One of the phrases that I hear over and over, but simply don’t like, is that ‘markets hate uncertainty.’ Forget the fact that markets are just made up of people and don’t have independent emotions, I’m talking about hating uncertainty.
From a theoretical standpoint, let’s think about how uncertainty affects markets. Let’s start with the idea that the value of an investment is the present value of its future cash flows. That’s a pretty standard textbook idea, but let’s look at a simple example to illustrate the point.
Let’s say that an investment will pay you $100 one year from now, which would be the future cash flow. What’s that worth to you? Well, if you think inflation is going to be two percent, you have to discount what you are willing to pay by two bucks (simple math here) so that you don’t lose purchasing power over the next year.
Moreover, whatever the investment is, you know there is some kind of risk, so you have to set a price based on how risky, or uncertain, you think that investment may be. If it’s the US government (even at AA), you can be pretty sure that they’ll pay you, so you might only discount by another percent and pay $97 for the investment.
If the investment is risky, you have to discount a lot more to reflect the uncertainty. I mean, what if the $100 turns out to be $90? You’d better set your price at least at $87 just to account for the risk.
Taking this idea and thinking about the stock market as a whole, the picture is always uncertain – you never know what the cash flows will be in the future. For starters, my little example was just one year – with a stock, it should hopefully last forever, so the number of cash flows is unknown.
Then add in the fact that earnings are actually more volatile than stocks and it sure makes figuring out what those cash flows will be even more difficult.
Now incorporate major shocks like the Brexit – what will happen next is hard to say for anyone. You can assume that British stocks in particular will suffer lower cash flows in the future, but you can’t tell by how much, so you have to discount your estimates even further.
The market doesn’t hate uncertainty, it’s simply adjusting current prices to reflect the changing nature of uncertainty. When people say this, it’s because prices are falling, which means that markets are more uncertain than they were before, because of some new information.
But here’s the good news: a higher discount rate can translate into higher future returns. One Nobel Laureate says that discount rates equal expected returns. I hate disagreeing with the prize winners (especially twice in a week), but that’s only true if your future cash flow estimates are correct.
Otherwise, that’s right. In our example, let’s say that the $100 pays off exactly as expected, but because we felt uncertain, we only paid $87 for it and made a nice return.
In fact, it’s that very uncertainty that allows stocks to pay more than bonds. For all of their complications, bonds are easier than stocks in that they (usually) have a defined beginning, middle and end, have promised specific cash flows and the borrowers often have printing presses that can generate the cash flows.
Stocks are trickier because they should last indefinitely, may not pay any cash flows (Berkshire Hathaway has yet to pay a dividend) and don’t have printing presses.
I would say that as a stock investor, I love uncertainty. If stocks had the same certainty as bonds, there would be no reason to discount their prices and they would earn the same return as bonds.
It’s the very uncertainty that markets allegedly hate that allows investors to earn attractive returns. No one said it was easy, I get that, but everyone also knows in their heart of hearts that risk and return go hand in hand.