June 26, 2026

Mechanical versus Fundamental

Over time, stock valuations are guided by fundamentals.  Essentially, stocks follow earnings with valuation multiples fluctuating based on a variety of fundamental influences, including GDP growth, inflation, interest rates, earnings visibility, geopolitical dynamics, fiscal and monetary policy, and investor/consumer sentiment.

In the shorter term, there are mechanical forces that impact stock valuations and have little to do with fundamentals.  For example, high-frequency trading driven by computer models can exacerbate volatility when trading becomes less orderly.  Short-selling can dislocate stock prices.  There are many “behind the scenes”, non-fundamental issues (e.g., algorithmic trading including dark pools, market maker “bad” behavior, hedge fund liquidity issues, etc.) that can make investors scratch their heads when they see unusual price action.

One such “mechanical” force is the rise of leveraged ETFs.  Leveraged ETFs allow investors to get 2x or 3x of the return of an underlying index or security.  For example, you can buy the straight 1x S&P 500 Index or you can buy an ETF that provides 2x or 3x the daily return.  If you have a bearish outlook, you can buy a 1x, 2x or 3x ETF that trades inversely to the S&P 500.  In other words, if the S&P 500 index goes down, these inverse ETFs appreciate. . .

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