Tag Archives: financial markets

Combining Stock Picking and Stock Indices

In A Random Walk Down Wall Street, Burton Malkiel suggests owning stock indices as the best way to trade in the market. He writes, “Indexing is the strategy I most highly recommend for individuals and institutions” (402). An exchange traded fund (ETF) trades like a stock, but consists of more than one stock (i.e. a fund). For example, the SPDR S&P 500 (ticker: SPY) is an ETF that tracks the Standard & Poor’s 500-Stock Index. Malkiel highly recommends purchasing a portfolio of all companies in an index such as the S&P 500 because you avoid the challenges of identifying between winners and losers, which might actually be impossible. According to Malkiel,

The logic behind this strategy is the logic of the efficient-market hypothesis. But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. (391-192)

As a result, owning a stock index is a smart and effective way to invest in financial markets. If the efficient market hypothesis (EMH) is correct, then purchasing an index is the only sensible decision since there is no way to correctly pick winning stocks. If the EMH is not correct, then purchasing an index will still at least produce the market return.

Despite these wise words, many investors still wish to be stock pickers. According to the Wall Street Journal, “Here’s the latest evidence that stock picking is back: Investors are buying and selling fewer exchange-traded funds… The data suggests that investors are increasingly favoring trades in individual stocks”. The article suggests that investors’ preference for ETFs is dependent upon the predominance of macroeconomic headlines. When macroeconomic issues dominate the news, then the correlation among stocks increases. Macroeconomic data contributes to systematic risk, which is something that all stocks are exposed to. According to Malkiel,

Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. (217)

When positive macroeconomic data is released, then all stocks will likely rise. When negative macroeconomic data is released, then all stocks will likely fall. As a result, investing in an ETF is an effective way to increase your exposure to systematic risk and diversify away unsystematic risk (i.e. factors particular to an individual company). And when macroeconomic issues become less prevalent, then investors would rather conduct stock picking.

Although Malkiel much prefers investing in indices, he understands that not all investors will always prefer investing in indices and offers four rules as a guide for selecting individual stocks. According to Malkiel, “Rule 1: Confine stock purchases to companies that appear able to sustain above average earnings growth for at least five years” (403). Following this rule will help investors select stocks with potential for future earnings growth. If the investor is successful, then the stock will increase earnings and the stock’s multiple might increase as well. According to Malkiel, “Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value” (403). Although Malkiel believes that it is impossible to calculate the exact intrinsic value of a stock, he does believe one can assess whether a stock is reasonably priced using the price-to-earnings (P/E) multiple. If a stock is trading at a P/E multiple that is significantly above the market average and the company’s growth prospects are not significantly above average, then that stock is overpriced and an investor should not but it. According to Malkiel, “Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air” (404). Due to the importance of psychological elements in determining stock prices, stock prices can skyrocket as investors’ expectations about future growth increase. Although predicting the expectations of investors in the future is inherently challenging, it is still a worthwhile pursuit. According to Malkiel, “Rule 4: Trade as little as possible” (404). Transaction costs such as broker fees and taxes can erode the profit from any investment strategy. In short, investors must resist the urge to trade frequently.

Although I am a strong believer in using ETFs to invest in entire indices, I also think there is a place and a time for picking individual stocks. After an investor has a well diversified portfolio, I believe an investor can take the risk and choose individual stocks. If an investor follows Malkiel’s  four rules, then I think stock picking can supplement ETFs.

Technical Analysis: Dow Theory

Early yesterday morning, I received my daily email from the Wall Street Journal. The “Morning MoneyBeat” provides insight on recent developments in the markets. According to the Wall Street Journal, “The much ballyhooed Dow Theory is flashing a warning sign: While the Dow Transports made a new high in March, the Dow Industrials did not. The latter’s failure to hit a new high is currently a red flag”. Having read A Random Walk Down Wall Street, I was familiar with Dow Theory as a form of technical analysis that focuses on resistance and support levels. According to Malkiel, “The basic Dow principle implies a strategy of buying when the market goes higher than the last peak and selling when it sinks through the preceding valley. There are various wrinkles to the theory, but the basic idea is part of the gospel of charting” (147). In this particular wrinkle of Dow Theory, the two critical components are the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average. The DJIA is probably the most followed stock index along with the S&P 500. The DJIA consists of thirty companies in a range of sectors. For example, it includes Goldman Sachs (financials) and Cisco (technology). The Dow Jones Transportation Average includes twenty transportation companies such as Delta and FedEx.

Although I am not a believer in technical analysis, I thought the logic behind the DJIA and the Dow Jones Transportation average as two components for Dow Theory might have been legitimate at one time. According to the Wall Street Journal,

Well followers of the century-old Dow Theory – popularized by Charles Dow – maintain the industrials and transports need to move in lockstep to confirm a market’s trend… The theory is based on the thinking that making goods is one leg of the industrial economy and moving those goods around is the second leg, so their trends should be in sync“.

The DJIA began as an index made up of primarily industrial companies, however, it now includes companies in a range of sectors. Although at one point it might have been true that the DJIA and Dow Jones Transport Average moved together, the DJIA composition of companies has changed significantly over the years to the point where it no longer makes sense to assume the two indices move together. For example, Goldman Sachs does not produce many goods that need to be physically transported. The only exception I could imagine is sending employees on business trips with Delta Airlines. As a result, I do not think the two indices still move together.

Regardless, executing trades based on Dow Theory is inherently flawed and will not allow you to make investments ahead of market moves. According to Malkiel, “Relative to simply buying and holding the representative list of stocks in the market averages, the Dow follower actually comes out a little behind, because the strategy entails a number of extra brokerage costs as the investor buys and sells when the strategy decrees”. Transaction costs associated with buying and selling securities would eat into any profits a Dow follower might (luckily) earn. An inherent flaw in a technical strategy like Dow Theory is that it relies on analyzing past price movements to predict future price movements. Unfortunately, relying on technical analysis will rarely prove fruitful.

Fed Meeting: Staying the Course Spooks Markets

During the meeting of the Federal Reserve today, there were no surprises. According to the Wall Street Journal, “The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December”. Asset purchases, which have been reduced from $85 billion a month, are on pace to be finished this coming October. Tapering and the ending (in the growth of) asset purchases was already priced into the market before the Fed’s meeting. In short, tapering is old news. Although asset purchases will likely be done in October, it remains to be seen how the Fed unwinds its massive balance sheet.

The Fed made some (relatively) more exciting changes with respect to forward guidance. According to the Wall Street Journal, “The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start”. As the unemployment rate has decreased to 6.7%, the 6.5% threshold for unemployment has become a less significant data point for policy makers. Furthermore, limitations of the unemployment rate have made it less meaningful as an indication of conditions in the labor market. I have mentioned in previous blogs that changes in the unemployment rate were not accurately portraying underlying conditions in labor markets . For example, an increase in the labor-force participation rate pushed the unemployment rate up to 6.7% in the last employment report. Although an increase in the labor-force participation rate is perceived as good, an increase in the unemployment rate is seen as bad. According to the Wall Street Journal, “It said instead [of the 6.5% unemployment threshold] that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008“. Therefore, I believe it was a good decision to ditch the unemployment threshold in favor of a larger set of economic indicators.

In addition, the Fed reconfirmed its forward guidance on interest rates. According to the Wall Street Journal, “The Fed took several steps to assure investors that interest rates won’t rise soon and that when rates do start rising the increases will be gradual and limited. For example, the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends“. Although this policy has been understood for some time, the Fed has finally decided to state this unambiguously. As the Fed continues to taper, most people assume that rate hikes will follow – the question is how soon they will follow. In addition to other factors, the inflation rate is going to be important in determining when interest rates will rise. If inflation remains below target, then rates will remain low long after the bond buying ends.

However, financial markets fell today – possibly due to what was said during the Fed’s meeting. According to the Wall Street Journal, “Even though the Fed’s official policy statement sought to give assurances of continued low rates far into the future and Ms. Yellen played down rate-increase expectations, stock prices fell and longer-term rates on Treasury bonds moved up”. Despite the lack of surprises, the Fed’s meeting managed to somehow cause worry among investors.

Apparently, the source of concern was regarding the perception of imminent rate hikes. According to the Wall Street Journal, “In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends – a conclusion that could come this fall”. Financial markets were not anticipating interest rates to increase in early 2015. After many years of aggressive expansionary monetary policy, the financial markets have become very sensitive to interest rate decisions.

Today’s Fed meeting essentially affirmed that interest rates will begin rising in 2015. Considering that asset purchases will likely end in October 2014, interest rate hikes in 2015 might seem sudden to financial markets. Regardless, I believe interest rates will begin rising in 2015 so financial markets might as well begin pricing that in. According to the Wall Street Journal, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015“. Although Ms. Yellen might have misspoke during the press conference, I think it is good that she was very clear about when interest rates will begin rising. Assuming there are no setbacks, I believe the economy is strengthening to the point where interest rates can begin to rise.

Financial Markets: Expensive Relative to Earnings?

The bull market in the United States is old news. Stocks rose again today. According to the Wall Street Journal, “The Dow Jones Industrial Average rose 181.55 points, or 1.1%, to 16247.22, its biggest daily gain in two weeks“. The question is how long the bull market will continue.

An important determinant for the duration of the bull market (i.e. rising stock prices) is corporate profits. According to the Wall Street Journal, “Some of the tectonic plates under the market also are shifting. Bit by bit, stocks have become more expensive compared with the profits of the corporations that issue them. High stock prices make would-be buyers wary, just like high prices for anything. At these prices, the goods, in the form of corporate sales and profits, have to be very high quality”. The notion of this statement is that high prices should be justified with high corporate profits. If high prices cannot be justified with high profits today, then high prices must be justified by high profits tomorrow. For example, Amazon trades at a very high price because of high expectations about future profits. According to Burton Malkiel in A Random Walk Down Wall Street, “Hazardous as projections may be, share prices must reflect differences in growth prospects if any sense is to be made of market valuations”. Such growth prospects reflect expectations about the future, which are inherently risky because the future is hard (maybe even impossible) to predict. In order to determine the health of the bull market, we must consider corporate profits both today and tomorrow.

A very common financial metric used to relate different stocks is the price-to-earnings multiple. According to Malkiel, “[Price-earnings (P/E) multiples rather than market prices] provides a good yardstick for comparing stocks – which have different prices and earnings – against one another”. The P/E multiple is calculated by dividing today’s stock price by the most recent earnings-per-share (EPS). Looking at the P/E multiple for two stocks provides useful information about differences in investor sentiment. For example, Amazon trades at an extraordinarily high P/E of 644 because it has a high price relative to its earnings. According to Malkiel, “It is clear that, just as Rule 1 asserts, high P/E ratios are associated with high expected growth rates”. Amazon’s high P/E reflects extremely positive investor sentiment regarding future growth. On the contrary, Apple’s P/E multiple is only 13. Although Apple earns much more than Amazon, investors have much lower expectations about future growth. At one point, Apple had a much higher P/E multiple. Stock prices change rapidly to reflect expectations about the future.

If we consider the P/E of the entire stock market relative to historical averages, then current stock prices seem high. According to the Wall Street Journal, “FactSet, for example, compares stock prices to companies’ earnings from operations for the past 12 months. That figure today is 16.4, up from 14.5 a year ago. That is well above the historical average of 14. Stocks topped out at this level in 2007 but in 2010, they returned to this price-to-earnings level and kept rising”. I believe historical averages have significant merit – especially relative to future projections, which are unreliable. One way to interpret the high P/E multiple of today’s stock market is that it is a result of high expectations for future growth. If today’s high expectations are not met tomorrow, then stock prices would likely fall to reflect lower expectations and P/E multiples.

Despite today’s relatively high P/E multiples, some investors might have reason to believe that stocks can rise indefinitely. According to Malkiel, “Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing”. Technical analysis assumes that stock prices reflect all available information and its followers analyze stock charts in order to interpret trends. If you believe in the castle-in-the-air view of stock pricing, then you might think stock prices can rise forever. According to the Wall Street Journal, “Barring a return to the irrational exuberance of the 1990s, stocks could find it hard to repeat 2013’s exceptional returns, and they could be in for a pullback”. Although financial markets might seem expensive to a fundamentalist (i.e. someone who performs security analysis such as analyzing P/E ratios), they might seem cheap to investors with irrational exuberance (i.e. investors who perform technical analysis).

Environmental or Genetic?

I read a very interesting article on Jason Zweig’s Wall Street Journal column today. Zweig depicts a childhood moment for Benjamin Graham, the author of “The Intelligent Investor”, that seemed to have impacted his investing strategy. Graham’s mother was a speculator who lost money in the Panic of 1907. According to the Wall Street Journal, “Graham never forgot the ‘humiliating’ moment in his childhood when his mother sent him to cash a check and the bank teller asked the manager if Mrs. Graham was ‘good for five dollars’”. Graham went on to become a one of the most successful investors ever and he utilized a strategy that focused on value investing. Graham was a champion of security analysis in which he searched for companies that were so despised by investors that they were trading very cheaply. Unlike speculating, this type of investing requires research in order to understand business fundamentals.

Although the environment that one grows up can powerfully shape the kind of investor you become, genetics might play a large role in whether an investor prefers cheap (unfavorable) stocks or expensive (favorable) stocks. According to the Wall Street Journal, “[Mr. Klarman, president of the Boston-based Baupost Group] went on to speculate that most people might possess ‘a dominant gene’ for chasing hot performance and overhyped assets, while only a minority have ‘the recessive value gene’ that confers a patient preference for whatever is battered and unpopular”. I think this is an extremely interesting idea, as it would mean that Graham might have been genetically destined to be a value investor. On the one hand, I do agree that genetics possibly might play some role. On the other hand, I certainly feel that the environmental conditions have a meaningful impact on whether an investor is comfortable with speculation or prefers thoughtful security analysis. For example, in my own experience growing up and witnessing the financial crisis of 2008-2009 has very much changed my perspective. I have vivid memories of the stock market decline and the extreme uncertainty it caused. As a result, I am cautious of asset bubbles and try to make informed decisions when I invest.

Furthermore, I participated in the Facebook initial public offering and watched as the stock underperformed in its first few weeks of trading. My experience with the Facebook IPO combined with the recent financial crisis, seems to have cemented my thought process as a value investor. In my opinion, the concept of speculation seems like gambling in which probability is your only friend. Despite my poor experience with Facebook (which has since risen in value and regained my favor), IPOs in general have been performing well recently. According to the Wall Street Journey, “Newly public companies have emerged as a bright spot for investors amid a nearly flat performance this year in U.S. stock market”. Although I am extremely skeptical of initial public offerings, this recent strong performance makes me reconsider my stance. For example, Twitter popped after its IPO and is still significantly higher than its IPO price. History shows that on average IPOs tend to outperform in the short-run, but underperform in the long-run.

My caution towards investing during an IPO is not only because of my recent experience with Facebook, but is also because of the lack of past performance as a guide. I value past performance because it provides an estimate of the future. Although one should not place significant faith in past performance, it at least provides realized returns that might serve as a basis for future expectations of returns.