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Going Back to School with Stock Market Fundamentals – Investopedia

Make that four weeks in a row of gains for the U.S. stock market, as the rally has become undeniable. The S&P 500 and the Nasdaq both climbed more than 3% last week, with the the Dow up 2.9%. The S&P 500 has now climbed 15% from its lows in mid-June, while the Nasdaq has clawed back 20% since then. That could technically be described as a new bull market for the index. A 20% retracement from a recent low fits the bill—or the bull—but there are a lot of opinions about that. But we can’t deny the strength of the rally, especially when we dig into the charts. The average stock in the Nasdaq Composite index is up 34% from its lows. Remember, just a few months ago, we were talking about the average Nasdaq stock being down 50% from its highs. The pendulum has swung back in a big way. Across the market, the breadth thrust has been pretty impressive. And no, that’s not a swimming stroke.

The breath trust indicator is a technical indicator used to ascertain market momentum. It is computed by calculating the number of advancing issues on an exchange, such as the New York Stock Exchange (NYSE), divided by the total number of issues—advancing plus declining—on it, and generating a ten-day moving average of this percentage. The Breadth Thrust Indicator was developed by Martin Zweig, a legendary investor, advisor and writer. That’s why some people call it the Zweig breath indicator. According to Zweig, there’s only been 14 breadth thrusts since 1945, and we’re in the middle of a brand new one. Ninety percent of the components in the S&P 500 are now above their 50-day moving average. That’s the highest level since November of 2021. The average gain following a breadth thrust, according to Zweig, is 24.6% in an average timeframe of 11 months. And a majority of bull markets? Those begin with breadth thrusts—they’re important.

Better economic news may have something to do with improving sentiment. Consumer confidence crept up again, according to the University of Michigan’s latest Consumer Sentiment Index (MCSI), and both consumer and producer inflation were down from their highs last month. Those may be the signs the Fed is looking for to believe that its rate-hiking battle against inflation is working, and maybe it will cool the pace of rate hikes at the next two FOMC meetings this year. Fed funds futures now show a 55% probability that the Fed will hike rates by half a percent at its meeting that begins September 21, and a 45% probability it will hike by another three-quarters of a percentage point. That number flip-floped last week, after the inflation numbers were released.

Meanwhile, the bond market continues to take a pessimistic view of the economic outlook, with the spread between the two-year and the 10-year yields continuing its inversion at negative 41 basis points (bps). Translation: bond investors do not have high hopes for the near-term prospects for the economy. That tug of war has a lot of rally doubters calling the recent surge in stocks a sucker’s rally. The short-interest percentage of the average stock in the S&P 500 remains at highs we haven’t seen since April of 2020. Short interest indicates how many shares of a company, index, or ETF are currently sold short—betting they’ll decline. That’s pretty pessimistic, but it could also be one of those contrarian indicators where extreme bearishness is a sign that the market could turn—and it has.

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Meet Brian Feroldi

Brian Feroldi is a financial educator who has written extensively about money, personal finance, and investing ever since he graduated from college in 2004. He shares his knowledge with the world on Twitter, YouTube, Instagram, and the Motley Fool. Brian first began investing in 2004, and his individual stock picks have consistently outperformed the market since.

In 2015, Brian became a full-time writer for the Motley Fool. He has since written more than 3,000 articles on stocks, investing, and personal finance. He has also appeared on a number of podcasts and videos.

In 2020, during the height of the COVID-19 pandemic, Brian spent more than 20 hours hosting “Fool Live”, a members-only Zoom session. Brian helped thousands of individual investors to keep calm and collected during the worst of the crisis.

What’s in this Episode?

It’s easy for investors like us to overthink how we invest. There’s so many options, so much information, and so many reasons for us to not take risks. And then there’s our animal spirits, telling us to run when we’re scared and be greedy when we’re confident. But what if we stripped out all of our primitive instincts back to the basics and asked ourselves some super-fundamental questions? Why should we invest? Why would we want to invest in stocks? Why does the stock market go up? Not every year—but its track record over the past 150 years—it’s pretty good. Brian Feraldi, the longtime financial journalist and market watcher, has written a terrific book that addresses some of these questions. It’s called Why Does The Stock Market Go Up?, covering everything you should have been taught about investing in school, but weren’t. And Brian is our special guest this week on the Investopedia Express. Welcome, Brian.

Brian: “Thanks, Caleb, for having me. Great to be here.”

Caleb: “I would normally ask why you wrote the book, but you wrote the book because nobody teaches these fundamentals. I mean, we do on Investopedia, but nobody’s put it in a beautiful little book, kind of like the way you’ve done with yours. Was that the inspiration just to try to distill all of this down to the basics, the ABCs and 123s of why this stock market of ours just has this magic way of going up year after year?”

Brian: “Very, very much so. I discovered investing right after I graduated from college in 2004, and as soon as I read my first book about money and personal finance, I just went on a binge reading series where I just devoured absolutely every book that I could possibly get. And I’ve read all of the classics on investing about Warren Buffett, Peter Lynch, Jack Bogle, etc, and they are just phenomenal, fantastic resources for investors. But the number one question that I had about investing was the title of my book: why does the stock market go up? So many of those fantastic books all say you should save a portion of your income, you should invest with a long-term mindset, you should dollar-cost average into the market, and the market continually goes up. And I was like, I believe you—I see the long-term history of the S&P 500—but what was never explained to me was why—what was the underlying force that caused the market to go up over time? So, because I personally was seeking that information 20 years ago, now that I know it, I just believe that there is a huge missing gap in the education of the average shareholder out there, that they don’t know why it’s going up. So that was the aim of the book—to fill in that missing piece of information.”

Caleb: “Yeah, we take it for granted. But if you do look at the track record, we’re looking at somewhere between nine and 11% average annual returns going back all the way to the latter part of the 19th century. The stock market’s been through a lot—we know that—lots of crashes, lots of bull markets, lots of bear markets. But there is this insurmountable climb that just keeps going up and to the right. And I don’t think enough people stop and ask themselves that question, we just take it for granted. Well, put your money into the stock market and, like magic, it goes up. But really, you and I have been around the block on this, in our careers. We see a lot of companies with no profits where were the stock goes up over time. We saw that with meme stocks, you see it in internet stocks, and probably going all the way going back to the tulip mania of the 17th century. You know, there’s this notion that it might be profitable one day, it might have the best idea, so investors put a lot of faith into the future even when they can’t see it. Why do they do that?”

Since its inception in 1926, the S&P 500 has yielded an average annual return of about 10.5%. Prior to 1957, the predecessor index to the S&P 500 (known as the S&P 90) included only 90 major stocks. The current composition of the index, with 500 component stocks, dates back to 1957. From 1957 through 2021, the S&P 500 has yielded an average annual return of 10.67%. During this period, annual returns have ranged from a maximum gain of 38.06% in 1958 to maximum loss of 38.49% in 2008, at the height of the Global Financial Crisis.

Brian: “I think that one of the most tricky things about investing is that in the short term, there’s absolutely no correlation at all with what a stock does and what the business itself is doing—a company can be losing money, could be losing customers, could be losing market share, and its stock could still go up. In 2020, we saw basically every stock go straight up. And in fact, the riskier the stock, the faster it went up. While this year, we’ve seen the exact opposite, where some companies are still growing, they’re increasing their margins, increasing their customers, increasing their profits, and their stocks have been going straight down. This is why Benjamin Graham’s wonderful quote is so appropriate: “In the short term, the market is a voting machine. In the long term, the market is a weighing machine.” The aim for my book and the aim for a lot of my education is to just make investors aware what the heck the “weighing machine” part of that equation means. If you look at the news or if you look at your phone, the only information that most investors—99% of individual investors—get about a stock, is price. You see the stock price! That’s the only information that you see. You actually have to do work to go and figure out the company’s earnings. What direction are the company’s earnings going? Same goes for the market in general. Everybody knows the price of the Dow. Everyone knows the price of the S&P 500. How many people know what the earnings of the Dow components are, the earnings of the S&P 500 companies? Once you discover that, and once you look at the long-term trend of the earnings of the S&P 500 and the price of the S&P 500, it just becomes crystal clear that those two things are linked in the long term. I have a strong feeling that very few individual investors actually realize that.”

Caleb: “Yeah, absolutely. And they’re always looking at price. Why? Because the financial media, present company included, is making a big deal about price because that’s the sports game aspect of it. That’s like, you know, the pre game is the pre market activity, the kickoff is the opening bell, the halftime report is the halftime of the game, and then the closing bell. We deal with price—we’re always talking about the Dow Jones Industrial Average or the Nasdaq, or this or that, or people are talking about the stock price of a company, but they’re talking about it really kind-of in a vacuum. And what we want to be thinking about is: what is this company’s ability to grow over time, and will investors appreciate the rise in its earnings and its growth over time and put more money into it? That’s where the real money is made—am I wrong?”

Brian: “Oh, very, very much so. What the price of a company does and what the business performance of the company does is 100% linked in the long run. Look at any of the largest most successful companies that exist today—Apple, UnitedHealth Group, Google, etc. Why are those stocks up many, many times in value since those companies first became public ten, 20, 30 years ago? In every case, the answer is the same: revenue and profits today are substantially higher than they were five years ago, ten years ago, 20 years ago. That growth in profits has led to the increase in the value of the organization, and shareholders have done very well by buying and holding those businesses. But if you look at all—all of the biggest winners of the last ten, 20, 30, 40, 50 years—in every single case, those shareholders of those great businesses were put through short term periods of immense pain—drawdowns of 50, 60, even 70% or more along the way to them delivering those huge returns.”

Caleb: “Let’s talk about our emotions and our animal spirits—I brought them up at the top. They want us to do, usually, the wrong thing when it comes to investing because we have this survival instinct. We talked about it with Josh Brown last week. We have this survival instinct about being fearful. When things are scary, we make some bad decisions. We want to sell our portfolios. When we get really greedy, we think we can pick the right stocks all the time and keep buying and keep making money, but often those turn against us. Why does that happen?”

Brian: “The reason that that happens is that every human was born naturally to be a terrible investor. All of our innate desires, all our innate thoughts are designed around self-preservation and designed around fear, right? We don’t want to be seen as different than the group. We take our cues from other people. The same exact principle applies to investing—if other people are excited about a stock and that stock’s going up, it naturally draws us in, and people want to buy stocks after they’ve gone up. Conversely, if other people are fearful about the economy and stocks are going down, our natural inclination is to sell, because we’re taking our cues from other people. That is just human nature. And that’s going to be the case essentially for as long as I’m alive. If you want to do well as an investor, you have to learn to resist the urge to take your cues from other humans. Boy, is that really, really hard to do—when you see other people making money easily, like what happened in 2020, and everybody’s bullish, everyone’s excited—it feels like it’s the safest time to invest because stocks are up so much. Conversely, right now, what have investors seen over the last 15-plus months? We’ve seen nothing but stocks going down, economic news getting bad, the headlines being terrible and scary, prices are declining. Naturally, nobody wants to invest in that kind of environment. It feels like it’s the scariest time to do so, which ironically makes it a great time to invest. So, you really have to understand that you were born to be a bad investor, and it takes time and training and understanding market history to overcome those natural biases.”

Caleb: “Which is why your book is so valuable. Okay, we talk about the market in these general terms, but inside the mechanisms of it—and most folks don’t care about this—but you and I watch this very closely. It’s changed a lot, in the last 20 years or so, for a bunch of reasons. Right? There’s a lot more access to the stock market, there’s a lot more information, there are a lot more institutions out there that are involved in the stock market, trading through algorithms and very sophisticated software programs, trading on metrics, trading on technical cues, and moving hundreds of millions of dollars around before we could even think about buying or selling a stock. That creates a lot of noise and a lot of activity and volatility and volume, which affects individual investors like me, you, and our listeners who are just trying to put together the right portfolio, do the right thing over the long term. Do these outside forces—and they’re big—have a big impact on how we invest or how we should think about investing, or is that just just part of the noise, Brian?”

Brian: “Once you understand the advantages that Wall Street has over new investors, it seems like it’s impossible to make money in the market, because to your point, algorithms out there can find the news, “interpret the news,” and trade based on the news faster than you can even read the headline of whatever news report that came out. So I kind of scoff to myself when I see other people trying to out-trade the news—it’s like playing poker against other people, except that everyone else can see your cards and you can’t see their cards. I don’t think that’s a game that I could win. Now, thankfully, there is something about investing where individual investors have a massive, massive advantage over professionals. And that one advantage is that we are managing our own money. We have no career risk. We don’t have to meet performance guidelines, we don’t have to explain our moves to anybody else. That allows individuals to truly invest with a long-term mindset. We can absorb huge amounts of short-term volatility. We can absorb losing to the S&P 500 over short-term periods. That’s extremely hard to do if you are a professional investor and managing other people’s money. For that reason, investors that manage their own money can truly adopt a long-term mindset. They can buy and hold great businesses or the index funds and not care about their short-term performance. That is the source of my long-term advantage over the market—I can’t trade faster, I’m not smarter than the index—but I can be more patient than the index. That’s the kind of thing I like to teach people to do because it’s your only advantage.”

Caleb: “Yeah, you make a great point. We don’t have to trade, we don’t have to buy, or we don’t have to sell. We are not portfolio managers. Most of us, whose job depends on us hitting a quarterly number or beating the benchmark, just need to make smart moves to build our portfolios and our wealth over time. And the truth of the matter is, if you do it consistently, the market delivers, and that’s through the magic of compounding—I call it the fairy dust that’s sprinkled over the stock market and over investors who have this sort of discipline. But if you don’t understand compounding, the rule of 72, and all these great things that that are so helpful in the process of wealth creation and the growth of the stock market in your portfolio over time, you’re never going to get it. A lot of people come up to me, they probably come up to you, Brian, and they say, “look at my portfolio. I have two shares of this, four of this, six or that, I bought them here and there.” But you and I always say “you’ve got to consolidate the positions, you have to dollar-cost average, you want to own these stocks at a very low average price point over time,” and their heads start to spin, but they’re missing out on the key things, which is this compounding over time—the continued contribution to your portfolio over time, with discipline. That’s what makes your money, right?”

Brian: “Very much so. And one of the biggest mistakes that a lot of investors make, new investors and even seasonsed investors alike, is they forget the number one rule of investing, particulaly If you’re going to buy individual stocks, which is: know what you own and why you own it. Many people in my Twitter or DMs, or even in real life, they tell me I bought x shares of ABC Company and I’m up x percent in x number of weeks, or x number of months. And the thing that I want to say to them is, okay, what does this company do?—Is its revenue up, is its revenue down? How does its balance sheet look like? Who is its management team? What’s its long-term potential? Does it have customer concentration?—asking the fundamental questions that they should be focused on. However, so many people, when they get interested in the stock market, don’t know any of that, don’t pay attention to any of that, don’t even know how to find that information. The only thing that they’re looking at is the ticker and whether or not that ticker is up or down today. That is exactly, exactly what I did when I first started investing 20 years ago. I was going after the meme stocks of the day, which were penny stocks on Yahoo’s discussion boards, predictably. And thankfully, I did terribly early on, because I had no idea what I was doing and I was buying garbage. So it’s natural that a lot of people that are new investors don’t know what they’re doing, and they buy what they see on Reddit or they buy what other people are buying, and they don’t know anything about the fundamentals of the business.”

Caleb: “You have a very important series of chapters here, but one that really caught my eye is this whole saving-versus-investing theme. I’ve been having this conversation with my kids and my nephews about what they should be doing in their late teens and their early twenties. What’s your take, because both matter—saving and investing—in terms of growing your wealth, but you have to do both. Where do you fall in that into that camp?”

Brian: “It’s actually a spectrum. It’s very natural for people that are interested in investing, myself included, to really try and hyper-optimize their portfolio to squeeze out an extra 5% of compounding. But if you put that into a compound calculator, an extra 5% of the market over a long period of time, the numbers are just magic. However, one of the truths is if you are new to investing, you are going to realize so much more wealth for yourself by trying to optimize your income and your expenses as opposed to squeezing out that extra return. If you have $10,000 saved and you make an extra one percent or 2% per year, great! Well, that’s a hundred or $200 difference, right? But conversely, if you’re at that stage and you can negotiate a raise, if you can upskill yourself, if you can save an extra five or $10,000, that’s going to have a much bigger impact on your net worth in the beginning. So in the beginning, when you’re just starting out, it’s really important to focus on your income and your expenses and your savings rate. Over time, as your net worth continues to grow, gradually your investment portfolio starts to take over as the main driver of wealth. So let’s say you’re 20 years in and you have $1,000,000 net worth. Well suddenly, a few extra points of gain can lead to ten, 20, 30, 50, $100,000 worth of extra value. And that in many cases can be more than you could earn from your job. So it is a spectrum. Everybody is on this spectrum, but by and large, people that are just starting out will do much better for themselves if they focus on their income and their savings rate, not their investing returns.”

Caleb: “Great point. Well, your book is so full of good information and laid out very basically—you have to admire that—being the Editor-in-Chief of Investopedia. The more fundamentally you can explain things to people, the better off they are, and people always appreciate that from us, and I definitely appreciate it from your book, Why Does the Stock Market Go Up: Everything You Should Have Been Taught About Investing in School? But Brian, you know we are a site built on our terms, our definitions, our explainers. I’m sure you have a favorite definition of your own or a term. What is it?”

Brian: “Well, thank you for that. And I must say that I am a massive fan of Investopedia—I have used it so many times, to look up definitions, so I just love your site. And if I had to come up with one term that I like, I would probably say it’s gross profit. So gross profit is on the income statement, it is revenue minus the cost of goods sold (COGS). And this is a metric that I have underestimated for the last ten or 20 years. But more recently, I have come to learn that gross profit is one of the most important numbers that a company—that any given company—can optimize for. And it’s a sign of just how much customers value a company’s product. In fact, I think gross profit is more important than revenue. So that’s one of my favorites.”

Caleb: “Yeah. Are they able to bring those sales down to the bottom line? That’s a very key indicator that shows you how efficiently they operate. Great term—we love that one as well. And you’re probably the first one of our guests to choose gross profit, so, good for you. Brian Feroldi, thanks so much for joining the Express. Folks, follow Brian at mindset.brianferoldi.com, I will put that in the show notes. Thanks so much for joining The Express, Brian.”

Brian: “Thank you very much for having me, Caleb. Great to be here.”

Term of the Week: Reverse Repo

It’s terminology time. Time for us to get smart with the investing and finance term we need to know this week. And this week, we’ve got to give it up to our pal Cassius Kuve for his timely suggestion. Cassius suggests reverse repo this week, and we love that term given what’s about to go down as the Federal Reserve reduces its nearly nine trillion dollar balance sheet. According to my favorite website, a reverse repo, or a reverse repurchase agreement, is a short-term agreement to purchase securities in order to sell them back at a slightly higher rate. Repos and reverse repos are used in short-term borrowing and lending, often on an overnight basis between banks. Central banks including the Federal Reserve use reverse repos to add money to the money supply via its open market operations (OMOs). Well, as Cassius points out, as the Fed unwinds its balance sheet and starts selling U.S. Treasuries in September, things could get a lot riskier in the capital markets, especially if we’re headed into a recession.

You see, the Fed’s reverse repurchase facility, RRP as it’s known—that’s its mechanism for buying government bonds—it’s attracted a wide array of investors helping mop up excess liquidity in the financial system. Led by money market funds, volume at the reverse repo window has topped $2 trillion for 39 straight days—that is a lot! Since the Fed raised rates by three quarters of a percent in July, the Fed is paying a record reverse repo rate of 2.3%. Investors are effectively taking deposits away from banks and putting them into government money market funds, which invest mainly in Treasurys and repos. These money funds, in turn funnel cash into the Fed’s overnight window, where other banks come to borrow every single day. Most investors, especially pure equity investors, don’t even know this is going on. But it is the steam engine of the American capital markets. The worry, as the Fed gets ready to sell $95 billion in government bonds come September 1, is that the outflow of deposits from banks and into money market funds could reduce bank reserves at a rapid pace that could hinder lending activities to the financial markets, and to the broader economy. That is not what you want to see if the economy is going into a prolonged downturn. Good suggestion, Cassius. We’re going to be watching the reverse repo market a little bit more closely in the coming months. And you, my friend, will be rocking Investopedia’s finest socks, hopefully in your next terrific video.

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