Why Are Global Stock Markets Doing So Well?
The year 2017 is shaping up to be one of the best years in a generation for international stock market investing. Jeff Kleintop at Charles Schwab points out that this is the only year in the 30-year history of the MSCI All Country World Index in which, at least through October, the global stock market has posted a gain every single month. If the media would just stop there, everything would be fine. Unfortunately they can’t seem to keep themselves from subsequently offering all kinds of reasons for the exceptional performance, most of which are speculative, unsupported, or in some cases downright nonsensical. Pick your cause: low oil prices; low interest rates; improved GDPs; Trump; Obama. In the end no one really has any clue about what drives the investment markets.
But I do. And I will share it with you right now as long as you promise not to give away the secret!
Basically there are two factors that determine stock prices. The first is company performance, as measured by net profit (earnings), free cash flow, or whatever investors choose as the best measure of a company’s current and future ability to grow. For a company whose earnings – we’ll use that as the most commonly accepted metric – are growing from year to year, you would expect its stock price to concomitantly increase.
The difficulty arises when we try to estimate the amount of the increase. Should an annual 10% growth in earnings translate to an annual 10% growth in stock price? Regrettably it rarely works that way. And the primary reason is the second factor, which I will call investor sentiment. A relatively simple way to understand this concept is through the company’s price/earnings (P/E) ratio. This is a multiplier that indicates how many dollars (or euros or yen) an investor is willing to pay for one share of the company’s stock. When the P/E ratio is high, it means investors are comfortable paying a lot of money to own that stock. When it is low, investors consider the stock a more risky investment (in terms of the future returns they expect) and as a result are unwilling to pay as much.
You may have heard in the media (or even from some investment professionals) that U.S. stocks in general are overvalued right now. I don’t believe that to be true. Every day millions of investors get together with the help of brokers and market makers to agree on a price for buying & selling the shares of every publicly traded company. So those prices must be valued correctly by definition. It would be more accurate to say that stock prices today are highly valued as compared to historical valuations. Or, put another way, investors are willing to pay more for a share of stock today for a company generating a certain level of earnings than they were willing to pay in the past. And we can quantify that difference using measures based on P/E ratios.
What does that tell us about future stock prices? Take Apple Corporation, for example. If the company’s earnings were to increase by 20% in 2018 and investor sentiment were to stay constant, i.e. its P/E ratio next year remained unchanged (at 18.9 as of this writing), then Apple stock would be priced 20% higher next year. Unfortunately, investor sentiment is driven by human emotions and behavior, which no one except Issac Asimov* has ever been able to predict. If Apple’s P/E ratio were to fall to 9 next year, then even with a 20% increase in earnings its stock price would drop by 40% (to its current price x 120% x 50% or to 60% of its current price). We can calculate this after the fact but have no way of knowing in advance how comfortable or averse investors will be towards the risk of owning Apple or any other stock next year, regardless of whatever explanations or predictions the media comes up with today.
So unfortunately, even if you could predict future company performance, investor sentiment is impossible to predict. It follows, therefore, that market performance must also be impossible to predict.
Michael Bloomberg, founder of a firm providing financial data widely used throughout the global financial services industry, and the eighth richest person in the U.S., was interviewed by 60 Minutes television earlier this year. When asked what he thinks is driving the impressive stock market performance, he replied, “I really have no idea.” At last, an honest expert.
*Read Foundation, Foundation & Empire, and Second Foundation. One of the great science fiction trilogies.