Past, Present, and Future Pricing

Friday Reflection | October 29, 2021

Stock market prices are perpetually incorporating new information. Once per quarter, the speculative price changes are reconciled against companies’ actual earnings. Analysts and investors dissect a regimented accounting of each company’s revenue, expenses, and profits from the prior quarter, and market prices adjust. Investors refer to this reporting period as “earnings season” and we’re currently in the middle of corporate earnings reports for the July-September time period.

Troves of information are produced every day via these earnings reports as well as separate news cycles, and sifting through it all requires differentiating the quality and materiality of each new piece of data with regard to future price trajectory.

More than half the companies in the S&P 500 have reported Q3 results, and those companies have grown earnings by +39% compared with Q3 of last year.¹ Among those companies, 82% have reported earnings that exceeded analyst estimates.² This quarter, we think that divergence from expectations reflects the difficulty of forecasting earnings during the shifting landscape of the lifting pandemic. As stock prices adjust for better than expected profitability, the S&P is responding – the index is up more than 5% since earnings season started in early October.

While earnings and price growth charged higher, actual economic data wasn’t as robust – which is a familiar chorus over the past year and a half. The Bureau of Economic Analysis gave its first estimate of U.S. gross domestic product data for the July-September period this week. The economy grew at a 2.0% seasonally adjusted annualized rate, falling short of the 3.5% consensus forecast among economists surveyed by FactSet.³ That was also meaningfully slower than the second quarter’s 6.7% growth rate. Equity investors were not deterred since economic data should bounce back as supply chain bottlenecks ease and vaccination rates progress, plus companies showed they are profitable even in a 2% GDP-growth quarter.

The bond market wasn’t as blasé about the slowing rate of economic growth. While stock investors can have an infinite time horizon, bond investors are focused on whether they’ll be paid back over a specific time period spanning the next few months to few years – often making the bond market a better barometer of current economic conditions versus the long-range optimism of the stock market. This has manifested in lower bond prices in recent weeks, as bond investors price in concerns about slowing growth paired with the potential for higher interest rates that may be needed to combat inflation.⁴

In certain industries, such as electric vehicle production, the juxtaposition of pricing the present and future is glaring. It appears to be a certainty that the world is moving towards electric vehicles, but the timeline of scaling production and profitability still remains fraught with uncertainty.⁵ Three auto companies that were in the news this week highlight the challenges of pricing the potential for future profits: Hertz Global (old guard company), Tesla Motors (new incumbent), and Lucid Motors (start-up with ambitious growth targets).

This week, Hertz announced their intention to make 20% of their rental car fleet electric, agreeing to buy 100,000 Teslas by the end of next year.⁶ This will give the 100-year-old rental car company a competitive advantage with travelers curious about EVs or conscious of their carbon footprint. It gives Tesla a bulk order and allows hundreds of thousands of potential buyers to test drive an EV for the first time. Hertz also announced interesting deals with Uber and Carvana, to expand its revenue channels beyond traditional airport car rentals. As a reminder, Hertz emerged from bankruptcy at the end of June. This news has boosted their stock by +15% and Tesla’s stock by +18% this week. No actual cars have arrived at Hertz yet, but investors are attempting to price the future potential of this announced deal for both companies.

Lucid Motors, a luxury electric vehicle company that went public in July before delivering a single car, also had a major press release this week. The company announced that the first customer deliveries will arrive on Saturday. The stock popped by more than +30% the next day. Fledgling companies in fledgling industries can be prime examples of investors overweighting hopes for future profits in the absence of concrete track records. The potential for significant price growth (or decline) lies in that uncertainty.

Investors also evaluate the potential for appreciation (or likelihood of depreciation) from current price levels. Phrased differently, how much phenomenal future growth is already priced in? Currently, the forward P/E ratio for the S&P 500 is 22.2, which indicates the market is pricing in materially higher earnings growth than historical averages – the 10-year average is only 16.4.⁷

While the broad stock market is valued above historical averages, it still appears affordable compared to the lofty valuations assigned to certain growth companies. The forward P/E of Tesla is currently over 126. New investors are paying an enormous premium over the reality of current earnings to account for continued growth. Both Lucid Motors and Hertz don’t even have a P/E ratio because they don’t yet have positive earnings. This underpins the sense that optimism and risk appetite of investors is alive and well heading toward the end of the year.

Decision making often exists at the intersection of past data and future expectations. There is never perfect information about future pricing or outcomes, and yet decisions must be made in the present and strategy adjusted along the way. We wrote about this paradox of partial information in investment decision making in an earlier reflection and it continues to be relevant in today’s market.

Regular rebalancing and diversification help smooth the cycle of risk that is created as past and future information is reconciled. This creates better outcomes for patient investors and reinforces the importance of balancing data that is concrete and retrospective with the growth potential of an uncertain future.

Resources

¹ Q3-2021 Earnings Summary as of 10/28/21 I/B/E/S data from Refinitiv

² This mostly reflects companies’ efforts to manage expectations to allow for positive ‘surprises’ – in the past 5 years, companies ‘beat’ estimates 76% of the time on average. Factset, Earnings Insight, 10/22/21.

³ Today’s GDP Report Was Even Worse Than Expected. Consumers Have Grown Skittish. Barrons

⁴ Bond traders’ mood turns sour as yield curves flatten all over the world MarketWatch

⁵ New Solutions, New Challenges – reflection on EV adoption and innovation North Berkeley Wealth Blog

⁶ Hertz Invests in Largest Electric Vehicle Rental Fleet Hertz Press Release

⁷ For the S&P 500, the average of the forward P/E over the past five years has been 18.3, and the average over the past 10 years has been 16.4. P/E & Yields on Major Indexes. 10/29/21 WSJ