October 7, 2023 was the darkest day in Israel’s history when Hamas terrorists invaded the country and killed some 1200 innocent people while violently taking 250 others as hostages. Reflecting the shock and uncertainty caused by that surprise assault, the Israeli stock market dropped 8.5% the next day. Israel responded militarily to eradicate the terrorists responsible for the attack and to bring their people home. Thinking this is their chance to finally finish the job, Lebanon-based Hezbollah joined the fight against Israel. The Houthis from Yemen also joined and so did militias from Iraq and Syria and very soon, tiny Israel was fighting a seven front existential war.
And you’d expect nothing good if you had your money invested in the Israeli stock market.
Yet since then, the Israeli stock market has just about doubled while her enemies remain vanquished. The all knowing market knew the outcome and yet there are no iron laws about it. Israel is a tiny country surrounded by powerful arch enemies so its survival is not always a given.
Because stock markets discount the future and if the future remains dark, stock markets can go to zero as has happened in Russia after the 1917 Bolshevik revolution and in 1949 China when the communists took over and nationalized all private businesses, essentially zeroing out the stock market.
There are no iron laws around mean reversion either. If mean reversion is certain then there is no risk. You don’t make money investing when you have no risk. You make money when outcomes are uncertain. And the more uncertain an outcome, the more money you could make or lose.
Interest rates were kept hugging the zero line since the 2008 financial crisis. Interest rates dictate discount rates that are used to value investments. When interest rates are low, discount rates are low and investment values are elevated. When interest rates rise, discount rates rise and investment values fall.
So when interest rates surged in 2022, the stock market that had priced in forever low rates was supposed to fall. The stock market did fall initially until ChatGPT came along, sparking a renewed stock market boom.
So don’t assume that interest rates rising will cause stock prices to fall. Though that is widely expected, there are no iron laws about it. And if you made changes to your portfolio expecting that stock prices will fall if interest rates rose, well, that blunder will remain a forever dent on your money.
An inverted yield curve means a recession is coming. Logically it makes sense as I explain it here but again, there are no iron laws about it as we have seen these past few years and occasionally through history.
Trillion-dollar market cap companies were incomprehensible in times past. Now there are a few. Not numerous but still a few. What does it take to be a trillion dollar company? To justify that price, that company has to earn $100 billion in profits every year forever assuming a 10% discount rate (expected rate of return). At 20% net profit margin means that company has to generate $500 billion dollars in revenue each year in perpetuity. How many businesses can do that? And why should you not assume at least a 10% discount rate considering that inherent risk?
But just because something sounds implausible does not mean it is not possible. These businesses own their markets with entrenched moats that are near impossible for competition to break through. The market is not dumb to reward these businesses with the valuation they carry because the back of the envelope math we just did does not account for any future growth.
Or maybe the discount rates (expected rate of return) should be revised lower as these businesses are considered safe investments which then justifies the valuation they carry.
So we can do all the discounted cash flow math we want yet there are no iron laws around what we may surmise as implausible to be possible.
You never want to make big changes to your money in anticipation of what you think will happen. Because you are more likely to be grossly wrong than right. The global economy is a complex adaptive system with millions of interacting variables whose effects are hard to package in a neat little prediction. It is best to let it play out and make changes based on what has happened instead of what you think will happen.
That does not mean you don’t make any changes to your money. You make changes based on your own unique circumstances. You make changes if your intended allocation for your station in life has drifted too far away from your intended target. You make changes based on how far you are away from needing the money? And how much of that money would you need from the total money you have and for how long?
You want to be like a captain steering your money ship, gently nudging from time to time in the direction of your goals while navigating around the proverbial icebergs that can sink you or veer you way off course.
Thank you for your time.
Cover image credit – Dan Xavier, Pexels