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Feb 9, 2022
One of Charlie Munger’s best quotes on behavioral bias is as follows:
“When you shout it out, you pound it in.”
Munger was referring to the kind of frequent and fervent repetition that leads to our perception of an idea or concept as important. On the financial news, there is plenty of shouting it out (figuratively and occasionally literally). There are several concepts that have been so pounded into our psyche that they absolutely, positively, must be important, right? By the time you finish this article, I hope that you look at some of these oft-referenced terms with a more skeptical eye.
Given the frequency that PE ratios are mentioned by analysts and investors, it is reasonable to assume that PE ratios inform a reasonable price for a given company. PE ratios describe the implied multiple of a company’s trailing or future earnings investors are currently willing to pay. A company with $50 million of earnings and a market capitalization of $1 billion would imply a PE ratio of 20 (20 x $50 million = $1 billion). However, making decisions solely based on a PE ratio is a classic investing trap.
Imagine you’re given the chance to pay a sum of money now for a percentage of another person’s earnings for the rest of their career. You’re presented with two people, both currently earning $50,000 a year. Looking solely at their wages, you would pay the same amount.
Now imagine one person is an abject slacker with no ambition, content to put in the bare minimum effort. The other person is a go-getter with a strong worth ethic, currently working towards an advanced degree. It’s safe to say that you would be willing to pay more for a percentage of the latter person’s earnings.
In a similar situation, one might have a cyclical income with a high degree of variability, while the other may have a highly stable annual income. Again, you would pay more for a percentage of the latter’s consistent earnings.
Hopefully the analogy to companies is clear – there are other factors more determinant of long-term value than a brief snapshot in time. A company with a “high” PE ratio can be undervalued, and a company with a “low” PE ratio can be overvalued. There is more to investing than “one number is less than the other number.”
There is no shortage of analysts willing to pitch their stock ideas in financial media. Their analysis often includes technical-sounding jargon and a variety of financial acronyms, accompanied by the name of a prominent investment firm.
Just ask yourself – if investment managers pay thousands (or tens of thousands) of dollars to access the best investment research, why give it away for free on CNBC?
Most of these guests are sell-side analysts, employed by a brokerage or investment bank. They are not involved in putting capital at risk; their job is primarily to produce research and short-term price projections that can be broadly disseminated. Since many of these analysts are employed by brokerage firms, one may reasonably wonder if the incentive is more skewed towards generating trading activity.
You will see far fewer buy-side analysts (such as Summitry’s investment team) laying out their work on national television. Our team’s work is the result of countless hours of research and analysis and is proprietary information. We would be crazy to give it away for free!
Moreover, sell-side analysts (transparently, to their credit) often offer predictions for one-year periods. It is not clear that provides any utility to the investor, as short-term moves are rarely driven by fundamental changes in intrinsic value.
I had the rare pleasure of sitting down to read a newspaper recently. It was a bit out of date, but it struck me how little headlines change:
“Comparing today’s market with those of yesteryear, old-timers are struck by the Federal Reserve’s clout […]”
“[Analyst] sees the Fed’s dominant influence as the main difference in today’s market.”
Okay, perhaps a bit more than out of date. The above quotes are taken from The Wall Street Journal published on February 24th, 1995. For historical context, the Dow hit 4,000 and short-term lending rates were 6%. The 49ers were weeks away from their last Super Bowl win and O.J. Simpson was still on trial.
More than two decades later, the 49ers have yet to win another Super Bowl and investors remain hyper-focused on the actions of the Federal Reserve, or Fed. The Fed certainly does have the ability to structurally influence financial markets, primarily through adjusting short-term interest rates or engaging in financial asset purchases. These measures are meant to adjust borrowing costs and liquidity. While the efficacy of these policies is hotly debated, they are limited in scope. The Fed cannot engage in fiscal (spending) policy, nor can it purchase most financial assets. Most importantly, the Fed cannot drive innovation, create new products or services, or improve productivity in the way that drives long-term stock market returns.
This is not to say that the Fed has no impact on markets. In the late 90’s, financial news covered the size of Fed Chairman Alan Greenspan’s briefcase as an indicator of changes to the federal funds rate. Even if for no other reason than sentiment, the Fed-focus becomes a self-fulfilling feedback loop. However, if your focus in 1999 was on Greenspan’s briefcase and not lofty market valuations, chances are you got burned.
There is also a surprising number of billionaires that seem to enjoy the gravitas of being interviewed by financial media. Other stories cover the asset allocation and money habits of billionaires. Both are useless if you are not a billionaire. Chances are you are not a billionaire. If you are a billionaire, congratulations and feel free to skip to the next section.
If not, avoid the trap with conflating a billionaire’s current investing decisions with how they became wealthy in the first place. There seems to be a perception that (a) billionaires have some level of special market insight and (b) following their moves will someone make one more likely to become a billionaire. Billionaires have entirely different goals and needs, presumably gilded yachts or eternal life. Either way, chances are your goals and needs are entirely different. A thirty-year old saving in a 401(k) and a sixty-five-year-old retiree drawing from her portfolio would have different investing goals, timelines, and allocations. The same is true for you and a billionaire.
Like PE ratios, economic data does certainly have a place. However, the danger involves extrapolating specific data points into broader economic predictions. For example, employment numbers are often revised multiple times before being considered “final.” This is not nefarious manipulation; it is an acknowledgment that the reported data is often preliminary. That said, relying on preliminary data to form a macroeconomic view implies a level of certainty that is difficult to justify.
Another confusing data point is unemployment numbers. Not only are there various measures of unemployment; the unemployment measures only consider those actively looking for work. If a long-time job seeker gives up and stops looking for employment, the unemployment rate drops. The fuller picture includes the labor force participation rate, which captures workers that drop out of the labor force. You would imagine the unemployment rate rising from 4% to 8% would be indicative of hard economic times. Yet what if that rise is caused by long-term unemployed individuals that have rejoined the labor force but have yet to settle in permanent jobs? You could argue this increase in unemployment is a positive economic development!
Finally, there is inflation. In the same vein as unemployment numbers, there are multiple measures of inflation. For example, the “headline” inflation includes more cyclical food and fuel prices, while “core” inflation excludes these items. There is a dictionary’s worth of inflation terminology, from “core PCE deflator” to “hedonic adjustments.” Unfortunately, they all suffer from the same issue – there is no universally accepted definition of inflation. While the concept is intuitive (decreasing purchasing power of a unit of currency), measuring it is not. In the billionaire example above, their personal inflation rate is going to be more influenced by gilded yachts than the price of ground beef. In the words of Lucille Bluth in Arrested Development, “I mean it’s one banana […] what could it cost? Ten dollars?”
We are also heavily influenced by visible and frequent prices. We tend to notice the cost of gas and groceries but forget that we may be paying less for better TVs than five- or ten-years prior. Moreover, everyone experiences their own inflation rate. A large family with teenagers will likely feel the pinch of higher food prices more than a single individual. However, that single individual may require extensive medical care, an area notorious for significant inflation.
The advent of the twenty-four-hour financial news cycle has meant that the day is increasingly filled with, well, filler. There is certainly value to financial news; there are important business and economic developments that require coverage, and financial journalists have helped expose fraudulent companies (remember Enron?). However, there is not enough that happens day-to-day to for all the news to be newsworthy. You will learn more about financial markets from Kindleberger’s Manias, Panics, and Crashes than the “Fast Money” traders, hands down.
I will leave you with the non-denominational version of the serenity prayer:
“Grant me the serenity to accept the things I cannot change,
Courage to change the things I can,
And the wisdom to know the difference.”
Seeing the Big Picture rather than the Big Stories
Watch this webinar where my colleagues and I contextualize what’s being reported in the news and if it’s something that should (or should not) influence an investor’s long-term financial plan.
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Claire Shifren, CFP®
Senior Financial Advisor