146 ShowMetheMoney
MARKET CIRCULARITY
The greatest deficiency in using market metrics for valuation is the
problem of circularity. To say that a share of Exxon-Mobil is “worth”
what the stock last traded for tells you nothing about how that last
trade was valued. Of course we know how it was priced: by the forces
of supply an d deman din the stock market. We also know from Part
I that those forces are far from rational; are infecte dby emotion,
psychology, an dnoise; an dmay even be chaotic.
But that is all we know. None of this tells you whether the price
is a product of analysis or hope or fear, is a product of discounting
expecte dfuture earnings or cash flows, or is base don a determine d
multiple of book values or on hunches an dguesses.
You can try to penetrate the problem of market circularity by re-
membering John Burr Williams’s point that the value of any asset isthe
amount of cash flow it will generate in the future, discounted by the
probability that those flows will materialize. You coul dargue that a col-
lection of comparable assets yields a particular return and use that
comparable return as the discounting factor. But not only are you left
with the challenge of defining comparable assets, you still have not de-
termine dthe basis on which those comparable assets havebeenvalue d
(other than, again circularly, by the market’s collective judgment).
Countless books an darticles have been written about how in-
terest rates an dother returns are determine dby the market, but no
one knows for sure. Interest rates vary according to people’s collec-
tive inclination to borrow for immediate consumption or invest for
future consumption (say, at retirement). These inclinations are
shaped not only by roughly quantifiable conditions such as produc-
tivity an dreturns an dthe supply of money but by behavioral an d
psychological conditions that are virtually impossible to measure and
in any event are highly unstable.
People undoubtedly have specific expectations about returns
from assets, but those expectations vary widely. Current survey data
show that people who live d during or in the aftermath of the Great
Depression now expect average annual returns on stock portfolios
that are in line with their averages in the postwar perio dof close to
10% while younger people with only history lessons rather than per-
sonal memories of that perio dexpect returns in line with those of
the 1990s of closer to 20%. (A similar gap has existe din other pe-
riods, such as the late 1960s.)^13