Are Internet stocks hot, or were they in 1999? That’s great. If they are hot, they’ll stay hot. Ooops. They didn’t? Well, they’ll come back. You say most are in the afterlife? Well, that’s an exception. Usually stocks that are hot stay hot.
Are social media stocks hot as I am writing this? They will stay hot. Yes, you can take it to the bank. Buy as much social media as you can and you will never regret it. There is Newton’s first law of motion that says that a body in motion tends to stay in motion. Translated to stocks, that means a sector that’s hot will stay hot.
Now, to be sure, there are laws of thermodynamics stating categorically that when an object deviates from the mean temperature in the nearby environment, it will tend to revert to that mean temperature. That is, even hot items will cool down to the general level in the neighborhood.
But that law does not apply to investing. Instead, you want to keep piling into stocks and funds that are hot. They will stay hot. Our friend, Professor Dichev, and many others in his field, have clearly demonstrated with facts and history that when a stock or a sector, or the market generally, is hot (Dichev is more about the market generally), it will cool down. Sometimes it will downright freeze.
So, when money flows into stocks are the largest, and when the market capitalization of stocks generally has risen to abnormal levels—that’s when it will soon come down. The prime example might be the Nifty Fifty of the 1960s. These were superhot stocks like Xerox, Kodak, and Litton that just could do no wrong—they were the wave of the future and you could never lose if you were invested in them. They then turned down and have stayed down for a long time. Too bad for Xerox. They invented Windows but saw little commercial application for it so they gave it away, basically, to a fellow named Gates (and no one’s ever heard of him again!). Too bad for Kodak, who did not see digital cameras coming and also did not see Fuji coming. IBM has done well, but the others have been a mixed bag.
Too bad for the Nifty Fifty companies: Most of them learned the hard way about “reversion to the mean.” Oh, didn’t they tell you about the term “reversion to the mean” back in finance classes, or maybe in statistics? It is the simple rule that if a stock or anything else in the world of randomness—and stocks do live in that world—deviates far from the average (i.e., the mean), it will eventually return to the mean, as the mean is calculated over long periods.
But that does not apply to you. You live in your own special universe. The normal laws of financial entropy (or anything else random and normal) do not apply to you. So, go ahead anyway, and bet the farm on the stocks that are hot right now. You will never be disappointed.
That goes for the stock market as a whole. If it’s hot, thanks to the innovations of exchange-traded funds (ETFs) and index funds, you can just buy the whole market. That’s what the nerdy kids are doing right now anyway. As I already told you, that’s a silly way to go when a genius like you can pick stocks that will outperform the market. But if you persist in buying indexes, just know that the best time to buy them is when the whole market is sizzling. If it is hot today, it will stay hot.
To be sure, two astonishing geniuses named John Bogle and Warren Buffett, and also Phil DeMuth, another astounding genius, and even pitiful old Ben Stein, have pointed out that when stocks rise a lot, usually it’s somewhat because of rising earnings—which is a great thing—and somewhat because Mr. Market is applying a higher valuation to those earnings.
That is, stocks trade as a multiple of their earnings. It’s nice when earnings rise, but when the world at large has determined that good times are here for good, and raises the multiple it applies to earnings—that’s when things get really great and jiggy. For example, if grouchy old fools think that there should be some caution applied to stocks or maybe to the whole economy, they will say that a stock is worth, say, eight times earnings. That was the way it was long ago in the bad old days of inflation in the 1970s and early 1980s. After all, cranky people argued, if you can get 10 percent on a safe Treasury bond—that was in the days long, long ago when Treasury bonds were considered a safe asset—why should you pay more than eight times earnings for a stock that has uncertainty in it? The stock will be yielding 12.5 percent and the bond will be yielding 10 percent. That seemed about right to those old fuddy duddies. But when “morning came to America” in the Reagan, Bush, and Clinton years, horizons were unlimited. No inflation. Rising earnings. Why shouldn’t stocks sell for 30 times earnings? After all, their earnings will soon rise to the point where the stock you bought when it was earnings 3.3 percent will be earning 10 percent. Why not put that in the price right away? Why not hold a stampede to buy? That’s when the world suddenly decides that the market is not worth 1,000 on the Dow. Now, it’s worth 6,000!
That’s when they are using champagne to wash their Bentleys on Wall Street. That’s when money is bubbling forth under every sidewalk in Manhattan and Greenwich.
You can be sure that when those days come, they will last. They always do. So, to make sure you fully understand, buy in when things are hot, and keep on buying, buying, buying. They won’t go down.