The Impact of Psychology: Beyond The Numbers
However much
analysts attempt to parse corporate data and extrapolate into the future, the
reality is that this is a fruitless quest.
Whether one’s goal is divining a reasonable price for an individual
stock or the stock market as a whole, the hitch is the same. Over time, there is a distinct correlation
between changes in company fundamentals and the values given to those
fundamentals, but at any given time there is frequently a disconnect between
what one might consider fair value and the actual market price.
On occasion,
there may be parity between the two, though more often than not the market
price will be above or below the level that might otherwise be viewed as
normal. The variances are largely explained by attitudes toward the
future.
At times when
prospects are rosy, investors tend to be generous with their valuations and
stock prices may rise well above benchmarks considered reasonable. Conversely, when times ahead are expected to
be difficult, the opposite situation develops.
A useful
hypothesis can be created using the Standard & Poor’s 500 data for the past
50 years. During that span, the average price-earnings multiple for that index was
16.6 times. By combining this multiple
with the Standard & Poor’s 500 earnings for each year throughout the
period, it is possible to create a measure of “fair value” against which to
evaluate the concurrent market prices.
The chart of
stock prices over the last 50 years shows notable correlation between values
and prices through 1996 and then a distinct divergence during the dot.com
excesses of the late 1990s. Talk of the new economy at that time led to
unrealistic expectations and the oft-repeated phrase: “It’s different this
time.”
It wasn’t.
The result was a market that was
overvalued by two-thirds and it took more than five years to blow off the
excess. The market as a whole plummeted
and more than a few technology issues that had soared towards hundreds of
dollars per share either disappeared or were crushed to minimal levels. The devastation was extraordinary, proving
once again that what goes up much too quickly is inevitably doomed to collapse.
The
flip side was two decades earlier, when the economy was stagnating and interest
rates soared into the teens. Market
prices slipped to less than 50% of what could be considered fair value, the
housing market was in the tank, the outlook for investors was bleak in the
extreme, and interest rates were in the mid-teens. It took another six years for those
discrepancies to disappear.
During
the most promising times, a stock’s price will benefit from improving
fundamentals as well as a favorable economic backdrop. In more difficult periods, discouraging
economic prospects may more than offset whatever strength may be gained from an
individual company’s good news. At best,
it may buffer price erosion. The silver
lining from all the storm clouds is the opportunity that accompanies them. When it appears to be the worst of times, it
may well be the best of times for courageous investors to buy.
That’s
easier said than done. Given the lessons of history, the time to reap the
richest rewards is when investors are too scared to act. The choice is always
the same. Either stocks are on sale or
it is the end of life as we have come to know it. In every case since the time when records
have been kept, the answer has been the same: Stocks were on sale.
Similarly, when everything’s rosy and prognostications by the gurus start heading toward Fantasyland, it’s prudent to scale back expectations and take a more conservative stance. It’s never as good or as bad as it appears.
N. Russell Wayne, CFP®
Any questions? Please contact me
at nrwayne@soundasset.com
Comments
Post a Comment