Discounting is the word stock market professionals use to describe the market process of factoring into current stock prices its anticipation of how the future will unfold, both for the market as a whole as well as for industries and individual stocks.
There’s a fear/greed aspect to this, just like everything else on Wall Street, or maybe every human activity. In a bear market, investors’ willingness to look ahead–even a month or two–diminishes severely. In contrast, at the height of a bull market investors may be factoring in expectations more than two years out. My experience has been that whenever the market is justifying today’s prices by citing events to happen more than two years hence, it’s a sign of speculative excess.
In the middle of the business cycle, the stock market typically looks about a year ahead. In June or July, Wall Street starts to seriously consider what the following calendar year will look like.
Viewing the bond market as an outsider, it seems to me that bonds, unlike stocks, are typically strongly anchored in the here and now, responding to events as they occur, but not much, if any, time before.
How is it possible for stocks to see into the future, as it were? An army of securities analysts. When I entered the business, both brokerage houses (the sell side) and institutional investors (the buy side) had large staffs of analysts constantly speaking with companies about the tone of their revenues and about business conditions in general. Firms were very willing to share their thoughts with their investment bankers and with long-standing large holders of their stocks.
Starting maybe 25 years ago, the buy side began to realize that many times its staff of analysts did little original research, but relied very heavily instead on reports they received from sell-side analysts (paid for by directing trading commissions) which they summarized for portfolio managers. Around the same time, the internet allowed reports to be sent through email (saving brokers something like $125,000/year per recipient in printing and deliver costs, so the number of copies of research was no longer an issue). The result was that many buy side firms signed their PMs up for brokers’ research emails and fired their analysts–creating huge cost savings, at least in the short term.
In the depths of the financial crisis of 2008-09, the big banks fired most of their veteran $2 million/year analysts, however, saving a bundle by replacing them with trainees.
As the skilled professionals who survived the two purges began to retire, it seems to me that the collective ability of Wall Street to predict the economy’s path and individual companies’ fortunes has eroded to some degree. If so, that’s good for you and me, who don’t have privileged access to this information and are able/willing to do our own research work.
In other disciplines, the academic world would also be an important information repository. Finance professors, however, are by and large lost in their imaginary world of efficient markets.
A relatively new substitute for human researchers has been computer-driven trading. One form of this is super-fast reading of corporate and industry news and equally quick buying and selling in response. Another direction is based heavily on academic conceptions of how the market works. A third, nor really prescriptive, looks for valuation deviations among stocks, bonds and their associated derivatives. There are surely more that I’m unaware of.
The result of these changes has been, I think, a substantial shift in the stock market discounting mechanism. As I see it, there’s an increased emphasis on the here and now–on the minutia of highly predictable things that may happen next week or next month, as well as re-discounting things that have already happened yesterday. There’s also a decreased focus, I think, on trying to imagine what the world, and company prospects, will be six or twelve months in the future.
Two implications, if I’m right:
–greater day to day price volatility in stocks than was the case, say, ten years ago. In academic-speak, this means stocks are riskier than they’ve been in the past. I think this conclusion is as crazy as anything else that comes from finance professors. Yes, the day-to-day water may be choppier, but I also think the chances of someone with a longer-term horizon buying at a more favorable price as the surf churns increase as well. More important,
–if fewer market participants are trying to puzzle out fundamental trends that will shape the world six months or a year ahead, which is what I think any sensible investor should be doing, then the rewards for being correct stand to be that much larger as the AI-driven market apparatus catches up with us.