With high growth companies leading this recent downturn in the stock market, I thought it would be helpful to explain what drives the direction, or trajectory, of the stock market in the short-term. By short-term, I mean over the next year or so.
The trajectory of a stock is the second derivative of the company. We can also say that the trajectory of the stock market as a whole is the second derivative of the economy. Without trying to complicate this by giving you a lesson in calculus, I’ll use a simple example to explain what the second derivative is.
In our case, a derivative is a rate of change so let’s think about a car as our underlying object. The first derivative of a car is its velocity (or speed) – it changes at a rate that we quote as “miles per hour.” If the car is in park and not moving, its velocity, or first derivative, is 0 miles per hour. If you’re on the highway and have the cruise control set at a constant 65 mph (you know, since we all follow the speed limit and never drive above 65), the first derivative, or rate of change, is 65 mph. The car is changing position at a rate of 65 miles per every hour driven.
To take this one step further, this means that the second derivative is the rate of change of the first derivative. In our example of the car, our first derivative is the velocity at which you’re driving. So the second derivative is a change in velocity. We call this acceleration or deceleration. If you’re cruising at a constant speed of 50 mph but then you accelerate to 55 mph in one unit of time then your second derivative is a rate of growth of 5 mph/unit of time, or 10% (5 dividend by 50).
Now let’s bring this back to stocks. The company is the underlying object, its annual rate of growth is the first derivative, and its acceleration or deceleration in its rate of growth is the second derivative. So if we have a hypothetical company growing profits at a constant rate of 6% per year, the stock should appreciate at a similar pace per year if it was maintaining the same valuation. However, if growth next year was projected to accelerate to 8%, the stock would climb higher at an increased trajectory. Conversely, if its growth was expected to decelerate from 6% last year to let’s say 2% this year, the stock would get hit despite the company remaining profitable and growing year-over-year. The reason is that the stock was pricing in a trajectory of 6% growth but now the company is expected to post 2% growth which is a lower trajectory so the price of the stock needs to come down until it matches the 2% growth trajectory.
This is why high-growth companies tend to be very volatile stocks. If a company grew last year by 20% but this year the growth rate is expected to accelerate to 30%, the stock tends to jump dramatically as investors now price-in the higher rate of growth. The flip side is that if/when growth slows from 30% down to let’s say 10%, a stock will get hammered because the trajectory of 10% growth is much lower than 30%. This is why it’s vitally important to look at not only the valuation of a stock before buying it, but also the market’s expectations for growth moving forward. Often times a stock can be facing such high expectations that it’s virtually guaranteed to fall short at some point, and when it does, the stock gets knocked back to reality. This is what we’re seeing right now in the market with all of the high-growth darlings as it becomes increasingly apparent that the economy is slowing.
The Trajectory of a Stock
Thanks for following!
-Nick
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