No one can explain why airplanes stay in the air. For that matter, no one can explain why anything that flies can stay in the air.
To be exact, engineers have never been able to perfectly explain aerodynamic lift.
On a strictly mathematical basis, they know how to design airplanes that will stay in the air… but the equations that engineers use to design them don’t account for why aerodynamic lift actually takes hold.
Millions of people fly around on planes every day (except for during the pandemic!) and there is no perfect explanation for why they don’t just fall out of the sky. That’s really rather insane when you think about it!
There are, of course, a few explanations that have been offered over the years; the most famous of these include the works of Daniel Bernoulli and Isaac Newton.
Bernoulli’s theorem explains lift as a consequence of the curved top of an airplane’s wing. Because of the curvature, air traveling across the top of the wing moves faster than the air moving along the bottom of the wing (which is flat). The increased speed atop the wing is associated with a region of lower pressure, which creates lift.
Simple enough, right?
The problem with Bernoulli’s theorem is that it only explains a portion of why planes stay in the air. To wit, it doesn’t account for why air moves faster across the curved surface, nor does it explain why an airplane can also fly upside down (i.e. with the curvature on the bottom)…
So can the OG of all "Sirs", Isaac Newton help clear this up??
(By the way... in case you're about to stop reading because you think I'm giving up on finance to head into aeronautics, have no fear. I mean, have a little, just not about that...)
Newton’s Third Law states that for every action, there is an equal and opposite reaction. That’s important in this instance because it explains that an airplane wing’s downward push results in an equal and opposite push back upward, which creates lift. This would of course apply to any shape of wing and regardless of whether a plane was inverted or right side up.
So we solved it with Newton?
Not so fast…
Newton’s Third Law still doesn’t solve for why there is lower pressure on the top side of the wing to begin with!
So, basically, we have no idea why planes can stay in the air… but we know they can.
An equity investor’s returns are really made up of two (not so) simple factors:
1. Earnings – how much a company earns in profits (including dividends).
2. Valuation multiples – how much investors are willing to pay for the company as a multiple of its earnings.
If you can solve for what a given company’s earnings will be (really difficult to do), then all you have to do is figure out what the market is willing to pay for those earnings (i.e. the multiple) and you will know what its stock price will be…
The only problem is that knowing the correct multiple with any level of certainty is virtually impossible.
Most would say it’s impossible because it’s based on such a wide number of variables… but I think it’s most difficult to predict because it’s so heavily impacted beyond those variables by just pure randomness.
I mean, you can guess what the correct multiple should be by comparing the company to its peers or some sort of historical average… and maybe that works… sometimes.
For example, if widget makers all trade in a range of 10-20 times earnings, then assuming that the widget maker you’re analyzing should trade at 15 times earnings is probably reasonable. But what happens if a recession hits and suddenly widget makers are only trading at 5-10 times earnings? Now 15 times seems really unreasonable, whereas before it only seemed average.
Just like the reason airplanes stay in the air, no one is totally certain why multiples are what they are… we just know that they are.
The Boeing 747 Jumbo Jet is a really large airplane. It weighs 412,300 pounds when it is completely empty. Throw some passengers, cargo, and fuel on that bad boy and it can clock in as high as a cool 970,000 pounds.
Now, having nearly 500 tons of steel hurdling through the sky at 650 miles per hour doesn’t exactly sound like a safe proposition on its face… so the plane better be able to stay up there as advertised. Since no one knows why planes stay in the air, airlines also better have some decent checks and balances in place in case one day planes just stop staying in the air (since no one knows why lift works, it’s reasonable to assume that one day it might not work, right?).
Lucky for all of us who have ever traveled on an airplane, this isn’t really an issue. Pilots go through an unbelievable amount of training to fly them, there is communication equipment on board that enables them to notify authorities if there ever is an issue, and airplane technology is now sophisticated enough to anticipate problems before they take hold. Add in robust safety checks before takeoff and you have a pretty safe process of flying… certainly safer than at any other time in modern history.
So, it’s better and it’s safe when there is a plan in place… it turns out preparing in advance for potential problems works for both airline pilots and financial advisors alike!
I could give you a lot of explanations for why multiples change over time the way that they do but one word pretty much sums it up:
When people feel good about the state of the world, they are willing to pay more for future earnings.
When the world doesn’t feel so great, they’re willing to pay a little less.
It isn’t really a whole lot more complicated than that.
Take Apple, for example; here is a chart showing the average multiple paid by investors to own the stock...
In March of 2020, the world seemed pretty uncertain and so investors were only willing to pay around a 19 times multiple to own Apple stock. The thinking was that earnings could contract and maybe the company wasn’t quite as valuable as many hoped...
Fast forward ten months and earnings never came down as feared… they only went up! Now, everyone was feeling much better about the state of the world and investors were willing to pay a roughly 40 times multiple for that same company. That’s a 110% increase in price just based on multiple alone (not accounting for any change whatsoever in the company's fundamentals)!
So here’s the question…
Just like airplanes, we can’t perfectly explain it… but we know it is.
So while we can’t control nor perfectly explain some of the unknown forces at work in the markets any more than we can aerodynamic lift, we can make sure that we have our portfolios dialed in for when turbulence hits.
Here is a pre-flight check list that works for any portfolio:
Make sure you have enough cash on hand – I gave this advice in March of last year when the world was coming apart at the seams and I will do it again now. Have enough cash to weather a full business cycle and keep yourself afloat. Liquidity is like oxygen… you don’t notice it until it’s gone.
Rebalance away from your winners – as hard as it is to move away from assets that have worked so well, nothing goes up forever. Continue to be diligent about rebalancing even when things look like they’re only going up.
Don’t believe the hype – Whether it was SPACs early in the year, meme stocks in the middle part of the year, or growth stocks for the past decade, don’t get caught up in the latest fad. Buy high quality assets and hold them for many years and the valuation will matter less and less through time.
See the big picture – it’s hard not to get caught up in the fast money world of NFTs, 10x investments, and the like but, trust me on this one, they never end well. Stick to your plan and stay humble… focusing on the long term is always a winning strategy.
Good luck out there… remain in your seats at all times and reach out if you need an in-flight check-in.