"Thus, often wrong, seldom in doubt, we opine with great certainty about things of which we know next to nothing. It almost goes without saying, but the less knowledge we are burdened with, the greater degree of confidence in our forecasts."
The headline worries of the day and explanations I have heard for recent stock market volatility are:
1) Actions of the Fed - increasing interest rates;
2) the ongoing trade war with China;
3) inflation and higher input costs for consumers and businesses;
4) the carry trade;
5) central banks removing liquidity;
6) political risks in the U.S. and around the world; and
7) an elevated U.S. stock market, among other concerns
I apologize if I have missed something.
I make investment decisions based on math in an effort to judge investment opportunities in terms of estimates of future returns and risk in specific stocks and bonds. There are many models available used to value stocks. An imperfect but simple model used to judge individual stock and market values and prices is designed to estimate justified (intrinsic) PE ratios. The model formula is as follows:
P/E ratio = earnings retention x earnings growth rate / required return or cost of capital - earnings growth rate
note: earnings retention equals total earnings less dividends/total earnings
Individual stock or market returns over a holding period are a function of entry price (P/E x earnings based on historic or future earnings), earnings during a holding period and exit price (PE x future historic or future earnings) plus dividends collected along the way.
On a daily basis, the stock market makes a judgment call on future earnings and capital costs that are directly influenced by interest rates, earnings growth rate prospects and earnings retention. Plugging these individual variables into the above formula suggests that:
1) lower earnings growth rates imply lower PE ratios / higher earnings growth rates imply higher P/E ratios;
2) higher capital costs imply lower PE ratios / lower capital costs imply increased PE ratios, and;
3) higher dividend payout ratios imply lower PE ratios / lower dividend payout ratios imply higher PE ratios.
Based on a PE multiple valuation approach, future stock prices are based on future earnings growth and the PE multiple applied to future earnings at the end on an investment horizon in the market or given stock. Using this approach and in general, stock returns are based on earnings growth and change in PE multiples between the entry and exit point in an investment. Worry list items outlined above effect earnings estimates and therefore stock prices. Current market worries may or may not be future worries even though they may affect current perceived intrinsic PE multiples as described below.
In addition to earnings, worry list expectations outlined above can be classified into the formula described above as cost of capital or growth rate factors that affect intrinsic PE ratios and therefore stock prices. For example, if the stock market view of the day or week is that forward earnings will decline or capital costs will increase at the margin, due to one or more of the reasons listed above, a stock price decline may be explained by the earnings growth rate decline and higher discount rate assumption on the PE ratio as modeled in the above formula. The opposite is also true, meaning that if the market view changes to a more robust forward earnings growth estimate or lower cost of capital assumption, stock prices would benefit from the change in model assumptions on the PE ratio. Finally, if forward assumptions change in connection to an increased earnings growth rate and higher capital costs then the PE ratio would be influenced by the assumption with the largest mathematical influence in the model, which means PE's could increase even if cost of capital (i.e. interest rate) assumptions increased, for example. Because of this reason, rate increases do not necessarily mean PE ratios and stock prices fall. Although there is a limit here, this phenomenon has occurred in recent years in stocks that I follow and own as valuation multiples have been sustained and increased to some degree, in a rising rate environment so far. The key to the above is figuring out what expectations are priced into the stock at any given time.
The stock market is a forward looking mechanism that is discounting information about the future on an ongoing daily basis. The volatility of recent days may or may not tell us anything about the future. I agree with Barry Ritholtz's view (described in the article below) that the volatility may be best explained as a random walk which means the volatility this week potentially has little meaning long-term (measured in years) which is the period of time I am investing in.
Because I follow a longer term investment horizon strategy, negative short-term overall market volatility tends to be my friend as it allows me to in general buy a stream of earnings at a lower valuation which tends to lead to higher returns over time with all other factors being equal. Stock period holding returns come from earnings growth and entry/exit multiples along with dividends, where applicable. As I am willing to hold onto positions for years over my investment horizon Ritholtz's view appeals to me. While I do not believe so, maybe this is a form of confirmation bias. Time will tell.
I am not making a market call as I do not invest this way. I do not know if we will see a significant stock market decline in October or in the near future. Experience and history tell me that we may one day face significant negative volatility and or a recession. I simply do not know if and when. In the meantime, I will hold onto my stock bets that are based on the long-term fundamentals of specific companies who are growing earnings/cash flows and are generating positive ROIC's as opposed to being worried about the market or economy as a whole. It is worth noting that if further meaningful negative volatility occurs, stocks may become more attractive bargains over the long-run. Or maybe not. We will have to cross this bridge when we come to it. In the meantime we will wait and see and avoid doing the impossible which is accurately predicting the direction of the market over the near term.
If my investment horizon was short or I did not have the ability to deal with volatility, recent market activity might be scary, dangerous and rightfully so. In this case, it may or may not be wise to be in the stock market depending upon one's circumstances and risk tolerance. On the other hand, downward market volatility tends to be a positive for long-term value investors with a horizon because it allows them to make long term multi-year bets at lower valuations with positive asymmetric return characteristics with the caveat that they may need to own stocks into a future market decline due to a recession or other volatility inducing event should one or more occur during their investment horizon.
As usual I recommend that investors do their homework and follow sensible strategies based on their individual circumstances.
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The Stock-Market Meltdown That Everyone Saw Coming
At least they saw it coming with the benefit of hindsight. The reality is, the explanations can’t account for what is probably a random event.
By Barry Ritholtz
October 11, 2018, 6:50 AM PDT
Easy to spot in advance.
Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”
Now seems like the right time to offer an after-the-fact explanation in great detail and with complete and utter certainty of what just occurred in the markets, and why.
Hindsight bias permitting, the factors that led to this sudden and unexpected decrease in share prices are just so obvious. Simple, compelling language describing cause and effect is both comforting and reassuring. The alternative to this soothing narrative is an unimaginable world of random disconcerting events. This stands in stark contrast to how we prefer to see the world around us: orderly, predictable, subject to expert management and prediction.
Sorry, to say, but that isn’t how it works.
We would have shared this explanation before the market dropped, had we been so inclined, but that would have spoiled the fun. Our powers of rationalization are somewhat less persuasive a priori than our overly optimistic belief in our own abilities. Besides, it is much easier to convince you of the reasons for what just happened than persuade of what is about to happen.
Thus, often wrong, seldom in doubt, we opine with great certainty about things of which we know next to nothing. It almost goes without saying, but the less knowledge we are burdened with, the greater the degree of confidence in our forecasts.
Why did the market suddenly drop 3 percent on Wednesday? It is as obvious as the nose on your face that the Fed’s tightening of monetary policy by raising interest rates to curb financial risk-taking is to blame. But we’ve known about this for a while, haven’t we?
As an alternative, maybe you’d like to blame elevated stock valuations, which surely is a valid point in the U.S., except that lagging emerging markets fell just as hard, and they are cheap, very cheap — certainly much less richly valued than U.S. and European markets.
No, you’re all wrong: It’s the trade war started by President Donald Trump. Not only is the U.S. dollar too strong, but tariffs are crushing an already weakened China, which hurts all of its emerging-market suppliers. But we’ve known about this too for a while, haven’t we?
Wrong again, say the partisan fire-breathers: It’s the Demon-Rats, and the possibility they will take control of the House of Representatives in the midterms, putting at risk all of the Trump pro-growth policies that are solely responsible for the healthy U.S. economy. Again, has anything changed in terms of the electoral outlook?
This market panic — or is it a crash, or a bear market? — was the worst day we have experienced since February of this year. It has now brought markets all the way back to levels not seen since – wait for it – July of this year. Was the market so bad then? This decline follows a market that has tripled since 2009, had zero volatility in 2017, and has continually confounded all experts who in one way or another couldn’t explain why the market was as good as it was.
Just for the sake of a little more perspective: This was the 20th time since the bear market ended in 2009 that the Standard & Poor’s 500 Index had a one-day loss of 3 percent. The Nasdaq-100 Index had its eighth 4 percent down day (although it was the biggest one-day fall since August 2011). Meanwhile, Wednesday’s decline has left the Standard & Poor’s 500 Index all of 5.2 percent below its September high.
True, some stocks were hit much harder than others. Facebook Inc. and Netflix Inc. are now officially in a bear market (if you believe a 20 percent decline is a bear market, but you already know I think that is nonsense).
But enough with facts. Go right ahead and feel free to try on any of your favorite after-the-fact-explanations about why markets fell. It really isn’t that hard. Just take your favorite pre-existing belief system and seek out facts that are consistent with that. Who am I to stand between you and your confirmation bias?
But the reality is simply this: The random walk thesis of how markets move is the best explanation we have. The alternative is looking at these events retrospectively, and from that vantage point they all seem so blindingly obvious. But if they were so obvious, why didn’t we see them coming?
