Broker Check

Why We Missed It

July 01, 2022

An asset price is the combination of some fundamental factor and the demand to own that factor, represented by its valuation:

Price = Fundamental Factor x Valuation

For example, a house price is equal to the square footage (fundamental factor) multiplied by the price-per-square foot (valuation). Viewing prices in this manner allows us to compare assets. If two houses with equivalent square footage are selling for $500/sqft and $750/sqft respectively, the more expensive home needs to justify its valuation or else it could be viewed as overpriced relative to the cheaper option.

Stock prices work the same way, and investors tend to value stocks based on earnings (although sales and cash flow are other examples). Using the formula above, a stock price is equal to earnings multiplied by the price-to-earnings ratio. Stocks with similar earnings but different valuations require deeper analysis to better understand why the demand differs.

Prices move when the fundamental factor and/or its valuation changes. If a homeowner adds a second story, the square footage increases and should add to the price of the house (holding all other variables fixed). Furthermore, if demand to live in the neighborhood rises, the homeowner may benefit purely from the increased interest in the area.

Again, the same applies to stocks. Either a company can improve its fundamentals or demand for its stock can rise. Let’s assume that a company just announced the release of a new product. The excitement causes its stock price to rise from $100 to $125 right after the press release. Here, the earnings have not changed, but demand just rose by 25% because investors anticipate a boost to future earnings.

Fast forward a year, and they report record sales. Earnings rise by 20%, but the stock price doesn’t move because expectations that were baked into the stock a year ago have now been met. If earnings rise by 20% and the stock price doesn’t change, that means the valuation has compressed, making the stock cheaper (and potentially less risky). Long term investors hope this process of increased expectations being met by the company will keep this cycle going.

The driving force

The S&P 500 index price can be examined in the same manner as any other asset. It’s the combination of the earnings growth of its constituents (fundamental factor) and the price-to-earnings multiple (valuation). The chart below breaks the annual performance of index into these two components over the past five years.

For example, earnings grew a collective 3% and the valuation expanded 26% to deliver a 29% price increase in 2019. This year, earnings have grown 10% since March 2021, but the valuation has compressed so much that it’s to blame for all of the downside this year1. To better understand why, let’s dig a little deeper.

Earnings growth is fueled by competitive positioning, management experience, economic growth, availability of credit, etc. These factors tend to evolve slowly over time, so sudden moves in stock prices rarely reflect abrupt changes in earnings.

The action tends to come from fluctuations in valuation. Again, this represents how investors perceive the value of the index’s earnings. Opinion is heavily influenced by emotions like fear, panic, greed, and euphoria. For example, if the S&P 500 drops 10% in a week, it is highly unlikely that the index’s future profitability could change that fast. What can change is how investors perceive the index.

That’s because emotions are fleeting, unpredictable, and not always rational. Sure, there are times when investors change their tune on a stock because new information has been priced in. But there are also times when valuations move for reasons unrelated to fundamentals. The challenge is that it’s virtually impossible to know with any certainty and consistency why valuations fluctuate over such short time periods as a few months.

That’s because earnings and other fundamental factors can often be predicted since they tend to be stable and more objective. If a company introduces a better mousetrap, and the market for mousetraps can be sized, then a skilled analyst should be able to determine the impact to earnings over the next few years.

However, valuation is purely subjective, and there’s no model, algorithm, or any other force in this known universe that can predict human behavior. That’s why it’s so hard (and risky) to try to trade on short-term movements in asset prices.

To be clear, in no way does this imply that investors should ignore valuation. It’s critical to any assessment of an asset price. Just don’t think that there’s some magic tool or process out there that can model near-term changes in human behavior. If there was, spouses would never have to ask their partner what they’re thinking, and parents would be better prepared for the sudden mood swings of their children.

Simply put, the drawdown in the S&P 500 and other equity indices this year has not been due to a degradation in earnings but rather a change in sentiment. This could imply that investors expect slower earnings in the future, a reset of what they are willing to pay to hold risky assets, and/or some other reason that’s a mystery. Whatever it is, the fact that it’s been more emotional than fundamental is why it’s caught so many investors flat footed.

The bottom line

We have tools and processes to estimate the direction of the fundamentals that drive the global economy and the companies that compete within it. These help us locate opportunity and size our conviction on key investment themes that we expect to play out over the next several years. But as explained above, these do little to predict the human behavior that drives the emotional component of markets.

This presents a conundrum because valuation changes can clearly fuel bear markets - we’re in one right now. These events can impact long-term financial goals when unprepared, so we can’t just ignore them or else we pose just as much risk to our investors as trying to guess when they will happen. We use financial planning to bridge this gap by assuming corrections, bear markets, and recessions will happen over time. 

The bottom line is that we didn’t wake up on January 1st of this year thinking we’d in a bear market today. Given the performance of the broader indices, I’d wager that very few investors out there expected it either. But our planning process isn’t dependent upon timing calls like these, nor is the probability of success for our investors.





1 As of 6/22/2022



This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.