Theme Investing: Mega-Trends And Market Psychology

Posted on 12.27.06 by poster @ 9:28 am    

Investing has always been a little like surfing. Successful investors spot key investment themes (waves) and ride them to profits. Sometimes the waves are shorter and smaller than we had expected. Other times the wave takes on a mind of its own and falls under its own weight. The hardest but most profitable thing to do is to be the lone rider of a wave that others have abandoned for the “next best thing”, and then wait for them to catch up. The key is to know when to get on and when to get off. Previous examples of trend investing include defense stocks during the second World War, oil stocks in the ’70s, and of course, the dotcoms.

Spotting the Trends
How do you spot the next wave? You need to step back from the daily noise of the market and look at the long term - we’re talking years, not weeks. You need to look for the long-term forces that will propel some stocks and draw money from other sectors. In the early- and mid-1990s the focus was on demographic trends and the graying of the baby boomers. In the second half of the 1990s, it was the Internet.

Demographics and the Internet also illustrate how long-term trends fall in and out of favor. Both seemed to peter out eventually. The profit potential of investing in companies that benefit from the graying of the baby boomers was the focus of many investors at one time, but it was overshadowed by the Internet, obscured by market psychology that tends to focus on the current hot theme.

The events of September 11th, for example, caused a major reallocation of money into sectors that benefit from rebuilding our infrastructure and making our society safer from attack. Prior to September 11th, the market was focused on telco inventory corrections and old dotcom names; the market lacked any new ideas to sell to investors. After the attacks, the spotlight turned to security and defense stocks. While many of these previously unnoticed stocks had potential, many did not have any. A blind rush to buy any stock with a “security theme” could have resulted in another bubble.

Funds moved out of the old favorites into new hot sectors. These significant changes in investment policy represented a reaction to a key event, much like the reallocation that occurred in mid-1990 as investors were drawn to the promise of Internet stocks. The demand for increased security represented a long-term structural and psychological change that provided a potential boost for stocks in that sector. The effects on insurance, airlines and brokerages reflected near-term concerns for profits as institutional investors raised cash to reallocate funds to security stocks. Other long-term trends remained intact, but market psychology tends to focus the Street’s attention on one or two sectors at any one time.

There are three key things to remember:

1. Differentiate between knee-jerk reactions and fundamental structural changes.

2. Don’t sell to avoid short-term losses. If you have decided that a sector/stock is a good long-term buy, don’t try to avoid a short-term loss with panic selling. If a sector is falling, individual investors will not get the best prices, so it is better to stay put. You have a better chance of getting the stock cheap by buying when everyone else is selling.

3. Stick with your game plan, but be vigilant for major structural changes. Demographic stocks may be a better buy today because we are all six years older, but a smarter investment would be airport security stocks with solid fundamentals. You, of course, need to do your homework before investing.