Covid-19 Diary Number 9 (July 31, 2020)

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Frequently in these posts, I have warned against market timing.  Though timing buy-and-sell decisions of individual stocks can have merit, timing such decisions in anticipation of moves in the overall market is simply too dangerous and is as likely to produce failure as it is success. By contrast, buying and holding a portfolio of stocks for the long term puts history and probabilities on your side.  The timing temptation is nonetheless ever-present and is especially intense in times like now, when the pandemic has birthed extreme market volatility.  So this might be a good time to explain exactly what an investor is doing when he or she decides to time market moves.

 The ultimate theoretical commentary on this subject comes from Prof. Burton Malkiel’s A Random Walk Down Wall Street. In this book, first published in 1973 and the latest edition in 2019, he argues that most investors continually digest the endless flow of information coming from the economy, politics, and specific bits of business news, and use this information to assess existing stock prices and whether to buy or sell.  But these continual price adjustments, the professor demonstrated, happen almost instantaneously; and because no one can know the next bit of news, the market appears to move in a random pattern from day to day, even moment to moment (hence the title of his book).  Whatever you see in the news, Malkiel demonstrated, the market has already digested and adjusted stock prices.  There is no way to get ahead of the process.

Much of the financial community agrees with Malkiel, though these practical men and women hesitate to describe the market’s reality in quite the definitive way he does in his theoretical exposition.  Sometimes, they say, some people can anticipate market moves, and not all moves are entirely random.  To make the point, Wall Street tells a joke at the professor’s expense: If you are walking down the street and see a five-dollar bill on the pavement, the good professor will tell you that it really isn’t there, that someone else has already picked it up.  The Wall Street crowd claims that sometimes the five-dollar bill really is on the pavement – meaning you can sometimes have a sense of the market’s next move.  Still, most practitioners understand Malkiel’s point and warn that timing efforts are always fraught.  To see why, consider how market timers implicitly claim to possess one of two nearly impossible abilities:

  1. The timer effectively claims to know the news before the fact. If this timer sees good news coming, he or she buys in anticipation of the market’s coming upward price adjustment.  If that timer anticipates bad news, he or she sells in order to re-buy at lower prices when the market gets the news and adjusts prices downward.  This market timer is acting on the assumption that he or she can see the future – a most dubious claim.
  2. The market timer may not claim an ability to see the future but effectively asserts that the mass of investors operating in the market have collectively misjudged the meaning of the available news and accordingly have priced stocks incorrectly. If this timer thinks that pricing is too low, he or she buys in anticipation that the market “will come to its senses” and adjust prices upward, regardless of the continuing flow of news.  If the timer thinks pricing too high, he or she sells in anticipation of the opposite adjustment.  Here, too, is a dangerous arrogance that the market timer knows better than anyone else where pricing should be.

Such insights – whether on the future or on appropriate pricing – come rarely and are as likely to be wrong as correct.  Acting on market timing is always dangerous.  Sometimes, however, investors show such irrational enthusiasm, or such unlikely despair, that the claims behind an investor’s timing decision do not look as outrageous as they otherwise might.  In such rare cases, timing may have a place, but even so, investors should not kid themselves about the risk involved.

COVID-19 Diary Number 8 (July 14, 2020)

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It seems that many people have begun to see the market rally as an opportunity to get out whole, or nearly so, after the frightening losses of late March. They despaired three months ago when stock prices went off a cliff, and now that prices have regained much of the lost ground, they wonder if they should get out while the getting is good. They don’t have reason to forecast another plunge in values; they just want to avoid the pain of another March experience.

Such anxiety is understandable.  March’s stock price retreat was unnerving and no one wants to go through that again.  But before selling out, investors should consider two things:

  1. Do they have an immediate need for the money? If they do, then the recent price recovery is a wonderful opportunity for them to get out of stocks –– not because prices have risen, but because (as readers of these blogs should know well), they should not have been in stocks in the first place.  Equities are only for those who have no need for the money for at least five years.
  2. If they do not need the money now or for the foreseeable future, they should consider the investment alternatives. There are five choices, none particularly attractive compared with stocks.  Though some might offer less volatility than stocks, the cost to the investor is lower potential returns:

–Cash is one option.  Cash deposits and certificates of deposit (CDs), unlike stocks, offer assurances that you will get your money back no matter when you want it. But these “cash vehicles” pay extremely low returns.  Deposits — whether at commercial banks, savings banks, credit unions, or money market mutual funds — all pay less than one percent a year.  CDs pay a little more, but you must tie up the money for at least a year to get that higher rate of interest –– and you will pay a penalty if you take it out early.  This post will give you more detail.  In all cases, the returns on deposits are less than the rate of inflation.  The cost of living, in other words, is rising faster than what the investor can makes on deposits of any kind.  The real buying power of what you invest in these instruments will decline, even though the dollar amounts you get back will rise. 

–Quality bonds offer yields above the rate of inflation, but only slightly.  That might have an appeal, but the yields are still low.  What is more, the odds are good going forward that the yields will rise, which means that the bonds you buy today will lose value tomorrow.  For an explanation, see this post.

–You can get a higher rate of return if you are willing to invest in the issues of companies that are less credit-worthy.  But when you invest in these so-called junk bonds, you risk fluctuating prices or even the outright bankruptcy of the issuer, which makes this alternative as volatile and emotionally fraught as stocks.

–You could turn to commodities — precious metals, industrial metals, foods, etc.  If the economy does well, these prices will rise, as will stock prices.  But as with stocks, there is a significant downside on commodity prices should economic prospects deteriorate.

–You might take your investment funds overseas. Stocks and bonds in other developed markets — Europe, Japan, Australia, Taiwan — have all the same potentials and risks as those in the United States, so they hardly offer a haven for those wanting to flee volatility.  They do have a place in a portfolio, as explained in this post but they are not a hiding place for the frightened.  Emerging markets, as explained in this same post, have appealing long-term characteristics, but are actually more volatile than U.S. stocks.

If you want to be “cute” and take the risk, you might take some money out of equities and sit on it in the expectation that some future disappointment will bring a stock price retreat, and then you might redeploy that money effectively. I described this strategy here.  “Cute” is the best way to describe it, because it violates the basic principle that stocks are for the long term, and no investor, no matter how clever or well informed, can time market swings.

 

COVID-19 Diary Number 2 (April 6, 2020)

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Though no one can yet say how the virus will continue to develop in the U.S., and therefore how the markets will go, a review of the past few weeks can allow this conclusion (with apologies to Winston Churchill at the end of the Battle of Britain): This is not the end or even the beginning of the end, but it is the end of the beginning.

Whenever markets suffer a shock – a collapse somewhere in the economy, natural disaster, war – participants panic.  This happened in March as the extent and severity of the Covid-19 pandemic became apparent.  Such panic could of course return if markets were to suffer another terrible surprise, but their recent behavior suggests this beginning phase of the market correction seems to have ended:

  • Equity prices have clawed back some of the ground lost to March’s panic. Stock prices fell precipitously between February 21, and March 23, with the benchmark S&P 500 stock index sliding almost 35 percent in just some four weeks, wiping out all the impressive gains of the prior three years.  Since then, investors seem to have recovered the sense that perhaps pricing had anticipated the worst, especially since the Federal Reserve (Fed) and the government have initiated policies to mitigate if not erase the recessionary effects of the measures needed to fight the spread of the virus. Pricing has begun to improve.  Stocks have risen some 19 percent from those lows, still some 21 percent below the highs of February, but a sign that panic has passed for the moment. 
  • Bond markets, while still fearful, remain relatively stable. On the first news of pandemic, Treasury yields fell precipitously, with the yield on the 10-year note dropping from just under 2.0 percent at the end of January to just over 0.6 percent by mid-March. To a large extent, the move reflected the Fed’s efforts to drive down all interest rates and bond yields. A flight to quality also was an element here.  As investors sold off bonds issued by entities with lesser credit ratings and put the proceeds into presumably safer Treasury issues, the yields on all other bonds actually rose, widening the yield spread lesser credits offered over Treasuries from a little over 3.5 percentage points late in February to just over 10.5 percentage points late in March.  This was not as high as the 20 percentage point spread that prevailed for a while in the Great Recession of 2009, but it’s hardly a sign of confidence. (This post will brief you on how bond prices and yields interact.)  The past few weeks have seen only modest improvement.  these yield spreads have declined to some 9 percentage points –– hardly much improvement but nonetheless a tentative sign of relative calm.
  • Commodity markets tell a similar story to bonds.As the lockdowns and quarantines effectively shut down the economy, industrial materials prices dropped quickly. Copper prices illustrate the common story, falling by almost 20 percent from early to late March. Oil prices did worse, falling some 40 percent during this time, though extra pumping by Saudi Arabia (because of a dispute with Russia) exaggerated the general price retreat. Prices of oil, copper and most industrial materials have since risen slightly –– again, not a sign of confidence but at least a halt to the earlier panic.
  • Currency markets, in contrast, have all but corrected their earlier panic.  When the seriousness of the pandemic first became evident, money moved toward dollars, as it does in almost every emergency.  A global index of the dollar’s value rose some 5 percent, but has nearly returned to its level of early March.  Some might interpret this as a sign that Covid-19 infections in the U.S. have risen, but on a per-capita basis the American infection rate is no worse than in most developed countries and a good deal better than some.  The movement away from the dollar speaks to a lessening of panic.

All this could change if COVID-19 changes its course.  If it worsens, panic could reappear, and the markets would return to their levels of late March or even lose more value.  But if the effects of the disease ease and promise a return to more normal levels of economic activity, the relative calm of recent weeks suggests that markets could regain ground quickly.

The Good Professor’s Measure

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A reader and good friend recently sent me an article by Robert Shiller, Nobel Laureate and Sterling Professor of Economics at Yale University.  In it, Prof. Shiller uses his own tool for evaluating markets, the so-called C.A.P.E. price-earnings ratio, to make the case that markets are overpriced and that the current market rally is running on emotion. Prof. Shiller is an impressive man, with credentials to boot.  His warning that a market correction is in the cards may well be correct, but his prediction gives me the opportunity to warn readers, once again, about the hazards of forecasting and trying to time the market.

The Shiller C.A.P.E. ratio has been around for a long time.  It differs in two ways from the conventional price-earnings ratio discussed here.  First, where the conventional ratio divides stock prices by recent or future earnings, the Shiller ratio divides the price of stocks by their average earnings over the last ten years.  Second, unlike the conventional ratio, the C.A.P.E. adjusts the earnings to take inflation into account.  Shiller argues that his two adjustments uncouple his ratio from problems associated with the conventional ratio, especially with respect to recessions.  When the economy pulls back, corporate earnings typically drop faster and further than stock prices, so that at market lows, when people should be buying, the conventional price-earnings measure looks high, suggesting that stocks are overpriced.  Shiller’s measure, because it uses long and deflated averages, gets away from this misleading effect.

It seems strange to adjust the earnings for inflation.  After all, stock prices – the point of comparison – are not adjusted for inflation.  The use of a long average introduces other problems.  Because earnings rise over time, his use of a ten-year average tends to make the C.A.P.E. ratio look high and the market therefore look overpriced much of the time.  Together, these effects make the C.A.P.E. measure give a sell signal even when much else suggests that stocks are a good buy.  Here are three illustrative examples:

  1. C.A.P.E’s implicit pessimism was certainly evident during the earnings and market surge between 2017 and 2019. Leading up to 2017, earnings had disappointed, biasing downward the ten-year deflated earnings average.  As a consequence, as 2017 drew to a close the C.A.P.E. measure indicated less attractive market valuations than at any time since 2001.  C.A.P.E. followers would have sold and missed the better than 20 percent appreciation in stock prices over the last two years.
  2. The recovery from the great recession tells a similar story. The C.A.P.E. ratio showed a buying opportunity in 2009, and it was a good opportunity.  The market rallied in the years following the recession’s end even though the economic recovery was disappointingly slow.  But because the ratio’s use of a deflated ten-year earnings average could not fully capture the post-recession surge in earnings, the Shiller ratio by the end of 2013 showed even less attractive stock valuations than at the start of the great recession.  Investors following the ratio would surely have sold and missed the huge gains of the next six years right up to the present.
  3. In 1990, the C.A.P.E. ratio showed the least attractive valuation in sixteen years. Yet the 1990s saw great market gains of some 274 percent!

The media’s treatment of Prof. Shiller’s efforts adds to the damage of these misleading signals.  He is a famous man and receives attention from financial journalists, who broadcast his warnings; several publications have given him his own platform.  When his early sell signals prove mistaken, people naturally forget them amid the endless flow of market commentary.  And when after several false warnings the market does correct – and there is always a market correction on the horizon – the media says, in effect, that he “got it right again,” or words to that effect.

My point is not to criticize Prof. Shiller and his efforts to chart market valuations.  He is a thoughtful and insightful man.  However, his is just one of many measures, all of which have their drawbacks.  We should not ignore Shiller’s work, despite the C.A.P.E. ratio’s sometimes misleading nature. But we should keep in mind that his measure’s failings show, compellingly, how difficult it is even for even the best-educated minds to forecast market moves and why timing the market is so dangerous, especially using a single measure.

Stock Basics

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Stocks remain a popular investment vehicle and with good reason – they amount to a wager on the economy’s future.  Equities, as stocks are often called, rise and fall according to all the particulars that affect corporate profits — but basically they rise when the economy has promise and fall during recessions or when investors otherwise doubt the economy’s prospects.  Because stock prices can at times move violently, investors, unless they are lucky timing their purchases and sales, will realize their best payoff over the longer term.  The longer you can wait for the returns, the more stocks you will have in your investment portfolio.  (More on this in a later post.)  

What Are Stocks?

Stocks are a partial ownership in all that the issuing firm owns and earns.  Companies issue stock to raise money, usually for expansion.  This money is called equity capital.  

There is no limit to how many shares a company can issue. Managements that prefer to limit ownership in just a few hands issue relatively few shares.  Companies with expansion plans that require a lot of financial capital often issue thousands of shares.  There are benefits and disadvantages to either approach.  Using equity (stocks) instead of borrowed capital (money) can make the company more financially stable.  In hard times, the firm has to pay lenders even if it makes no money, but shareholders can claim only a share of the profits.  The disadvantage of issuing more shares is that they dilute the value of existing shareholders.

The most common sort of stock is called, not surprisingly, common stock.  These entitle their owners to any distribution of company profits, called dividends.  Owners are also entitled to elect board members and vote on other basic matters of ownership.  Each share gets one vote, not each shareholder.  The largest shareholders generally have control of the company’s decisions.  Companies sometimes issue preferred shares.  These tend to command more generous dividends than common shares and usually stand before common shares should the company suffer bankruptcy, but they typically lack voting rights.

Making Money in Stocks

Stocks offer two ways to make money:

  1. Dividends are periodic cash payments (almost always quarterly) that management pays shareholders out of the firm’s profits, what financial people usually refer to as earnings.  Dividends are entirely at the discretion of the corporation’s board of directors.  Usually, the board makes its decision based on how much the company has earned and what other uses it has for the money — say investing in new facilities.  Companies that are growing fast and need to invest to keep up with their expanding business pay low or no dividends.  Slower growing firms with less need for the money pay higher dividends.
  2. A more important way of making money in stocks is price appreciation.  This is determined solely in the market where investors trade available shares of stock. Neither management nor the board of directors has any direct control over this activity.  If the company is doing well, earnings are growing, and there is a promise of further growth, people will want to own a piece of that action and their buying bids up the price of the stock.  This works in reverse if the firm faces trouble.  Appreciation can also reflect dividends.  Higher dividends will often attract buyers whose demand prompts price appreciation.

The Roots of Price Fluctuations

Stock prices fluctuate as investors alter their expectations of future profits.  Financial theory holds that the fair price of a stock is only a reflection of the flow of future dividends and the earnings that might support future dividends.  That future flow is discounted, because dollars you have today can be invested and earn money, whereas future dollars are inevitably uncertain and cannot earn until they are paid.  A well-regarded algorithm, called the “dividend discount equation” calculates a fair price for a stock by so discounting prospective earnings and dividends.  Anything that improves a company’s profits next to the expectations previously built into its price will to raise that stock’s price.  Anything that makes the future look more problematic tends to drive its price down.

A number of factors can influence these calculations, some general, some specific to the industries in which the company operates, some specific to the company.  A complete list would fill several volumes, but here are seven main issues that move stock prices:

(1) The Economy

Because profits generally follow overall economic activity, an improved economic picture promotes a general rise in stock prices, called a rally or a bull market.  Economic clouds prompt stock price declines, called a correction or a bear market. Because no one can know the future, stock investors continually assess economic trends and revise their opinions accordingly. The flow of news is continual.  The list of indicators, statistical or otherwise, is too long for this space and absorbs the attention of thousands who work in the industry, making it very hard for an individual to get ahead of the market’s regular reassessments.

The movement of interest rates also has an effect.  Because lower interest rates make borrowing cheaper and so more likely that consumers will spend and business expand, they usually signal an economic pickup that tends to lift stock prices.  An interest rate increase, because it has the opposite economic effect, tends to depress stock prices.  Interest rates also feed directly into stock valuations. Because higher interest rates offer better ways for your dollars to earn, they prompt investors to discount future dollars more severely, depressing stock prices.  An interest rate decline has an opposite effect.

(2) The Industry

Even more than changing perceptions of the general economy, industry-specific considerations move stock prices.  Are oil prices rising?  That’s good for those who produce oil and who service the oilrigs.  It’s bad for those who use oil — airlines and truckers, for instance.  A technological breakthrough may benefit some at the expense of others.  A bumper wheat crop abroad will hurt American wheat farmers by depressing the prices their harvest can command, but it could help food processing firms who buy grain. These few examples only hint at the constant flow of industry information that just as constantly changes market opinion and moves stock prices.

(3) Legislation and Regulation

Here, too, the flow of news is endless.  If Washington, for instance, were to support a major infrastructure-rebuilding program, prospects for construction firms would improve and their stock prices would rise accordingly.  A decision to step up defense spending would definitely boost prospects among defense contractors and so the prices of their stocks.  The Affordable Care Act (ACA) improved prospects for health care insurers (at least initially) by driving millions of new customers their way.  But such news can cut the opposite way.  The adverse effect of such spending on Washington’s finances might negatively impact stock prices by threatening to push up interest rates or taxes or both.

Regulation, at the national, state, or city level, can have its own effects.  Environmental rules will enhance the prospects of some firms at the expense of others, say solar over coal.  Stricter financial regulations after the crash of 2008-09 had a powerful effect on financial firms, especially smaller ones.  Safety regulations raise costs for some firms and industries but create opportunities to those that sell products to help other firms comply with those regulations.  Here, too, the flow of information constantly changes investor assessments of the future and thus stock prices.

(4) News About Staff

If a company hires someone with widely recognized ability, investors may expect an improvement in the company’s fortunes and buy its stock, pushing up its price.  The loss of a key executive can raise questions about the future and so depress the company’s stock price.  A large number of departures, even of not-so-famous, middle-level employees, can raise questions about the firm’s ability to manage and so push down its stock price.

Scandals also move prices.  A staff member who runs afoul of the law can depress the company’s stock price by increasing investor worries over fines or other legal actions. This sort of news tends to break suddenly, creating violent swings in stock prices.  Bad news for one firm, of course, might also lift the prospects of its competitors and so of their stock prices.

(5) The Firm’s Product Line

Any change in product line, positive or negative, will move the company’s stock in a sympathetic direction.  Drug companies are particularly vulnerable.  Bringing new drugs to market is a very lengthy process, and failure could cost these firms dearly.  Lawsuits involving pharmaceutical companies are more expensive than in other industries. But a successful new drug, sometimes referred to as a “blockbuster drug,” can lift profit prospects dramatically and the company’s stock price with it. Drugs are just one example.

(6) Natural and Political Events

Stock prices also respond to geopolitics and natural events. Revolution, war, elections, and natural disasters anywhere can disrupt business and affect stock prices.  Tariffs, much in the news today, can help the firms protected by them and hurt those who have to face them.  An earthquake could wipe out an industrial operation.  Even if insured, the firm’s stock price would suffer because the company would have lost its ability to engage in otherwise lucrative businesses.  If the disaster is large enough, that company’s insurers might find themselves facing huge payouts that could bring down their stock prices.  For investors, reassessment is always continual as is the movement of stock prices.

(7) Buybacks, Mergers, and Acquisitions

Management may from time to time decide to use retained earnings to buy back their own stock on the market.  Typically, it is done in lieu of raising dividends.  Such additional demand for the stock will tend to raise its price.  But when the buyback program ends, the sudden drop in demand for the stock can depress its price.

Mergers and acquisitions (M&A) happen for all sorts of reasons.  They usually generate a lot of drama and so a great deal of media attention. Sometimes the buyer sees what the financial community calls “synergies,” meaning that the business of the acquired firm has many similarities to that of the acquirer and hence opportunities for efficiencies or market dominance.  Sometimes the merger occurs between two quite different parties that see a way to diversify their respective product lines.  Some acquisitions are hostile— meaning that the firm being bought resists the transaction.   Others are amicable— meaning that both parties like the idea of merging.  The effect on stock prices varies depending on the structure of the deal, which can become very complicated.  Generally, the buyer’s stock suffers and the stock they are buying rises, at least initially.  This often happens in a hostile acquisition, as the buyers will try to blunt opposition by raising the price they offer for the other’s stock.

Getting into the Action

Taking all this into account, you might well ask why any individual investor would risk stock ownership.  Such a hesitation is understandable.  But an investor who will not need the money for a long time and has basic confidence in the firm’s management and its products can feel secure that its stock will rise over the long term.  There are also ways to enlist professional help in making all these continual assessments. More on these options in subsequent posts