Financial Physics

Financial Physics Model

Introduction

The behavior of the stock market is inherently so complex that no single variable can predict how the market is going to behave or what would be its future returns – at least not on a regular and consistent basis. In this book, we attempt to present a unified theory for the stock market return. We call it Financial Physics. Financial Physics represents a framework of a few key variables and their impact on the stock market’s overall direction. We unify two ideas - one is investment return based on true fundamentals of economics and other is emotional return based on the emotions of investing. We will show that Financial Physics Model consisting of primarily two variables; Fundamental Return and Emotional Return, fairly well explains stock market returns over both long and short term periods. Since the model is fundamentally based rather than statistically based, this should reasonably assess its validity and accuracy.

In Chapter I of Financial Physics Model - Unified Theory of the Stock Market - we will show that the stock market return are determined by the interaction of just two parameters: investments return represented by the earnings growth and dividend yields of our corporations (Fundamental Return) and second speculative return (Emotional Return) represented by the price that investors are willing to pay for each dollar of earnings. Corporate earnings and dividends have provided a steady underlying stock market return over the long term. Whereas emotional returns on stock represent the impact of changing public opinion about stock valuations – it changes from daily, month to month, from optimism to pessimism.

Using the framework of our Financial Physics Model we will analyze the overall stock market performance using S& P 500 index as a benchmark for the past 100 years, 40 years, 20 years, 10 years and 5 years respectively. We will analyze how well these three variables (earning growth, dividend yield and valuation change) fit into these equations. It will also give us an indication about how much each of these variables contributed to the total stock market return in the past.

We will show that over the long period, fundamental return contributed more to the total return than emotional return and they are very predictable. We will show that in the long run, fundamental returns – the earnings and dividend generated by American business are almost entirely responsible for the total return delivered in our stock market.

However, over a short period of time, such as year or even several years, emotional return based on the change of P/E multiple seem begin to have a significant impact on the total stock market return. Thus as the time horizon of investment decreases, emotional return begin to play a significant role in the determination of overall stock market returns and becomes a major contribution to the market noise.

In essence, in the long term, market looks calm and beautiful as an ocean when watched from a distance, but it becomes more and more turbulent and chaotic as one approach closer and closer to the ocean! Thus our model advice to investors is to ignore the short-term noise of the emotions reflected in our financial market and focus on the productive long-term economics of our corporate business.

In Chapter II of Validation of the Model - we will further attempt to confirm the validity of our Financial Physics Model based on a Micro Level. This time, we will apply the model to various individual stocks from different industries; Consumer, Health Care, Financial, Technology etc. We will compute and compare the expected individual stock return based on our Financial Physics Model versus actual stock returns during the period of 2000-2006. We will see that the stock return computed based on our model comes remarkably close to the actual individual stock return during this period, thus further confirming the validity of the model

In Chapter III of Forecasting of Future Market Returns - we will try to predict the overall future market performance for the next decade based on our Financial Physics Model. We understand that the mathematics of the market place, it would be extremely challenging to predict the future. However, we will try to systematically isolate and analyze each variable of our model namely, earning growth, dividend yield, and valuation change and its predictability to determine the future market return.

The nation’s Gross Domestic Product (GDP) at its heart, after all, is the sum of the revenues of all U.S. businesses. As business revenues grow, business earnings grow, and GDP grows. The business factors that drive earning growth are the same factors that drive GDP growth. If one assumes that the S&P 500 index is an excellent proxy for the market as a whole - there is a historic and permanent relationship between S&P 500 index earning growth and real economy growth - GDP growth.

Over the last seven decade, real GDP (not adjusted for inflation) has grown around at 3.5%. Past GDP growth of 3.5% per year has been driven primarily by population growth of about 1.0% and productivity growth averaging about 2.5%. In future population growth is likely to slow down, perhaps by a little. However, in our view, this will be compensated by increase in the productivity growth due to the globalization and digitization of our new world.

If we assume that in future also, GDP will maintain its present growth rate of 3.5% a year and if we add to that an annual inflation rate of about 2.5%, one gets about 6% growth in the nominal GDP. This essentially represents 6% earnings growth of S&P 500 index in the future. Since World War II, earnings have grown at about 6% a year, slightly trailing GDP or economic growth.

There is also quite a consist link between corporate dividend payout and the total size of the U.S. economy. There is a direct year-after-year relationship between dividend yield and GDP and Dividend Yield over time are fairly steady with respect to the GDP. We will find that, year after year, corporate dividends paid to shareholders by firms listed on NYSE are almost equal to 2% of GDP.

Thus if we combine these two variables, corporate earnings growth of approximately 6% (real GDP growth rate of 3.5% and about 2.5% inflation rate) with dividend yield of approximately 2.0% of GDP - over the long run, stock market should enjoy a total fundamental return of about 8.0% on a compound annual growth rate (CAGR) basis.

The third variable in the equation namely Emotional Return depends on the change in valuation which is significantly influence by the prevailing interest rates. Interest rates effect on valuation is the same way gravity acts on matter. The higher the rate, the greater the downward pull and lower the financial valuation and its contribution to the total market returns.

In a very simple Federal Reserve Board model, which estimates the fair value of the market, one compares stock earning yields (inverse of P/E in percentage) with the 30-year bond yield. For example, P/E of 20 for S&P 500 provides stock would provide earning yield of 5% which compares favorably with the present 30-year bond yield of 5%. At the end of 2006, P/E ratio of S&P was roughly about 17. Thus, in our estimate, the present S&P earnings yield of 6% (P/E ratio of roughly about 17) is reasonably priced when compared to the present long term interest rate of 5%.

In the case where the long term interest rates of 5% and present P/E ratio of 16 does not change, then the contribution from the speculative return will be zero and thus the market total return will be the same 8% provided by the fundamental return.

In Chapter IV of Stock Screening Methodology – we have devised certain stock screening strategies based on our Financial Physics Model. Our model clearly indicates that the fundamental return is a major contributor to the total stock market return. We screened almost 5000 public companies based on annual sales, EPS growth with Net Profit Margins and Return on Equity. Furthermore, we have divided the total stock universe into three groups: Small, Medium and Large based on their annual revenues.

In Chapter V of Stock Selections- screening strategies established in the previous chapter of stock screening methodology were programmed and analyzed for one year, five years, seven years and ten years. As we were putting together the finishing touch on this chapter in early 2007, all necessary stock selection data goes through as of December 2006. Thirteen companies made it through this rigorous selection process; four companies in Small Cap (Aggressive Growth), eight companies in Medium Cap (Moderate Growth) and three companies of Large Cap (Conservative Growth and Dividend).

In Chapter VI of Portfolio Construction and Analysis – we have built a portfolio consisting of these thirteen companies with equal dollar amount invested in each stock. Furthermore, we back tested the overall performance of the portfolio for one, two, three, four and five years and compared their returns to the S&P 500. Our results indicate that our portfolio consistently outperformed by wide margins for each of these five years.

In Chapter VII of Path to Financial Freedom – we have presented an investment frame work based on our Financial Physics model. We have simplified and devised a rule, what we call “RR Rule of 20”. We strongly believe that of one follows the “RR Rule of 20” – he/she is on his/her way to the Financial Freedom.

Enjoy reading. Please let us know how you feel about our Unified Stock Market Theory – our Financial Physics Model and agree with our RR Rule of 20!