The drivers of total return are dividends and changes in price. Dividends are driven by fundamentals. Price is driven by fundamentals and sentiment.
Fundamentals are the basic measures of business – the growth or decline in revenues, profit margins, earnings, etc. Fundamentals drive long-term returns.
The short-term driver is investor sentiment. By sentiment, I mean investors willingness to pay more or less for current fundamentals.
During every market cycle, investors eventually reach a point where the price they’re willing to pay for fundamentals changes.
To keep this simple, I’ll use earnings since it works well with P/E. Prices rise for two reasons:
- Earnings can rise while the price paid for $1 of earnings stays the same (the E in P/E rises and P paid for E stays the same), pushing prices higher.
This can certainly impact sentiment, but the second reason is driven by sentiment:
- Investors are willing to pay more for the same $1 of earnings (the P in P/E rises), pushing prices higher.
Ultimately, the cycle leads to investors willing to own more stock and pay more for it too. History has shown this can continue unabated, even with little to no earnings growth (or no earnings at all like the dotcom bubble), for some time. The herd can stay irrational for a long time, then turn in a second.
Simply, the average investor’s willingness to own more stocks, and pay a higher price, drives returns.
It’s no surprise that as stock prices rise, investors get more comfortable owning stocks. Buying whatever performed well yesterday is a popular hobby of the herd. The willingness to own more or less stock coincides with the peak and trough of the market cycle respectively. So returns are inversely related to sentiment – future returns are highest when sentiment is lowest and vice versa.
I believe sentiment is the best measure of future returns. Find a way to measure sentiment with precision and you’ll time the market perfectly, limit losses absolutely, and have the best investment strategy ever.
Too bad it’s not possible.
At best, you can project it as a probability (which still leaves room for being wrong).
This is why Marks believes in cycles. If you can spot serial bad behavior you can protect yourself when sentiment turns. Essentially, you anticipate what the herd will do by thinking a few steps ahead.
The Upshot has a cool little puzzle that covers this concept well. Below is a quote from the follow-up explanation after you submit your answer:
In the stock market — or the housing market, for that matter — people often struggle to think more than one or two steps ahead. That’s a big reason that bubbles can form. It was true that a lot of dot-com companies from the 1990s were on to something new and important, just as it was true that housing prices rarely fall. But if everybody else decides that dot-com stocks and houses are a great investment, a problem can easily develop. The prices of those assets can rise so high that they’re no longer a good value.
The initial instinct wasn’t wrong. The failure to think ahead was the error.
- Lessons From the Long Bull Market – J. Rekenthaler
- Worry Only When You Think You Have It Figured Out – M. Housel
- Why is More Information Making Us Worse Investors? – C. Roche
- Time Is an Investing Ally, Not an Enemy – B. Ritholtz
- The Positive Feedback Loop is Broken – Reformed Broker
- Three Edges to Beat Mr. Market – Seeking Wisdom
- Mental Model: Misconceptions of Chance – Farnam Street
- A New Insight for Investors: How Financial Markets Interact with the Economy – AIER
- The Idolatry of Interest Rates Part II: Financial Heresy (PDF) – J. Montier