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What tune do stock market prices dance to?

20th January, 2020

Published in the Sunday Times on 19th January 2020.

Time-in or timing?

Here’s a quick thought experiment. Just over six years ago you invested in the equity of a company that more than quadrupled both its revenues and gross profits. As a shareholder would you expect to have been well-rewarded?

The company is Twitter. Since its IPO (Initial Public Offering) in June 2013, its share price has returned 85% less than the broader market (23% versus 108%). Expectations at the outset were clearly too lofty, and Twitter’s share price has simply grown into its valuation multiple. Which today stands on a less lofty, but by no means cheap, 35 times next year earnings. Time may well heal this wound for shareholders, but it does make the adage “it’s time in the market, not timing” ring a little hollow.

What drives company share prices quoted on the stock market?

Of course I’m guilty of cherry-picking here to make a point; that company earnings and stock prices can behave in ways many would consider to be contrary. But here’s a broad stock market statistic that in no way has been singled out:

In his book Practical Speculation, former hedge fund manager Victor Niederhoffer notes that in 65 years of market data, earnings rose in 43 years and declined in 22. The stock market averaged gains of only 4.9 per cent during the 43 positive years. Yet returned 14.2 per cent on average in the years of declining earnings. For reference, in 2019 US earnings were flat, yet the S&P500 had one of its best years on record, recording a 31.5% gain.

Two things drive markets over time:

  • Earnings, including dividends.
  • And the increase or decrease in how much investors are willing to pay for those earnings (i.e. what valuation multiple).

That’s it. Despite utterances from many investment professionals, it isn’t any more complicated than this. Every movement – short or long term – is a function of one of those two things. From there follows some commonly held beliefs:

Earnings and markets move up and down together. And the greater the earnings increases, the higher the market’s return.

Both statements have an appealing, if superficial, plausibility. Yet both are entirely false. Almost everything we are taught, hear or read about stock prices and company earnings is bogus.

And to the extent that you may harbour some notions that the economy and earnings are positively related, consider the following:  In the US, of the 69 years since 1950, eight have seen real economic growth contract, essentially recession years. However, in 23 of the years (33% of the time) earnings from the S&P 500 companies experienced declines.

The point is not that stock prices dance to some completely different tune to the economy and earnings, but trying to predict the former based on some insight about the latter is a fool’s errand.

The daily assertion on news reports that stocks are up on earnings optimism or down or concerns about the economy, amount to nothing more than an invitation to trade and usually in the wrong direction. So let me try and set the record straight as we settle into the new year and potentially make some important investment decisions.

Are share price movements predictable?

Back to the two things that drive stock markets over time – there are a couple of important details to add:

  • Populations grow and workers generally get more productive over time. Hence, earnings tend to grow and compound in a way that makes their growth reasonably predictable at an aggregate level i.e. earnings are more predictable at the market level rather than at individual company level.
  • Changes in valuations are highly unpredictable because they mostly reflect shifts in public sentiment. And they don’t compound over time. There may be a reasonable argument to be made for increasing valuation multiples as interest rates decrease and vice versa, but there are limits to this effect.

So we have two variables. One is predictable and compounds, the other is unpredictable but doesn’t compound. Long term returns are therefore likely to be more significantly influenced by the factor that compounds over time, than the one that doesn’t.

From a media perspective this is very unedifying. Short term stock price changes are highly unpredictable and don’t significantly influence long term returns. So why all the daily commentary you might legitimately ask?

There’s lot of trite advice dished out in relation to stock market investing. I don’t wish to add to it, but the Ben Graham analogy of the stock market being a voting machine in the short term and a weighing machine in the long term has particular relevance. Decide if it’s for you and if so, keep this analogy close in mind.

To the extent that stock markets over short time periods might be reflecting changes in mood more so than changes in fundamentals, it is within your gift to either use this pricing mechanism for good or ill (buying or holding when that sentiment is overly pessimistic and vice versa).  

But as in the Twitter case, you might need a longer than average holding period if your timing is off. This of course is less relevant for the market as a whole than it is for single stocks. Caveat emptor.  

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