Towards the end of last year, I published a series of short posts on what I saw as a newly emergent but potentially powerful trend in financial markets, in which sentiment seemed to overshadow analysis and fundamentals as a driving force. In light of recent events — that is, the surging stock price of GameStop and related others, the explosive influence of retail traders and the message boards where many converge, and the observed ripple effects into other parts of the investment world — I am combining the original articles into a longer essay, edited for consistency and to eliminate redundancies between them. Some things happen gradually, then of a sudden… We saw the sudden that unfolded the past week, this is about the preceding gradual.
The most basic fundamental
Financial markets are sentiment markets in large part, even as we feign to strip out the emotion from the buy or sell decision. It is a matter of degree, perhaps, and self-control, to stick with data, the practiced formula and its principles, the so-called fundamentals that are taught. Yet in so doing — rigidly, consistently, like a machine — one makes a statement on a view, and by contrast on the others that may not coincide. That isn’t something lacking in emotion, truth be told, not altogether. There’s really no escaping it.
Perhaps there was a time, in fairness, when the established rulebook and its index of set precepts — the multiples and ratios, the discount rates, the cash flow estimates and present values and so on — served as reasonable guideposts, and also as a way to show, if only to oneself, that one held a quantitative grasp on what was happening, that one knew how to carve out noise from signal, scientifically, like a pro. Perhaps there was a time when this was even true, before the guesswork turned extreme: What will a business be (not how big, or small, but actually what) ten, five, sometimes fewer years, from the moment?
Perhaps, as well, after the world turned digital and thus an infinite producer of an infinite supply of bits, marked by ubiquity and unimaginable speed; perhaps, as this began to happen, the known and followed rules turned gradually weak, and weaker as the nature of the starting fundamentals shattered. There also seems to be consensus among those who know these things, that money flow concurrently has added to the breakage with an infinite supply, ubiquity, and speed, all of its own.
It’s tough to say which triggered what, and how these things are or are not connected. That would be an expression of opinion — a sentiment — which brings us back to where this essay started. And here we are: A time of broken models…
… a time when almost all the assets are intangible…
… and the perspectives tend to form unguided, nearly blind…
We’re in a time, I think, when on a min-to-max continuum, the extent to which pure sentiment drives market moves has shifted far towards the max. In a way this had begun with Bitcoin and its crypto cousins, trading wholly sentimental as they do, having grown to massive global presence thus. And the phenomenon was further prodded by the loud emergence of the retail traders as a market force. Or raw emotion may have always been the driver, and is now only much more noticed through the social outlets, where sentiment is yelled and amplified.
In any case, it seems like sentiment is now another fundamental to consider, and the analysis — cold and as much as possible detached — might therefore be adjusted to include a set of working variables as they appear to have become:
- Prices rise or fall in sentimental clusters that evolve in the financial markets, which are network systems of many clustered links.
- The evaluation now may be as much financial as it is psychological, cultural, and social; that is, the exercise is as much now predictive of cash flows next quarter, or next year, as it is to predict prevailing sentiment during that period.
- Sentiment (the reaction to new (or older) information, more than the information itself) leads to where capital quickly follows. The future bank, perhaps, will be a media conglomerate. No, it already really is.
- There is entertainment in investment, as there is entertainment in consumption, and one may recognize this sentimental factor before the placing of a trade.
- Sentiment can be contagious; the market is, by definition, right.
And now if this is how we play, it does not have to be a stock that’s traded. It could be anything at all, as long as there is sentiment around it, and enough of that to move the price.
The biggest risk
Our favored valuation multiples have over time climbed up the income statement ladder, rung by rung, and, before long, we may transcend the income statement altogether.
We used to chart the P/E multiples back when, feeling as though earnings were a close enough cash flow proxy, which was what we really cared about. D&A, it was implied, was new capital investment to replace the old; so, E and FCF resembled one another well enough, at least in shorthand.
In the next phase through the years, when CAPEX was replaced by software builds — a direct income statement item for most firms — the valuation estimates moved up from net and total E… to EBITDA, an update to the cash flow substitute, which mainly only missed on working capital. All items down below it in the P&L, that is, after the B (“before”) and not a part of the discussion — I, T, D&A — were deemed to be irrelevant, redundant, or, in fairness, too much information for a stock that trades. T was hardly paid by early growth endeavors, D&A non-cash, and I, on debt in tech, was nearly non-existent, and if it was, it would be captured in the discount factor anyway.
Afterwards, adjusted forms of EBITDA and other income statement metrics were invented, some even close to versions of gross profit, which sits a few line items over EBITDA (i.e., before SG&A have had a chance to get subtracted). And now we do away with all of that, the tortured metrics and adjusted calculations, the footnotes and the caveats that need to be explained. As we got closer, rung by rung, to revenue, or as we like to say, “top line” (which is exactly where its name suggests), we go straight up to the source without a fuss, avoiding all expenses and subtractions clean and simple.
That valuation metrics are now of the revenue-based variety may also be for reasons other than momentum in the pattern. Perhaps the earnings or adjusted earnings would be puny, or straight negative and meaningless while revenue, for public companies at least, will be a large and growing positive amount.
In any case, as this has started to occur, some companies are passing others by in creativity. For when you can’t climb any further than the very top, the top can still, with art, be lifted. For instance, one high-flyer that recently entered the Bitcoin trade, books Bitcoin volume (yes, the dollar value of coins purchased on its platform) as revenue. Maybe the system was inspired by retailers, who hold inventory for sale and book the items to the revenue account in the course of doing business. In this finance field, however, where the item passes through not even underwritten, the approach might strike some as poetic license. And we can see below how beautiful is the effect.
But no matter. The point of all these observations is bigger than the single case.
Valuation multiples, for as long as markets traded actively, have been a way to gauge the fairness of a price. It is a statement on return potential, or payback, in a sense. All things equal, and suspending disbelief, a price equivalent to a 20x P/E, let’s say, implies that it would take some 20 years to recover one’s investment… if yearly earnings stay unchanged and paid as dividends, in the thought experiment.
We all know this would in real life never happen, but the benchmark is what matters. It establishes a frame of reference, a common ground, some sense of orientation, which in markets as much as anywhere facilitates communication and a way to plan. You might feel comfortable purchasing a stock that would take 20 years to pay you back, in theory, because next week, or month, or year, perhaps, you’d sell to someone else who is ok with 25.
Revenue multiples are no different, as long as these somehow correspond with something grounded. But in some cases now, where the multiple can be as high or greater than 100x next year’s expected number, what does this even mean? That if the company hits the mark — and does without expenses — it would take a century or more to earn back the investment?
This is oversimplified, I know, because that company would grow (though, with expenses)… but still, the point is bigger anyway.
It could be that the market value of the company described is fair and reasonable and contains enormous upside. It could be that the accounting treatment of Bitcoin volume in the prior illustration is sound and passes all the audit tests and rules in every global jurisdiction. In fact, I don’t doubt either of these things.
The point is that the market may have lost its compass. Some prices rise or fall now based on arbitrary benchmarks meant to justify prevailing sentiment, rather than the other way around. When risk is discounted at the risk-free rate (more on this below), that is a sentiment expression with too many variables to process. Sentiment is much more complicated than accounting, or multiplication, and there isn’t a good way to quantify it.
But more importantly for the investment process, it’s very hard to guess its future movements.
The third body
In short, the current market context calls for a new look at drivers and parameters, established during times and markets that reflected greater structure, or a structure that was maybe more conducive to methodical assessment.
This section of the essay takes its cue from recent IPOs, the “mispricing” of which, according to observers, reflects a “broken process”. Below are headlines that depict the tumult:
While much of the debate has centered around the notion of a price that underwriters set too low — a notion presupposing a correct and ideal price, a price that offers a sufficient upside for the markets to become excited in the after-trade, though not so much as to adversely impact the issuer’s treasury or the selling shareholders in too noticeable a way — these debates seem largely to be shaped by a perspective founded in the way things used to be. Which is to say, before sentiment took over as dramatically as it has.
But sentiment is fickle, it’s contagious, it can move (or not) in ways that the best of specialists can’t easily predict. And in a market ruled by sentiment, the place to catch one’s bearings may not be the S-1 filings and related commentary, which aren’t read as carefully, I don’t think, as the breathless headlines that precede the IPO… For instance, here is one picked randomly, but typical. There are hundreds, thousands maybe, it almost seems like nothing but:
The countless such in the past decade, regarding countless startups and the countless private rounds — the billions raised, the tens if not hundreds of billions in value recognized for companies only a few years old, the unicorns, the unicorns!, the growing size of venture funds supporting all the growth and booming opportunity — the never-ending flow of headlines of this type has fed and keeps on feeding sentiment, which stirs and builds and grows.
The articles below the headline don’t necessarily provide the details of described transactions — the subjects being private, after all, and the terms of the transaction not disclosed — but had the average reader dug that deeply in (a tall order, to be fair, in light of the barrage of content that is shared at every turn), one would have noticed that the private offering in question had been preferred (not common) stock, ranking high above the common in the pecking order of the capital cascade. And one might have further noticed that there was a liquidation preference involved, which works to safeguard a minimum return of capital to the preferred investor. Had one taken note of some such things, one would have correctly concluded that the resulting unicorn-plus valuations were in actuality a sort of gimmick in the circumstance. The deal was for a long-dated call option, in modern day-trader’s parlance, with an almost assured recovery of the option premium in a downside case.
Had there been a clearer reference to these things and others, and had these features been digested and internalized, maybe then the excitable predisposition of sentimental traders to participate in the trajectory would have been less pronounced. Perhaps the IPOs would not have been “mispriced,” and the expectations of insiders may have more closely matched the outcome… Perhaps.
It’s very difficult to know for sure, as it is difficult to know anything for sure when one is moved by sentiment, let alone when this involves a market filled with it. But there is something we do know, it seems, because it’s proven out in mathematics: When a pair of bodies is joined by still a third, what was a stable and predictable relationship between the pair devolves in chaos (Wikipedia: Three-body problem).
The public stock markets for the longest time were dominated by two bodies — the marketers (brokers, bankers, analysts, sales & traders, indexers and ETFers, etc.) and their institutional investment counterparts (hedge funds, mutual funds, pensions, insurance companies, sovereigns, family offices, etc.) — as for the longest time the retail trade was quiet, passive, and diminutive in the shadows. When this third body, suddenly now active, large, and highly sentimental joins the mix, the result is, as they say, what it is.
There was no IPO “mispricing” and the system isn’t “broken.” There was no way around surprising outcomes because the stage had previously been set. The market is, by definition, right, as mentioned, and it wants to be accepted on its terms. These days, this means, the market needs us to be versed in sentiment and the third body, and to refresh our familiarity at every moment while the moving bodies move.
The sentimental vista
There are any number of ways to define, or interpret, sentiment. This can depend on context. For financial markets, which are multivariate and deep, the context and its drivers, the resulting definitions and interpretations, are like a mosaic — personal, social, geographical, political, historical, economic, industrial, educational, speculative — but it’s all speculative, really. The markets are a network system in which clusters form or dissipate, to build or shrink the sentiment of an idea in its time.
In a narrow finance sense, a definition that was previously used herein and which may be most closely suited to the subject, is the discounting of risk at the risk-free rate. One acts upon a view as though the risk of being wrong can be ignored. This is a sentiment of considerable strength.
It isn’t that the risk is left unrecognized, necessarily, or that the belief is necessarily held strongly. Rather, the substance of the view, the risk, the discount rate, are all inconsequential: The sentiment is positive or negative all the same. It may be caught like a contagion and transmitted, muted or destroyed.
There are times when sentiment climbs to an escalated level to take a dominant position in the market’s varied stance. And there are times, like now, I think, when sentiment seems like the major driving force. Perhaps because there is so little substance to support the market flows, or, more correctly, because substance is in a state of what appears like never-ending change… Businesses are changing, industries are changing, economies are changing, society is changing, and now biologies and ecosystems, too. It is quite difficult — no, it’s impossible — to see what happens on the other side of transformations and rebuilding and disruption at such monumental scale.
With all of the above by way of backdrop, what follows is a thesis, not advice; the difference cannot be overstated.
- Many believe that excesses of sentiment were rooted in the individual investor community after the economic collapse of early-2020. This may be true, but it also feels like the contagion spread more broadly to the bigger money, which may well continue until the varied levels of uncertainty subside.
- Sectors and established categories, small caps and large caps, growth and value, are increasingly dubious distinctions outside of sentiment, which can have reflexive consequences; and the rotations, ups and downs of these, throughout the year that’s passed, have set the tone of movements going forward.
- Price action and market trends in many cases have been and will be justified by finance fundamentals — after the fact — as anything can be when there’s a will and a creative spirit, when sentiment is in actuality the driver; to draw general conclusions from the particular case will thus require caution.
- All this poses special challenges for investors, some previously alluded to: (1) Sentiment is difficult to forecast. (2) Spotty, often capricious, and uneven, sentiment is difficult to hedge. (3) Sentimental correlations are unstable, and so portfolio construction becomes inordinately problematic.
- Spilling over from the elements above, alternative new markets have come into their own, where price has been and always will be built on sentiment unabashedly; for instance, art, collectibles, and other assets where financial metrics play no role at all.
- One such alternative new market, which has already started to explode, individually for the first few years but now also institutionally, is cryptocurrency; the explosion is likely to continue, driven by sentiment.
- The most successful investors will be successful at anticipating market sentiment (and its changes) during an investment period; by necessity, therefore, investment periods will shorten at one end of the barbell, where change in sentiment is easier to grasp, and lengthen at the other end, where sentiment, over the long run, is more likely to settle down and meet with fundamentals on a common ground.
- Over the course of time, the markets (which are always right) will incorporate the acts, extremes and fickle patterns of sentiment into an analytic system, to expand upon legacy methods of financial evaluation and economic forecast; this may not happen as quickly as this year or next, considering the dense complexity that underlies.
But it will… Because every fantasy book needs a map. Often several.
In an economy that can’t be trusted
When an economy is understood, up or down, it’s possible to plan, to concentrate resources, and to invest with reasonable confidence, even if results don’t follow as expected. If the previous section presented its thesis from the institutional perspective, more or less, what follows is a market thesis from that of the retail trade, in an economy that isn’t understood, and can’t be trusted.
- The life-long economic plans and actions of an individual — an education, a career, a residence — are concentrated investments that can’t be easily diversified or hedged, offloaded, changed, or liquefied. From the vantage point of many individuals, the economy maps these things out, which is to say, it guides and lets us track the big decisions.
- In 2020, so much of the economy was rendered worthless. Often permanently. On a dime… for reasons unrelated to the individual’s affairs. This was unprecedented, it is said, both in its magnitude and unexpectedness. And it has naturally left a deep impression.
- The active retail trade that drove the market in this time was, in this way of seeing things, a sort of panic. Its flight was to liquidity, to diversification, to the hedge — those things, in other words, which are the opposite of what the natural economy presents to many — as economic plans took such an awful turn for such large numbers.
- With markets rising fast while the economy lingers uncertain, it isn’t as has been by some suggested that the two have been “decoupled.” Nor is it that the market is six months ahead, or only that, as others keep insisting. The connection is just different now… The driver of the market is still economic, as it’s always been, but the lead is much less opportunity supply (business performance) than opportunity demand (investor flows).
- In short, the market has become inordinately pushed by a particular type of sentiment, which is not necessarily irrational (for reasons stated). This atmosphere may take some time before it fades, as markets in the long run tend towards the business fundamentals all the same. But in the meanwhile, cold, detached, the analysis may be less quantified and formulaic than it has been in markets past…
- … because a current price is based on an expected future price, which, more so than before is based on future sentiment…
- … and because sentiment is different and more complex than earnings, which furthermore are not, like sentiment, contagious…
- … and because sentiment, much more than earnings, is prone to unexpected change…
- … and because sentiment may not be market-wide, but picks its spots, or fades from them, in isolated clusters in the market network mesh.
Once again, this is a thesis, not a forecast, but the potential consequences are worth noting. Indeed, they’re being noted in real time.
The original posts transcribed in separate sections, can be accessed here before edits.
Other related reading:
Reinterpreting the networks (2020)
If it’s not a bubble (2018)
Interpreting the networks (2017)