If you believe economists and finance academics…actually, never mind that…I was going to point out that it might be their ‘experiments’ that are flawed rather than investor psychology, as they claim to have proven. But my beef today is the very nature of information over time. A phenomenon I’m calling ‘the tyranny of the denominator’.
It’s quite simple, really: when we compare things over time, the comparison ceases to be accurate. That’s because apples become oranges.
Consider, for example, the claim that stocks go up in the long run. Sure, a chart seems to show they do. But you’re comparing apples to oranges.
The stocks in the index are not the same over time. The badly performing ones drop out of the index and the growing ones get added. This adds an upside known as survivorship bias.
The purchasing power of money over time is not the same. And so, what looks like a rising stock market might actually be the devaluation of money.
The time and stock market indices that finance professionals and academics like to put on display when they trot out the ‘stocks go up in the long run’ story is not universal. Try using a Japanese stock market index or look at the Dow Jones Industrial Average between 1918 and 1982 adjusted for inflation, when it didn’t go up.
My point isn’t about stocks, though. Nor am I disputing whether stocks go up in the long run. I’m saying that our measures of these claims are useless or worse. I want to make you aware of this, so that you can spot the same effect elsewhere.
Here’s what I want you to notice: time has turned a comparison of apples and apples to a comparison of apples and oranges, which makes counting them and reaching conclusions about the number obsolete.
The same phenomenon plays out right across financial markets, and life itself. The tyranny of the denominator obfuscates our ability to understand just about anything that features a comparison over time. Once you realise this, you’ll discover that we don’t know a fraction of what we believe to be true.
But what does this have to do with the denominator — the bottom half of a fraction? Well, it’s just a way of expressing the fact that, when we try to measure something, the ground it’s standing on can shift too.
Usually, when we measure how things change, we focus on the numerator — the top half of a fraction. For example, GDP measures the economy. When GDP goes up, we have a higher standard of living. When it goes down, our standard of living falls.
But what about the denominator — the size of the population amongst which that GDP is divided?
A significant enough change in the population can render the GDP growth figure misleading. If the population grew more than GDP, our standard of living actually fell.
If the news reader reports a huge jump in GDP without mentioning how migration and demographics have changed, do we have any idea what’s really going on? Or are we misled?
Australians and the Japanese have an intuitive understanding of this. Actually, they don’t, but given where they live, they should.
In Australia, population growth through immigration boosts GDP figures. That’s how Australia escaped recession in 2008. On a per capita basis, we did have one back then.
Japan has had a ‘missing decade’ for three decades now. Economic growth has been miserable and the Japanese are used to recessions and deflation. Many get pay cuts each year.
But this analysis may be flawed because of the tyranny of the denominator. Adjust for population decline and you’ll find the Japanese economy is doing OK.
Once you adjust for population and deflation (the cheaper cost of living in Japan), you’ll find the Japanese economy is doing great. And you should consider investing in it.
Everyone who has been to Japan can attest to this, of course. You see dilapidation in abandoned places in the countryside but a very high quality of life in other parts of Japan. Especially adjusted for the cost of living.
Why does any of this matter to investors? Well, as Mark Twain is credited with saying, ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’
I’m worried that our presumptions, which inform investment decision-making, are based on fallacies created by changes in the denominator over time. That’s why I call it a tyranny.
Here’s a good example based on the benefit of hindsight. During the recovery from the COVID crisis, as flights began to reappear in the sky, data analysts cheered this as a sign of the economic recovery and bought airline stocks…
…the problem was that the flights were often empty due to a quirk in how airlines buy slots at airports.
If you compared the number of flights before the pandemic to after, you would’ve seen a spectacular economic recovery. But you were comparing apples to oranges. More specifically, apples had become oranges.
You would’ve reached the wrong conclusions about the recovery in air travel. And the economy in general. The end of the pandemic was a uniquely bad time to invest as markets plummeted in 2022 and recessions began.
Another example comes from stock buybacks. Instead of paying out dividends, companies are often buying back their own shares on the market. This means each of their remaining shares held by investors owns a slightly larger share of the company, which is good news for shareholders.
But it makes a meal of comparisons over time because the number of shares is declining. You have to adjust for the changing denominator.
Here’s the real point: When you look at a chart of a company’s share price going up, is the company’s value really rising as share prices go up, or are they just buying back their own shares, making each individual stock more valuable, but not the overall company?
My article about the rising US dollar is another prime example of the tyranny of the denominator, which investors need to keep in mind.
What if markets haven’t actually crashed in 2022? It’s just that the denominator they’re measured in — the US dollar — has become more valuable relative to everything else.
What if the pound, the euro, and the yen aren’t going down, as the media reports, but the US dollar is going up?
The point is that the value of the US dollar changes, so comparing things in terms of US dollars (prices) over time is misleading. The denominator has changed.
Of course, all these presumptions and perceptions might still be true. But we don’t know because the data is obfuscated by changing denominators.
Now, let’s apply the same idea to the future…
Are Japanese markets a place to avoid because of a declining economy? Is deflation the death knell of prosperity? Do stocks really go up in the long run?
What if these presumptions don’t hold up? They’re just the tyranny of the denominator misleading us into poor decision-making…
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
