December 9, 2008
The Red Coats of Investing
Fundamentalism is in decline. No, I’m not going to be talking about religion today, but rather two different schools of investment analysis. Technical analysis versus fundamental analysis.
Technical analysis is all those charts and graphs that often look like a foreign language to the uninitiated. There is an old saying that a picture is worth a thousand words, well, a chart is worth a thousand numbers – literally. The data used to generate my charts is just the price of the investment. Nothing fancy, just the price. But it tells a lot.
There is an art to reading charts and graphs, and, of course, there is never any guarantee that the chart will lead me in the right direction, but I don’t have to be perfect. Since 1950, the stock market went up on 51% of the days it was open. One goal is to improve the probability to something better than 51%.
Fundamental analysis, on the other hand, looks at a basic piece of financial data on a company and uses that as a basis to compare the value of that company to another.
Fundamentals include factors like how much company earnings are you getting for each share of stock. Or how much for sales per share, cash per share and so on. The theory behind fundamental analysis is to find where the value is and invest there. It makes sense on the surface.
I tend to question fundamental analysis because there is so much that we don’t know about the actual corporate finance behind the fundamental numbers. Some companies, like Fannie Mae and Enron, have been reported to “cook the books” to make themselves look different on paper than they really are.
In addition, normal earnings comparisons can be very misleading in times of economic change. As an example, let’s look at General Electric. GE sported price to earnings ratios greater than 20:1 for most of the past decade. This means that you could by a dollar per year of GE earnings for $20. A 5% earnings yield.
Today, GE’s earnings are reported to be $2.04 per share, about the same as when GE was $40 or $50 per share. But as of December 5th, GE was selling for $17.85. Where as a dollar of earnings used to cost $20 when share prices were $40, with the current price of GE stock only $17.85 as of December 5th, a dollar of GE earnings only costs $8.34. GE earnings are on sale. Smokin’ deal, right?
But what if GE’s business is slowing down like so many others, and next year they barely make a profit? Even if the GE share price stays right where it is today, all of a sudden the price of GE on an earnings basis is no longer a good deal.
This is the problem I have with fundamental analysis. You are using last year’s data to buy next year’s investments, and there are many things that are not going to be factored into that particular fundamental data. Every method of investment analysis has it’s flaws. This is one of fundamental’s flaws.
Besides, when the whole market is going down, having a company with solid value is sort of like having the penthouse suite on the Titanic. Eventually, you still go down.
Fundamental analysis is a buy and hold investors tool. They will tell you that over the long run fundamentals will prove to be what drives a stock’s price. I would add the word “very” in front of long run. It can take 10 or 20 years for fundamental values to be recognized in share price. The problem is that in years like this an investor can get squashed in a few months and be wiped out well before the market recognizes his wisdom.
The reason I focus just on the charts and the numbers that generate them is that all of the data that can be known about a freely traded investment, including the consensus of what millions of investors think will happen in the future, are all distilled into one single number, the price of the investment.
The price tells it all. Everything else is a distraction. That is why it is the basis of most of the charts I use. And if the price action tells me that the sum total of all investors are saying “forget fundamentals. It is time to get out of the market”, I’ll get out, too.
Investors who cling to buy and hold in markets like this are like the Red Coats of our Revolutionary War. They had a way of doing things that could be very effective in the right environment, but they refused to adapt to obvious changes in the circumstances and got whipped by a small, poorly equipped group of rebels that had the sense to change tactics during each battle.
Investment managers who are willing to Adapt to Changing Markets seem to have an inherent advantage in this rapidly changing investment environment. Think of us as the Minutemen of this industry.
Records, Records Everywhere!
History is unfolding right in front of our eyes, in excruciating slow motion. Economic and financial records are being broken every day, it seems. Consumer prices plummeting. An unprecedented housing market collapse. Huge companies going out of business overnight. Dizzying price movements in the stock markets. The old saying “Who’da thunk it” does not even come close to summarizing what is going on these days.
With the wild swings in the stock market. Down 6% two days in a row. Up 6% each of the next two days, one would think that price volatility could not get much worse. Don’t count on it.
Friend and hedge fund manager John McClure, of ProfitScore, and I were discussing the current market volatility which is averaging 4.06% since September 29th. This number is the average range of movement without regard to whether prices were going up or down. 4.06% per day average price movement!
He suggested I look at the volatility experienced during the 1929-39 period and compare it to the recent market volatility, so I did. Wild trading days during 1929-39, those days that experienced a movement of 3% or greater, up or down, occurred at a 4 times greater frequency than what we have experienced between 1998 and now. Fasten your seat belt. The wild ride may get wilder.
The good news is that many of the wild days of the 1930’s were after the market bottomed in 1932, and big moves in an upward market can create a lot of smiles. Something we could all use more of right now.
One thing that is causing the current volatility is hedge fund liquidations. Most hedge funds restrict redemptions to quarterly or annual time frames. The funds are seeing massive redemption notices, and they must raise a lot of cash to pay off their investors on December 31st. Every market advance is met by a wave of selling as hedge funds liquidate. Although I expect this volatility to subside toward the end of the year, we may have to wait a while for the hedge fund driven selling to be over.
The bright spot in this is that much of that money will be reinvested directly back into the stock market, and could spark a strong rally going into next year.
Gift Certificates are popular gift items at Christmas time. Retailers love them because they get paid up front for the goods that will ultimately be sold with gift certificates. But this also presents a risk for holders of gift certificates. The risk that the retailer may not be in business much longer and the gift certificate may end up worthless.
I don’t want to sound too Grinch-like, but my advice is to use your gift certificates promptly. Very promptly this Christmas.
I am again incorporating the same hedging technique (called Long/Short) that I had been using until late September to stabilize the value of our growth portfolios. Hedging involves buying an investment that moves opposite of another one to cancel out market risk. The value is created by being correct in choosing the strongest investments to own “Long”, and the weakest to have as the hedge (“Short”) as well as the amount of hedge to use.
You may remember that in September I became concerned about the default potential of the inverse investments used as the short side of the hedges. I just could not measure it as formerly “blue chip” companies dropped like flies so I decided to avoid it altogether. That left me with fewer tools to use for the past two months in managing the risk of the market place. I basically could either be invested or be in cash and that was about it. So we had been 40% invested in the S&P 5002 and 60% out of the market. The decline in mid November had me move 100% to cash again.
The lightning strikes of defaults in the financial industry have abated as reports from
The Treasury Department tells us that close to $300 billion injected into the economy has indeed stabilized the financial system and averted a catastrophic collapse. The wave of “lightning strikes” suddenly knocking out big companies seems to have passed, so it seems like the Fed has achieved its first goal in the bailout.
Many of these financial institutions underwrite the hedging investments I use, and the risk of their defaulting now seems greatly reduced. For this reason, I have again begun using hedging for Careful Growth1 accounts.
Careful Growth1 holdings currently include Biotech, Consumer Staples, Utilities and Pharmaceuticals with a hedge and cash holdings that equate to about 44% invested and 56% out of the market.
To put things in perspective, the S&P 5002 has lost 45.12% of its value year-to-date. Our Flexible Income1 program is down 2.82%, Careful Growth1 is down 9.72% and our balanced accounts1 are down 5.92% for the year. I’m not satisfied with the numbers but they are 35% or more ahead of the market.
I’m looking forward to having the market improve so that we can put up some gains going forward. Hedge funds are (were) a multi-trillion industry and I think the huge amount of selling we have seen the past few months will taper off as their cash needs for redemptions are met. Then we will be able to have better markets as each advance is no longer met by a wave of selling. 2009 ought to be a good year in the stock market as government money floods into the markets. But compared to 2008, just about all years are better.