[Price Action VS Fundamentals] When Should You Take Action?
The financial markets are essentially a conglomeration of investors' expectations of underlying assets (e.g. property, stocks, bonds, etc). From time to time, investors' expectations will detach from reality which is why the market undergoes boom and bust cycles that causes unnecessary panics or manias among investors.
If you are reading this, chances are that you may have some questions about the recent price action of your investments – be it positive or negative (chances are that it is negative) – and ask yourself what your next best course of action would be.
To help you make sense of your situation, you need to acquire the technical skills to help you differentiate between investors' expectations (as reflected in the price actions) and reality (as reflected in the fundamentals of the underlying assets) to decide when an action is justified and when it is not.
In this article, I will go in-depth to share with you how you can make sense of what is happening in the markets today and whether or not the profits and losses that you are experiencing are sustainable based on where investors' expectations are relative to the actual reality.
Perhaps you are sitting on a sizable profit and thinking to yourself if you should double down on your investments or take profit. Or perhaps you are sitting on a hefty loss and wondering if you should continue to remain invested or cut your losses.
Once you’ve understood how to differentiate between investors' expectation and reality, it will help you to identify opportunities and threats that often pops out from time to time in the market and also to make an informed decision based on reality rather than unrealistic expectations.
The Basics: Why Detachment Happens
To understand why investors' expectations can and often detach from reality, you will have to first understand this concept of – securitization.
Securitization is the process of pooling and repackaging of homogenous illiquid assets into marketable securities that can be sold to investors. In other words, securitization is the transformation of illiquid assets into liquid securities.
Let’s take REITs as an example, without securitisation, it is impossible for individuals like you and I to be able to invest in commercial properties such as offices like MBFCs or shopping malls like Waterway Point that are valued in billions.
Another example would be stocks where the securitization of a company/ business (i.e. Apple) produces what we call a share (or stocks). If you own an Apple share, you are technically a proud business owner of a trillion-dollar company (the only question is how many shares you own).
Securitization is what made investing possible for the masses which, while beneficial, also introduces a whole different set of problems – and that is price volatility. With a simple click of a button, retail investors are now able to buy and sell illiquid assets almost immediately which will contribute to the overall price action.
If more people wish to sell than to buy, prices will be depressed. If more people wish to buy than to sell, prices will be elevated. The problem here is that while the securitized asset (i.e. REITs) is liquid, the underlying asset (i.e. properties) is not.
And given that investors – especially retail investors – buy on the rumour and sell on the news, it has resulted in frequent detachment between investors' expectation of the performance of the asset and the actual fundamental performance of the asset itself.
A comical depiction of how the markets work is as follows:
Unfortunately, the detachment between investors' expectations and the actual fundamentals of an investment is present in all types of markets – be it upward, downward or sideway markets. If plotted in a chart, this is what it will look like:
The dotted line represents the direction of the trend
The black line represents the performance or the fundamentals of the underlying asset
The red/green line represents investors' expectations and hence price action of the underlying asset.
Sharp readers will realize that while not unjustified, investors' expectation is often an exaggerated version of the fundamental performance of the underlying asset. Prices tend to move by a greater degree as opposed to the actual changes in the fundamental performance of the asset.
Depending on the degree to which investors' expectations deviate from the fundamental performances, it may present a threat - in the form of an overvalued market (highlighted in red) - that could lead to losses or an opportunity - in the form of an undervalued market (highlighted in green) - that could provide profits when investors expectation normalizes to reality.
The phenomenon of a self-correcting expectation is what is known as “reversion to mean” of which the asset prices (which is a reflection of investors' expectations) would revert to their long-term average levels (which are often determined by the fundamental performances).
As I often say, humans are emotional but we are not dumb. In the short run, it is possible to sell shit at the price of gold but in the long run, people will realize the true value of what they bought and behave accordingly.
To elaborate on the theoretical aspect, I’ll use both a broad market example and a stock-specific example to explain.
Broad Market Example: US Dot Com Bust
The first example would be that of the Dot-Com bubble that occurred during the late 90s and burst in the early 2000s.
Using the IT sector % of representation of market cap to infer price behaviour and the IT sector % of representation of earnings to infer the fundamentals, one would realize that while there is indeed fundamental growth in the IT sector, investors' expectations had detached from reality which had resulted in the boom in prices during 1997 to 2000 before the eventual bust in 2000.
When the bubble burst, we can see that the stock prices had come down drastically and had remained stagnant for a long duration while fundamentals slowly caught up to eventually match the representation of the market cap itself which is an accurate reflection of how reality should be.
Stock Specific Example: Parkway Life REIT
The second example that we will be examining would be a Singapore-listed REIT – Parkway Life REIT.
For context, Parkway Life REIT is a Healthcare REIT that was listed in 2007 and owns 61 properties (3 Hospitals in Singapore, 57 Nursing Homes in Japan & 1 Specialist Clinic in Malaysia).
Investors who invest in Parkway Life REIT are essentially investing in the healthcare properties that the REIT owns and they directly profit from the rental income generated and capital gains from the underlying property itself.
The reason why I’ve decided to use Parkway Life REIT as a stock-specific example is that while the fundamentals of the REIT itself are fairly stable (refer to distributable income [from ops] per share), the price action of Parkway Life REIT is very volatile (which shouldn’t make sense in a perfect world).
From the above chart, investors can see 3 separate periods that exhibited the detachment of investors' expectations and reality followed by the inevitable reversion to mean.
Before 2019: Investors' expectations of Parkway Life REIT are rather muted, which is justifiable given that the fundamental performance of the REIT itself is stable and their growth is slow by design.
2020 to 2021: Investors' expectations of Parkway Life REIT took off as a result of the COVID-19 pandemic to a point where investors are willing to pay such a high price and receive a low dividend yield in anticipation of future growth of the REIT itself. (detachment from reality)
However, investors who are swept by the COVID-19 hype have failed to recognise that while the environment is favourable for the healthcare sector, it is impossible for a healthcare REIT to grow at the pace that investors expect due to the limitations of the REIT structure and nature of the lease agreements.
2022: As the hype dies down and as interest rate increases, investors start to realise their mistake of overpaying for their unrealistic expectations and prices have started to come back down to levels near their fundamental performances. (Reversion to mean)
Assuming that you are an investor who only reacts to price action without taking into account of fundamentals, chances are that you will be lured by the 100% gain in the stock price of Parkway Life REIT in less than 12 months and fail to recognise the reality that the REIT is overvalued based on its fundamental performances.
When the market starts to wake up its senses and prices revert to their long-term fundamental mean, investors will end up with a 35-50% loss on their investment which only provides a 2.6% yearly dividend yield given the price that they bought at. As a result, investors will have to hold the stock for 15 to 25 years just to breakeven on their losses assuming that prices do not change.
The lesson here is that: at the end of the day, it doesn’t matter how safe or stable the company is, if you do not pay attention to the fundamentals and valuations, there is a high probability that you will be making a loss on your investment in the short run and at best breakeven on the long run.
TLDR: What Can You Do as An Investor
As investors, you will have to learn to identify factors that you can and cannot control and focus only on controlling the controllable.
To put it simply, as an investor:
You are unable to control the strategic direction and actual performance of a company/fund but you can decide whether or not the strategic direction or underlying exposure of the investment that you are considering is suitable to you based on your investment objective. If it is suitable, you can consider investing in it and if it is not suitable, you should avoid it.
You are unable to control investor sentiment, price action or market liquidity but you can control the targeted price that you want to buy/sell/increase/decrease should you decide if the investment is suitable for you.
You are unable to control the geopolitical events and currency movements but you can control the allocation of the investment you want to have in your portfolio and control the degree of influence which such sector/country/region exposures could have in your overall portfolio.
Whenever the asset price experiences a significant price action in either direction, the key question you should be asking is if there are any changes in the actual fundamental performances or if the price action is a result of irrational changes in investor sentiment.
If the fundamentals of the investment have changed, the next question you should be asking is if the investment itself is still suitable to you based on your investment objective and take action accordingly. If the fundamentals have changed for the worse, you should consider decreasing your allocation or completely removing the investment from your portfolio depending on the valuation and the new target (intrinsic) price. If the fundamentals had changed for the better, you should consider increasing your allocation or perhaps not making any changes at all depending on the valuation and the new target (intrinsic) price.
If the fundamentals of the investments have not changed, the next question you should be asking is if the investment is overvalued or undervalued based on your target price. If the investment is overvalued, you should take action to reduce your allocation. If the investment is undervalued, you should take action to increase your allocation. This is to position yourself to capture the upside revision or avoid the downside correction when the asset prices revert to mean and back to reality (as we’ve seen from the example of Parkway Life REIT).
At the end of the day, before you react impulsively to the price action, learn to take a step back and question the cause of the price action itself and whether or not it is justified (based on the changes in fundamentals) or is it just simply a case where investor sentiment had detached from reality.
Once you’ve understood the source and causes of the price actions, you can make an informed decision as to what your next best course of action would be. Should you increase/decrease your position? Should you take some profit or cut your losses?
All of these can also be found in my eBook: “The Price Of Financial Freedom” which will provide you with a comprehensive guide to help you achieve financial freedom and live life on your terms in the shortest amount of time.
You can download a copy of it for free on my website:
If you do not know how to get started with your financial planning or if you do not have the time to manage your finances, you can consider engaging an Independent Financial Advisor who can help you make sense of the market, accelerate your progress and achieve financial freedom by 5 to 10 years earlier!
To find out more information about how you can benefit from my financial and investment planning services, you can check out what I do on my website here:
Daniel is a Licensed Independent Financial Consultant with MAS and a Certified Financial Planner (CFP®).
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This article is meant to be the opinion of the author
This article is for information purposes only
This article should not be seen as financial advice
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