Why do price declines sometimes precede the fundamentals?
Gary Simms, a “frequent flyer” on this blog, recently posed two excellent questions, each of which merits a separate post. This is the first.
To paraphrase: “If the fundamentals—sales, profit, or earnings growth—are what drive the price of stock, why does a decline in a stock’s price so often come before the fundamentals decline?” Great question!
Stock prices decline for only one of two reasons: fantasy or fact.
By “fantasy,” I mean shareholders have jumped to a negative conclusion from some event, rumor, story, or combination of those. Acting on their hunch, the herd is simply guessing what might happen and getting out before it does. (Institutional investors are not immune from this behavior. Their colleagues, like lemmings, are often afraid not to jump when they do, for fear they might have missed something they shouldn’t have.)
More often than not, the "event" is not even related to the company, or even the industry it’s in. It could be merely the opinion of some talking head on Bloomberg or the like; and conjecture about how those imagined consequences might affect the company are sometimes pretty far fetched.
By "fact," on the other hand, I mean a significant and discernable change in the actual fundamentals. What caused the early price move may actually produce a change in fundamentals; and the herd may have been right…or not. More often than not, they’re wrong. (If they were more often right, the long-term trend of the market would be down instead of up, wouldn’t it?)
This is why I urge you never to be tempted to sell a stock because the price goes down; but, when you see a decline in price that has no apparent relation to the fundamentals, you might want to dig a little deeper to see what you can find in the financial news that could tell you just what’s spooking the herd.
As a general rule, when the price of a stock goes up or down for any reason other than a change in the fundamentals, it will most often come back to where it was. What goes up will come down and vice versa.
Your task, then, is to strip the fantasy from from the facts and act only on those facts. More often than not, it’ll be a good time to scoop up a bargain. But… Just often enough to take the fun out of it, the herd can be right!
Next post (Thursday): Gary’s second question – What to do when the PE acts unpredictably?
Fundamental Investment Views, Investment Concepts, NAIC Veterans' Lounge, Successful Investing
