Making Friends with Bears Through Math

"Operations for profit should be based not on optimism but on arithmetic."

– Benjamin Graham

A fascinating aspect of the financial markets is that long-term returns are driven almost entirely by math, while short-term returns are driven almost entirely by psychology. It’s useful to consider both.

From a long-term perspective, a security is nothing but a claim to a future stream of cash flows that investors can expect to be delivered over time. Given a historically-reasonable estimate of future cash flows, knowing the current price is identical to knowing the expected long-term return. That part is arithmetic. From a short-term perspective, the price of a security is just the highest price the most willing buyer will pay and the lowest price the most willing seller will accept. That part is psychology.

If potential buyers become more eager to buy, and existing holders become more reluctant to sell, the price will rise. Conversely, if existing holders become more eager to sell, and potential buyers become more reluctant to absorb the shares, the price will drop. With every transaction, regardless of whether the price goes up or down, dollars that were held by the buyer are now held by the seller. Shares that were held by the seller are now held by the buyer. Not a single dollar has gone “into” or come “out of” the market. There’s just as much “cash on the sidelines” after the transaction as there was before – because every security created by an issuer (whether it’s a share of stock or a dollar of base money) has to be held by someone, at every point in time, until it’s retired. In the meantime, the stuff just changes hands.

In our own discipline, the “arithmetic” piece involves valuation methods that link prices, estimated future cash flows, and long-term expected returns. For any given set of expected future cash flows, the higher the price an investor pays, the lower the long-term rate of return the investor can expect. The lower the price an investor pays, the higher the long-term rate of return can expect.

The main pitfall, as we’ll discuss below, is that anytime investors use a valuation ratio (for example, a price/earnings ratio), the denominator had better be representative and proportional to decades and decades of expected future cash flows. While earnings are necessary in order to produce deliverable cash flows, variations in profit margins can make a single year of earnings a very poor choice for a valuation benchmark. Having studied and introduced countless valuation measures over time, we find that the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues (a measure I introduced in 2015) is best-correlated with actual subsequent market returns across decades of market cycles.