Market
Report
"After slogging through three brutal years, Wall Street now
finds itself contending with an intense war in Iraq. Although the year opened on
notes of optimism with some eye-popping stock-market gains in early January,
those hopes have faded. Now, unless there is a postwar reaction of great
optimism, 2003 could be yet another challenging year for investors.
"Persian Gulf War II hasn't followed the quick script that many
on Wall Street anticipated, creating one more difficulty for investors. While
strategists continue to insist that the focus shouldn't stray from the
fundamentals -- earnings and interest rates -- it is nigh impossible to shove
thoughts about the war out of investors' minds. Indeed some strategists think
the war, with its concurrent impact on international relations and trade, could
alter the investing landscape for years.
"'This is another test of globalization,' says James M. Griffin
Jr., market strategist and economist at Aeltus Investment Management in
Hartford, Conn. 'We may be stepping away from the
Eurocentric stage, where things are pretty much pacified, in order to engage in
another area. This ... will work out in the long run, but we will be a warrior
society for a time, and the market will be subject to that flow of news.'
"Since the war started, war-related emotion has dominated
trading action. Good news on the military front sends shares higher. Signs of
difficulty have had the reverse effect, sometimes with punishing results. With
trading volume light on many days, daily swings can be amplified and stock
prices have less to do with standard fundamental business issues. At some point,
most strategists believe, investors will have to burn through the fog of war in
order to focus, once again, on the domestic business picture."
[Source: "Stocks, War
Move in Lock Step As Investors Play Waiting Game." By
David Kansas.
Stock Market Quarterly Review. April 1, 2003. In
The
Wall Street Journal
& Factiva.]
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Buffet's Short Quiz
"If you plan to eat hamburgers throughout
your life and are not a cattle producer, should you wish for
higher or lower prices for beef? Likewise, if you are going to buy
a car from time to time but are not an auto manufacturer, should
you prefer higher or lower car prices? These questions, of course,
answer themselves.
"But now for the final exam: If you expect
to be a net saver during the next five years, should you hope for
a higher or lower stock market during that period? Many investors
get this one wrong. Even though they are going to be net buyers of
stocks for many years to come, they are elated when stock prices
rise and depressed when they fall. In effect, they rejoice because
prices have risen for the "hamburgers" they will soon be
buying. This reaction makes no sense. Only those who will be
sellers of equities in the near future should be happy at seeing
stocks rise. Prospective purchasers should much prefer sinking
prices."
[Source: Chairman's
Letter. By Warren Buffet. 1997 Berkshire Hathaway's Annual Report
to Shareholders.]
Stock
Market Quote
"We're seeing a lot of panic
today. The secret of investing is that there is no secret other
than to put your money away regularly, intelligently and stay the
course." -- Jack Bogle
[Quoted in "Ten Steps to
Investing Sanity In an Upside-Down World." By Ian McDonald. Fund
Fiend. July 17, 2002. In
The
Wall Street Journal
&
Factiva. Bogle founded the
Vanguard Group. For more of Bogle's philosophy, writings
and research see the
Bogle
Financial Markets Research Center.]
Stocks for the Long Run
“I wrote the first edition of Stocks for
the Long Run with two goals in mind: to record and evaluate
the major factors influencing the risks and returns on stocks and
fixed-income assets, and to offer strategies based on this
analysis that would maximize long-term portfolio growth. My
research demonstrated that over long periods of time the returns
on equities not only surpassed those on other financial assets,
but that stock returns were more predictable than bond returns
when measured in terms of the purchasing power. I concluded that
stocks were clearly the asset of choice for virtually all
investors seeking long-term growth.” [Source: Preface. In Stocks
for the Long Run. By Jeremy Siegel. 2nd ed. New
York: McGraw Hill, 1998. In netLibrary]
Stock-Picking Rules
"Having been smitten with the gambling urge
since birth, I can well understand why many investors have not
only a compulsion to pick the big winners on their own but also a
lack of interest in a system that promises results merely
equivalent to those in the market as a whole. The problem is that
it takes a lot of work to do it yourself, and as I've repeatedly
shown, consistent winners are very rare. For thos who regard
investing as play, however, this section demonstrates how a
sensible strategy can produce substantial rewards and, at the very
least, minimize the risks in playing the stock market game...
"Rule 1: Confine stock purchases to
companies that appear able to sustain above-average earnings
growth for at least five years.
"Rule 2: Never pay more for a stock than
can reasonably be justified by a firm foundation of value.
"Rule 3: It helps to buy stocks with the
kinds of stories of anticipated growth on which investors can
build castles in the air.
"Rule 4: Trade as little as possible.
"The efficient-market theory warns that
following even sensible rules such as these is unlikely to lead to
superior performance. And nonprofessional investors labor under
many handicaps. Earnings reports cannot always be trusted, and
once a story is out in the regular press, it's likely the market
has already taken account of the information. Picking individual
stocks is like breeding thoroughbred porcupines. You study and
study and make up your mind, and then proceed very carefully. In
the final analysis, as much as I hope investors have achieved
successful records following my good advice, I am well aware that
the winners in the stock-picking game may have benefited from Lady
Luck."
[Source: A
Random Walk Down Wall Street. By Burton G. Malkiel. Revised
ed. New York: Norton, c1999. pp. 386-91. In netLibrary.
Investor
Psychology
"Heuristics
In Investor Decision Making
Investors, even professionals, fall prey to important logical
fallacies and psychological failings. Some of the latter are
relatively new; others have been known for decades. These
psychological pressures impact our decisions under conditions of
uncertainty in a very predictable manner, not only in the
marketplace, but in virtually every aspect of our lives. The
bottom line is that these powerful forces lead most people to make
the same mistakes time and again. Understanding them is your best
protection against stampeding with the crowd, and may help you to
profit from their mistakes instead. But as you read on you'll see
it's much easier said than done.
"Improving
Your Market Odds
Despite what many economists and financial theorists assume,
people are not good intuitive statisticians, particularly under
difficult conditions. They do not calculate odds properly when
making investment decisions, which causes consistent errors.
First, we must learn why such mistakes occur so frequently. Once
their nature is understood, we can develop a set of rules to help
monitor our decisions and to provide a shield against serious
mishap. We will then see how the contrarian strategies are
anchored upon these intuitive statistical limitations."
[Source: "Heuristics
in Investor Decision Making." Adapted from Chapter 10 of Contararian
Investment Strategies: The Next Generation: Beat the Market by
Going Against the Crowd. New York: Simon & Schuster,
c1998. (HG6041 .D658 1998 Library West). The
Institute of Psychology and Markets: Research.]
Warren Buffet on Interest
Rates' Effect on Stock Prices
"At all times, in all markets, in all parts
of the world, the tiniest change in rates changes the value of
every financial asset. You see that clearly with the fluctuating
prices of bonds. But the rule applies as well to farmland, oil
reserves, stocks, and every other financial asset. And the effects
can be huge on values. If interest rates are, say, 13%, the
present value of a dollar that you're going to receive in the
future from an investment is not nearly as high as the present
value of a dollar if rates are 4%."
[Source: "Warren
Buffet on the Stock Market." By Carol Loomis.
Investor's Guide 2001. Fortune December 10, 2001, p. 80. In
ABI/INFORM.]
The Fed Model
"How can we judge whether stock prices are
too high, too low, or just right? The purpose of this
weekly
report is to track a stock valuation model that attempts to
answer this question. While the model is very simple, it has been
quite accurate and can also be used as a stocks-versus-bonds asset
allocation tool. I started to study the model in 1997, after
reading that the folks at the Federal Reserve have been using it.
If it is good enough for them, it's good enough for me. I dubbed
it the Fed's Stock Valuation Model (FSVM), though no one at the
Fed ever officially endorsed it.
"On December 5, 1996, Alan Greenspan,
Chairman of the Federal Reserve Board, famously worried out loud
for the first time about 'irrational exuberance' in the stock
market. He didn't actually say that stock prices were too high.
Rather he asked the question: "But how do we know when
irrational exuberance has unduly escalated asset values, which
then become subject to unexpected and prolonged
contractions..."1 He did it again on February 26,
1997.2 He probably instructed his staff to devise a
stock market valuation model to help him evaluate the extent of
the market's exuberance. Apparently, they did so and it was made
public, though buried, in the Fed's Monetary Policy Report to the
Congress, which accompanied Mr. Greenspan's Humphrey-Hawkins
testimony on July 22, 1997.3
"The Fed model was summed up in one
paragraph and one chart on page 24 of the 25-page document [the
Fed's Monetary Policy report to the Congress, July 22, 1997]...The
chart shows a strong correlation between the S&P 500 forward
earnings yield (FEY) -- i.e., the ratio of expected operating
earnings (E) to the price index for the S&P 500 companies (P),
using 12-month-ahead concensus earnings to the estimates compiled
by Thomson Financial Fist Call -- and the 10-year Treasury bond
yield (TBY). The average spread between the forward earnings yield
and the Treasury yield (i.e., FEY-TBY) is 29 basis points since
1979. This near-zero average implies that the market is fairly
valued when the two are identical."
1. http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm
2. "We have not been able, as yet, to
provide a satisfying answer to this question, but there are
reasons in the current environment to keep this question on the
table." http://www.federalreserve.gov/boarddocs/hh/1997/february/testimony.htm
3. http://www.federalreserve.gov/boarddocs/hh/1997/july/ReportSection2.htm
[Source:
Asset
Valuation & Allocation Models. By Dr. Edward Yardeni.
Prudential Financial.
July 18, 2002.
Dr. Ed
Yardeni's Economic Network.]
The Efficient Markets
Hypothesis
“The
efficient markets hypothesis (EMH) has been the central
proposition of finance for nearly thirty years. In his classic
statement of this hypothesis, Fama (1970) defined an efficient
financial market as one in which security prices always always
fully reflect the available information. The efficient markets
hypothesis then states that real-world financial markets, such as
the U.S. bond or stock market, are actually efficient according to
this definition. The power of this statement is dazzling. Perhaps
most radically, the EMH ‘rules out the possibility of trading
systems based only on currently available information that have
expected profits or returns in excess of equilibrium expected
profit or return” (Fama 1970). In plain English, an average
investor – whether an individual, a pension fund, or a mutual
fund – cannot hope to consistently beat the market, and the vast
resources that such investors dedicate to analyzing, picking, and
trading securities are wasted. Better to passively hold the market
portfolio, and to forget active money management altogether. If
the EMH holds, the market truly knows best.”
[Source:
Inefficient Markets: An Introduction to Behavioral Finance.
By Andrei Shliefer. Oxford; New York: Oxford University Press,
2000. p. 1]
Fama,
Eugene. (1970). “Efficient Capital Markets: A Review of Theory
and Empirical Work.” Journal of Finance, 25:383-417. In
JSTOR: http://www.jstor.org/journals/00221082.html
Inefficient Markets - Behavioral Finance
"Behavioral
finance has, during its short history, been considered a
controversial field. Some consider it heresy. Why? Few have ever
believed that all investors really make decisions according to the
rational axioms of choice under uncertainty. Rather, defenders of
the rational efficient market hypothesis have argued that markets
can be efficient even when many investors make systematic errors;
as long as there are a few smart arbitrageurs, according to this
logic, market prices will still be rational. But this argument is
flawed. Limits to arbitrage allow for the possibility that prices
can diverge from intrinsic value, even in the presence of rational
arbitrageurs. [Source: Abstract. "The End of Behavioral Finance."
By Richard
J. Thaler. Financial Analysts Journal 55 (6): 12-17 November-December 1999. In ABI/INFORM.]
Revised:
April 1, 2003
