By Jack Forehand, CFA, CFP® (@practicalquant) —
I am a fundamental investor. I like to look at the value of a stock in the same way I would look at any business. Ultimately, that value should be a function of the future cash flows the business can generate discounted back to the present using an appropriate discount rate. Early in my career, I looked at everything that occurred in the stock market through that lens. If a stock went down, I assumed it must have been because those future cash flows were either going to be less than expected or were being discounted at a higher rate.
But as I have gained experience in markets, I have realized that view is a naïve one. That doesn’t mean that a business’ ability to drive future cash flow shouldn’t ultimately drive its value. But it does mean that it will only do so to the extent that those fundamentals drive the flows into and out of its stock.
There is a quote attributed to Ben Graham that says that the market is a voting machine in the short run and a weighing machine in the long run. What that essentially means is that flows can drive short run stock performance, but we would expect the true value of a business to be what matters in the long run. Although I agree with the theory of that quote. I think it needs some revision to be more accurate. The correct way to look at it in my mind is a lesson I learned from Ben Hunt at Epsilon Theory. That lesson is that the market is always a voting machine. In other words, flows will always drive stock prices. The reason it becomes a weighing machine eventually is that we would expect rational actors who are creating those flows to eventually care about the underlying value of the company the flows are going into and out of.
Despite that reality, there has been more and more evidence in recent years that things other than fundamentals are driving market flows, even over longer periods of time. This has been one of the biggest lessons I have learned from hosting our podcast Excess Returns. We have had a series of guests on who have discussed the ways in which market flows are driven by things other than the fundamentals of individual companies.
As a way to help collect my own thoughts on the issue, I thought it would be interesting to put them all together in one place.
Here are three things that drive market flows other than fundamentals that I think we all should pay attention to.
This idea goes back to the work of Ben Hunt at Epsilon Theory. Often in markets, what drives flows is not necessarily the facts, but instead the story that is told about them. The best example of this is probably Tesla. How many investors in Tesla do you think are making their investment decisions based on their calculation of the present value of its future cash flows? I would guess not many. Instead, much of what occurs in the stock is driven by stories, and Elon Musk is certainly one of the best story tellers out there.
That isn’t a value judgement on whether Tesla is cheap or expensive based on fundamentals (although those who know my value bias might know my opinion on that). It is more an acknowledgement that what has driven Tesla’s stock price for a long time is a function of its story. This is also true of other growth stocks. But that story has taken a back seat recently to the story of inflation. The competition between those stories, and how well supporters of them are able to tell them is likely to be a major driver of what happens going forward.
 Passive Flows
It is hard to argue that passive investing has been anything but good for the average investor. Since most active managers underperform the market after fees, the decision of more and more investors to go passive has been a sound one. But some worry that when too many investors make that decision, you end up with flows that distort the market and drive up the prices of the biggest companies more than is warranted by their fundamentals.
We recently interviewed Mike Green of Simplify ETFs, who has been doing some of the most innovative research in this area, for our podcast. Mike made a compelling argument that passive flows not only impact the relative performance of individual stocks, but also result in a more fragile market with more tail risk both on the upside and the downside. Mike’s arguments are too detailed to cover here, but I would recommend you listen if you want to learn more. I certainly learned a lot interviewing him.
 Option-Based Flows
My experience with options in my career essentially consisted of learning some complicated options valuation models in order to pass the CFA exam. After that, I pretty much put them out of my mind. But that changed in 2020. It was clear that options played a big role In the bear market that year and the rally that followed, and that led me to dig deeper into what was going on. We spoke to Jason Delorenzo of Ad Deum funds on our podcast about this in much more detail than I will cover here, but the general idea is that when an investor buys or sells an option, there is an options dealer on the other side of that transaction. And that dealer doesn’t want to take on risk so they need to hedge that position. That leads them to buy and sell the underlying security. Those resulting flows can have major impacts on markets and those impacts continue over time as dealers continue to adjust their hedges.
In aggregate, options dealer flows can have a stabilizing impact on the market. But in times of volatility, they can have the opposite impact. These flows can account for a significant amount of daily volume in something like the S&P 500 so they are certainly something investors should be aware of.
Is the Weighing Machine Dead?
All of this talk about flows that have nothing to do with fundamentals might be disconcerting. But I don’t think it means that fundamentals are dead. What I do think it means is the market has changed. Those changes mean that factors beyond fundamentals drive stock prices more than they used to and for periods longer than they used to. But ultimately investors are still buying a share of an actual business. And the cash flows of that business should eventually determine its value. Although I think the weighing machine lives on, those of us who are fundamental investors might have to live with longer periods of voting before it does its work.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.