Field of Dreams

Ever since humans first started transacting with each other, exchanging their goods necessitated an agreement over the “terms of trade”, such as price (units of one item for another) and delivery time and place. The price was always a factor of the difficulty, danger, and time required to produce the item (economists later called it “cost”), as well as the usefulness or pleasure the item could bring to others (economists later called it “utility”). 

Based on these concepts of cost, utility, and price, the familiar laws of supply and demand were developed. These laws pretty much state that (everything else held constant) an increase in the price of a good will cause “rational” consumers to demand less of it (assuming readily available substitutes), and “rational” producers to supply more of it (assuming additional production is possible).

Of course, reality is never as simple as theoretical models. In real life, everything doesn’t stay constant for long— The price and availability of substitute goods are probably changing at the same time as the price and availability of the original goods change, the incomes of consumers may be increasing or decreasing, government regulations may be affecting the production of goods, and supply chain disruptions may throw the whole mental exercise in the trash bin (i.e. the pandemic of 2020).  

Moreover, the whole concept of ‘rationality’ can be called into question. For instance, the law of demand implies that as the price of a good increases, rational consumers engage in an automatic process of comparing the utility (or value they derive from the good) to its new higher price. For some, the value derived may still exceed the higher price and they will continue buying this good, albeit at lower quantities given their income constraints. For others, the value derived from consuming the good may not be worth the price, and they will decide to go without it. That is rational behavior based on cost-benefit analysis.

So, how can we explain that sometimes the higher the prices of some goods go, the more consumers are attracted to them? For example, women may spend a small fortune on a handbag because a celebrity or influencer was seen carrying it. Men may spend equally absurd sums of money for wrist watches worn by celebrities in a movie. Is this rational behavior? These consumers are not celebrities, they are not James Bond, no royalty has bestowed them with a “license to kill”, and the deepest dive they will ever attempt is in their backyard swimming pool. And so it begs the question, is the law of demand invalid?

Some economists would say this is an exception to the law of demand. And what’s a law without its exceptions after all? The law of demand applies to Ordinary goods (majority of goods), not Veblen goods (they could have said Luxury goods but giving it a special name makes it sound more scientific). Paying a high price for Luxury goods, consumers may believe they are buying quality, or status, or prestige, or all of these combined. Does trying to impress others count as rational behavior? Well, for rich consumers, it may be rational to spend a small part of their overall wealth to signal their success. For non-rich consumers, it is probably not rational behavior to endanger their finances just to appear rich. Social sciences are complicated because they are dealing with human beings whose decisions are based not only on cost-benefit analysis but also on feelings, emotions, and moral values. 

What about investment assets? These are not Luxuries. They are stores of value and people buy them to protect their purchasing power for a future time when they may need it. Yet, as asset prices go higher, more people tend to buy them creating “bull markets’, and when asset prices go lower, more people tend to sell them creating “bear markets”. That too seems to violate the law of demand and the rational behavior of “buy low - sell high”.

Again, some economists would say this is yet another exception to the law of demand. The law of demand applies to Ordinary goods (majority of goods), not Giffen goods (they could have said Necessity goods but again giving it a special name makes it sound more scientific). The higher the price of an asset goes the more people buy it. To the extent the higher price reflects higher perceived quality (earnings generation capacity) or safety, the behavior may be rational and justifiable. But to the extent the higher price mainly reflects ‘recency bias’ and ‘extrapolation’ (the asset price has been increasing; therefore, it will keep increasing) the behavior is not rational. Instead of a comparison between price and value derived from the asset, the decision is based on “the greater fool theory”— believing that somebody else will pay a higher price for the asset in the future.

The ‘greater fool’ fallacy applies to all kinds of investment assets; real estate, stocks, bonds,  commodities, bitcoin, etc… Once investors stop comparing the price to the potential benefit from holding the asset, all rationality is thrown out of the window and market bubbles are created. For example, we have seen housing prices doubling in a span of 2-3 years without a corresponding increase in the population. Another example can be seen in the stock market with prices of companies with little to no earnings trading at all-time highs (specifically, investors who buy these types of assets do so based solely on the belief that they will be able to unload them to someone in the future at an even higher price). 

This sounds like the famous “if you build it; he will come” from the 1989 Kevin Costner film “Field of Dreams”. In the film, an Iowa corn farmer plows down his plants (before harvest time) to build a baseball field because he hears a voice in his head telling him “if you build it; he will come” and sees the ghosts of Shoeless Joe Jackson and his Chicago Black Sox teammates coming to his farm to play ball. Naturally, no one else hears the voice or sees the ghosts of the baseball players, so to everyone else the farmer appears to be a raging lunatic destroying his farm and driving his family to poverty. At the end of the movie, the ghost of the farmer’s father comes to the new baseball field to play catch with his son. A very emotional ending indeed. He built the baseball field and his father’s ghost came! The story ends there without exploring the aftermath of his actions.

Movies and dreams are one thing and reality is another— Investing is a very humbling experience. Do it long enough and there is no doubt you will be served your share of humble pie. Who amongst us hasn’t chased his/her ‘field of dreams' once or twice, with disappointing results. However, we don’t tell people to stop chasing their dreams because we don’t see what they “see” and we don’t hear what they “hear”. Instead, what we try to do is introduce a degree of rationality to the investment decision making process— Does an asset deserve the current price? Does it generate earnings? Is the earnings yield (earnings/price) better than other assets? Are the earnings real and sustainable? If not, we keep looking elsewhere.

The artificial intelligence (AI) theme has certainly overtaken the hearts and minds of (many) investors as of late. Countless new ‘start-ups’ (otherwise known as ‘businesses that make no money’) have sprung to life in order to claim some of the capital that hopeful investors are throwing indiscriminately at anything ‘AI’. Case in point, iLearning Engines (ticker symbol ‘AILE’) touts its ‘AI’ focus to investors but has a vague description of the services it actually provides and little explanation as to how AI is actually involved in their services, or how the company has developed said AI capabilities. The company’s financials show negative equity, a mountain of liabilities, and more than half of the company’s assets are receivables. The company posted six cents earnings per share (EPS) last year, eight cents the year before, and two cents the year before that.

Back in April of this year, the intraday high price for this stock almost reached $20 per share. Investors who paid that price to buy six cents of annual earnings basically accepted an annual earnings yield of 0.3% ($0.06/$20). We often find ourselves observing these irrationalities while asking “why would investors do that?” Especially when a savings account at the bank can currently beat that yield (without assuming the risk). Unfortunately, risk is the forgotten element in the mind of an investor. Instead of considering risk, investors now seem preoccupied with the high ‘potential’ returns these AI firms ‘could’ generate. The words “potential” and “could” are usually overlooked by eager investors. But this is a great example of why they shouldn’t be overlooked— Last week, AILE’s stock price declined to $1 per share as it was revealed that 95% of the company’s revenues came from a single unnamed customer. This customer happened to have the same address as the AILE’s chief executive officer’s home address. So, are the company’s revenues real? Are the receivables (more than half the assets) on the balance sheet any good? If not, even at $1 per share this stock may be overvalued, (even though the earnings yield would certainly look more enticing). 

The point here is that we ask the same questions about the overall stock market— Are the prices justifiable by earnings? Are the earnings sustainable? Are the earnings yields better than other assets? For instance, the US stock market represented by the S&P 500 index has a trailing Price to Earnings (PE) ratio of 35*. This implies an earnings yield of 2.85% which cannot currently beat the yield of US treasury bonds, meaning the US stock market is currently overvalued and chasing it higher may not be a great idea at the moment. For the market to become a ‘good deal’ again, either prices will have to come down or earnings will have to go up in the future.

Others prefer to look at future earnings to gauge how cheap or expensive the market is, thus focusing on the forward PE ratio, which currently stands at 20.7* (implied earnings yield of 4.83%), while the historical average forward PE ratio is 16.5* (implied earnings yield of 6.06%). These metrics also suggest that in previous years investors were promised better yields from their US stock holdings. Compared to the Chinese stock market’s forward PE of 9.3* (implied earnings yield of 10.75%) with a historical average forward PE of 11.8* (implied earnings yield of 8.47%), the US stock market looks expensive, making foreign markets the better deal at this time.

All of this data suggests investors currently should be careful chasing their ‘Field of Dreams’ in an expensive US stock market. Right now, investors who are buying popular AI stocks (and even some bigger S&P 500 companies) are probably overpaying and taking on unwarranted risks. Add in the seasonality factor, (the second part of September through October historically offers the lowest stock market returns of the year) and preserving some dry powder makes a lot of sense right now.

Remember, you don’t have to swing at every pitch. There may be much better pitches ahead…

As always, we’re here to offer you our opinion and analysis of the financial markets to help you grow your assets and achieve your financial dreams.

We hope you have a safe and happy Labor Day!

Stay Fierce! 

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