How Supermodels Killed the Nasdaq
Hooray!
The inflation problem is over!
Like a heroic figure of old, the mighty Jerome Powell has successfully vanquished the parasite that’s been draining your bank account and pummeling the stock market.
I’m kidding, of course.
We're nowhere close to being out of the woods yet.
Inflation rose at a rate of 8.5% — still quite near 40-year highs, and the exact same rate of increase that we saw in March.
Yet by and large, the market seems to be reacting with a joyous uproar.
Which, to me, is nonsensical…
Especially if you actually look at the data and the possibility that this might embolden the Fed to accelerate their plan to tighten the belt even further.
And extra especially now that, in classic government doublespeak, we’ve seen the passage of an “Inflation Reduction Act” that seems like it will do nothing but increase inflationary pressure.
So in this issue, we’re not going to mess around.
First off, for anyone wondering, we’re going to stab at the heart of what inflation ACTUALLY is…
I’m going to show you why measuring it is so hard (and in the process reveal a disturbing truth about the financial world)...
Then I’m going to show you exactly why this number matters to investors, since it can really mess up your month (or your retirement).
Let’s jump right in.
What the Heck Is Inflation, Anyway?
Most people assume that inflation means things — goods and services — are becoming more expensive.
This is only half the story, though.
See, in the 21st century, money doesn’t actually mean anything. Go back exactly 100 years and your $20 bill looked like this:
If you can’t read the fine print at the bottom of that bill, it says “Twenty Dollars IN GOLD COIN Payable to the Bearer on Demand.”
You could, quite literally, bring a dollar bill to a bank and scream, “GIVE ME MY TREASURE.”
And they would just say, “Oh. Ok.”
If you tried to do this now, you will be told to leave and possibly tazed and arrested.
That is because, as of August 15, 1971, the U.S. went off the gold standard.
Now, for some folks this was a good idea. Others think it was a God awful idea.
I ain’t here to debate. This just be how it be.
But now there’s a problem:
What is a single U.S. dollar actually worth?
That’s not a rhetorical question. I legitimately do not know. No one does.
Oh, there are theories, sure.
But those all put the value of the dollar as something relative to, like, other currencies? commodities? the amount of stuff you’re able to buy?
It’s here, anyway, that we see the other half of the inflation equation.
Inflation is not just “prices going up.”
Inflation is also “the value of the dollar decreasing.”
Sounds similar, but these are two different forces.
For instance, one reason inflation has gone up is because companies feel like they can get away with it in 2022. Corporate leaders “have boasted to investors of their ability to pass along price increases to consumers” while they collect record profits. (source)
The corporate price gouging complaint is one I tend to hear more from the political left, usually.
On the flipside, another reason inflation has gone up is because a LOT of money has flooded the U.S. economy since March 2020. The amount of money in everything from checking accounts to money market funds to cash in circulation has increased from $15.4 trillion to $21.6 trillion. (source)
The dilution of the dollar through "money printing" is a complaint I tend to hear more from the political right, usually.
Now here’s, at last, a place where both liberals and conservatives can kiss and make up…
They’re both right to complain!
I’ve spoken at length about all the indescribably complex and multivariate causes of our current inflation woes... how these spur both problems on the pricing and monetary policy front... and also what I’m actually worried about in the future (more on that next week).
But when people talk about “prices getting higher” or the “devaluation of the dollar”...
They’re talking about two different sets of behaviors that lead to effectively the same result, which we call inflation.
Even though we see the same result, though, the way to fix the problem is different depending on what caused it.
The astute among you will recognize a few problems with that…
First off, how do you measure something as subjective as “devaluation”?
Devaluation relative to what?
And how do you measure “prices getting higher”?
Everything from gasoline to prostate massages costs something different. And their prices do NOT move in lockstep.
For example: TVs.
A TV that cost $1,000 in 1950 would be worth $8.32 in 2022.
Isn’t that nuts?
That’s NOT inflation. That’s a totally insane average deflation rate of -6.43% per year.
Plus, what you get nowadays for each dollar you spend in terms of quality and features is ENORMOUS compared to what you got in 1950. (That’s not easily quantifiable, and it is another aspect of inflation that people don’t often think or talk about.)
So that raises the question…
How Do We Measure This Nonsense?
Here’s something 99% of people do not know about finance.
It’s all models. All the way down.
Everything in finance, from the price of an option to how likely you are to pay back a mortgage loan, is just a mathematical model that SOMEONE put together and SOMETIMES works and SOMETIMES accurately predicts stuff.
Then you have models that use models in their calculations, giving you a model of models.
And so on.
I’ve alluded to this before, but every model has, embedded inside of it, the creator’s perception of what’s valuable and what’s not. What should be factored into the model and what shouldn’t.
And often they have, like, buckwild biases about the world that leads them to build models completely divorced from reality.
(I’m looking at you, Smart Beta cultists.)
Inflation is a good example of how models can mislead, obscure, or even just tell contradictory stories depending on what you’re looking at.
That is, if inflation is a measure of the relative purchasing power of the dollar…
Then one way we can model inflation is not by looking at the dollar, but rather the combined COST of things dollars can buy for you: Propane, Converse sneakers, used Hyundais, Taco Bell quesaritos, airline tickets to Sacramento, shiatsu massages, talking alarm clocks, an elegant ficus plant for the corner of your den. All of it.
The Bureau of Labor and Statistics collects detailed pricing data on 200 different categories of things and smooshes it into a model called the Consumer Price Index, or CPI.
And THAT is the 8.5% number that’s been making headlines in August 2022.
As in: when you assess the price of each item, then combine them, and then adjust the combined amount so that it equaled 100 in 1982 or so…
You get this:
The CPI today is 8.5% higher than it was one year ago. It is -0.02% lower than it was in June.
But there are problems with this model…
For one: What if some commodities are seeing crazy inflation (like gas) and some are seeing crazy deflation (like TVs)?
You can’t treat these equally, of course. Why? Because not everything you can buy has equal importance.
Like, if a gallon of gas costs $10 but big screen TVs now cost $99… People are going to be FLIPPING OUT about the gas. They will not care that they don’t have to spend as much on TVs.
But hey! An index is just a type of model, too! We can track the combined movement of a lot of stuff, but we can also individually adjust the importance of particular things when calculating the final, combined value of the index.
So the CPI… weights things weirdly, smooths things out weirdly, adjusts and manipulates things weirdly.
I’d show you the math, but you’ll have more fun just seeing it for yourself on this page.
I won’t bore you with the million other problems with the CPI and simply skip to the point where I tell you that there are actually many different measures of inflation, all of which measure and weigh and value and smooth things differently.
It’s basically “Alphabet Soup”... you’ve got the Core PCE, the Trimmed PCE, PPP, Core CPI, Chained CPI, PCEPI, the BPP, the EPI, the 5 year treasury 5-year forward inflation expectation rate…
The magazine The Economist even measures inflation by observing changes in the price of the McDonald’s Big Mac hamburger across the world.
So the U.S. Federal Reserve Bank, in its battle against inflation, is targeting something that has no objective measure.
And I’ll do you one better…
Not only is inflation spurred by a nuanced, indescribably complex nest of pricing choices, regional differences, and monetary policies…
Not only is there no “true” way to measure inflation…
But no one knows what a “normal” rate of inflation is even supposed to be!
The Fed tries to keep the number around 2%.
But this number originally comes from an experimental and arbitrarily decided policy partially crafted by a kiwifruit farmer and enacted by the New Zealand parliament in 1989. The law was written and decided upon in haste, because the parliament wanted to go home for Christmas.
By 1991, other countries started copying this policy. 2% became the norm. In 2012, this became the stated target of the U.S. Federal Reserve Bank.
So the Fed (and every central bank) is trying to limit inflation to an arbitrary, invented rate.
This all matters for investors, since they’re trying to beat inflation and have their money grow at a rate that allows them to buy more stuff.
But it matters a HECK of a lot for investors of tech stocks, biotech stocks, mining stocks, and pretty much any growth stock that doesn’t have revenue or profits yet!
Yes, Inflation Killed the Nasdaq and Your Hopes of Ever Retiring on the 3 Shares of TSLA You Could Afford
Forget the price of a company’s shares for a second.
If you wanted to buy a company, a whole company, like, say, Twitter…
How would you decide how much you’d be willing to pay for it?
Even if you could, for example, try to buy every share available on the market... there a problem with that: Some people could just willingly decide not to sell to you unless you pay them $1,000,000 per share.
So you need to find out a reasonable amount you would be willing to offer to a majority of the shareholders… a specific dollar amount you’re not willing to spend above on the acquisition.
This is sometimes determined by building a model to find the company’s “acquisition multiple,” which is a topic for a future issue.
But there’s a problem…
This model often depends on YET ANOTHER MODEL that calculates the present-day value of current and future profits and/or cash flows and/or dividends.
Twitter doesn’t have profits, cash flows, or dividends. Except for a few years here and there, it never has. And there’s no way of knowing if it ever will.
Its actual revenue, however, has grown over 1,000% since 2013.
So we can just build a model based on revenue, right?
Well, I used the words “present-day value” deliberately.
With prices going up and the relative value of a dollar going down as time marches ever forward… the relative present-day value of a company’s future revenue is going to change, quite dramatically, based on the rate of inflation we see moving ahead.
So if we make some assumptions about Twitter’s future revenue growth (9%) and average acquisition multiple (5.2x), based on what we’ve seen in the past…
We get an estimate of what Twitter’s future stock price might be worth over the next 10 years, adjusted to today’s dollars:
With low inflation, Twitter’s revenue growth allows the price to keep climbing in relative present-day dollar value.
But with high inflation? Even high revenue growth can’t beat the parasitic effect of inflation on future asset values.
(I’m sure Elon thought this all through when he offered $54.20 per share to buy Twitter.)
It’s here, in this model, that you should be able to plainly see why growth and tech stocks EXPLODED in 2020, when inflation went super low…
And why, in 2022, tech stocks and other growth stocks have been struggling.
For instance, based on this model, if you want to buy Twitter with the expectation of making money while inflation is crazy high…
The only way you could reasonably expect to see a profit over the next 10 years is if you buy the stock under $39.44. (It’s over $44 today.)
But back in 2020? All the models suggested that tech stocks were going to go sky high because of how low inflation and interest rates were.
(This… might be why Cathie Wood gave Zoom the INSANE valuation of $1,500 by 2026.)
To put it as simply as I can…
High Inflation Mollywhopped Wall Street’s Growth Valuation Models, and It’s your Retirement fund that Suffers as a Result
With inflation this high, anything assessed based on its future revenue seemed suddenly overvalued, according to the models.
So hedge funds and institutions started selling growth stocks faster than you can say “Quantitative tightening.”
Hence: Bear market. Hence: Why so many stocks are down -50% or more.
But anything that’s making lots of profits now? Anything that’s seeing revenue grow faster than inflation?
The models think these stocks look amazing.
… For now.
So here’s what we’re going to do:
This month last year, I made a model that pretty successfully predicted how much inflation would surge by now.
Next, I’m going to revisit this prediction…
Then I’m going to use the same model to make another prediction…
And to cap it off, I’ll talk about what we should consider investing in accordingly.
Featured Image of a Model on Wall Street Courtesy of OpenAI
