Monthly Archives: October 2009

It’s Not That Random

I am continually amazed that some people still look at investing as a random walk.  Perhaps this idea stems from the lingering effects of Burton Malkiel’s 1973 book “A Random Walk Down Wall Street.”  Professor Malkeil’s thesis centers on the difficulty of “beating” the market.  He shows that investors who use either technical or fundamental analysis will generally do no better than ones who employ a passive (i.e. index funds) strategy.  His work and all that followed it seem to hold up pretty well when considering the “average” investor and all investors taken as a whole.  In aggregate, investors may not beat the market over time, but that does not mean that every investor fails to beat the market.  His work cannot account for great investors such as Warren Buffett, Peter Lynch, John Neff, George Soros, Julian Robertson, Bill Miller and so on.  It also fails to explain why billions of dollars in hedge funds continue to perform better than the market year after year.

I think some people must find comfort in the idea that investing is random.  Often it appears to be random.  We all have heard stories about somebody’s brother-in-law or cousin once buying a stock and seeing it go up 100% (or whatever).  Often the beneficiaries of this good luck have limited experience with the markets and no formal training.  Thus, this twisted logic goes, if this person can make money in the market, it must not be that hard or it must be random.

From this point of view, it’s very easy to conclude that investment is akin to gambling.  You place your bet (buy a stock, for example), roll the wheel (wait a while) and then either collect your winnings (the stock goes up) or mourn your losses (it goes down).  The idea that there might be a way to remove some randomness from this exercise probably never crosses the gambler’s mind.

Professional investors have many tools available to them, which may be generally out of reach to the individual investor.  Let me briefly suggest four of them which I consider important.  First is time.  Someone who is looking at the market every day as a full-time job is very likely to do better than someone simply doing it as a hobby.

Second is information.  Although the average investor has good access to public documents such as annual reports, their potential information flow is only a trickle compared to that from which the professionals drink each day.  From expensive databases to daily market intelligence from professional prop traders; from direct communication with CEOs to the ubiquitous Bloomberg terminal; from company visits to complicated computer algorithms, the professional has a much better information flow to aid in making decisions.  I’m not talking about “insider information,” the use of which is illegal, but just better and/or more information.  Better information often leads to better decisions.

Third is training.  One does not need a degree in finance, accounting nor the CFA (Chartered Financial Analyst) designation to be a good investor, but it surely helps.  In my view, the better one understands statistics, calculus, economics, accounting, probabilities, corporate finance, monetary policy, taxation, valuation measures, human nature and the laws of physics, the better investor one could be.  Simply buying a stock based on one “high concept” idea (renewable energy, for example), is a recipe for doing no better than the proverbial random walk.

Fourth is experience.  Pattern recognition is an important component of investing, and those who have been through a number of investment cycles (bear and bull markets) are more likely to make good decisions at crucial times, exactly because they have “seen this before.”  I’d be the first to admit that I had many white-knuckle days during the last year, but despite all of the uncertainty and dire pronouncements that “this time is different,” I could draw some comfort from the fact that I had seen similar levels of fear before – both in 1987 and 2000.  These experiences helped to guide me through the worst of the bear market and to prepare me for the next phase of the investment cycle (the new bull market).

I am not suggesting that investing is easy.  It is a very challenging exercise, one that is very different than gambling.  The professional investor has tools that can skew the odds of success in his or her favor.  For those of us who have chosen this path, it can also be a very satisfying and rewarding exercise.

It’s Just a Number

Here it comes – another grumpy post…

Sure, I’m as happy as anyone that the Dow Jones Industrial Average (DJIA) has once again breached the 10,000 level. Yet all this attention over the attainment of one particular level – we sure love big, round numbers, don’t we? – is, in my view, really beside the point. The fact that the 10,000 level is big news is just another sign that a large percentage of the population looks at the stock market as one thing – the DJIA. These reports fail to note that the DJIA is comprised of only 30 stocks, 30 big stocks. Until recently, it contained former “blue chip” names such as Citigroup (C) and General Motors. Most of the Dow companies are “American” only in that their headquarters are located in the United States. A huge portion of these companies’ revenues and profits come from operations outside this country. Most of them are experiencing solid growth in China, Brazil and other so-called emerging economies. My point is that the DJIA represents just an abstract number, a data point which actually represents the aggregate opinions of thousands of investors regarding each company – its valuation and future prospects.

For me, the bigger celebration should have been August 3rd of this year, when the S&P 500 broke through the 1,000 level, which in addition to being a nice, round number, was an important resistance level, and is now a key support level. Most people who invest in stocks don’t just buy “the market;” they buy Raytheon (RTN), Agrium (AGU), OM Group (OMG), or whatever. The concept of the market being just one thing, one number, probably increases the common misconception that investing is akin to gambling. The market goes up; it goes down. It may seem quite random to many people. This is unfortunate.

Stock prices are higher than they used to be because interest rates are low, earnings are growing and skepticism is still high. These are not random forces – they are powerful, sustaining and sustainable forces. The Fed wants to maintain low interest rates to aid many industries, including autos, finance and housing. Earnings have been growing due to aggressive cost cutting from the early days of the recession and a resumption of spending. Skepticism and cash levels are high because investors have been dealt a gut punch, which may take a while to get over. Oh, and by the way, many of the “gurus” on television told them to sell stocks and hold cash earlier in the year.

Many of the articles “celebrating” the 10,000 level were replete with warnings from traders and strategists suggesting that the party can’t last and that “the market” is ripe for a fall. In my view, this is the real reason to celebrate this level – people are still very worried about a lot of stuff. This concern, this worry will keep sentiment from becoming overly bullish. Overly bullish sentiment is one of the things I really get worried about.

The typical bull market lasts about 4 years and can propel “the market” to a multiple of its bear market trough. For me to predict that we could see Dow 20,000 by 2013 would break all three of my rules of making predictions: 1) if you predict level, don’t predict timeframe, 2) if you predict timeframe, don’t predict level and 3) I don’t make predictions. Yet, if this bull market turns out to be normal, 20,000 by 2013 would not be unexpected. Remember folks, you heard it here first…

Where’s the Love?

One sign that we are in a new bull market, in my opinion, is how excited everyone seems to get whenever the market goes down a bit (like it did on October 1st) or when a bit of disappointing economic news is released (like today’s employment report).  It is as if people don’t really believe that the stock market rally, which started in March, is real.  This has led to an uncomfortable feeling by many investors that hovers awkwardly over the triangle whose corners are marked by “fear”, “hope” and “despair.”  Because of the massive hit investor wealth has experienced (although we would note that the market is only down 8% from this time last year!), investors fear that all the recent gains could be somehow wiped out in an instance.  They hope things will get better, but so much of the commentary aired in the media focuses on huge, potentially negative imponderables such as the U.S. government budget deficit, the weak U.S. dollar, inflation, etc., that this hope easy turns to despair whenever we hit a patch of bad news.

To me, this bruised and confused investor psyche is actually a positive thing.  It suggests that investors have learned from past experiences, and that they are not quickly embracing risk assets just because they might go up.  The fact that investors are carefully weighing their feelings about risk and reward is a very healthy development.  Part of the whole sub-prime fiasco was due to investors not accurately measuring risk (why is that AAA-rated mortgage bond yielding more than other AAA-rated bonds?), and the consequences which followed taught us all a lot about the risk/reward continuum.

Indeed, this is a rally which is hard to love.  But then, most bull markets begin in the detritus of a recession.  They are hatched under the cold light of dimmed expectations and loss.  They are nurtured by fragile and tottering economies.  They appear truly healthy and strong and receive universal adoration by the masses only when they are near the end of their run.  Yes, bull markets usually end only when the most conservative investor places his last farthing into that “can’t fail” spec trade or the person so close to retirement “finally” shifts all of her 401k money into small cap growth funds.

Early bull markets aren’t meant to be loved.  Because we can’t truly be sure what they are, it is normal to fear them a bit.  Those who can accept the risk inherent in the young bull should be rewarded more than those who wait “for the dust to clear.”  I believe that focusing on the big picture (the big three positives – growing earnings, low interest rates and bearish sentiment) is really the best way to invest right now. The occasional bad day in the market or disappointing economic data point may be enough to cause a lump in the throat, but not enough to force a course change.