Stocks and Trading Thread - Channeling your inner Mono

[crazy canuck]

I think misunderstood

I think you need to find a place with a better reception.

A place without idiots.  Good idea 

[DGuller]

I think misunderstood

I think you need to find a place with a better reception.

A place without idiots.  Good idea 

I don't think you will ever find it in your lifetime.

[grumbler]

I think misunderstood

I think you need to find a place with a better reception.

A place without idiots.  Good idea 

And if you go there, we will be one.  I like this plan.  Except, of course, that this plan has been promised multiple times in the past and we always end up with you posting again.

[alfred russel]

Taking PEs as a historical benchmark has the added problem that "E" is an accounting answer. The accounting rules that lead to that answer have changed dramatically over the years, and the rules lead to rather dramatic differences across industries (for example, you would generally expect a tech company to have a low PE versus an industrial company, even if they had the same projected growth).

Actuarities always gotta be boring up every thread. 

If you don't like earnings then look at free cash flow.

Free cash flow is much better.

No one buying a business would use a PE ratio--they might use an EBITDA multiple, discounted cash flow model, or something else, but I've never seen a PE ratio.

An example (of a zillion of them)--we used to amortize goodwill over 40 years (goodwill being the excess amount paid for a business over the value of the other assets--it can be a very substantial part of many company's balance sheets). That means 1/40th of the balance is recorded of the expense and reduces net income (the E in a PE ratio). Obviously this was completely arbitrary, so the rule got changed so it is no longer amortized--it never hits net income at all (there are certain circumstances, but those rules are complex). Today the board is contemplating reinstating the amortization of goodwill, and making the period 10 years.

The point being that accounting is an arbitrary process that has dramatically changed over time. The rules in the 1970s are materially different than the 2020s, as are the businesses. If you want to talk about historical averages, you should be adjusting the "E" for these changes, and applying them to industry standards (with the mix changing over time).

[alfred russel]

The market was overvalued. In early February, the S&P's PE ratio was 25. Today it's about 21. It should be below fifteen. It might not actually be even that low after dinged up companies report their dinged up quarterly earnings reports. It's not unreasonable to say that the value that was destroyed was never really there to begin with.

Why should it be below 15?

That implies you are getting earnings of 6.7% on your investment. Is that a good return? I don't know, but for market segments that don't require significant investments and are stable or growing, that may be a rich return with interest rates where they are.

Also, who knows what is going to happen with earnings, but obviously a lot of companies are going to get hammered. If earnings fall 80% for a company, or it has losses the first half of the year, I don't think that implies the value should fall dramatically if liquidity isn't a concern and projections for 2021 and beyond remain mostly intact.

[MadImmortalMan]

15 is where it goes when it snaps back.

I'm really wary--afraid actually--of "this time is different" or "new normal" methodologies. I'm afraid of succumbing to them. I'm also wary of limiting my view of reality to my own lifetime.



This writer is arguing from that perspective. But when I look at that chart I see a 40 year distortion. Like the famous GDP vs wages comparison or home prices vs wage comparison. They all sort of correlate, even.

Piketty described the entire post-war period in the West as a multigenerational aberration, so it's not unprecedented.

There are lots of good explanations for higher ratios. Fed rates, online/retail trading, computer trading, regulations, etc. They all make sense and are considered structurally new and permanent things. What about railroads. Weren't they a permanent structural change in the way the economy works? Standardized shipping containers maybe even moreso? Long-distance trucking and interstates, FDIC, 401ks, accounting rules, there are lots of things that could be called permanent structural changes in the economy or how the market itself works, but none of them seem to have altered the basic ratios much in the long run.

That implies you are getting earnings of 6.7% on your investment.

The dividend is my return. Anything else requires selling/trading. Stocks (S&P) generally return a remarkably stable ~2% yield.

I'm aware that this secular shift might last our whole lifetimes, and that would mean that at least for us it's effectively a new normal. Why I use 15 and not 13. Watching the ratios has been a successful strategy for me even so. It's how I nailed Shenzhen. I went to 50% cash around the state of the union in all our retirement accounts and lost a month's profits because the S&P was approaching 25. 

It's definitely too quick and dirty, but it does work fairly well. At least it has for me.

[alfred russel]

I'm really wary--afraid actually--of "this time is different" or "new normal" methodologies. I'm afraid of succumbing to them. I'm also wary of limiting my view of reality to my own lifetime.

The discounted cash flow model is not some "new normal" methodology:

Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. Studies of ancient Egyptian and Babylonian mathematics suggest that they used techniques similar to discounting of the future cash flows. This method of asset valuation differentiated between the accounting book value, which is based on the amount paid for the asset.[2] Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book The Theory of Interest and John Burr Williams's 1938 text The Theory of Investment Value first formally expressed the DCF method in modern economic terms.[3]

From wikipedia.

There are a lot of issues with the chart below, and I think to an extent it tends toward numerology. I would like to point out that the most massive spike in the chart is also the point at which you could generate some of the most massive returns in the past 50 years - that coincided with the financial crash when earnings plummeted. The spike in PE ratios wasn't because the market was overvalued (it appears it was significantly undervalued) but because the "E" had a short term and dramatic decline.

[Admiral Yi]

Mimsy:  Fredo and I are not bringing up easy money as the equivalent of some disruptive technology, but as the determinant of the next best use of your money besides investing in stocks: bond yields.  A historical PE of 15, converted to earnings yield, gets 6.7%.  That compares reasonably to historical bond yields of, what, 4.5-5%?  Now compare the modern 25 PE, yielding 4%, to current bond yields of what, 1.5-2%?  The point is when 10 years are yielding 80 basis points you're going to settle for a pretty minimal equity yield.

That's leaving out what I consider to be an overlooked aspect of current PEs, which is the abundance of loss-making or break-even, potentially disruptive growth companies.  Amazon is a famous example.  Amazon's earnings are notoriously tiny compared to its revenues, but its growth is unstoppable. And it has enormous market cap means its ridiculous PE (60 last time I checked before The Plague) is going to push overall market PE dramatically. Tesla is another one that I am familiar with.  No full year of profitability yet, so PE is infinite.  I think people preaching the reversion to 15 PE line fail to account for this increase in "growth" stocks.

[Admiral Yi]

Norway's sovereign wealth fund owns 1.5% of global market capitalization.

[Admiral Yi]

Tesla is going nutter butter again.

[Habbaku]

I have long since given up on figuring Tesla's price out.

[alfred russel]

Mimsy:  Fredo and I are not bringing up easy money as the equivalent of some disruptive technology, but as the determinant of the next best use of your money besides investing in stocks: bond yields.  A historical PE of 15, converted to earnings yield, gets 6.7%.  That compares reasonably to historical bond yields of, what, 4.5-5%?  Now compare the modern 25 PE, yielding 4%, to current bond yields of what, 1.5-2%?  The point is when 10 years are yielding 80 basis points you're going to settle for a pretty minimal equity yield.

That's leaving out what I consider to be an overlooked aspect of current PEs, which is the abundance of loss-making or break-even, potentially disruptive growth companies.  Amazon is a famous example.  Amazon's earnings are notoriously tiny compared to its revenues, but its growth is unstoppable. And it has enormous market cap means its ridiculous PE (60 last time I checked before The Plague) is going to push overall market PE dramatically. Tesla is another one that I am familiar with.  No full year of profitability yet, so PE is infinite.  I think people preaching the reversion to 15 PE line fail to account for this increase in "growth" stocks.

I'm going to go accountant on everyone for a second, but I think that this is a very important point so try to hang with me. This was the major pet peeve of Bill Gates in the 90s (he lost the arguments with the accounting gods).

A manufacturer (like Ford) invests for the future by buying machinery and equipment.

A technology company (like Microsoft) invests for the future by investing in R&D and people.

If you buy Machinery and Equipment for $1 million, you have an asset on the balance sheet for $1 million (no immediate impact on earnings).

If you spend $1 million on R&D, or recruiting an awesome team of software engineers, you have $1 million of expenses that go through the income statement (immediately reducing your earnings).

The point being: If Ford has a PE of 15, that doesn't mean it can pay 6.7% to shareholders: it has to invest in machinery and equipment - not just for growth but also to just keep its plants running (as stuff wears out, you need new stuff). It might not even be able to pay anything. If Microsoft has a PE of 15, because its investments are largely reflected in the "E", it might be able to pay something close to 6.7%.

If in the Ford economy a PE of 15 was a fair return, you would expect the average PE to go up as the economy shifts to a Microsoft economy, even before we consider what has happened with interest rates.

[Admiral Yi]

The point being: If Ford has a PE of 15, that doesn't mean it can pay 6.7% to shareholders: it has to invest in machinery and equipment - not just for growth but also to just keep its plants running (as stuff wears out, you need new stuff). It might not even be able to pay anything.

But depreciation *is* an expense.

[alfred russel]

The point being: If Ford has a PE of 15, that doesn't mean it can pay 6.7% to shareholders: it has to invest in machinery and equipment - not just for growth but also to just keep its plants running (as stuff wears out, you need new stuff). It might not even be able to pay anything.

But depreciation *is* an expense.

It is, but depending on the policy, it may be over 20 years or more. With inflation and even modest growth in the business, it doesn't even out. Microsoft takes 100% of the hit today; Ford is still taking some of it a couple decades from now.

[Admiral Yi]

It is, but depending on the policy, it may be over 20 years or more. With inflation and even modest growth in the business, it doesn't even out. Microsoft takes 100% of the hit today; Ford is still taking some of it a couple decades from now.

So, are you saying if depreciation was not a thing, and Ford had to expense equipment purchases today, Ford would have a higher PE?