What Actually Drives Stock Prices? Sam Ro on Earnings, Valuations, and Market Noise (EP.249)

0:02We all need to make smart decisions with our money. The Long Term Investor podcast shows you how by distilling complex financial matters into easily digestible lessons. And now here's your host, chief investment officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff.

0:21The Long Term Investor Host:Welcome back to The Long Term Investor. Today, I have Sam Ro returning to the show, this time to help make sense of the headlines, the valuations, and the market narratives that so often distract investors from what matters most. This conversation is a timely reminder that while the story changes every week, the long-term drivers of returns, especially earnings and business fundamentals, still do most of the heavy lifting. Now, before we dive in, I'd like to remind you that I have a new book coming out in the fall called The Perfect Portfolio, and you can receive exclusive updates and invitations to subscriber-only webinars by signing up at theperfectportfoliobook.com or using the link at the top of the episode description.

1:05The Long Term Investor Host:Sam was such a popular guest last time, so I'm really excited for you all to hear from him again. Let's get into it. Here is my conversation with Sam Rowe. Welcome back to The Long-Term Investor. Today, I have returning guest Sam Rowe, author of the awesome Substack, TKR. Sam, thanks so much for joining me here today. Thanks for having me. I read your stuff every week. Maybe just start there. Tell the audience about your Substack, the type of stuff you're writing, and what your subscribers get when they join your newsletter. Ticker is news, data, charts, insights for the long-term investor. I guess we probably have a lot of overlap in terms of our target audience.

1:50You know, the story is I come from the news business where every day we have to try to explain why the market's moving in that particular day and all the forces and factors, whether it's fundamentals or technicals that might explain that. But I always gotten a lot of feedback from people saying, you know, I don't know if this framing is particularly helpful. I read the news every day, but I don't know what this means for me in the context of, you know, my 401k plan, or in the context of the fact that I'm, you know, invested for the next 10 or 15 years, you know, should I be scaling back, taking risks back, should I be reallocating, etc, etc.

2:34So I write about all the same news and data and the market events that happen, but with the long-term investor audience in mind. So it's got to be, yes, there are these geopolitical events that might be moving markets today, but I will also make sure to include information that helps us understand what that means in a longer-term context. You know, stuff like a hot research note is circulating on Wall Street and everyone's talking about, you know, what the market might do in the next year. And I'll make sure to balance that out with sort of the historical context of what that all means and the odds of a strategist nailing a price target.

3:24And again, how we should be thinking about this in the context of 5, 10, 15 year longer term time horizons. So, you know, there's not a lot of stuff that's particularly unique, unfortunately, in terms of news or data. It's just that it's framed in a way for people who do think long term. And it seems like there's an audience for stories that are framed that way.

3:52The Long Term Investor Host:Well, it's certainly what draws me to your work. And what's funny, as you explain what your sub stack is, I think we had the same conversation last time. I always call it TKR so that for those listening or watching TKER.com, that's how you find Sam's stuff and you're calling it Ticker. So I think this is the second time now in a 12 month period where you've corrected me and I'm probably telling everybody the wrong name, but at least everybody can spell it now and recording on March 3rd. To be honest, Sam, I don't know when this is publishing exactly, But the big news story today is what's going on between US and Iran.

4:29The Long Term Investor Host:Last week, it was AI-induced fear, particularly around a research piece from Citrini. One of the things that's interesting, though, is let's say we do publish this episode a month from now. It might be a totally different story that has everyone's attention. With that in mind, tell me a little bit about kind of as you're reading the news, what are some thoughts and questions in your mind? What are things that you have people asking you? And what are some of the things that you are planning to write about? I was thinking, especially with with Iran, I was wondering about how I might approach writing about this for my audience.

5:08And, you know, one of the first things I often do is go back to see what I've already written that might help me, you know, back into some research that might be helpful for in today's context. And the last time I wrote about geopolitics and risk events and the threat of the Strait of Hormuz being disrupted and oil prices rising was a little less than a year ago when we did have tensions escalating in Iran after some targeted attacks from the U.S. And so a lot of what we're talking about in the current episode is very, it's not the same, nothing's ever the same, but it's very similar to what we faced yesterday or last year.

5:59So with that in mind, I try to think about, well, okay, let's instead of just sort of thinking about these generic ideas of geopolitical tensions rising and uncertainty rising, well, how can we make connections back to what's happening to, you know, what's going on into financial markets and things that might be affecting our portfolio? a few things come to mind. One, there's not a whole lot of commerce happening directly between the U.S. economy and the U.S. publicly traded businesses with the economies in that region. Some businesses are more exposed than others, but if you are somewhat diversified in your portfolios, the exposure is somewhat small, and it's small enough that you probably are dealing with geopolitical risk on a rolling basis.

6:58But there is this question about things like energy prices, and specifically oil prices. What's interesting there is how the implications of higher or spiking oil prices, how that has evolved over time. And I think there are three things that are worth noting, and they're sort of interrelated. One, the US has become a net exporter of oil. So when oil prices do rise, there are some offsetting factors from a, you know, macro perspective. There are businesses in the US that might actually benefit from higher oil prices, they suddenly see their margins go up, suddenly the economics of drilling in certain, you know, shale basins might improve.

7:48And so there is kind of an offset there. From the consumption standpoint, you know, nobody likes to see gas prices rise, nobody likes to see their energy bill rise. And yeah, that will have a, that will be a headwind for consumers in the context of, you know, personal spending. However, the, everything we do is a little bit less energy intensive because, you know, thanks to, you know, perpetual improvements and how things are improving from a technological standpoint and a fuel efficiency and energy efficiency standpoint, it takes less energy to do the same things that we were doing years ago.

8:33So stuff like the fuel economy for cars just hit a new record high. This is information that's available on the EIA, but we don't need to look up the EIA. Anyone who's driven a car for more than a couple of years knows that you're getting more mileage out of a gallon of gas than you did with your previous car or the used car that your parents handed down to you. That's one thing. And in a more macro sense, spending tied to energy consumption, whether it's electric bills and gasoline or whatever, that spending as a percentage of personal consumption expenditures has been on a very long secular structural, whatever you want to call it, decline since basically the late 70s and the early 80s.

9:26So, you know,$100 or, you know, a 20 % spike in oil prices today has far less of an impact than a 20 % spike in oil prices 10 years ago or 20 years ago or 30 years ago. Not that we're going to get a 20 % spike in oil prices, but it's just, you know, we as both an economy and a stock market and a consumer have just been less and less exposed to things like oil. And so, again, every geopolitical event is different, and we'll pay attention to things like escalation. But for the time being, history tells us that our exposure has been shrinking. And even when exposure was higher, the markets tend to eventually look past these events.

10:21The Long Term Investor Host:And so it's crazy to me, though, Sam, is if you open up the Wall Street Journal's homepage in really big letters, this is the headline. You might notice that markets are down. And if you don't follow markets a lot, you wonder, well, I remember there was a sell-off last week. Are markets like in a downturn? In reality, they're really not. And if you look, as you were talking, I pulled up a number from Vanguard that if you look at the going back to 1962, just looking at geopolitical events, the average total return six months after event is 5%. And then if you look one year out, it's 8%, you know, total return after a geopolitical sell off.

10:58The Long Term Investor Host:And I guess if we had to make a headline that we weren't going to be ashamed of a year from now, if we were to look back on this, maybe it's something like, hey, you know, people feeling a little jittery today. But at the end of the day, the long term driver is going to be earnings. And a lot of times what I will tell clients, volatility, very normal. It's always the narrative, not the actual volatility that I think gets people nervous. And so I have them ask themselves, well, how do you see this impacting earnings? And what I really appreciate about your approach is here, you've kind of had a very thoughtful analysis of the energy impact of what's all going on.

11:39The Long Term Investor Host:But if I had to guess, you were going to say, what's going to be the biggest driver of returns the next 12 months, I assume you'd say it's earnings. Is that right? Absolutely. And, um, you know, I think this speaks to something I've written about, you know, quite a couple of times on, um, it is sort of like a popular, a popular way of thinking that, that I think has resonated with my subscribers and it gets shared a lot is this idea that we sort of have to, um, separate how we think about the world. Um, you know, maybe from a policy standpoint, you can feel certain ways and you have certain views about how, you know, the administration is implementing policy for social reasons or whatever.

12:24There is another way of viewing the world from the lens of the economy, you know, kind of like how we were talking about before in terms of our exposures when it comes to things like, you know, higher energy prices might be bad, lower energy prices might be good. But from strictly, again, from the investor perspective, the only perspective that actually matters is what's going to move the or what's going to have an effect on the various assets in my portfolio. And, you know, like you're saying, you know, at the end of the day, really, if there's any source of gravity, when it comes to asset prices, especially stock prices, it's going to be earnings.

13:08Over time, it's going to be earnings. And if we're going to get volatility because of market volatility, because of geopolitical events, or, you know, some reports that might have people concerned about the near future, and all these things. Yes, we do want to check in on, you know, earnings. And unfortunately, Unfortunately, every company out there is giving us a very tangible, quantifiable update every three months. But assuming there's not a whole lot of change in terms of those prospects for earnings and earnings growth, the market volatility is just a reflection of risk premiums going up and down.

13:52So if the market's selling off today because of some geopolitical event, then maybe it's just the market just applying a bigger discount to the earnings that we're paying for, which would actually explain why returns tend to be stronger in the months following something like a geopolitical event. Because you have volatility, because uncertainty, you know, gets priced in in the form of a discount, then the upside is, you know, by definition is going to improve, assuming, you know, the earnings prospects are intact.

14:28The Long Term Investor Host:And I think what we're talking about is just so fundamental and yet gets so lost among market watchers or investing enthusiasts in the first place. You know, the long term prices tend to go up as profits increase. They tend to go down as profits decrease. but then they also move just based on expectations of the future. I'd mentioned at the opening, hey, last week, people started questioning their viewpoint of the future when there was just kind of a scenario analysis, like a tail risk event scenario analysis that came out about AI where, yeah, the economy grows, but less people have jobs as a result, and then people can't pay their mortgages, and then that just continues to tailspin in a really negative direction.

15:11The Long Term Investor Host:What I think is always important for people to remember, JP Morgan does a great job putting out a chart like this where it shows, hey, what drove return last year or the year before that or years before that? And you can see it's change in earnings, the cash paid to shareholders, whether that's dividends or buybacks, and then changes in valuations. And so that valuations is almost like a psychology measure of sorts. today in the US valuations are high because things have been going pretty good. On the other hand, just because valuations are high doesn't mean for sure that you're going to have bad returns in the next year.

15:47The Long Term Investor Host:There's some evidence that over 10 year periods, it's a little bit predictive, if not perfectly so. But when you look at today's earnings landscape and valuations, what are kind of just some of your high level thoughts on markets in general? We could probably talk about this for six or seven more hours. I'll call my wife and tell her, don't wait up. Here we go. Everybody strap in. A couple of things. Fortunately, you don't have to really torture the data to get what seems like a reasonable explanation as to what's going on from the perspective of things like valuations. One thing that we have very clear evidence of is profit margins, both net profit margins and operating profit margins for the publicly traded companies of the stock market, in particular the S &P 500, which accounts for like 80 % of US publicly traded equities, have been on a structural rise for a couple of decades now.

16:57And, you know, it's a little wonky, but, you know, all things being equal, when profit margins are going up, your return on equity, you know, what you should be getting on the money you invest in stocks improves. And so when you do have a better return on equity, then, you know, it makes sense that valuations are higher. And if you want to put it in plain English, another way to put it is if you have structurally higher profit margins, you can also just say, well, companies are just operating better. Companies are making more money with what they have. And when companies are better by any measure, you would think that you want to pay a premium for the earnings generated by that company.

17:45So, yes, there's a lot to say about this historical relationship between things like PE multiples and forward returns in the market. But unfortunately, and while there is some, you know, it's such a clean measure when you do chart that out, elevated PE ratios and then long term 10 year returns gives you a very compelling dot plot, which basically tells you that, you know, there's a very history says there's a very high likelihood of relatively low returns. Unfortunately, it's just the oversimplification of what's going on in the world. How can you determine what's going to happen in the future in terms of financial market returns based off of one variable that's backwards looking?

18:42And if anything, something that we've learned in recent years, and listen, I'm not saying that we should see high double-digit earnings growth into perpetuity. I'm not saying that won't happen. I have no predictive power there. But what we do know is at least in the last couple of years, we have had incredible earnings growth. And that has been accompanied by elevated profit margins all along the way. And all of that seems to explain pretty well what has happened in the stock market. And, you know, I'm just I'm just remembering. And I read about this recently regarding valuations. You know, it happens to be the case that you, Peter, had actually written a piece about 10, maybe 11 years ago.

19:29I remember this. I remember this, Peter. uh this was uh and i i use it was a crazy time 2015 was a crazy time because that was when uh we first heard that the cyclically adjusted price earnings ratio made famous by people like robert shiller that measure had finally returned to a level that was last seen during the global financial crisis, a sentence and a headline that would freak everybody out. But, you know, as you mentioned, in your piece, you know, there is actually, you know, quite a range of outcomes, you know, when it comes to the forward returns at a certain level. But importantly, importantly, Unfortunately, what the history doesn't show that couldn't have been predicted about what would happen from 2015 to present day is that we had incredible earnings growth.

20:34And that helps explain why we have a market where we are today.

20:38The Long Term Investor Host:That's such a great example of why the internet is the best thing ever, because here I am reading Sam's newsletter on a weekend and I see him linking to something that I wrote so long ago. I think, oh my gosh, is that still out on the internet? You know, as we, and I even just now was Googling it to be like, wait, when was that? And yeah, it was about 10 years ago. And I think a lot of what you're talking about with valuation obviously resonates with me. You can use it to set expectations, but if you invest according to it, there's a good chance you're going to get burned. No perfect predictor in the near term, but to say like that PE ratios are high and what are we defining as high?

21:20The Long Term Investor Host:Well, if it's historical averages, one thing that always comes to mind is, well, if I'm going to pay, like how many dollars am I willing to pay for a dollar of earnings? Like, you know, am I willing to pay$15 for$1 of S &P 500 earnings. Well, I might be willing to pay more today than I was back when there was no accounting values whatsoever, or when like, the Fair Disclosure Act didn't exist. Or there, you know, you mentioned just the fact that companies are run better, but information is a lot more trustworthy. And so that valuations should be above long term averages, just kind of as their base rate, to me makes a lot of sense.

21:58The Long Term Investor Host:But yeah, I also recognize like back then when I was writing the piece. And I can find one mention of it in 2015 and one in 2017. I'm looking at kind of the takeaway and I'm saying, hey, like if I had to make a bet over the next 10 years, it's more likely that these are going to trail its long-term averages. But in the range of outcomes, they sometimes beat it. And sure enough, in the range of outcomes we got, we got better profit margins. We got a lot more earnings growth than we would have ever expected 10 years ago. That's a reminder that there are no sure things in financial markets. Even the expectation, you know, how we, and I hate to say it, but even the way we set up our investment, long-term investment strategies, there's no guarantee that we are, you know, we end up in a place where we are even within, you know, a comfortable margin of error of what, you know, we're hoping for.

22:54And so, but we do our best to keep an eye on what we understand to be the fundamental drivers of prices and things like that. But getting back to your point, I think one of the biggest mistakes an investor can make is to have too much confidence in what is not a perfect metric or a perfect indicator of future returns or whatever, which is actually just the case for everything. um if you had such a high degree of confidence that again like this is backwards looking information um that that uh we were gonna underperform for the next decade um you know it's very unfortunate like hopefully you found some other way to you know make up for for that underperformance and some other athletic class that you know hopefully did well um but yeah you You know, it's tricky.

23:57I mean, here's another way to think about valuation ratios that, you know, might be 17 on a long-term average, but it's at 22 or 23, which feels high. Or, you know, is it 14, you know, a great buying opportunity? I mean, listen, I'm actually using some very crude math here to say this next thing. But, you know, I know Yuri and Timmer at Fidelity has done some of this analysis and Goldman Sachs often publishes this in reports that are freely available on their website. But they will do like just a straight relationship or regression of things like S &P 500, 12 month earnings, you know, going back, you know, 100 years and prices going back 100 years.

24:52Now, again, we're sort of falling into this trap of, well, how much can we rely on long term history? But bear with me for just a second. When you track earnings over time and overlay that and do a linear regression with prices over time, that's one of the tightest correlations you're going to get in anything that's observable in the universe is that earnings and prices track each other very well. Now, when you do zoom in with a microscope, you do see that earnings has noise along the way and prices has noise along the way. Those fluctuations in this what looks like a very smooth line, two smooth lines, those fluctuations is the P-E ratio.

25:35By definition, it's the P-E ratio widening and contracting. When the P-E ratio might go a standard deviation above its long-term average, that's still within a reasonable margin of error where things might actually just still turn out right. Again, gravity, a P-E ratio is not gravity. Gravity is earnings, right? And so if we really want to be concerned about the future, you have to really, you know, let's get back to the basics here. I need a case for why earnings are going to fall apart. I don't need a case for why, you know, P.E. ratios might contract from 22 to 18. I mean, give me a break. It's like we're talking about like 100 P.E.

26:21ratio. That's completely different. And, you know, again, this is also kind of intuitive when you think about it. If you are starting a business tomorrow and it's finance in a certain kind of way and your plan is to try to earn back your investment in 18 years. with a PE ratio, but it turns out that you get to year 18, but you have to wait four more years, and it turns out it takes 22 years to earn that money back. Hey, that's not bad. Most businesses don't turn out that well. So yes, again, that said, an extended valuation ratios is certainly a thing that you use to manage expectations. But again, at the same time, you know, history also tells us that, you know, you might actually still get a healthy return, even when valuations are elevated.

27:14The Long Term Investor Host:I really like that example. And allow me to wander around a little bit as I know what I'm going to ask you, it's going to take me a little bit of a path to get there. So we're talking about expectations and such, and you know, the imperfection of using valuation as what might happen over the next one year or 10 years. And I actually did an episode on capital market assumptions a little while back. I'm scrolling episode 240. So if you're watching us on YouTube or on Cheddar, you can go to the longterminvestor.com. You can go to episode 240 and kind of see why different ways in which people set return assumptions can really impact your financial plan.

27:52The Long Term Investor Host:And I'm just not a huge fan of somebody who's going to have a larger weight towards what they think is going to happen over the next 10 years, in part because of some of these outcomes. Now, one thing that has happened in the past couple of years that I think is kind of interesting is throughout the past 10, I guess we've been saying, look, international valuations are a lot lower than US valuations. And as a result, we would expect international to eventually win. At the win, is that going to happen? We've never been sure. They certainly won in 2025. They're certainly looking good now. Will it continue?

28:26The Long Term Investor Host:But what's interesting is when you look, kind of going back to what we were talking about earlier, where returns are driven by changes in earnings, the cash return to shareholders, and the changes of valuation. And if you look at how did the US just crush international over the past decade plus, a lot of it was that they were outgrowing on fundamentals. But the past two, three, four years has been that they've been outgrowing on price multiples relative to those fundamentals. So it is possible to continue to win on having better fundamentals. The other way, like winning because simply people are willing to pay more for the same fundamentals, that's not something that's super sustainable.

29:04The Long Term Investor Host:And I think that's a lot of what we've seen more recently in US finally underperforming non-US stocks. I know you've written not terribly long ago on this topic. Like when you look at those sorts of returns in the go forward, what are some of your thoughts in that space? There's so much to unpack when it comes to thinking about U.S. stocks versus international stocks and how you want to be allocated and for what reasons. And that's really important. Um, you know, the first quick thing I'll say, and I think this has been repeated a thousand times, but it bears repeating is that, you know, when you do invest in non-US stocks, it's not as simple as trying to get exposure to non-US companies.