I give sell-side analysts a hard time, but when one of them says something meaningful, I’d like to think I give credit where credit is due. This week, Morgan Stanley’s Chief Equity Strategist, Adam Parker (who looks entirely too tan and happy to be doing actual work if you ask me), published a research piece saying it was folly to prognosticate about the future value of stock indices.
I must not be getting out enough, because the following quote had me rolling on the floor:
Trying to figure out where the market is going is like taking something we don’t know how to forecast (the price-to-earnings ratio for the market) and multiplying it by something we aren’t very good at forecasting (the earnings for the market).
Parker makes the point that we discuss in IOI 102 — namely, that investors mistakenly treat financial numbers as if they were constants of nature (like the rate of acceleration due to gravity) rather than as quantities that may and do change over time. This quote of Parker’s I found especially incisive:
We are constantly asked about the price-to-earnings (P/E) ratio for the market. We have always written that we don’t think anyone can forecast the market level P/E ratio in time frames less than a few years. However, in volatile times, we can try to contextualize where we are and what’s changed. Our best guess is that 50% of an average US recession is already priced into the S&P 500… Given the market peaked in May of 2015 roughly 13% above today’s level, and 1600 is about 15% below where we are currently trading, we think it is reasonable to say about half of a recession is embedded in today’s market level. Likely, more than that is embedded in certain industries and stocks. One question we get a lot is “what’s the right market multiple?” Of course the answer is “we don’t know.” We don’t think there are any data points that empirically have predictive value in forecasting the market multiple.
[bold emphasis mine]
While we agree with Parker that back-of-the-envelope ratio analyses are of limited use in making investment decisions, we have been working on a way to look at a fair value range for the U.S. market as a whole using the IOI framework of focusing in on the three fundamental drivers of value that we discuss in length in IOI 101:
- Revenue growth
- Profitability
- Investment level
The work on this is still in its initial stages, but we’re quite excited about the possibility of developing a fundamental valuation range based not on market multiples, but on observable operational measures and a sensible perspective on future growth. Stay tuned for more information about this.
Here is the original Business Insider article where I first saw Parker’s comments.
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