Can we learn about investing from puppies?

Image: João Braun. Source: Pixabay.

There’s a study of probability and random walks called “A Drunk and Her Dog.” The idea is that if a person comes out of a bar – heavily intoxicated – and starts wandering home, their path will resemble a random walk. Each step is independent from the other. The same could be said of a puppy: every new scent and every new sound dictates a new path to explore, the last sniff forgotten as soon as the next stimulus arrives.

Both the puppy and the drunk follow random walks. But if the puppy *belongs* to the drunk (and vice versa), the puppy will yip and the drunk will move towards him to let him into the house; the puppy will try to steer towards his mistress, if only to avoid getting locked out. If you follow either the drunk or the puppy, each path will look like aimless wandering. But the two paths are cointegrated: there’s an error-correcting mechanism to their madness. Neither wants to get too far from the other.

Cointegration can be found in financial markets. Securities markets are open, free, and competitive spaces where large numbers of well-informed professionals compete skillfully, vigorously, and continuously as both buyers and sellers. It’s no wonder that prices appear to follow a random walk, jumping at every new development. We don’t know tomorrow’s news, so on any single day, the easiest way to know where a stock’s price will be is to ask where it was the day before – just like the way to find a puppy is to ask where he was a minute ago.

But another way to find the puppy is to ask where his mistress is headed, because the puppy is likely to follow her. And if stocks are like the puppy, fundamentals are like the mistress. Both of their paths may appear random, but they never completely disconnect from each other. Stock prices are tethered to their fundamentals, and fundamentals are impacted by the stock price.

Here’s a picture of fundamentals and prices:

S&P 500 and Estimated Forward Earnings P/E Ratio 1986 – 2022. Source: Bloomberg.

The relationship between stock prices to company earnings moves around a lot over time. Some folks might say it was a random relationship. But it’s surprisingly close. On average, the market never gets too far from its earnings. And on average, earnings have gone up, driving stock prices up. Because, ultimately, investing isn’t about ETFs or mutual funds or bits and bytes. Stocks represent partial ownership of real companies that make and sell real products for a profit.

On any given day, markets and fundamentals will surprise us. We don’t know the future. But over time, growing fundamentals will help stock prices grow. And growing markets help everyone do better – even tipsy dog-lovers with their puppies.