“Discounting” or the “discounting mechanism” or the “discounting process” is Wall Street jargon for the idea that the stock market is a futures market, which reflects in today’s prices consensus beliefs about future events.   The general idea is that the current price will move only when surprising new information about a company or its stock emerges, and the market reacts by bidding the stock up or down.  Maybe the most common factor being “discounted” at any given time is expectations about future earnings, although this is by no means the only one.

Discounting is a fuzzy concept.  The real trick, which only comes with effort and experience, is to be able to make a good guess at whether the information you have that makes you want to buy a stock is already factored into the price.  It may be that the person on the other side of the trade doesn’t have your information yet.  It may equally be he thinks it’s last week’s news.

My discounting rules

I think there are some general rules about discounting, though.  Specifically:

*When the market is rising and the economy is expanding, investors in the US tend to be willing to discount  things that they think will happen well over a year, or maybe two, into the future.

*In a falling market and a contracting economy, when investors are fearful, they discount very little.

*In a “normal” market, investors begin seriously considering the following year’s earnings in June or July of the current year.

*Bad news about a company is almost never fully discounted, even if it is widely expected, until the company announces it.

*Long-term trends are discounted only very slowly.  For example, the attack on department stores by specialty retailing in the Seventies took at least a decade to play out.  So, too, the positive effect of disinflation in the Eighties on consumer staples.

*Inflation and interest rates have profound impacts on what discounting means.  During the accelerating inflation of the Seventies, investors typically tried to buy a stock at a p/e multiple of 50% of the growth rate and sell it at 1x the growth rate.  In the disinflation of the Eighties and Nineties, investors were content if they could buy at 1x the growth rate and hold until the growth rate gave signs of slowing.  In the low interest rate period of the internet bubble, investors were willing to buy at 2x or 3x the growth rate (which turned out to be a horrible decision, but,still, some people did it for four or five years).

What’s really important now

On a business cycle basis, we should soon be switching from discounting nothing about the future to being willing to imagine possible rising earnings for some companies in 2010.

Consumer behavior patterns over the next decade may well be different from what they have been in the recent past.  The first to figure out the new rules will make the most money.  I think Wall Street is particularly bad at this kind of stuff, so we all have a good chance to be at the head of the pack.

The future for inflation and interest rates are both up in the air.  The Wall Street rule of thumb, which I choose to subscribe to in this instance, is to figure out what the consensus is and bet heavily against it.  For what it’s worth, my preliminary guess is that inflation will stay low.  Yes, commodity prices will rise.  But inflation in the US is mostly wages.  Where is the upward pressure going to come from?  Not the banks.  The financial world is in for serious wage deflation, which should counteract at least some upward pressure elsewhere.  Is Wall Street going to be able to think this about itself?

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