the discounting mechanism and the business cycle

An important thing that doesn’t get talked about much is that the stock market is just that, a marketplace–one where the hopes and fears of investors meet the objective characteristics of listed companies and express their interaction in stock prices.

In a typical optimistic market, investors are willing to discount (Wall Street jargon for “factor into today’s stock price”) potential earning power for a given company as much as two or three years in the future. In the wild, covid-driven, zero-interest-rate market of 2020-early 2021, investors have been willing to discount profits considerably farther ahead than that. Potential investors may also let their imaginations run a bit into overdrive as to how good those future earnings might be and/or how likely the best case scenario is to occur.

In contrast, in a nervous market like the one we’re in now, it’s possible that the balance sheet and income statement characteristics of the companies don’t change that much (in the current case, my guess is that overall S&P earnings come out about the same as rates move higher but that the winners and losers shift a bit). What certainly changes, however, is that investors undergo a dramatic mood change. They pull in their horns. They are no longer willing to discount earnings several years in the future; in the most ugly markets I’ve lived through, investors won’t pay for any future earnings, even next week’s. They shift from dreaming about how good things might be to focusing on the most conservative outlook. Stock selection shades away from tomorrow’s potential winners to more mature, steady income generators.

This may just be me, but it seems that over the past decade or so many professional investors have shifted away from being anticipatory to being reactive. That is, they’ve played down the traditional emphasis on detailed study of individual companies/industries, with an eye to uncovering those whose profits will likely significantly exceed consensus estimates. Instead, they now focus on swift, AI-driven, response to news reports–either company-specific or general economic–that appear to have a bearing on future profit potential. Why do this? …it’s cheaper than having a staff of seasoned analysts and clients think the “objectivity” of computers gives them a better defense if their chosen manager underperforms.

This would explain why the selling we’re now experiencing seems so relentless and so willing to push prices down significantly. Whether I’m right or not, selling does seem to me to be both aggressive and not particularly selective. The result may ultimately be the creation of a new class of “value” stocks–cash-rich, earnings-poor companies that have come to market during the pandemic.

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