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John is the Chief Investment Officer (CIO) at Secfi. An expert in portfolio construction and investments, he helps individuals maximize returns and control risks unique to their situation.
Hey All,
It’s good to be back after the Thanksgiving break. I’m sure I say this every year, but it is really nice to spend time with family and reflect on all that I am thankful for. 2023 has certainly been a trying year for many of us — layoffs have continued, IPOs have been pushed, valuations in private markets are down, etc. And that’s not to mention any personal issues any of you have had to deal with.
But it’s also important to step back and look at all the positives. For me, that’s spending time with my wife and the life we’ve built in Austin. And it’s seeing all of the hard work my team and I have been putting into building Secfi Wealth this year bear real fruit. We have amazing clients and I love seeing their hard work pay off for them, financially and in their lives
Plus, I think it’s important to reflect on the macro. While 2023 hasn’t necessarily been the best year for many, it isn’t as bad as many were predicting. The pandemic is mostly behind us, unemployment is still near historic lows, and inflation continues to slow down. Even consumer spending continues to be relatively strong, especially over the holiday weekend. While stats like those are just a drop in the economic bucket, many are no longer forecasting a recession in the next year.
Despite that half-glass full view of things, it can be hard to shake the bad feelings. I get it. We’ve been inundated with a lot of negative news over the last two years, so finding those diamonds in the rough can be hard to see, or even believe. It’s why consumers are still worried about inflation, despite months of positive trends.
This duality between our expectations of things and the reality of things had me thinking something that had happened last week. More specifically, last Tuesday, November 21. Nvidia released their quarterly earnings report. Guess what? The numbers were stellar. But their stock price fell. In fact, it’s still down. Why?
First, just how good was Nvidia’s earnings report? Revenue increased 200% year-over-year and net income came in at $9.2B for the quarter. That’s up from $680 million in the same quarter last year. You don’t have to be an investment or business expert to see that these are pretty amazing results. So you’d expect the stock to explode on that news, right?
Well, the stock fell as much as 3% the next day. This happens all the time. Sometimes markets get “good” news but prices fall. Sometimes things go up on “bad” news.
That’s because it’s all about expectations. There are plenty of Wall Street analysts making predictions all the time about company results. You’ve probably seen tons of articles that say a company beat “estimates” or that they fell short of “estimates.” Well, those “estimates” are from Wall Street analysts. But those estimates are not the same as expectations. They may be related but they don’t determine the price of any stock, the aggregate investing public does.
Think of it this way. Whenever a new movie comes out, a bunch of professional film critics see it first and provide their take. Sometimes, critics collectively love a movie but it tanks at the box office. Sometimes, they hate a movie yet everyone sees it on opening weekend. Film critics don’t determine whether a movie will be successful or not, even though their take on it can influence whether or not someone decides to go buy a ticket.
Another crucial element of stock prices is that expectations of the market, as a whole, are already embedded in today’s price. Those expectations can be higher or lower than the estimates from Wall Street analysts. Some of the smarter, or more trusted, analysts may influence expectations with their thoughtful estimates but they are just their own estimates, and not necessarily the market’s expectations.
Here’s a model that I find useful to describe how prices are set.
Price = Expected Future Cash Flows / Aggregate Investor Required Rate of Return
In this model, a change to the numerator OR denominator can impact the price. In the case of Nvidia, it’s likely that investor’s expectations for future cash flows (driven by revenue and profit margins) were even higher than analysts’ estimates. So when they saw the earnings results, they realized that their expectations were likely too high for the future and the price fell. Maybe something will happen next week that indicates future cash flows will be higher in the future and the price will rise again. Totally possible!
Another recent example is all the recent OpenAI drama and the impact on Microsoft’s stock price. For those few tense days, investors all over the world were constantly updating their expectations about Microsoft’s future business results and cash flows. The price was bouncing all over the place as a result. Everytime a new, surprising piece of information came out, the stock immediately reacted. This all happens in real time on the stock exchange, even if you can’t see it. If OpenAI stock were traded, you better believe it would have had serious volatility over last week as expectations about its future whipsawed with every new news article.
Yes, this is actually a thing. It’s known as the “Keynesian beauty contest.” And it’s not just about what others think, it’s what others think others will think. It’s recursive and, yes, very meta.
It’s been hypothesized that this phenomenon might contribute to asset bubbles and crashes, often referred to as the “greater fool theory.” In other words: “I don’t think this asset is worth this much, but I think another sucker will think it’s worth this much, or more, so I’ll sell it to them!”
I’ve heard people hypothesize that startup valuations got caught up in something like this “greater fool theory” during the pandemic. Thankfully, at the end of the day, fundamentals matter and serve as an anchor to what otherwise might become untethered expectations spiraling in either direction, resulting in serious misallocation of resources.
So, we covered how Nvidia’s stock was likely impacted by the expectation for cash flow in the future. But what about the denominator of that equation, which was about required rates of return?
Mathematically, if the required rate of return rises and expected future cash flows stay the same, prices fall. This is easy to illustrate with bonds whose cash flows are fixed and contractual. If you own a riskless bond that pays 5% and interest rates on riskless bonds rise to 6%, the value of your 5% bond goes down because you can now get 6%. In other words, the required rate of return for lending money increased to 6%, rendering the cash flows from a 5% bond less valuable.
In stocks, the same relationship applies. If the world becomes a much safer or riskier place all of a sudden, for whatever reason, the rate of return people require to hold stocks (which are risky assets) will go up or down and prices will rise or fall! Time varying risk premiums are responsible for a lot of the volatility of the stock market.
You can stop worrying about explaining every price move. But you can have an explanation. Valuations went up? Expectations for future cash flows must have gone up, or the required rates of return must’ve gone down.
A lot of famous investing quotes can be framed in this model. For instance, Warren Buffet’s well known quote: “Buy when others are fearful and sell when others are greedy.” Which is just a more interesting way of saying buy when required rates of return are high and sell when they’re low.
Price moves can be confusing, especially when they seem to contradict the news. But when you apply an expectations model to price moves, it can help remove some of that mystery.
Things we’re digging:
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