The Importance of Market Psychology

Psalm Chapter 121 verses 1-2 state, "I lift up my eyes to the mountains - where does my help come from? My help comes from the Lord, the maker of heaven and earth."

When it comes to life, there is no other place that I can look for help than to God. It's not always easy as I'm also accountable for taking responsibility on various components of my life, so sometimes I can rely too much on myself. It doesn't take very long though to see how relying upon myself ends up getting me in a worse position.

For investing, there is a similar correlation to becoming to focused on my own parameters, without considering other variables. It is always important to revisit prior market cycles and events to gauge how the present is shaping up. While taking responsibility for managing my portfolio is highly important, I cannot ever discount the importance that market psychology plays in impacting individual companies to broader market performance in concert.

The psychology of the stock market has an infinite amount of variables that are at play over the course of time. Today, there is one thing that is clear, aggressive growth companies are overvalued broadly. Despite the broad overvaluation, some select aggressive growth plays are significantly discounted. This current schizophrenic environment is going to adjust at some point over the mid- and/or long-term.

I will illustrate this divergence using Coupang, Inc. as a brief example.

Clearly 2021 has been a strong year for major e-commerce growth plays. This has been lead by companies including Sea Ltd. (SE), Shopify, Inc. (SHOP), and MercadoLibre, Inc. (MELI), while Amazon, Inc. (AMZN) has slightly underperformed - this makes perfect sense per a growth trajectory modeling perspective. This is especially the case as Amazon is a diversified business, leveraging non-e-commerce operating segments to grow its e-commerce units.

However, when it comes to Coupang, the company has traded with a strong correlation among Chinese e-commerce peers including Alibaba, Inc. (BABA), and JD, Inc. (JD). There is some rationality to this, but collectively it is a major inconsistency. More glaring is that fact that both JD and Alibaba have witnessed improvement from their bottoms, while Coupang has continued to be pressured to the downside, setting new lows and witnessing severe resistance to any break out.

Over the next five years or so, I expect that Coupang will revert to the mean non-Chinese companies, exceeding Amazon's performance and growing in-line with e-commerce play growth leaders. But it goes much further than the top leaders when we consider smaller and newer entrants such as BigCommerce Holdings (BIGC) and ContextLogic, Inc., or Wish (WISH). Even BigCommerce is trading at a substantial premium versus a company like Copuang, while Wish has seen its overpromised bubble pop dramatically. I expect muted growth moving forward for BigCommerce, or further downside to allow for a better annualized investment return over time, especially once valuation levels reset.

We can take this example further to many areas of the stock market. We can look at FAANG-M, we can look more broadly across aggressive growth plays, and we can consider major indices as well like the NASDAQ and S&P 500. In all cases, we find very strong results to date for 2021. The problem is that Wallstreet analysts and retail investors alike have become complacent with steep premium valuation levels. In fact, even professional analysts on Wallstreet are setting Price Targets well above conventional levels for newer entrants that have much more to prove before commanding any premium, let alone today's valuation level.

The question is why? The answer is simple - psychology. Wallstreet analysts move in tandem with one another and the low inflationary environment has justified higher premiums for higher risk assets. But inflation has little to do with valuation levels directly. It may seemingly make sense to assign a mid-term EV/Revenue and Cash Flow multiple for Shopify at 20 times EV/Revenue and 90 times Cash Flow per share today, but it makes the same sense regardless of whether inflation picks up steam, especially as a company like Shopify is competing to be a leading long-term e-commerce winner, with Cash Flow inflecting strongly. Ironically Shopify will weather any inflationary storm better than most legacy peers.

But what about companies that are newer, smaller, with more to prove trading 30 to 70 times EV/Revenue and no Cash Flow inflection yet? These types of companies are in a very precarious position, especially as Wallstreet analysts will pivot quickly once the music stops, all racing to set lower valuation-based Price Targets.

So how do I consider psychology in preparation for tomorrow's changes? This is challenging, but it involves experience with where valuations have been in the past, where they are today, and where they may likely be headed for the future.

For aggressive growth plays, I have hundreds of companies with financial models built that are of interest to me, and regardless of whether I am looking at Facebook, Inc. (FB), Cisco, Inc. (CSCO), or Shopify, or BigCommerce, among the many others with varying EVs, there is a strong divergence amongst valuation. I do not believe that many companies are worth over 20 times EV/Revenue. Nor do I believe that many companies are worth more than 100 times Cash Flow per share over time. But there are strong indications of leading companies sustaining EV/Revenue multiples in the 15-20 times range and/or 30-60 times Cash Flow per share levels. I view this historical information as a good indicator of where things will fall over the mid-term.

That being said, larger growth companies with less robust growth will likely see EV/Revenue multiples in the 6-10 times level, with Cash Flow per share multiples around 12-20 times. I see the most risky areas for investors within the smaller and newer aggressive growth peers. Especially those trading north of 20 times EV/Revenue and in some cases with little to no Cash Flow. Some of these companies may see massive sell-offs reverting towards very low multiples - case in point, Wish, as growth trajectories are realized to not be what was originally expected.

Today I believe we are at a dangerous place for aggressive growth broadly. But it is not equally represented as smaller and newer plays are being valued the most aggressive, and even larger peers are seeing valuation levels too steep. There is a selective and targeted group within the middle ground that have been negatively impacted in 2021 that will offer tremendous upside potential due to the major mispricing by the market. Recognizing these relationships and inconsistencies is paramount to successful investing in aggressive growth plays.

Coupang is one example, but there are definitely others. The takeaways are first acknowledging that while the market is always right over the long-term, it always adjusts over shorter durations of time. This is orchestrated primarily by Wallstreet in a uniform manner to attempt to manipulate and control the short-term opportunities. The same analysts that are saying Monday is worth $350 today, will be saying it is worth $250 after a major correction occurs. There is no focus by Wallstreet of who the true winners will be, it's simply a game of musical chairs.

Retail investors are at an all-time peak in exposure to the market, while at the same time being hyper-aggressive following Wallstreet's lead. The GameStop, Inc. (GME) meme, fomo, yolo, etc., movement is going to end with some severe pain. The good thing is that many younger retail investors only have thousands at risk so the pain isn't going to necessarily wipe them out. But retail investors always need to check their mindset as Wallstreet uses a plethora of FUD tactics to influence and cause confusion to throw retail investors off track. The most egregious bein P/E ratios, EBITDA and many other financial metrics that are meaningless as a focus independently, especially when it comes to valuation.

While today the stock market is definitely frothy, there are many discounted opportunities that have been mispriced. This isn't by chance, but is for a reason. Sometimes the reasons are so ill-informed that even Wallstreet gets burned - case in point Affirm Holdings (AFRM). For sophisticated, professional and retail investors alike, the name of the game is psychology. Keeping a level-headed approach will win out over time - always. Of course experience, intuition built from experience, portfolio management strategies and access to capital all play important roles with psychology. But recognizing why things are the way they are today, and that they will not remain so for tomorrow is paramount. It's not about being contrarian, it's about being practical and a realist.

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