Future Expectations

Every stock that you own is an ownership stake in the future profits of some business. Naturally, these future profits may not be realized or may fall short of expectations which could lead to decline in the stock’s value. But what do these profits depend on? Mainly two things : the profit margin and the total revenues earned by the firm. You multiply them and voila, you have the profit. Now imagine that you combine all the publicly traded companies in America into one giant corporation. The performance of the “stock” of this entity is approximated by well-known indexes like the S&P 500, the Dow etc. We call this thing the “stock market” or just the market. We will get to bonds and other asset classes later, but similar rules apply there.

One reason why thinking about the market as a whole is useful is because the total sales of this construct correspond approximately to the Gross Domestic Product (GDP) of the United States. In other words, you could expect the total market sales to grow approximately at the rate of growth of the economy as a whole. It’s nice to be able to link the market to something in the “real economy”!

But what is the GDP anyway? It’s pretty much the sum of all goods and services being traded between people and businesses. Naturally, if the population grows, the GDP will grow too because you have more production to feed, clothe and otherwise serve these new people. But the GDP typically grows faster than population growth because of human ingenuity – after all people are constantly thinking about new stuff to produce.

Just go watch Shark Tank if you don’t believe me.

The profit margin of the market as a whole tells us something about human efficiency at the national scale. It is another form of ingenuity : how to keep costs low while still producing something worth buying. Naturally, this factor can be hit hard if there are run-away costs i.e. high inflation. It is also why the HR department at your firm tries to low-ball you on salary.

Far from being disconnected to the real world, it looks like the stock market is trying to capitalize on major human forces of ingenuity. But it is indeed confusing why the market moves so wildly – up one day, down the next.

As it turns out, the value of the stock market at any given time depends on future expectations of profit margins and sales.  This is a very important concept. But, what is it about future expectations that turns markets into the wild west? The answer lies in the delicate balance between growth and discount rates.

Discount rates are crucial to understanding how markets work. Imagine that you have two neighbors, one of them has a tough time holding down a job while dealing with a drinking problem, and the other is a model of punctuality and stability. Both happen to have the same business idea and request a loan for their start-ups. Let us say that each start-up expects to earn $10,000 every year for the next 10 years. Which start-up is worth more right now? Obviously the boy scout’s. Why? Because all those $10,000 installments of his future earnings are more likely to actually happen. The other guy might well end up in jail – in other words, he is more risky! His future earnings are not so valuable right now – they need to be discounted at a higher rate.

In the same way, different companies deserve different discount rates. So do different countries e.g. the US stock market’s future earnings should be discounted at a lower rate than those of the Greek stock market (say).

So we have two things working against each other. The discount rate decreases the value of future earnings of a stock market. But, human ingenuity over time leads to growth in earnings. When you account for both these forces, it turns out that the value that remains is very sensitive to the difference between the two.

We need to do some math to see that in action and I am going to give you a simple formula to get a ball-park “theoretical” estimate of market value:

Market Value of a Firm = Current earnings paid out as dividend / (discount rate in % – growth rate in %)

Let us say a company pays out $10 million every year as dividend to its investors. It also expects to grow at the rate of 5% per year but due to the riskyness of its business, it deserves a discount rate of 9%. Using the formula above, you get a valuation of about $250 million. Now let’s say there is some news that appears to increase the risky-ness of this firm by a bit, so the discount rate goes up just a tad to 9.5%. Let’s say growth prospects also look slightly weaker and we adjust the growth late lower to 4.5% per year. Now the valuation of this firm works out to only $200 million. The firm’s stock value has lost $50 million or 20% because of these small adjustments to growth and discount rates!

This is fundamentally the reason why stock values can go up or down by a lot due to seemingly innocuous news items. It can seem downright insane at times because of the size of our large corporations. Google (GOOGL) stock is worth something like $500 billion as of this writing. A very small adjustment in it’s expected growth rate or discount rate can easily change its value by 10% which would amount to a gargantuan $50 billion.

Now, the issue becomes clearer. A company such as Google could add or subtract as much as $50 billion of value over a matter of days. In other words, this business of future expectations makes it extraordinarily difficult to value the stock market, because after all what hope do we have of estimating growth and discount rates in the unknown future with such accuracy? There are whole armies of smart equity analysts all over the world devoted to figuring out these two numbers, but, to be very honest, they don’t achieve much.

Not that the market cares of course. Since market values are about the future, they have very little to do with what has been going on in the world lately. The market is like that guy in Memento : it forgets the past almost as soon as it happens. This is not some evil conspiracy against the common folk, it is what the market is supposed to do. And no, this feature does not make it disconnected from the “real economy”.

About seven years ago, in March 2009, this was a matter of some contention.

The first quarter of 2009 was a scary time whether or not you worked in the financial industry. It felt like the wheels were coming off the financial system. I recall the stunned silence around the trading floors with old hands looking as if they were suffering from PTSD. Four months earlier, I had been one of the many Lehman Brothers “assets” taken over by the London-based Barclays Capital. Every day the new leadership was letting go a dozen or two of the people sitting adjacent to my section. However, as soon as March arrived, the global stock market could not care less. For the rest of the year, the S&P 500 rose by 50% while the American economy went on to lose 3 million more jobs. Some emerging markets were even better – Brazilian stocks rose by a whopping 120% for the rest of the year while Brazil’s exports plummeted.

This stellar market performance was not well received by the media. There were murmurs of conspiracies, manipulation even. Even most people in banks were clueless as to what was going on. However, they and the media pundits should have known better. The market was rising because of future expectations. It was saying “look, things are very bad now, but eventually they will be O.K.”.

The job losses in America went on for most of 2009, but after that a recovery indeed took hold. By the time Barack Obama was inaugurated for his second term in 2013, all of those 3 million lost jobs had been recovered and roughly 2 million more had been created. Businesses were again running profits and it no longer looked like the world was about to end.

2009 was a told-you-so year more than anything else.