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The Limitations of Market Perfection

Today’s stock market is overpriced. But it hasn’t stopped investors.

When you dig a bit deeper though, there are indications that maybe it’s time to pump the brakes some.

What are stock prices? They’re reflections of future value, which is often computed using a discounted cash flow model.

But prices can be wrong.

A company can be valued quite highly, but in reality, the business fundamentals that are supposed to back that valuation do not correlate with such a high value.

There’s a concept in the stock world known as the margin of safety, which is a cushion against analytical error and unforeseen bad consequences. Stock prices are already discounted to account for this margin of safety.

The opposite of this concept is a perfect scenario – a premium that pushes stock prices up as a result of perfect analysis or good fortune.

There are times when, despite the fundamentals, the valuation will climb so high that it is unlikely to produce a future profit, even if things go perfectly. Again, the stock’s price has already discounted the perfect outcome.

This latter scenario is where we are now.

Equity valuations are at record highs because investors are making errors.

When using a discounted cash flow model, interest rates and earnings growth are highly correlated.

But right now, investors are not treating them that way. They’re lowering interest rates without also lowering growth rates.

Declining interest rates don’t validate higher stock prices. But investors are acting as if they do.

In essence, people are betting that interest rates will stay low forever, and growth will increase. Sounds perfect.

But since the market has discounted the perfect scenario, it means there is little upside.

Now, that doesn’t mean a crash is certain. But peaking stock prices could be a sign of upcoming recession.

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