discounting in the age of algorithms

what discounting is

In traditional Wall Street parlance, discounting is factoring into today’s prices the anticipated effect of expected future events.  Put another way, in the best possible case, it’s buying a stock for, say $.25 extra today, thinking that in a week, or a month or a year, news will come out that makes the stock worth $1, or $10, or $100 more than it is today.

two components

They are:

—having/developing superior information, and

–correctly gauging what effect dissemination of the news will have on the stock.

In my experience, the first of these is the easier task.  Also, the answer to the second problem will likely be imprecise.  In most cases, “The stock will go up a lot when people understand x” is good enough.

examples

In the early days of the Apple turnaround, the company launched the iPod, which ended up doubling the company’s size.  So the key to earnings growth for AAPL was the rate of increase in iPod sales.  The heart of the iPod back then was a small form factor hard disk drive.  There were only two suppliers of this component, Hitachi and Seagate (?), so publicly available information on production of the small HDDs had some use.  Much more important, however, was that there was only one supplier of the tiny spindles the disks rotated around.  And, unknown to most on Wall Street, that small Japanese firm published monthly spindle production figures, which basically revealed AAPL’s anticipated sales.

Same thing in the early 1980s.  Intel chips ran so hot that they had to be encased in ceramic packaging–for which there was only one, again Japanese, source, Kyocera.  Again, monthly production figures, in Japanese, were publicly available.

In both cases, the production figures were accurate predictors of AAPL (INTC) unit sales a few months down the road.  Production ramp-up/cutback information, again public–though not easily accessible–data, was especially useful.

Third:  Back in the days before credit card data were widely available, retail analysts used to look at cash in circulation figures that the Federal Reserve published to gauge the temper of yearend holiday spending intentions.  The fourth-quarter rally in retail stocks sometimes ended in early December if the cash figures ticked down.

In all three cases, clever analysts found leading indicators of future earnings.  As the indicators became more widely known, Wall Street would begin to trade more on the course of the indicators rather than on the actual company results.

today’s world

Withdrawal of brokerage firms from the equity research business + downward pressure on fees + investor reallocation toward index investing have made traditional active management considerably less lucrative than it was during my working career.

A common response by investment firms has been to substitute one or two economists and/or data scientists for a room full of 10k-reading securities analysts who developed especially deep knowledge of a small number of market sectors.  As far as I can see, the approach of the algorithms the economists/programmers employ isn’t much more than to react quickly to news as it’s being disseminated.  (They may also be looking for leading indicators, but, if so, I don’t see any notable success.  Having seen several failed attempts–and having worked at the one big 1950s -1970s  success in this field, Value Line–I’m not that surprised at this failure.)

My thoughts: 

–there’s never been a better time to be a contrarian.  Know a few things well and use bouts of algorithmic craziness to trade around a core position

–For anyone who is willing to spend the time watching trading during days like Wednesday there’s also lots of information to be had from how individual stocks move.  In particular, which stocks fall the most but barely rebound?   which fall a little but rise a lot when the market turns?  which are just crazy volatile?

the stock market cycle–where are we now?

As I wrote yesterday, stock market price-earnings multiples tend to contract in bad times and expand during good.  This is not only due to well-understood macroeconomic causes–the effect of higher/lower interest rates and falling/rising corporate profits–but also from psychological/emotional motivations rooted in fear and greed.

(An aside:  Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds (1841) and Charles Kindleberger’s Manias, Panics and Crashes (1978) are only two of the many books chronicling the power of fear and greed in financial markets.  In fact, the efficient markets theory taught in business schools, which denies fear and greed have any effect on the price of financial instruments, was formulated while one of the bigger stock market bubbles in US history, the “Nifty Fifty” years, and a subsequent vicious crash in 1973-74, were taking place outside the ivory tower.)

Where are we now?

My take:

2008-09  PEs contract severely and remain compressed until 2013

2013  PEs rebound, but only to remove this compression and restore a more typical relationship between the interest yield on bonds and the earnings yield (1/PE) on stocks.

today  The situation is a little more nuanced.  The bond/stock relationship in general remains much the way it has been for the past several years, with stocks looking, if anything, somewhat undervalued vs. bonds.  But it’s also now very clear that, unlike the situation since 2008, that interest rates are on an upward path, implying downward pressure on bond prices.

In past plain-vanilla situations like this, stocks have moved sideways while bonds declined, buoyed by an early business cycle surge in corporate profits.

Since last November’s presidential election, stocks have risen by 10%+.  This is unusual, in my view, because we’re not at the dawn of a new business cycle.  It comes from anticipation that the Trump administration will introduce profit-boosting fiscal stimulus and reforms.  The “Trump trade” has disappeared since the inauguration, however.  Our new chief executive has displayed all the reality show craziness of The Apprentice, but little of the business acumen claimed for the character Mr. Trump portrayed in the show–and which he asserts he exhibited in in his long (although bankruptcy-ridden) career in the family real estate business.

Interestingly, the stock market hasn’t weakened so far in response to this development.  Instead, two things have happened.  Overall market PE multiples have expanded.  Interest has also shifted away from business cycle sensitive stocks toward secular growth stocks and early stage “concept” firms like Tesla, where PEs have expanded significantly.  TSLA is up by 76% since the election and 57% so far this year–despite the administration’s efforts to promote fossil fuels.  So greed still rules fear.  But animal spirits are no longer focused on beneficiaries of action from Washington.  They’re more amorphous–and speculative, as I see it.

Personally, I don’t think we’re at or near a speculative peak.  Of course, as a growth stock investor, and given my own temperament, I’m not going to be the first to know.  It does seem to me, however, that the sideways movement we’ve seen in the S&P since March tells us we are at limits of where the market can go without concrete economic positives, whether they be surprising strength from abroad or the hoped-for end to dysfunction in Washington.

 

discounting and the stock market cycle

stock market influences

earnings

To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded.  But profit levels and potential profit gains aren’t the only factor.  Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting:  fear vs. greed

Stock prices typically anticipate or “discount” future earnings.  But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news.  As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence.  This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09.  During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level.  The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon.   S&P 500 earnings rose by 5% that year.  The index itself soared by 30%, however.  What happened?   Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again.  This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

Where are we now in the fear/greed cycle?

More tomorrow.

results from Disney (DIS): a lesson in how the market works nowadays

DIS and ESPN

A relative in the movie business called my attention to Marvel Entertainment a few years ago.  When it was acquired by DIS in late 2009, I held onto the stock I got and added more in the mid-$20 range Marvel, of course, has been pure gold for DIS, even though DIS initially went down on fears that DIS had overpaid.  Naturally I sold the stock way too early, in the mid-$60s–acting more like a value investor than a growth stock fan.

My first thought on reading the DIS 10-K, as I acquainted myself with the company,was that the company really should have been named ESPN, since at that time the cable sports network accounted for 2/3 of DIS’s overall operating profit and virtually all of its earnings growth.

red flags about ESPN

Over the past several years, a number of key warning signs have popped up about ESPN, however:

–ESPN decided to expand into the UK, signalling to me that it considered its US franchise on the cusp of maturity

–but ESPN was outbid for soccer rights by locals and effectively terminated its international expansion ideas–not good, either

–DIS began to shift cash flow away from ESPN and toward the movie and theme park business, which I took to be a sign of corporate worries about ESPN’s growth potential, rather than simply diversification for diversification’s sake

–serious discussion has begun over the past year about the demise of cable system bundled pricing, which likely benefits ESPN substantially (I suspect we’ll find out how substantially sooner rather than later)

–since ESPN.com’s recent format change, I find myself almost exclusively using Time Warner’s Bleacher Report for sports information

–personally, although this isn’t the most crucial part of my analysis, I think the progressive dumbing-down of ESPN coverage, in imitation of sports talk radio, to gain a wider audience will backfire.

To sum up,, there has been an increasing collection of evidence that ESPN probably won’t be the same growth engine for DIS that it has been in the past.

Yet…

…DIS shares were down by about 10% in Wednesday trading (in an up market) on the first signs in the earnings report of the factors I’ve just listed.

discounting?

Where was the market’s discounting mechanism, which in the past has been continuously evaluating corporate strategy and factoring worries like the long list I’ve mentioned above into the stock price?

…only on the earnings report, not before

To my mind, DIS trading yesterday is another indicator that information isn’t flowing on Wall Street as fast as it once did.  That’s neither good nor bad;  it’s just the way the game is being played in today’s world.  What we as investors have got to figure out is how to adjust our own behavior to fit altered circumstances.

My initial thought is that it may be riskier than it has been to dabble in down-and-out industries like mining or oil until the final bad news has hit income statements.

 

more on discounting

In actual practice, judging what the market has already discounted in the price of an individual stock or the prices of stocks in general, is a tricky thing.  Even seasoned professionals are often wrong.

There are trends in overall market direction that are relatively easy to spot.  In a bull market, investors tend to ignore bad news and respond strongly to good.  In bear markets, the opposite happens.

Perhaps the main reason for professionals that technical analysis is more than a curious practice of a more primitive time is that watching for deviations from the usual daily price action of individual stocks can give clues to what other investors are thinking/doing.  Rises on unusually high volume, for example, can suggest that others are figuring out what you already know and have acted on.  On the other hand, failure of the stock to react positively to news that supports your positive thesis suggests that what you thought was a new, investable insight actually wasn’t.

The reality that investors only act piecemeal, or the idea that we act differently when infused with greed than when in the vise grip of fear are both much too untidy for the statisticians who formulated the Efficient Market Hypothesis/Capital Asset Pricing Model that arose in the 1970s (and which–mind-bogglingly–is still taught in business schools).

These theories have no place for observation/practical experience.  They assume that everyone has the same information and that the market factors new information into prices instantaneously.  What’s particularly ironic is that they were formed during the early 1970s.  How so?

–1972 was the peak of the “Nifty Fifty” or “One-Decision Stocks” speculation.  Investors believed that a small number of stocks–Kodak, Xerox, National Lead, for example–would grow rapidly forever.  Therefore, they should never be sold, and no price was to high to pay to acquire them.  The result was that this group of names traded at as high as 110x earnings–in an environment where the 10-year Treasury yielded 6% and the average stock traded at 11x.

–this high was immediately followed by a vicious bear market in 1973-74 that saw stocks trade in mid-1974 at discounts to net cash on the balance sheet–and still go down every day, on the theory that money in the hands of management scoundrels wasn’t worth 100 cents on the dollar.

How is it that these guys didn’t notice?

discounting and today’s equity market

Discounting is the term Wall Street uses for the idea that investors factor into today’s prices, to a greater or lesser degree, their beliefs about the future (I wrote a detailed post about the process in October 2012).

 

Two of the major macroeconomic factors the market is wrestling with now are the timing and extent of the Fed’s future moves to raise interest rates from their current emergency lows, and the possibility that Greece will default on its debts and exit the euro.

 

My experience is that almost nothing is ever 100% discounted in advance.  There’s always some price movement when the event actually happens.  Having said that, the coming rise in interest rates in the US has been so anticipated–and talked about by the Fed–for such a long time that there may even be a positive market reaction to the first rise.  This would be on the idea that Wall Street would give a sigh of relief when there’s no more anticipatory tension to deal with.  More likely, there’ll be a mild negative movement, for a short period, but that’s all.

The Greek financial crisis has also been in the news for a long time.  But we don’t have the same extensive history of behavior during past economic cycles to draw on, the way we do with the Fed.  We do have Argentina as a case study in what happens to the defaulting country (personally, I expect the consequences of default for Greece would be pretty terrible for its citizens).  But the focus of investors’ concern is what damage might be done to the EU by Greece’s leaving.  In addition, lots of non-economic factors are involved in this situation.  There’s Greece’s central role in Europe’s beliefs about its own exceptionalism.  There’s the Greek portrayal of the EU’s requirement that Greece implement structural economic reform as a condition for debt relief as 21st-century Nazism.  There’s the status quo in Greece that has benefited from the country’s profligate borrowing.  There’s fear of the unknown that must be urging politicians to paper over Greece’s problems.

In addition, my sense is that the markets’ overriding emotion so far is denial–hope that the whole situation will go away.  Current thinking seems to be that the parties will arrange for some sort of default, along with capital controls to restrict the flow of euros out of Greece, that will allow Greece to stay in the EU.  Still, I find it very hard to calculate odds or even to anticipate what the worst that can happen might be, or the best.  This makes me think that very little of the possible negatives of “Grexit” are factored into today’s prices.

More tomorrow.

the equity discounting mechanism: how it’s working today

Happy Halloween!

discounting at work today

My previous post was about what the equity discounting mechanism is. Today I want to give my take on how discounting is working in today’s US stock market.

The US market has been rising since June, despite the evidence of widespread global slowdown. How can this be?

economic slowdown, but uptrending market??

Several macro reasons:

  1. After five years of decline, the US housing market has been giving strong signs of bottoming for some months and is recently beginning to rise. Housing is important in the US, not only for the construction jobs it brings, but because it’s the largest source of wealth (or potential wealth) for most Americans.
  2. Around mid-year the leadership of the EU seems to have stopped living in denial about the Eurozone’s structural problems and begun to take positive action to address them. Yes, resolution may take a half-decade. Yes, Greece may get tossed out and the UK may voluntarily withdraw. But the basic direction of government policy appears to have changed.
  3. Beijing has already taken a number of measures to reinvigorate its economy. Yes, any dramatic steps will probably await the installation of new top leadership in the Communist Party there. But, again, the basic stance of government economic policy appears to be reversing itself from contractionary to expansionary.
  4. The US Fed has announced that it intends to keep the current extraordinarily-low level of short-term interest rates in place for at least the next 2 ½ years. Ultimately, rising interest rates will be a threat to world bond, and to a lesser extent, stock markets. But that’s not likely to be anytime soon.

two discounting judgments

Two qualitative discounting judgments are involved in the upward move of global indices over the past five months:

–the first is that there’s no longer any percentage in betting that conditions will continue to deteriorate. That’s already been fully, or very close to fully, discounted by the prior price declines.

–the second is that the three macro forces listed above are powerful enough for investors to begin discounting potential future good news into today’s stock prices.

 unusual?

In my view, there’s nothing unusual about this. It’s the standard macro-based anticipatory discounting that has occurred at business cycle turning points over the thirty years or so that I’ve been involved in global stock markets.

To my mind, what is unusual, though, is the apparent disconnect between the macro discounting judgment that the worst is behind us and the very violent micro discounting being done as companies report 3Q12 earnings results.

two separate judgments

In theory, these are two separate kinds of judgments–how benign or hostile the overall economic environment is likely to be vs. what earnings prospects are for individual companies. But in practice, investors, in my experience, tend to ignore poor company results during a transition period between macro trends. The bad numbers are usually dismissed as “old news,” the last artifacts of a trend that has already been relegated to the scrap heap (or, if you prefer, the recycling center).

Not this time, though. Companies that disappoint are being aggressively sold off.

Why should this be?

More important, should this strong micro-related discounting undermine confidence that the macro trend has indeed reversed?

I can think of a couple of reasons macro and micro discounting could be following different paths:

–the most likely, in my view, is the current valuations of business cycle-sensitive stocks. Typical market turning points in the past have been 2009-like affairs. Not as ugly, but conceptually similar. Those bottoms occur at the end of extended bear markets, when overpowering fear is rampant and all stocks have been sold down to levels which—in hindsight—will appear ludicrously low. The most cyclically sensitive will often be crushed, priced as if they’re going out of business.

In the quarters immediately following these market turns, the negative effect of earnings disappointment on individual stock prices is offset by the positive of extremely low valuations.

That’s not the case today. We’re more than three years past the 2009 bottom, and about 100% higher than the absolute lows. So disappointing stocks don’t have the valuation cushion they normally do.

If I’m correct, the selloffs of cyclical stocks on bad earnings doesn’t undermine the macro case that the overall market trend has changed in a favorable way. It just means this upcycle is different and will be more muted than the standard pattern.

–it may also be that both buy-side and sell-side firms are no longer integrated, having both macro and micro researchers, as they have been in the past. In the integrated model, either the chief investment officer or a committee of senior staff would set an overall investment policy. To a significant extent, the overall investment stance, bullish or bearish, would be coordinated with, and reflected in, recommendations about individual stocks.. In an up market, portfolios wouldn’t sell cyclical stocks; disappointing earnings would be ignored. On the sell side, cyclical stocks would continue to be recommended, not downgraded.

In today’s world, in contrast, brokerage firms have dismantled their research departments. Many hedge funds specialize in macro research only. Others run highly concentrated portfolios that hold only a handful of names. There are many more short-sellers, as well.

So it may be that the market for individual stocks is becoming much less uniform in its thinking—and thereby much more volatile–than it has historically been.

–there are other possibilities, but less probable and not worth mentioning here.