Among competing hypotheses, the one with the fewest assumptions should be selected.
William of Occam
Michael Mauboussin: Here’s what active managers can do
The use of this principle is valuable, but not completely determinative in science. It often has an important application in investing.
Let us consider two hypotheses.
- A method of valuing markets that relies upon backward-looking data, looks at replacement value, or depends upon some other fixed ratio. Put another way, all the most popular valuation metrics.
- A method that considers prospective earnings, expected inflation, and interest rates.
Method one has been wrong for many years. In fact, it has been mostly incorrect for decades. Method two has been on the right side of market moves, but still shows significant deviations. What can we learn from Occam’s Razor?
Since this method has been mostly wrong, many explanations have been offered. I think I left a few out, but you get the drift.
- Not recognizing “fundamental” risks – Euro collapse, China collapse, recession, Brexit, etc.
- Depending upon dubious earnings estimates
- Fed intervention – money printing and pumping up the market via QE
- Plunge protection team
- European Central Banks
- Suckers’ Rally
- Myopia of the investment world – no efficient markets
- High Frequency Traders and Algorithms
Since this method has been mostly right, little explanation is needed. The expected increase in market prices and multiples is consistent with the theory. It should continue for another 8-10% and further if forward earnings increase.
Should investors accept the complex and ever-changing explanations for method one? Or perhaps should they consider that the method itself is flawed?