Morgan Housel, who is rapidly distinguishing himself as the best writer at Motley Fool, has a great post up in which he exhorts us to focus on five big knowable things when it comes to investing, stepping high through the muck and mire of trivia and formula on our way toward the larger truths.
I particularly liked his nugget on valuations:
2. The single largest variable that affects returns is valuations — and you have no idea what they’ll do
Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.
The dividend yield we know: It’s currently 2%. A reasonable guess of future earnings growth is 5% per year.
What about the change in earnings multiples? That’s totally unknowable.
Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?
If someone said, “I think most people will be in a 10% better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.
The necessity of technical analysis for short-term market-followers is based on exactly this premise – company fundamentals do not change within hours or days but sentiment surrounding what the valuation for those fundamentals should be certainly can. Watching supply/demand – the essence of technical analysis – allows the trader to do exactly that in real-time, although the predictive value of this activity is much debated.
Morgan’s point about guessing what the sentiment of investors will be in the distant future is well-taken. We can model earnings, revenue and cashflows til the cows come home – but as to what multiple the market will be willing to award to those metrics, we may as well shake a magic 8-ball.
Please head over and read the other four points Morgan makes here, this is great stuff.