It’s already in the price

In online financial discussions, there are bears and bulls, boomsters and doomsters.

Sadly, the curse of investing debates and discussions is that the bear case looks / sounds smarter.

To add the spurious impression of evidence, the doomsters often back up their argument with a link to some crappy online article…YEAH, BUT WHADDABOUT THIS?!?

This has always been so but particularly during 2020 during which, to be fair, there has been no shortage of apocalyptic news.

How can a global tracker be down only ~5% when eny fule kno that we are in a global pandemic and slow-motion economic train-wreck? 

The first point is that, if you are still watching The News, that’s an own-goal. Just because you see something on The News, that doesn’t mean it’s accurate or representative.

It’s more like the other way round: the less representative something is, the more newsworthy it is. Dog bites man…yawn, boring. Man bites dog…now you’re talking. I avoid media disinformation by cutting out the middleman and going direct to primary sources. Much of the mainstream media is rapidly being dis-intermediated into irrelevance.

My second point is that the stockmarket is not the economy. The global stockmarket is made up of the big publicly traded corporations of the world. The stockmarket is made up of Big Tech, Big Capital and The Rise of The Machines.

The stockmarket does not include the small businesses, the independent private businesses, the (good) pubs and restaurants, the local businesses. Last week one of our local gyms went bankrupt; another casualty of lockdown…not a problem for the stockmarket but a personal tragedy for the young family that ran it.

My third point is that the stockmarket is looking forward. All the news you are seeing relates to what happened yesterday. It takes time for official economic data to be gathered, analysed and released. The economic data you are seeing reflects how the world was last year, last quarter or last month.

In contrast, the stock exchange is looking far, far out into the future. Anyone who has prepared discounted cashflow models valuing companies knows that a large percentage of the value of the company usually sits in the continuing value: the perpetuity value of the cashflows outside the explicit forecast cashflow period.

The value of any asset is the the present value of the future cashflows that will accrue to the owner of that asset. So the “correct” share price is today’s value of the future dividends to be received by the shareholder.

A simple way to think about this is consider the dividends paid on shares. If the annual dividend yield is 2% then it takes you 50 years to get your purchase price back (assuming no sale and no dividend increase). With dividend growth, that duration changes but you get the point. People often say things like “the City is short-term” but the market is actually looking years and decades ahead.

The stockmarket is like a gigantic super-computer that gathers information, reflects uncertainty, weighs up all the bets placed and produces prices that reflect that information and that uncertainty. In the jargon, the stockmarket is “efficient”. That means it reflects the available information and uncertainty well enough that you can’t beat the market by reading newspapers, broker research or listening to your mate Dave down the pub.

So how good is that super-computer? How good is the market at pricing the zillion pieces of information, picking out what’s important and discarding the noise? Well, given the impossible scale of the task, the super-computer is REALLY, REALLY good at it.

This is not to sat that the market is always right. The stockmarket is not 100% efficient. It is not some all-powerful deity or omnipotent being. But it’s got far more processing power than any person.

The beauty of working in corporate finance was that I got a ringside seat to watch several market bubbles. When I started out the Japanese stockmarket was climbing down from an insane 80x price : earnings ratio (at a time when the US stockmarket was trading on ~16x and the UK on ~14x). That was followed by a biotech bubble, a football club bubble, the late 90s tech bubble, the housing credit and sub-prime bubbles, the commodities supercycle (what happened to that?) and another gold bubble.

So this is the problem in the stockmarket: we know it does crazy things from time to time, but we can only know for sure in retrospect after The Fat Lady Has Sung.

I don’t think that we humans are wired to naturally understand the concepts of discounting a future that has an infinite range of future possibilities. People often think in binary terms: things get labelled “good” or “bad”. People are terrible at thinking in nuance, probabilities and second order consequences.

This is what Howard Marks calls “Level One Thinking”. Level One Thinking makes an observation but doesn’t consider the knock-on effects or the reactions of other players in the game.

What is second-level thinking?

First level thinking says, “It’s a good company, let’s buy the stock.” Second level thinking says “It’s a good company but everyone thinks its a great company and its not. So the stock’s overated and overpriced; let’s sell”.

First-level thinking says “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says “The outlook stinks, but everyone else is selling in panic. Buy!”

First-level thinking says “I think the company’s earnings will fall; sell” Second-level thinking says “I think the company’s earnings will fall less than people expect and the pleasant surprise will lift the stockmarket.

The Most Important Thing – Howard Marks

One of the things that confuses rookie investors is that they see stockmarket prices often going UP on bad news and DOWN on good news. How can that be?

A useful concept here is the idea of The Expectations Treadmill. Imagine that Amazon is not a company but rather a professional athlete running on one of those treadmill machines that you see in most gyms.

With the amazing past performance of Amazon, the expectations of the market are high and so Amazon has the speed of its treadmill set FAST. So Amazon has to run hard just to keep up with analyst and investor expectations. It only takes one small stumble for Amazon to fail to keep up with the expectations treadmill and the price to fall sharply.

Now imagine a fat and unfit company walks over to the same treadmill. The analysts and investors set the speed low based on what they’ve seen of them in the past. The conveyor belt moves so slowly that it isn’t that hard for our overweight friend to keep up and even outperform the treadmill. That’s your value stock, that is. He may not look good, but in the short term, he’s just as likely to outperform Amazon. You can make a decent argument for tilting towards quality over the longer term. But over the short term its a coinflip.

The beauty of the market is that it aggregates wisdom. Prices are are formed by many people with skin in the game; millions of people with different opinions who are backing those opinions up with real money: people’s hard-earned savings.

It’s currently very easy on the internet to find someone who says that the stockmarket hasn’t realised just how bad the economy is likely to be over the next 12m. But the stockmarket has already considered that and priced in the uncertainty. Why would you think that you’re the only person that’s considered that? What is your edge?

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  1. skin in the game is key for accountability. we put out two stock series. the first is our own stock holdings each month versus a tracker. the second, the malevolent missy series, follows a newer investor who buys and equal amount of one stock per month and the same amount of 2 popular trackers. we own all of the missy stock and bought them with our own hard earned money. we also try to explain our thinking in building a growth stock portfolio this way. in the end it’s very transparent because the data are all public and they don’t lie. cheers.

  2. What is even worse is that there is a whole industry in “pump and dump”.
    They lure in naive “investors” and take their money – an obvious example is the Sunday papers “stock of the week” but in he age where all.information is online there’s so much more deception that’s going on.

    With the gyrations of the stock market these days I get the image of small.investors being a shoal of fish – moving this way and that in a shimmering display of coordination – market up 3% one day on good news and down 5% on bad news.
    All the while the sharks are eating alive any fry that swims too fast, slow, turns to early or.turns too late.

    I now.believe that you can from the stocks but not the market.

  3. […] TEA breaks down the efficient markets theorem for our times (24) […]

  4. Just do the exact opposite of the crowd and you’ll be right more often than not, in life and in investing. Is my belief anyway.

  5. Great article, never a bad thing to go over the facts of (investing) life.
    Can you share how you find authoritative sources for day to day news? BBC seems to have sunk to a new during COVID and I struggle to find sensible updates

  6. The news just seems to cause me anxiety for many reasons. It’s better to step away as you lose nothing and get to keep your sanity.

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