Stock Market Weighing Machine In Long Term
While in the short term the stock market is a voting machine, in the long term it is a weighing machine, says RBC Harbour Group, citing Benjamin Graham, the father of value investing. It says this means that in the short term, the stock market can have aspects of a popularity contest as various themes and stories capture the public’s imagination. These securities can go on to put up significant gains, often in the absence of any material profits as investors ‘bet on the future,’ it says. On a market-wide basis, this is best exemplified by looking at price-to-earnings ratios as the price that investors put on future earnings is often driven by sentiment which ebbs and flows over time and is fueled by ‘animal spirits.’ It finds the second half of the quote “much more interesting.” As time horizons lengthen, changes in valuation will come and go, but the fundamentals of the business will garner a larger and larger influence in time, measured by metrics such as earnings, free cash flow, and the dividend payments those provide. Unfortunately, when markets are volatile, extreme swings in sentiment can move security prices much, much further than is justified by fundamentals. This can make it extremely difficult for an investor to maintain a long-term view at the time it is of utmost importance. Success in investing comes from being able to separate the emotions of fear and greed that drive short-term thinking in order to focus on the long term, it says. In the short term, sentiment can drive valuations (P/E ratios) and security prices very quickly in both directions, but in the fullness of time it is overwhelmingly earnings that drive returns.