UNDERWRITING THE STOCK MARKET

A major paradox of stock selection is that the trajectory of the market is likely to be primarily deterministic to the trajectory of my portfolio, YET most sophisticated stock pickers are spending little time forecasting the market.

This isn't due to neglect or laziness, but due to lived experience with regard to the difficulties of forecasting the trajectory of the S&P 500.

It is the general consensus, with which I agree, that it is easier to forecast the bottom's up KPIs of businesses that I can closely diligence rather than the myriad economic & geopolitical inputs that ultimately drive the trajectory of the market.

The two paragraphs above are an oversimplification, however, and with the S&P recently flirting with 6,000 and on an epic tear over the last 15 years, I thought it would be helpful to lay out some of the frameworks I have picked up along the way (taught to me by people much smarter than I am).

***DISCLAIMER: PLEASE DO NOT TAKE ANYTHING HERE AS A FORECAST, FOR EDUCATIONAL PURPOSES ONLY. ALL DATA SOURCED FROM FACTSET

1) THE MARKET IS STRUCTURALLY DESIGNED TO APPRECIATE

When I buy the S&P 500, I am buying a broad cross-section of the largest and most influential publicly traded companies in the US across various industries.

These companies 1) grow earnings per share, and 2) pay a dividend.

Generally, this EPS CAGR is realized at a faster rate than nominal GDP given the S&P 500 captures the winners in the economy (the Tesla's, Nvidia's, Apple's) and due to the underlying structure of a P&L (i.e. ~5% revenue growth translated into ~7% EPS growth due to operating leverage and FCF deployment on buy-backs).

So that is what we have seen this century so far - 6.8% EPS growth supplemented by ~1.5% dividend cash payout. All else equal if I hold my P/E multiple on that rising EPS, the market should appreciate in-line with these drivers (i.e. 20x on $1 going to 20x on $1.068 with the dividend in hand or reinvested).

And the good news for stock market investors is that given the strength of these collective 500 companies against the backdrop of our growing global economy, EPS generally rises.

EPS of the S&P 500 has only declined in 4 of the last 24 years, with only 2 double digit declines ('01 off tech bubble bust by -11% and '08 by 23% due to GFC).

2) MARKET MULTIPLE IS A CRITICAL RETURN OVERLAY

So if I think about the 8% return drivers above as providing a propulsive effect on the market, shouldn't I observe a fairly steady, consistent return stream in the MSD/LDD?

Oh if markets were truly an "efficient, sober discounting mechanism".

In the real world, the markets are much more volatile than the underlying earnings stream of the S&P 500.

Take '22 as just one recent example where S&P 500 EPS grew 3.4% in a market that was down 19%.

If I go back to my ~8% return drivers, but assume my starting P/E is 15x and my exit P/E is 22x, I have overlaid a return driver of multiple appreciation on top of these baseline drivers. Yippee. This is the formula we are looking for constantly in underlying stocks - expanding EPS with appreciating multiples.

This is exactly what has happened over the last ~15 years. From the GFC bottom March 9th, S&P 500 EPS has 4x'd, yet the market has 9x'd. The juice was the market P/E expanding from 9.9x to 22.4x.

This combined lollapalooza of expanding earnings and expanding multiples has been a powerful tailwind to equities over the last 15 years.

I believe it is important to understand this decomposition to help us better understand where we may go over the next 10-15 years (more on that later)