Do Fundamentals Matter In a Market Driven By Sentiments?

George Soros once said ‘Stock market bubbles don’t grow out of thin air. They have a solid basis in reality – but reality as distorted by a misconception. Eventually the gap between reality and its false interpretation becomes unsustainable, and the bubble bursts.’

So, do fundamentals matter in a market driven by sentiments? When your funds are invested in the stock market, does your heart skip a beat every time you hear people talking about the impending fiscal cliff?  When you hear that the real estate sector is not doing well, you keep wondering what impact it might have on your investment portfolio. But then you remember that when you had invested, your financial advisor had assured you that ‘we are only cherry picking the fundamentally strong stocks in the fundamentally strong sectors’ – so you need not worry about every dip or spike in the market. So then, what should you do? Should you stay calm and not worry; or should you calculate your risk and pull out some of your funds when the market sentiments look gloomy?

When do market sentiments matter?

Well, the answer is – in the short term. When you are investing in the securities and derivatives markets for short term returns, you need to keep a tab on every business, economic or political news that could impact your portfolio. You should remember that in the short term horizon – the market movements are completely based on traders’ sentiments and news. As a result of this, stocks tend to be typically overvalued or undervalued from their real fundamental valuations. The market movements on a daily and weekly basis are usually immediate news based or technical charts based. So you might hear of news of fire at a manufacturing facility of a company and see its prices plummet. The fact that the facility is adequately covered under fire insurance is not considered by the day-traders who over-react to the news and start a frenzy selling leading the stock prices to spiral downwards. But when you are in it for a quick bite of profit, the correct reading of sentiments is what is most important.

Do fundamentals matter anyways?

When you are invested in the stock market for the long run, you should not be worried about the daily fluctuations, market sentiments and news based trading tips. Over the long term, the stock prices of a company are driven by factors relating to Company, Industry and Economy – the fundamentals of the company, the industry outlook, and the overall economic scenario. When you are building an investment portfolio for the long term – every stock should be picked after careful fundamental analysis of the company’s financial performance, growth aspects, SWOT analysis and a thorough check of all its fundamental parameters. The industry outlook and the overall economic situation should be studied in detail using tools like Porter’s models, economic policies and political news. Only stocks that fare well on all levels should be included in your investment portfolio.

Let’s take the example of ‘Defensives’ – these are stocks of companies that seem to be unaffected by the frenzy of sentiments even in an economic downturn. Typically, you would find stocks of FMCGs, pharma and medical companies, utilities like electricity and gas falling under this category. These companies will continue to do well even in bad times – because you will consume their output as your daily habit; and you won’t stop eating or drinking even if there is a strain on your finances. This makes defensives a fundamentally strong investment especially in a bear market; when other stocks continue to fall.

The Crux

Instead of falling into the divide between market sentiments and fundamentals, you should simply ask yourself – what is my investment horizon and what is my objective? Are you in the game as a trader or are you investing for long term returns? Answer this correctly, and you will see your doubts dissolving away.

– Research Optimus