the discounting mechanism

Discounting is Wall Street jargon for the process through which profit-relevant information about a given company is factored into its stock price.

When I started as a securities analyst (in 1978) Wall Street was just beginning to recover from a half-decade long slump caused by the worst economic downturn since the Great Depression and the end to fixed (and outrageously high) commissions on trades. At the same time, the passage of ERISA was sparking demand for professional third-party managers for corporate pension plans.

So there was huge demand for analysts.

By the 1990s, portfolio management companies worked out that they could save a lot of money by relying on brokerage research, paid for by higher commissions on trades, rather than in-house efforts. So the buy side began to lay off research staff. After the housing crisis of 2007-09, brokers decided to save money by firing their high-priced experienced analysts and replace them with recent college or business school graduates.

What did old-style researchers do? In my case, I spent over thirty years studying tech and the global gambling/hotel businesses, and somewhat less following global natural resources. I’d read the SEC filings, visit the companies, try to figure out corporate culture and how firms in a given industry jockeyed for position with one another. I’d also try to find leading indicators that would give me an idea of whether a firm’s prospects were looking up or down. Nothing unique to me or exotic in itself. Sort of like picking up a bat, walking to the plate and swinging at a pitched ball. For example:

–one of my first companies was Singer, the sewing machine company. It was trading a $7 a share and had gone nowhere for years. After all, the peak for consumer purchases of sewing machines in the US had been in 1929. The IR person told me the company’s factory in Elizabeth, NJ looked like something from Dickens. On the other hand, it had cash, tax losses worth $25 a share if they could be used, a leading flight simulator business, a booming emerging markets sewing machine operation and lots of property in the vicinity of New York City. All in all, the pieces were worth $50+ a share if the company were broken up …and Singer’s new chairman appeared to have decided to do precisely that.

–when Apple had been left for dead as, in effect, a penny stock, Steve Jobs decided to bet the farm on the iPod. So iPod sales would end up being the near-term key to the company’s survival/success. How to find out, legally/ethically what sales were likely to be?. One way would be to visit Apple stores and ask. Another would be to look for relatives, acquaintances, people on the street/bus/train using one. But the iPod was essentially a small form factor hard disk drive. Suppliers–there were only two–was a natural way to go. But it turned out that there was only a single supplier of the spindles that the drives spun around–Nidec, in Japan. The company ended up regularly sending representatives to NYC to try to get investors interested in it as a play on Apple.

–to me, one of the most interesting aspects of Macau gaming a decade or so ago was that the Hong Kong market was totally oblivious to the fact that half the profits from Las Vegas casinos came from non-gaming entertainment. So the market was twice the size locals thought it was.

Anyway, information like this would slowly but surely leak into the market. If nothing else, brokers would see who was buying and what was working, and spread the word to other customers.

My sense is that this sort of research doesn’t happen much any more. Maybe because it’s much cheaper to have a trading bot react quickly to reported results rather than try to figure out what they might be.

Look at TSLA, for example. It was down by 12% on an earnings report whose general contents had been widely circulated in the press and in internet chatter over the past several weeks. I don’t follow TSLA any more, but the negative news seemed to me to be so widespread that in another day one might have argued that the bad news was over-discounted and the stock would go up on the report.

This is just my take on how today’s market works. If this is right, though, it has implications for what will happen to stocks during the first half.

more tomorrow

setting the macro stage

interest rates

The Fed Funds rate was effectively at zero from the onset of the 2008-09 financial crisis until the end of 2015. Two reasons: the extent of the economic havoc wreaked by extreme speculation by banks that wrecked their balance sheets, bringing world commerce to a standstill; and the equally extreme unwillingness of congressional Republicans to use fiscal policy to help repair the damage (an editorial note: in contrast with the savings and loan crisis, neither Republicans nor Democrats had any interest in holding bank officials to account for their criminal behavior).

The rate was just short of 2.5% in mid-2019, when then-President Trump began to pressure the Fed to lower rates, in what I read as an attempt to disguise the negative effects of his markedly anti-growth agenda, which had driven the real rate of expansion of the US economy to at best +1%.

Then the pandemic came, with Trump’s deer-in-the-headlights denial that there was any medical issue, supplemented with his anti-Asian hate rhetoric–again leaving monetary policy as the only tool to fight the economic contraction the pandemic caused.

The Fed Funds rate stayed at zero until early 2022, or about two years, before beginning its sharp rise to the current 4.5%. Again, two reasons: the willingness of the Biden administration to use fiscal stimulus as an adjunct to monetary; and the effectiveness of vaccines to bring covid under control.

inflation

Inflation in the US was 9.1% over the twelve months ending last June. That figure has fallen to 7.1% for the twelve months ending in November.

Price rises, which had been running at about +1.0% per month in mid-2022 have been +0.3% and +0.1% in the two last reported months.

Ex food and energy, prices are rising at about a 6% annual rate.

In other words, inflation appears to be slowly coming under control. Two factors involved–higher interest rates and supply bottlenecks easing, with previous shortages (and higher prices, like for used cars or hand sanitizer) turning into gluts.

what I think 2023 holds

The Fed has made it clear that it does not think that short-term interest rates are high enough yet. Let’s assume that Fed Funds gets to 5.0% and stays there through this year, before gradually declining next.

Just to get a ballpark number for interest rates–and derive from that what the market PE should be–let’s say that the trend rate of real growth in the US economy is 1%. Given that the domestic population is barely expanding and that we choose not to grow through immigration (shades of Japan!) that’s probably too high. Productivity growth might help, but the nation as a whole is anti-education as I think the deterioration of the public school attests, so it’s hard to see where big productivity gains will come from.

If we think, as I do, that the real policy target for the Fed is 3% inflation, then nominal growth will be, say, 4%–maybe less. If the target is in fact 2%, as the Fed seems to be saying, then nominal growth will likely end up at 3%-ish

In either event. it seems to me that a period of Fed Funds at 5% is enough to slow the economy to this level.

The 10-year Treasury note at 5% (yes, it’s below 4% now) would imply a PE for the S&P 500 of 20x. A 4% 10-year yield would imply 25x.

S&P 500 earnings for 2022 are projected by Ed Yardeni to be around 215. At a multiple of 20x, this would imply the index at 4300, or about 10% above where it ended last year.

He’s projecting earnings of 225 for the S&P in 2023, with yoy declines of about 4% in the first half being more than offset by a robust 4Q23–with earnings gains continuing in 2024. For the year as a whole, the earnings gain would be +4.6%, a number that to my mind is not that different from zero.

Can the S&P 500 index get to the projected result for December 2023 of more or les unchanged by remaining flattish for an entire 12 months? That would be highly unusual.

More tomorrow.