Insights

“An explanation is a statement of what is there in reality and how it works and why. But the important distinction is between a good explanation and a bad explanation… This is what the growth of knowledge is actually about. A good explanation is one that is hard to vary while still explaining what it purports to explain.”

– David Deutsch

The investment industry is rife with inductive reasoning, the idea that the future can be predicted by looking at the past. Examples of such reasoning abound, including the idea that the longer one’s holding period, the less likelihood of losses. Indeed, when market participants report investment performance over a particular chosen past and suggest that those returns indicate the future performance while disclaiming that past performance is not indicative of future results, they rely on just that kind of a belief. The idea that since it happened in the past, it will happen in the future may very well be the correct explanation in a specific case. But that does nothing to explain why it will happen.

A simple experiment highlights the shortcomings of inductive reasoning[1]. Take water in a beaker, put a thermometer in it, and then turn on the heat source. Now, as long as the heat source is relatively constant, the temperature rises at a relatively constant rate. Say you observe that it is rising at the rate of 10°C every minute. Now, if you are an inductionist and know nothing about water’s boiling temperature, you will forecast rising temperature into infinity. Of course, that is entirely false. Once the water reaches its boiling point, the temperature stops rising and plateaus at about 100°C. What happens is that at the boiling point, particles in the liquid state acquire escape velocity. Escape velocity requires energy. For this reason, we can have heating of water without an increase in temperature.

As we wrote in the previous article, “After an extended period of above-average increases in prices, it is only reasonable that there will be a general belief that prices will continue to rise at those high rates.” So why will or won’t such price increases continue? The primary driver here is the relationship between property prices and the cost of constructing such properties, referred to as the replacement cost. In a capitalistic society, if property prices were to rise well above their replacement cost, it will set in motion a process wherein capital will flow towards construction projects, increasing the supply of properties on the market, eventually resulting in lower prices.

A similar process takes place with most businesses as well. If stock prices stay well above what it costs to build such businesses and entry barriers aren’t significant, entrepreneurs will launch many more companies and bring them to investors. Eventually, such a process will drive business valuations downwards.

We have to account for an important difference compared to the boiling water experiment. The valuation point at which the reversion takes place for stocks prices isn’t a constant. It depends on entrepreneurs’ confidence in the ability of stock prices to stay high, ease of setting up new businesses, capital funding environment, and any entry barriers. What is clear though, is that at high enough prices, the process of new business creation kicks in.

[1] Brett Hall, The Beginning of Infinity, Part 1 | https://nav.al/infinity