Anchoring Bias And 'A Market P/E'
Kate and William had a boy. Our bet on a name is George, but only because that appears to be the odds-on favorite among the London bookies. Still, all that money flowing around must at least be a little “Smart”, right? But as ConvergEx's Nick Colas notes, the same dynamic applies, albeit on a larger and hopefully more informed scale, when it comes to how capital markets price securities. We have our baselines – the price-earnings ratio of the market, the interest rate on Treasuries, the average price per square foot for real estate, and so forth – and then we tweak everything else up or down from there. That method has the benefit of simplicity, but comes with problems as well. More than anything, Colas warns, it pushes investors to “Anchor” their notions of valuation to benchmarks which may move when the wind shifts.
Via ConvergEx's Nick Colas,
Big news stories have a way of subsuming other events which happen to occur on the same day. Today, for example, the world waited for news of the latest British royal and almost entirely missed the fact that Nate Silver has left The New York Times for ESPN/ABC. OK – the people who care about one may not pay much attention to the other. Fair enough. And in case the name has slipped your mind since the last general election in the U.S, here’s a reminder of what Mr. Silver does and why his career move is big news:
- Nate Silver made his name calling the Presidential elections of 2008 and 2012 using statistical analysis of historical voting patterns and current polling. He got 49 of the 50 state results correct in 2008, and all of them right in 2012. His website – www.fivethirtyeight.com – became required reading for political pundits and interested citizens alike. You may not have liked the answers he gave, but his track record merited your attention.
- Mr. Silver’s first love is baseball, not politics. After finishing a degree at the University of Chicago, he built a computerized analytical system to forecast the performance of professional baseball teams and their players. After he sold it to a baseball website company, he wrote both baseball analysis and began to dabble in the science of political polling as well.
- Against that backdrop, Nate Silver’s move to ESPN seems to make sense. Until you realize that we’re talking about a guy who apparently has an edge in both political forecasting and baseball. And that just seems weird. It is like hearing that Derek Jeter has been hired away from the Yankees to run MIT’s Statistics department.
In fairness to Silver (and Jeter, for that matter), the move makes sense in a broader context: namely, the ability to analyze large data sets accurately is a tremendously useful and apparently transferable skill. The tools required and the intellectual frameworks used are the same, or close enough, whether you are looking at Iowa caucuses or National League playoffs. The numbers are the numbers…
A large chunk of Wall Street feels the same way about the challenge of making a return on their capital. High frequency trading shops look for split-second arbitrages across the myriad pools of liquidity where stocks trade, looking to pick off mispriced shares before someone else notices them. Statistical arbitrage shops analyze the historical relationships between assets and try to find opportunities when these diverge. Quant shops feed their computerized investment process with any and every input which may provide an investment signal, from fundamental information about a company to long term weather forecasts, looking for stocks to buy or short. The numbers are the numbers...
For the more fundamentally minded investors, “the numbers” mean something else. A few examples:
- Expectations. How much a company should earn in the quarter, or what unemployment rate an economy might generate.
- Valuation. The price earnings ratio for a company, or its notional breakup value. The appropriate value of a country’s equity market, given its interest rates and economic growth outlook.
- Performance. What is the sustainable profit margin for a given business, or industry? What is the track record of growth for a country or geographic region? How much should stock markets rise on average?
Yes, computerized investing uses these factors as inputs, but humans use them differently. We are deeply susceptible to something called “Anchoring,” a mental shortcut which means once we hear a number our attention is invariably drawn to it. Here’s how it works:
- Take your age, and double it. Now subtract six. And multiply by 100.
- How many types of domesticated animals are there in the world?
- The answer is 36. If you guessed in the thousands, you may well have “Anchored” off the first question.
Here is what all this means for investors today:
- The S&P 500 is up 19% for the year so far. Anchored against the long run average of stock market returns – somewhere in the 7-11% range – and you’d think we are due for a pullback. But anchored on the thought that we’ve barely managed a 2% compounded return since January 2000, and you’d say we have a lot of catching up to do. Both are true. Neither has anything to do with where stocks will trade in the future.
- The U.S. equity market trades for 16x current year earnings expectations of $105/share for the S&P 500. Long run P/E ratio data will anchor you at 14-16x earnings. By that measure, stocks are getting expensive. But if I told you that the “Anchor” was that stock valuations were tied at the hip to interest rates, you’d perhaps argue that we had a long way to go.
- The current yield on the 10-year Treasury is 2.49%. Anchor again long run averages of 5%, and you’d be pretty worried if you owned bonds. But consider that long term rates are a function of future inflation expectation and economic growth, and it is harder to get worried. Five years into a “Recovery” and the U.S. economy can’t even reliably generate 200,000 jobs per month.
- A given stock trades for 8 times forward earnings. That’s half a market multiple, so it must be cheap, right? Now what if I started with the statement “The company in question has way too much debt, a subpar management team, is losing market share, and has a weak board?” Oh yeah, and it trades like it.
There are plenty of other examples of “Anchoring” in capital markets – that list is the result of just a few minutes with an index card and a pen. The upshot, however, is that these mental tricks we play on ourselves are exclusively the domain of human decision-makers. The more you can control them, the better.