Stock Price and Market Model

Good morning RIPvestors,

welcome to another post in the investing series, where I gradually introduce you to the world of investments and go deep on topics I have some experience with, mainly related to investments in Switzerland.

Other posts in the Investing series:

• Investing basics
• Financial Investing
• Funds Investing
• Fees & Taxes
• Stock Price and Market Model
• Investor Profile and Lifelong Investing Strategy
• ETF 101
• Stick with it
• My take on Cryptocurrencies – Part 1: The Ugly
• Interactive Brokers 101

In this post I’m going to show you my understanding of the stock market and the players involved. My humble goal here – I’m totally NOT an expert this field – is to help you (and myself) becoming aware of the risks associated with investing in stocks/funds, understanding the basic mechanics behind a stock’s price and avoiding common pitfalls like panicking and trying to time the market.

Essentially I’m going to throw a lot of mostly useless words at you that probably won’t impact much your behavior as investor. Sadly though, in the world of “risky” investments even few apparently small mistakes can destroy an otherwise good strategy. For that reason – to avoid disasters and better react to bad news – I think it’s useful to build a solid knowledge base. For the same reason astronauts spend more than 90% of their training time facing simulated disasters. The difference here though is that I’m not as good as the thousandth part of an astronauts’ trainer 🙂

“Hi RIP, I’m a little bit lost. I’m following you since the first episode and my mood is continuously flipping between enthusiasm and desperation… Can you just tell me how, when, where, on what should I invest??”

Relax my imaginary friend, there’s still a long way to go. My goal, by the end of this post, is that you’ll know as much as I am and you’re going to tell me what I should invest into. The rest of the series is just technicalities to implement your strategy. Here we’re going to dig as deep as I’m able to into the realm of the market rules.

Let’s start with the single most important thing to know, and let’s do that by asking a question: What’s in a stock price?

I think it should be intuitively clear why this is the single most important piece of knowledge about the stock market, but let’s assume it’s not. If you understand why a company is evaluated at X and what you’re paying when you buy it, you’d recognize all logical fallacies when taking impulsive decisions. Bullshits like: “everyone should buy X, they are growing a lot!“, “Emerging Markets didn’t grow in last 6 years, you shouldn’t buy” or “The market is high, you should sell” should ring a bell inside you.

So then, what’s in a stock price? Or in general, what’s in a price of anything sufficiently traded in free market model? I said “sufficiently traded” because if the market is not wide you may experience under/over pricing due to lack of knowledge by some of the traders.

In the stock price of a company X in a free and wide enough market is the averaged risk adjusted opportunity cost of the flow of X’s expected returns over time.

What a complex definition! And I made it! It’s mine, mine! Let’s dig deeper.

Let’s start with an example: “I want to sell you this Stone. This Stone will produce, out of thin air, 10 Dollars per day. Inflation adjusted, Forever“. How much would you pay for the magic Stone? Let’s for simplicity assume that the 10 dollars per day are the only asset we’ll be owning and that we can’t make any other business decision like trying to become famous by showing to the world that we own a magic object (how cool would it be??).

There’s not a unique answer to this question. But to try to come up with a price I’d do the following analysis: how much would I need to obtain the same cash flow with another known investment strategy? That’s my individual opportunity cost. Let’s assume I’m risk averse, so my default strategy with my money is buying bonds and I’m looking for better alternatives, whatever gives me more than the very low at the moment bonds’ returns. Another potential buyer may be less interested, since they may be running a nice business where every extra dollar they invest on it doubles every year. This potential buyer will be willing to pay less for the Stone, since they need less dollars than me to obtain the same cash flow. Their opportunity cost is higher. If you have a wide market, the opportunity costs eventually reach an equilibrium so do the prices.

Opportunity costs play the stabilizing role of inserting a nice negative feedback loop into the price of everything. If there’s an economic boom and everything is growing 20% each year my opportunity cost is very high so I’m willing to pay less for things. The opposite happens on recessions.

Such a Stone is a good model for a treasury bond, not for a stock. Expected company revenues are harder to predict (mean estimation) and yield very high uncertainty in the prediction itself (variance estimation). The means may drive the price, the variance may alter the opportunity cost. One thing is to have a guaranteed and predictable cash flow over time, another thing is to have a lot of unknowns. Would you rather buy X that earns 5% guaranteed per year or Y that is expected to earn on average 5% per year but may go up and down by up to 90%? Right, volatility comes with a cost. That’s why I added “risk adjusted” component into the price. That’s why you may get a predictable 2% from bonds but expect 6-10% returns (averaged per year over a very long period of time) from the riskier stock market.

Anyway, setting aside opportunity costs and the risk component (variance) the most problematic variables left in our price definition are the unknown expected returns over time.

Here’s where all the magic happens. Why a stock’s price bumps by +-10% after a political news, a quarterly earning disclosure, a company acquisitions, a government maneuver? Well, because the expected returns of the company over time change.

And btw, expected by whom? This is another individual factor. You can try to make your offer for buying a stock based on your personal expectations. It won’t impact the market price though. If your offer is below the market price, none would sell you. If it’s above everyone would buy from you. So what’s the market price? It’s the equilibrium. It’s the average expectations of future returns. It reflects the expected returns over time of the company, expected by the very large population of buyers and sellers. Expected by all the publicly available information about the company, the sector it operates in, the rumors about acquisitions, the hire rate, layoffs, current and past earnings, newspaper headlines, current and future projects… the price of a stock of a company contains the expectations of its future, based on all the publicly available information.

Well, I’m using the word “stock” where I should use “capitalization“, which is stock price multiplied by number of circulating stocks. Not a big issue, the same concept applies. I’m also focusing on stocks instead of index funds but the same rules apply. An index fund in just an aggregation of stocks.

So, let’s say once again, since this is the basic rule of everything about stocks: the stock price of a company embeds the expectations of its future returns, based on all the publicly available information.

“Ah cool… anyway, RIP, when is my stock price raising?”

Essentially, it is raising when today’s expectations are better than yesterday’s. Well, not exactly. Meeting expectations should earn you the risk adjusted opportunity cost. In an age where in US people wonders if you should take 5%, someone else aims to 3x risk free guaranteed returns of 2% (i.e. 6%) of a balanced portfolio with other assets categories represented along with stocks, I guess that 6-8% per year is a valid expectation those days, for investments in USD currency at current inflation rate (~1%). In Euro area, with inflation rate close to zero, expected returns may be 5-7% in EUR currency.

Anyway, it’s important to understand that it’s not enough that the company you’re investing in is doing well, it has to do better than expected (or at least as good as expected). This is true in the other directions. If a company is expected to shrink, it may still be worth investing in it. The price already reflects bad expectations and just keeping up or shrinking less than expected may end up in a stock price increase!

Let’s take a look a the implications of this rule.

1) How to beat the market:

• Exploit systematic bugs, like high frequency trading (becoming a middle man for a fraction of a second and exploiting buy/sell gaps). You are not good at it, trust me. Avoid this.
• Knowing things others don’t. Very very hard, there are more informed people than you and me around. And btw, brought to the extreme this practice is considered illegal. It’s named Insider Trading.
• Influencing the expectations. Not for you and me, my friend. We’re no one. But if you’re very rich, like a bank, you can influence the news and try to convince investors that a particular stock/fund is good/bad to artificially sell high and/or buy low. It’s also considered illegal to some extent and it’s named Market Manipulation.
• Influencing companies. Obviously this is not for you and me too. To influence a company you must be in control of resources in the critical path of the company itself. May be you’re in the government of a country where the company operates and you can choose to add a special tax that impacts the company. Or you may be you’re a bank that is going to lend money to the company. Or may be you’re another company who cooperates with the company under analysis. The market in interconnected and if you’re Elon Musk and you’re going to claim you’re revolutionizing how we’ll produce and store energy, then the lithium mining industry gets a big boost.
• Taking control of the company and being a successful businessman. Again, if we’re talking about companies quoted on a stock market, this suggestion is not for you and me. But this may actually be the best strategy in the small scale. Like “instead of investing in other companies and being ok with 7% yearly return, invest in yourself and aim to 100% yearly return! We may explore this in a future post. In the meantime, if you’re really interested in this topic, go binge reading the entire James Altucher blog (and his books).
• Being lucky. People occasionally win at the casino. Those who claim to have beaten the market may be in this category. May be the year after they will fail. May be they’ll beat the market for 10 consecutive years, like among 1024 people betting on subsequent coin flips one will statistically win 10 times in a row. Would you trust that guy more than anyone else?

So the short answer is: do not try to beat the market. You’re far from having access to the necessary information. Do not trust those who claim they do. Accept you’ve been lucky if you got an amazing return this year and accept it doesn’t guarantee the same return for next year – and it doesn’t prevent from achieving better returns too.

2) Ok, let’s not try to beat the market. Let’s time the market!

“Cool RIP, I got it. Thanks. I’m ok with just matching the market… well, actually performing slightly worse due to frictions (taxes and fees)… but I saw the market going up and down. What if I only jump on the boat when the market is going up??”

Oh no, please, don’t! I know it’s tempting my imaginary friend, but it’s dangerous and a lot frictional. Let me explain why: there’s no high and low while you’re riding the wave. These are words for a retrospective analysis only. You can only tell “it was a market high“, you can’t tell that the market is high right now. If it were, and everyone knew, it would be falling yet. Its price would already be reflecting it. One can tell right now that we are at the all time high of S&P 500. Right. Look at what happened in 1993, when the S&P 500 was at an all time high:

Let’s repeat: you can’t tell when a market is high or low and you shouldn’t try to guess. Again, is this an all time high for the stock market? Well, as the Mad Fientist said in a recent Q&A at Camp Mustache:

Just to show how overwhelming the upper trend in the market actually is, starting 65 years ago, we’ve had a new high over 1100 times which is about once every 15 days, the market has been opened. So you’re hitting new high’s about once every 15 days.

And if you pick any month of any year, it turns out you have a 75% chance of the market being higher one year later. So, three out of four times, this month next year is going to be higher.

So, the overwhelming trend is up. And this could be the lowest the stock market ever gets, but nobody ever knows. So just keep the faith.

Perfectly spelled.

Ok, just one more time. Take a look at this:

So, please, do not try to time the market!

“RIP… I think I got it, but now I really don’t know when to invest. Let alone other basic questions like what to invest into and when to buy/sell…”

Well, I think it should be clear now but let’s explore the territory with few more questions: do you believe the economy will keep growing as expected (assuming you know what the investors expect)?

“I guess so… Actually I don’t know… someone says we’re all doomed, there will be war, Earth’s resources depletion, the asteroid hitting us and killing all species on Earth,…”

Let’s set aside catastrophic events for the moment (I wouldn’t care about losing my money if an asteroid will hit us). Do you think we are all too optimistic about growth and stock prices are overrated since we’re hitting the top of our civilization and there will be no more growth? Well, if this happens on a short notice, all of a sudden, it won’t be a nice world to live in anyway… If we have more time, there will be a transition to a new economy (more on that in a future episode) and I’ve always been optimistic about that future!

And, btw, how can you tell? Are we burning all Earth’s resources too quickly? What about solar energy? There’s a guy (this Elon Musk) who’s planning to use it widely. If that’s the way to go we are still at a nano fraction of a percent of our capabilities, since we’ve not yet built a Dyson Sphere and we’re using a tiny fraction of the tiny fraction of energy that reaches the Earth from the Sun. So I don’t buy all the catastrophically approaches where we are at the peak of our potential economic growth. Maybe there’s a conspiration to make prices artificially high and then suddenly make everything drops, like a gigantic Ponzi Scheme… but I don’t buy either. They were saying the same 100 years ago. If it were the case, well, someone forgot to pull the trigger then (ahem.. how are you doing Mister 1929?).

“Ok, agree with you RIP. There’s room to be optimistic. So… when should I invest? for how long? when to buy/sell?”

Cool. Getting there! Let me first show my market model to you: you essentially are playing the roulette game at a casino. But you’re not a player, you’re the Croupier. You know you’ve the math on your side but you also know that a bad luck hand can make you broke. You know if all you’re going to do is accepting a single bet on a single number you win that money in 97.3% of the cases but you lose 36x that amount in the remaining 2.7%. Still the game is unfair at your advantage by roughly 3%, thanks to the number 0.

Anyway, it’s still not a game you want to play. Too high risk on a single bet. That’s a job for insurances. But if you accept a lot of bets, you know that the Laws of Large Numbers will help you and you’re more likely to win. What are bets in our case? Days in the market and different companies in your portfolio! Differentiate as wide as you can. Stay in the market as long as you can.

So, when should you invest? As soon as possible. Every day you wait because “the market is high right now” (but high compared to what?) you’re accepting less bets on your casinò and you’re letting favorable opportunities on the table.

Another way to model the market is throwing everyday a 100 sided dice and imagine you winning if the outcome is in the range 50-100 (51 times out of 100) and losing if it’s in the range 1-49 (49 times out of 100).

Here are similarities:

• It appears random. The more I try to look at pattern in market values, the more they seem white noise, totally random. Don’t pretend to be an expert on this. Embrace chaos.
• Yesterday’s outcome doesn’t impact today’s one. Don’t bet on late numbers. Past wins and losses are meaningless, everyday it’s a new ground zero. Yes, it may go up for 10 consecutive days and it still means nothing for tomorrow’s dice roll. Refusing to play a match because “last 5 rolls have been high numbers” doesn’t make any sense.
• After a lot of dice rolls the probabilities that you win are higher than that you lose. The game is unfair for you, but in the good way!

“RIP… Is it really just that? That simple? I see TV shows with analysts who seem to explain stuff and they give advice… everyone seems to be expert… are they all making everything up?”

I’m not an expert, but this is the simplest model that makes sense that I can come up with. And I’m basing my investing strategy on it. That’s because I’m not trying to beat the market (we’ve seen what it means and what are the requirements). I’m not trying to outsmart global expectations for each company. Sure I’ll pick a differentiation strategy based on my personal tastes (but trying to avoid biases), but still the wider the better. And still there’s no such a guarantee that when we’re at an all time market high it means it’s going to fall. History already proved that!

“But RIP… then why Emerging Market is not growing very much recently, while the S&P500 grew something like 10% per year in last 100 years?”

Really? Cool! Does it imply it will keep growing and performing better than the emerging market’s index? If that’s guaranteed everyone would just invest on the S&P500 and none would in EM. Everyone would be selling EM and buying S&P, the price difference would grow till the point where maybe the EM is underpriced and the S&P is overpriced. Who knows? Plus, are you 100% sure than in 30 years US will still be growing so much? What if another country will be growing a lot that is not now. Their stocks would experience a double boost that you’re loosing if not playing with them right now. And to grasp this concept you should, again, try to see the derivative nature of market values. The market value of a thing reflects expectations on future profits. When you buy a thing, you aren’t betting that the thing will grow, you’re betting that the thing will exceed expectations, whatever expectations are. If the public expectations are that it will grow like crazy, you’re already paying for that when you buy it.

“But RIP… so all the fairy tales about S&P 500 growing 10% per year and the 4% rule and the Trinity Study… they don’t make sense, Do they?”

When I think about it, sometimes I say “nothing makes sense” and we’re living in a bubble and a gigantic scam, like someone says. But I want to believe that behind stock prices there are companies, with real revenues and solid plans for the future. If you look at the past, our standards of living have improved a lot and that’s a concrete thing.

I’d also like to believe that growth is not a requirement (more on this on a future post), since the common complaint is that “we can’t grow forever!. Even though I already mentioned that we, as a civilization, may be close to our limits (Earth’s resource depletion) or at the early stages of our space colonization. I like to be optimistic on that!

Before thinking about an interstellar civilization, let’s look at what we’ve got here, now. The question is: are we being too optimistic or not? Is there a way to measure it?

Yes, there is. Let’s take a look at the Market indicators.

3) Market indicators measures our optimism, not the probability of failures.

Is the market so random and not measurable? Can’t we tell which companies are overpriced right now?

The short answer is no, we can’t. But what we can measure is our optimism, i.e. the expectations about future revenues of a company. it can somehow be useful, but so far no absolute rule has been extracted. Getting a golden formula that will tell you that the market is going to crash is the dirtiest market analyst’s dream, but they are all still chasing a Chimera (like this or that).

What we came up with so far are few Market Indicators, like the CAPE also know as Shiller P/E 10. It measures the ratio between capitalization and earnings (averaged over last 10 years). It can be calculated for a single company, for an index, a country or any other aggregation you need.

As you can see the higher the ratio, the most likely the market seems to be close to a crash. And we’re now at 2008 levels…

Anyway, let’s see some CAPE breakdown by country.

Ok, we saw previously that S&P500 CAPE is around 26, so it’s no surprise that US CAPE is ~25. What’s a surprise is that most of the other countries of the world have a CAPE way lower! What does it mean? Technically, that the total capitalization of all the companies quoted in Russia is roughly 5 times the average yearly returns they had in last 10 years. It means if you’d buy a company among the quoted ones in Russian stock market, all the stocks of that company, and just distribute to yourself all the revenues and their performance will keep up with what they used to in previous 10 years (adjusted by inflation), then in 5 years you have your money back. And the company. In US you’d need 25 years (and, I don’t know why, in Denmark ~37 years)!

Does it mean that the US Market is overpriced and close to a collapse? We don’t know, but at least we have a measure of our optimism and you can take actions about it. You can follow a trend or not. My suggestion is always to diversify and not bet only on the countries on which everyone is betting all their chips.

“But RIP… you bragged about investing 3 days after Brexit and exploiting a temporary bump of +-10%! Isn’t it Timing the Market? Isn’t it finding patterns and trying to outsmart the experts?”

Ok, you’re right 🙂 But in the end I was just lucky. I made my bet on the fact that the Brexit would essentially be a no-op in the long term. I was right. I was lucky. I bought at the bottom and earned +10% in a couple of days on ~30K CHF. Awesome! I want to teach myself to resist the urge to make other bets. Like few months ago, when my S&P 500 share fund price reached 190 USD, I was tempted to sell everything, wait for the collapse with a grim on my face and then buy again at a lower price. I dream about it a lot of times. But I don’t do, and that’s very good that I don’t fall in these gambling moves – which would have been a ridiculous failure, since now the fund’s share price is above 200 USD. Plus, I’d have paid trade fees that alone would accumulate over time to a consistent sum if I’d try these stupid moves very frequently!

I’m the Croupier in my casino, not the player!

Conclusions

Don’t play with market, play in the market.

Stay in the game as long as you can.

Diversify.

Acknowledge that 90% of news and advice (including this post) are bullshit.