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1/22: The inflows of new participants to the stock market is impressive. Trading volumes are up and the % of everyday people holding stocks is on the rise. But there are signs that these new investors have non-traditional views about what owning a share of stock represents.
2/22: Instead of immediately delivering the punchline (which I’ll get to), here are two charts that when combined define the crux of the mental shift.
The first is a chart that shows the correlation of share price to earnings per share (Source: @awealthofcs):
The first is a chart that shows the correlation of share price to earnings per share (Source: @awealthofcs):
3/22: This chart is strong proof that over time there’s a near perfect correlation between stock prices and earnings. Stock prices go up when earnings go up. Therefore, the enterprise value of a company ultimately collapses to a function of how much money it makes.
4/22: The second is a chart of the average hold periods for stocks over the past 9 decades (Source: @reuters article):
5/22: Unpacking this chart isn’t straightforward, but it shows that the turnover of positions for the typical investor has collapsed from years to months. The most recent data point represents an all-time low of 5.5 months and I bet an update would show it’s even lower today.
6/22: And if the data were unpacked more, it’s a near certainty that the decline in hold times would be even more pronounced if you removed index/mutual funds that have extremely long hold periods and old school investors who buy and hold certain stocks forever.
7/22: So if there’s a clear correlation between earnings and stock price, does this mean that stock investors are generating additional signal about future earnings with a similar cadence to their trade velocity. Herein lies the divergence in philosophy.
8/22: The value of a company is a function of the quality, quantum and durability of its current earnings machine plus a discounted view of the projected quality, quantum and durability of its ability to earn money in the future.
9/22: But the way the market works, the vast majority of information about how a company is performing is released every three months in an earnings announcement. Occasionally there are in-period announcements that matter and other external data sources that can provide context.
10/22: And typically this new information is wrapped in a narrative constructed by Management that guides investors and analysts about what the company is doing well, where it’s facing challenges, and how the future is likely to unfold.
11/22: So someone can buy a stock with the intent of analyzing all relevant information to determine if the financials and Management’s narrative justify staying the course. Staying implies that analysis concludes that the current and future earnings profile looks attractive.
12/22: For these investors, when they buy a share of stock they believe they’re buying rights to a share of the future cash flows of the company. Good management teams will invest in activities that produce even more cash in the future. This is what an investor is buying.
13/22: But “investing” can be looked at through another lens. To invest means owning an asset with the goal of generating income from the investment OR THE APPRECIATION OF THE VALUE OF THE ASSET OVER A PERIOD OF TIME (Sorry for yelling but Twitter doesn’t allow underlining).
14/22: Because the friction on trading stocks has been reduced to zero, many next-gen investors think of buying a share of stock as owning a tangible asset that moves up and down in value and can be unwound at any time.
15/22: So while the movement in a stock might be due to new information on a company’s performance being shared with the public, many next-gen investors look to buy stocks that have polarized investor communities that systemically create volatility intra-news-period.
16/22: Why? Volatility creates opportunities to produce outsized returns. Earning a steady 5-6% a year (or even 10%) doesn’t interest investors who aren’t starting with a lot of money in their accounts. It takes doubling up over and over to build something worth protecting.
17/22: A more accurate definition of this behavior would be speculation, which in simple terms is the forming of a theory without firm evidence. In the markets, speculation involves trading high risk instruments with the expectation of significant returns.
18/22: And it’s even more complex when you add in the other “benefits” of speculation. Finding polarizing investment opportunities allows an individual to join a movement. And taking a strong position creates opportunities to build social cred and one’s personal identity.
19/22: This framework also explains why options have gained in popularity. If volatility creates alpha, the leverage associated with options magnifies the alpha. This also magnifies polarized positions and magnifies social cred. Go big or go home.
20/22: But it’s difficult to consistently generate winning positions when you’re effectively buying a slice of a company with an expiration date attached to it. Winning requires getting the entry price, the direction of the stock movement, and the timing all right.
21/22: Stories are easy to find about active traders who have 3Xed, 5Xed or 10Xed their money in weeks. More common but less shared are stories of people who bought options and lost everything. A commonly sited stat is that 80% of day traders lose money over the course of a year.
22/22: TL;DR: There isn’t a single way to earn money in the stock market but an investor shouldn’t confuse “Investing” with “Speculation”. One is based on analyzing the future cash flows of a company and the other is based on chasing volatility. Best of luck to all!
