Pulling Earnings From The Distant Future

The rally in the markets for the past 2 weeks has many scratching their heads. It must be especially dissonant for business owners and landlords who see the market and their own P/Ls as 2 trains headed in opposite directions.

For the visually inclined:

Sure estimating forward earnings right now is like using binoculars to study the moon, but the point remains. The market despite being lower than it was in early February may actually be equally or even more expensive as a discount of future cash flows.

Let’s remember that stocks were up 30% in 2019 despite earnings being flat. Pure multiple expansion. Mocha Joe plays the buy-stocks-then-fall-into-a-coma-game:

So I’ll add 3 comments to this in descending levels of conviction.

1) The market is actually more expensive than the Credit Suisse chart suggests

Why? The implied volatility is much higher than it was last summer. If you are willing to pay the same multiple for an asset whose volatility has doubled you are willing to accept a lower geometric return. I know many people want to shut down when they hear “geometric return”. The more you are exposed to it, the more intuitive it becomes. Internalize these bits:

  • When talking about compounding quantities like investment returns, geometric returns are what you care about.
  • An expected geometric return allows you to compare assets of different volatilities (without resorting to Sharpe ratios). By pulling in the notion of volatility it is more obvious that this market is more expensive than the June 2019 market.
  • For the formula people, geometric returns = arithmetic returns – σ² / 2. Returns are dragged down in proportion to volatility squared.
  • The easiest way to remember why compounding is so heavily impaired by volatility is to recall that you need to return 50% to make up for a 33% loss. So to make up a loss you need to return Loss / (1 – Loss). This reality means your wealth-growing process hates volatility.

I’ve explained this in more depth and with different types of examples in The Volatility Drain. (Link)

2) The market appears willing to pull earnings from ever further into the future 

Perhaps this is a form of inflation. Perhaps the “Fed Put” looms larger in investor discount rates as every market crisis is deemed inseparable from a human crisis. To use a computer science analogy it’s like the Fed response has become the “greedy algorithm” which chooses immediate gratification at every node in the search tree.

Either way, I’ve said this before: I wish I could buy call options struck on the P/E ratio not the SP500. (Link)

For savers who hang out in cash looking for bargains, this is what financial repression looks like. A city without a single dive bar. You can pay up for bottle service, velvet ropes, and bad music. Or stay home.

3) Gun to my head: the next 10% in the market is higher.

First, nobody is putting a gun to my head, so this is a no-skin-in-the-game guess. Not investment advice. But sentiment seems to think that this rally is stupid and makes no sense a la Mocha Joe reasoning. This means the “stupid price” is making a lot of people look stupid. And since markets like to maximize the area of stupidity under the curve, the integral is largest if we rip even higher. I’m only using second-order reasoning but since the market can go either up or down it might be just as effective as 4th, 6th, 8th or any even number order reasoning.

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