Monthly Market Dashboard: Pascal’s Market

The topheaviness of this market is impossible to ignore. According to our friends at J.P. Morgan, a basket of the top ten stocks in the S&P 500 returned 67% between the beginning of 2023 and the end of January. The other 490 stocks returned 9%. Eighty-six percent of the index’s return since January 1, 2023, has been in ten stocks.

One of the more well-known arguments in popular philosophy is Pascal’s wager, proffered by the 17th-century French mathematician, philosopher and physicist Blaise Pascal. The Cliff’s Notes version is essentially that God’s existence might be impossible to prove, but believing in God was the smart bet. The reasoning here was that if God exists, then believers reap eternal rewards, and if God does not exist, then believers have lost nothing of lasting importance by believing. On the other hand, while non-believers lose nothing of lasting importance if God doesn’t exist, they lose a great deal if God does.

Now, my old Sunday School teacher might not appreciate this analogy, but let’s substitute the concept of valuation in the place of a Creator in Pascal’s wager. Either value exists and matters, or it does not exist. Let’s define value as the book value of a company, the actual accounting-based value of a firm—assets minus liabilities. We could also use a DCF, a discounted cash flow model, to approximate the present value of all the cash flows associated with a company. If one were unfamiliar with the concept of valuation and were tasked with allocating dollars, how would one do it? Well, probably by buying stocks that are going up, right? Wouldn’t that be the point? As I once heard someone say in my dentist’s office, “when I see a stampede, I jump on a cow!” In a world where intrinsic value does not matter, and prices are all that count, there’s no reason not to just buy whatever is going up.

“Unless that crop report…” — Mortimer Duke, Trading Places, 1983

If the Trading Places co-villain Mortimer Duke hadn’t been so despicable, it would have been easy to feel sorry for the old man when his illegal attempt to corner the frozen concentrated orange juice market was foiled, impoverishing the Duke brothers. They had been so sure of their success. “Just keep buying,” they instructed their trader as prices skyrocketed. Of course, when their sure thing (a stolen crop report) turned out to be wrong, it was, as one of the smartest traders I know likes to say, “Turtles all the way down.”

A stock with a high price vs. its current book value will almost always get cheaper, either by growing book value by leaps and bounds over many years by growing earnings, or by failing to meet investor expectations and causing the stock price to plummet as earnings fail to materialize. It’s usually the second one, and you won’t hear about it at the dentist’s office.

We firmly believe that value does exist and does matter. Sometimes, adhering to a strategy that emphasizes discipline isn’t that easy, but as Pascal advised and as the Dukes discovered the hard way, that’s the way to bet!