irrational exuberance and keep the market on an even keel. But given its potential for swiftly snowballing risks, Fools should slip into shorts with great care -- lest they lose those shorts altogether. Still curious? Find out more about short-selling a stock and how short squeezes happen.  BREAKING THE BANK 5 Reasons the Stock Market May Look Historically Expensive We talked last week about the stock market’s current sky-high Shiller P/E ratio -- the total value of the entire market, divided by the 10-year average of its total earnings. Fool Sean Williams notes that around 35 right now, it hangs well above its historical average, marking the second-highest peak in the metric’s history. (The 44 multiple it reached just before the dot-com bubble burst remains the record holder there.)  What’s driven the market’s valuation so high? And can it actually last? Some of the potential reasons seem a lot more comforting than others: Better access to information. Investors nowadays have many more ways to get accurate, reliable information about stocks. This helps them make smarter decisions, and supports higher market values overall. Super-cheap lending rates. When the Federal Reserve lends banks money at rock-bottom rates, generally stable investments that offer a fixed interest rate -- from savings accounts to bonds -- pay a lot less in interest, and thus look a lot less appealing. Folks seeking to grow their money turn to stocks instead. And we’ve rarely seen the Fed keep rates this low, for this long. Bountiful buybacks. For good or ill, companies just keep buying back shares of their own stock. This makes every remaining share more valuable, boosting earnings per share, keeping shareholders happy, and inflating share prices. Fiscal stimulus. The government pumped trillions of dollars into the economy last year as COVID-19 hit, and more is likely on the way. That confidence boost helps to keep stocks buoyant. Emotions. My emotions! My emotions! Investing’s not always cold and rational. Us squishy human beings have these things called “feelings,” and they sometimes govern the decisions we make. (That’s not always a good thing.) For more on what’s likely keeping the market’s valuation so elevated -- for now, anyway -- read the rest.  ALEXA, DO LEMMINGS ACTUALLY RUN OFF CLIFFS? Not sure what to ask your smart speaker? Keep up with what's happening in the market by asking your Amazon Alexa or Google Home to "Play Motley Fool podcasts." NO WORRIES 3 Ways to Help Conquer Your Investing Fears With all this talk of highly valued, irrational markets, we don’t blame you for getting spooked. But it’s gonna be OK. Really.   Fool Maurie Backman feels your pain; she used to be scared to invest, too. But these three strengths helped her conquer those concerns and start building lasting, long-term wealth: An emergency fund. When you’re not sweating the short term, it’s easier to keep your eyes on the future. Before you start investing, make sure you’ve saved up more than enough to cover any unexpected immediate needs. An investing strategy. No two investors are the same. We each have our own risk tolerance and priorities. Read up on different investing approaches, then make a plan that works best for you -- and stick with it. Data, data, data. The more you know about how the market works, and what kind of historical trends it’s followed, the easier it’ll be for you to put its ongoing peaks and valleys into perspective. Learn more about how Maurie Foolishly faced her fears when you read the rest.  A MOMENT OF YOUR TIME, PLEASE FEATURED PODCAST Dan Heath on the Economic Upside of "Moments" Creating a powerful experience for customers can deliver economic upside for businesses. Dan Heath, co-author of the best-selling book The Power of Moments: Why Certain Experiences Have Extraordinary Impact, explains how Southwest Airlines makes more money by entertaining passengers during their flights. Subscribe on iTunes AS OPPOSED TO ALL THE ILLEGAL WAYS Quick Reads 7 legal ways to reduce your tax bill: Pay less to the IRS without incurring its wrath.   Stranger things have happened: The big milestone change that makes Netflix (NASDAQ: NFLX) a lot less risky.  Why railroads are on a roll: A very old business has found profits in a clever new(ish) approach.  IT'S THE LEAST WONDERFUL TIME OF THE YEAR Social Media Post of the Week See all our Instagram posts! Join the 1,300,000+ people who follow us! 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