Volatility isn’t Chaos

 

Stock prices are uncertain future cashflows in disguise.…

 

Have you ever stopped to think about what a stock’s price per share actually represents? Or why that price moves in such an uncertain, seemingly erratic and volatile manner?

What if I told you that, in its simplest form, a stock’s price reflects nothing more than a multiple of the discounted present value of a company’s expected future earnings? The volatility of price is simply reflective of the market’s constant attempt to reassess and reprice those future unknown earnings based on widely known and available information.

Investment manager Ken Fisher often highlights this forward-looking nature of markets, as referenced in the opening quote of this essay. In short, investors, and the market, are typically looking 3 to 30 months ahead. They analyze all widely known and available information at the company level, as well as economic, global, and political factors, to form expectations about a company’s future earnings prospects.

Because those future earnings are inherently uncertain, and because many of the variables that will ultimately influence them are unknown, the market is constantly adjusting prices to reflect the most reasonable forward-looking assumptions and thus discount those into the price at which the security is bought and sold.

Here’s the key: many of the factors that will shape future earnings simply cannot be known in advance. It is this uncertainty that drives price movement. Volatility, therefore, is not chaos, it is the ongoing process of markets recalibrating expectations in real time.

Risk and reward are permanent bedfellows. That relationship is especially true in equity markets. The less certain the future cash flows, the greater the required return investors demand. And the greater the required return, the lower the price investors are willing to pay today.

Consider a simple example:

Company A – Highly predictable cash flows and stable earnings, Earnings are more dependable. Because investors have greater confidence in those future cash flows, they require a lower return. A lower required return means a higher present value, and therefore a higher price relative to earnings.

Company B – Moderately uncertain cash flows, B carries more variability in earnings outcomes. Investors demand a higher return to compensate for the unknown, which lowers the present value of those earnings.

Company C – Extremely uncertain, speculative future earnings, Little to no visibility into future earnings. Because the range of potential outcomes is so wide, investors require a very high return to justify owning it, and the price must adjust accordingly.

This is the pricing mechanism at work, incorporating expectations about future earnings into each security’s price based on its unique characteristics. Businesses with more stable cash flows tend to experience less price variability, while those with a wider range of potential outcomes may exhibit greater movement and potentially higher expected returns over time.

The market continuously evaluates growth prospects and future conditions. As expectations change, prices adjust. Not randomly, but as a reflection of evolving assumptions. At its core, equity pricing is the balancing of expected return and uncertainty.

So how should investors respond when future earnings can never be known with certainty?

Uncertainty is unavoidable. Every asset class carries tradeoffs. The goal is not to eliminate uncertainty, but to seek appropriate compensation for bearing it.

Decades of academic research suggest that differences in long term returns have been associated with identifiable characteristics, often called factors. Rather than trying to predict which company will outperform next, portfolios can be structured around these persistent drivers of expected return.

Decades of research also suggest that certain cash flow and relative price characteristics have historically been associated with differences in expected returns. Among them:

Size – Less large companies have historically provided higher expected returns over long periods, reflecting their dynamic growth potential and evolving business opportunities.

Relative Price (Value) – Companies trading at lower prices relative to their fundamentals have historically delivered higher expected returns, as markets adjust when business conditions improve or expectations change.

Profitability – Companies with stronger profitability metrics have historically demonstrated the ability to generate more consistent earnings, which has been associated with favorable long-term return characteristics.

In other words, instead of trying to predict the unknowable future earnings of any single company, there are strategies that acknowledge uncertainty and seek to systematically target the source of the return that markets have historically rewarded. The market already prices individual securities based on forward-looking expectations. A factor-based approach accepts those prices and instead focuses on systematically tilting toward areas of the market that have historically been associated with higher expected returns. Uncertainty cannot be eliminated. But it can be harnessed as is reflected on the chart below: