Warren Buffett's Value Investing Approach
Warren Buffett's approach can be summarised as follows: “Despite these gyrations in the market prices of financial assets, many of them do have an underlying or fundamental economic value that is relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. In other words, the intrinsic value of the security is one thing;
The current price at which it is trading is something else. Though value and price may, on any given day, be identical, they often diverge.” So Buffett compares the fundamental value of the asset in question with the price set by the market. His process of selection and analysis follows various principles that we will now describe.
First of all, “Buffett will only invest in easy to understand, solid, enduring businesses that have a simple explanation for their success. […] Look for long-lasting companies with predictable business models.” He invests only in companies and industries he understands and with which he is comfortable.
His advice is to “buy stock in a great company, run by honest and capable people. Pay less for your share of that business than that share is actually worth in terms of its future earnings potential.
Then hold on to that stock and wait for the market to confirm your assessment. […] He puts his money in easy to understand, solid businesses with strong, enduring prospects and capable and ethical management.”
For Buffett, the product the company offers must be enduring and still exist in ten years' time. As he justly points out, “thirty years of performance makes for a great company. Three years does not.”
“Buffett avoids complex companies that are subject to dramatic change because of their uncertain futures. Earnings and cash flow are two of the pillars of a successful company.”
He, therefore, recommends avoiding companies from developing industries and buying securities issued by companies we understand, whose models and income growth are predictable. He invites investors to look for companies with strong barriers to entry, i.e., those with a product or service that is:
needed or desired;
not overly capital-intensive;
seen by its customers as having no close substitute; not subject to price regulation.
Buffett pays particular attention to the company's management. He wants to know whether it acts in the interests of shareholders to create long-term value or, on the contrary, to get rich to the detriment of shareholders.
With his company, Berkshire Hathaway, “Buffett makes money only when his shareholders make money. He treats shareholders as partners, and every decision he makes is made with the aim of improving shareholder value.”
He suggests buying businesses, not stocks, and he considers that while the price of a stock may be volatile, the price of a company is not. For Buffett, market downturns are buying opportunities and “most of Buffett's greatest investments were made […] during bear markets when share prices of great businesses had plummeted”.
Furthermore, he believes that a few good investments are enough, and there is no need to make a large number of purchases; “one good decision a year is a very high standard”.
Moreover, it is interesting to note that Buffett suggests ignoring macroeconomic factors and events, and focusing instead on those that affect the company and industry.
He also recommends ignoring stock forecasts and short-term price fluctuations and favoring strong companies likely to succeed independently of market movements. Buffett confesses “that he can't begin to predict the movement of the markets”.
He also recommends that investors “think 10 years, not 10 minutes. […] Buffett's philosophy is based on patience and a long-term outlook.”11 So we can clearly see that he is an investor rather than a speculator seeking immediate profit. As for the stock market, he describes it as “a ‘relocation center’—a means whereby money moves from the impatient to the patient”.
As he amusingly notes, “Wall Street is the only place where people go to in Rolls Royces to get advice from people who take the subway.” Buffett does not believe in experts, technical analysis, or any advice on how to make money fast.
He is a proponent of value investing, a slow, laborious job focused on the long-term, whose aim is to “seek out discrepancies between the value of a business and the price of small pieces of that business in the market”. However, this price difference must be significant to justify an investment.
Buffett, therefore, seeks to “determine the discounted value of the cash that can be taken out of the business during its remaining life”.
As we might imagine, Buffett reads for several hours a day to get information on companies he is interested in (annual reports, articles, etc.), but does not waste time studying stock forecasts or financial theories based on formulas.
The rest of the time he spends on the telephone and, especially, thinking about and focusing on what he believes is the essential notion: value.
Although this approach is very interesting, not all investors are able to allow themselves such a long time horizon.
In addition, technological and social developments occur much more quickly than they used to. It has become difficult to guess whether a company's product will still be around in 10 years and if the company will still exist.
Certainly, we admit that this may be the case with “traditional” companies but, for example, with the development of the Internet and free news websites, investing in a newspaper is perhaps a more risky bet today than it once was.
Buffett's approach may sometimes be too limited, but it does have the advantage of focusing on the value of a company, often one which operates in an industry temporarily neglected by investors.
If we look at recent investments Buffett made during the latest crisis, these seem to be focused on the banking and insurance industries, sectors abandoned by investors in the thick of the financial crisis.
For Buffett, it is better to adopt a patient approach, to wait for a strong market correction and buy companies whose listing is clearly lower than their intrinsic value.
Now it will be interesting to look at the approach of Benjamin Graham, regarded by many analysts, including Peter Lynch, as the father of modern financial analysis. Moreover, Warren Buffett holds that Graham influenced his life and his way of seeing and understanding the markets.
Indeed, it was Graham who established the investment strategy based on the concepts of value and the margin of safety. The following points are taken from the famous book The Intelligent Investor.
Benjamin Graham's Approach
One advantage of Graham's approach is its great simplicity, in that he distinguishes just two types of investor: the defensive investor and the enterprising investor.
The former seeks above all to avoid errors or significant losses, with a minimum of effort and time spent on frequent decisions.
Furthermore, “the more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the unexpected and the disconcerting in this part of his life. […] The conservative investor should seek to minimize his risks.”
This type of investor will, therefore, seek both security and freedom from bother and must expect lower profitability.
The second type can spend more time picking securities and, therefore, make more investment decisions based on his or her intelligence and skills. He or she can, therefore, hope to achieve higher profitability.
In terms of portfolio construction for both these types of investors, considering bonds and stocks, Graham recommends in general never to invest more than 25% or less than 75% in one or the other of these categories.
The Defensive Investor
According to Graham, the defensive investor should divide his or her funds between high-grade bonds and common stocks, with a balanced proportion of 50/50.
The aim of this type of investor is to preserve this distribution as much as possible. He or she might reduce the proportion of common stock to 25% when the market reaches very high levels, and increase it to 50% following a long bear market, for example.
In terms of bonds, Graham believes that government bonds are the best choice and he recommends avoiding high coupon bonds that expose conservative investors to too much risk, ranging from declining value to default.
Taking an additional risk for an increase in return of only 1% or 2% is not worth it. He also advises avoiding ordinary preferred stocks which are unsuitable for defensive investors.
Stocks, through their strong historical profitability, provide protection against the negative effects of inflation, that is, depreciation in investors' future purchasing power. Graham suggests simply following these four rules for the selection of common stocks:
1. Have an adequate though not excessive diversification (10 to a maximum of 30 different issues).
2. Each stock selected should belong to large, preeminent and conservatively financed companies, such as the leaders in a given industry.
3. Each company selected should have a long record of continuous dividend payments.
4. The investor should impose a maximum price for his stocks, in relation to its average earnings over the last seven years. He suggests a limit of 25 times the average earnings and no more than 20 times those of the last 12 months.
The Enterprising Investor
Like the defensive investor, the enterprising investor should also distribute his or her funds between common stocks and high-grade bonds.
However, he or she may consider foreign stocks, ordinary preferred stocks or so-called secondary stocks (not the industry leaders) but only when they are available at a discounted price (no more than two-thirds of their estimated value). Furthermore, he suggests avoiding an investment policy based on growth stocks, due to their tendency to fluctuate sharply.
Graham also believes that the approach which consists in buying low and selling high—the market timing strategy—is akin to speculation and “the average investor cannot deal successfully with price movements by endeavoring to forecast them”.3 He notes, however, that all bull markets have shared certain characteristics:
a historically high price level;
high P/E ratios;
low dividend yields compared to bond yields;
much speculation on margin;
many new common-stock issues of poor quality.
We will cover market timing in the following section, but these points were worth introducing at this stage of our analysis. A 50/50 split is also recommended but with a significant margin of 25% to 75% for the stock component. Regarding stocks, Graham recommends investing in three fields:
1. The relatively unpopular large company
The enterprising investor should first of all focus on large companies that have become temporarily unpopular, that have the financial ability and brain power to carry them through a temporary crisis and back to a successful position. The use of qualitative or quantitative filters is also recommended.
2. Purchase of bargain issues
Graham considers an issue to be a “bargain” when its value calculated using discounted future cash flows is at least 50% higher than the price.
Special situations, or “workouts”
This refers to taking advantage of opportunities that appear during corporate restructuring or reorganization of debt.
Markets tend to undervalue companies engaged in the process of reorganization or in complicated legal proceedings. Nonetheless, this is an unusual field that will only interest a small minority of enterprising investors.
Graham also recommends maintaining a balance between the two asset categories. The stock position should be reduced during bull markets, and the bond component increased accordingly. Conversely, during bear markets, it is better to buy stocks than bonds.
As opposed to the speculator who aims uniquely to anticipate market movements, “price fluctuations have only one significant meaning for the true investor.
They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”
He even believes that it is completely impossible to forecast bond price movements. In his opinion, “the investor must choose between long-term and short-term bond investments on the basis chiefly of his personal preferences”.
For Graham, “the chief criterion used for corporate bonds is the number of times that total interest charges have been covered by available earnings”. The ratio, which obviously is not fixed over time, will depend on the industry in question and minimum coverage is recommended.
For Graham, an investment decision involves comparing the price of a stock to its estimated value according to analysis. He is obviously a proponent of value investing. In addition, he developed an interesting list of seven criteria for determining whether to include stock in a defensive investor's portfolio.
1. Adequate size (avoid overly small companies)
2. A sufficiently strong financial condition
3. Uninterrupted dividend payments for the last 20 years
4. No losses for the last seven years
5. Increase in per-share earnings of at least 33% in the past 10 years
6. Current price no more than one and a half times book value
7. Current price should not exceed 15 times average earnings of the past three years.
For the portfolio of an enterprising investor, Graham suggests using other, less stringent selection criteria.
1. Financial condition current assets worth at least one and a half times current liabilities, and debt not more than 110% of net current assets (for industrial companies)
2. Earnings stability (no deficit in the last five years)
3. Dividend record (some current dividend)
4. Earnings growth.
The Margin of Safety Concept
For Graham, the margin of safety, or the difference between the intrinsic value and the current price, represents the margin of error for any investor. This difference between value and price should ideally “be about half, or at least no less than a third of the fundamental value”.
This margin will depend on the purchase price: it will be greater if the price paid is low, and lower if it is high. However, he admits that even with such a margin, an individual stock can suffer heavily, and the best means of protection remains diversification.
Before concluding with this approach, it is interesting to note that this school of thought pays no attention to the betas of stock, or to the models of Sharpe or Markowitz, or to the covariance of returns between securities, and focuses solely on the value of a company and its stock price. Yet it is still far from enjoying unanimous support.
Peter Lynch's Approach
Peter Lynch was fund manager of Magellan from 1985 to 1992 and never experienced negative performance during this period. As well as combining the various elements that we have discussed in relation to Buffett and Graham, Lynch has developed some very interesting avenues.
Moreover, he is highly skeptical about the value of academic theories of finance and has strong doubts regarding the efficient market hypothesis. According to Lynch, it is impossible to forecast market movements and he only believes in “great businesses” (under-valued and/or under-appreciated companies).
For Lynch, “stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide.”
Here his analysis is similar to that of Malkiel, which we will discuss in the following sections. Furthermore, according to Lynch, “the best companies always end up succeeding, the mediocre ones failing, and their respective investors being compensated accordingly”.
By advising to invest only in what is simple and what we know, Lynch echoes Warren Buffett's approach but looks above all for what he calls “ten baggers”, a stock whose value increases by ten times its purchase price.
According to Lynch, there are plenty of these in the world around us and for a small investor's portfolio, one ten bagger is enough to make all the difference in terms of performance. Unlike for the portfolio of a large fund, which must select many ten baggers to make any difference.
Lynch spends hundreds of hours analyzing companies and speaking with CEOs and financial analysts but, above all, he recommends keeping an eye on the world around you to identify investment opportunities, if possible before anyone else. We can spot them in our workplace, at the mall, during a trip or in the course of conversation.
These unique opportunities can be discovered months or even years before analysts examine and begin to recommend them. Lynch suggests that investors be curious and observe what's going on around them in order to find investment opportunities. “Take advantage of the valuable, fundamental information from your job that may not reach the professionals for months or years.”
He tells of how he discovered Hanes, makers of L'eggs stockings, thanks to his wife and her friends who use the product. After a little research, Lynch invested for the Magellan fund and his initial investment increased six-fold. The analysts did not start to study this company until they noticed the significant increase in its stock price.
As he summarises perfectly, the aim is to discover investment opportunities before Wall Street. Indeed, a financial analyst will only pay attention to security once its price has undergone substantial movement.
However, finding a company is just the first step; the next step is obviously to analyze it. You might find an interesting opportunity in an industry, but you still need to choose the right company. Lynch recommends investing in stocks rather than in the market.
He focuses solely on companies, or individual stocks, and favors relatively small businesses that offer greater growth prospects than large multinationals. Finally, he recommends investing “at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator”.
The first step is to classify the stock in one of the six categories that Lynch has established, although companies may move from one category to another over time. Furthermore, companies have three growth phases and it is important to determine if the company in question is changing phase.
Firstly, there is the start-up phase, then the rapid expansion phase where the company is moving into new markets, and finally the mature (saturation) phase where growth becomes difficult. Here are the different categories.
Slow growth companies develop slowly, more or less at the same rate as the progression of GNP (gross national product). A slow growth stock can generally be recognized by the regular and generous dividend paid to its shareholders.
Electricity companies, for example, belong to this category. When considering this type of stock, it is important to ascertain whether dividends are paid regularly and if they grow over time.
These stocks are faster than slow growth stocks and can reach an annual growth in earnings of 10% to 12%. Companies like Coca-Cola, Bristol Myers, Procter & Gamble, and Colgate Palmolive belong to this category. They have little chance of going bankrupt, but it is important to verify their long-term growth rate.
The potential profit on these stocks depends mainly on when they are purchased and at what price. The P/E ratio is decisive in indicating to investors whether or not they are overpaying for the stock.
For example, an investor who has held a Procter & Gamble stock since 1963 has only quadrupled his or her initial investment. For such a long holding period, the risks taken have not really paid off. The holding period is a very important issue that we will cover later on.
For Lynch, in the case of stalwarts, it is better to make a return quickly. They are bought with an expected gain of 30% to 50%. Once sold, a similar stock that has not yet been recognized should be sought in replacement.
During a crisis, people travel less, put off buying a new car, buy fewer clothes, eat out less often, but continue to buy as much cereal and the same amount of dog food. That is why companies like Kellogg's or Nestlé, for example, are candidates worth including in a portfolio.
The Fast Growers
Fast-growing companies develop fast, sometimes at an annual rate of 20% to 30%. Lynch holds them for as long as their earnings are increasing, their expansion continues, and no obstacle is encountered.
The growth rate of earnings is obviously essential for this type of stock, but it is especially necessary to compare the P/E ratio to the earnings growth rate to see if the two curves move in parallel.
When analyzing a product or service, it is also crucial to determine the share of sales in total turnover.
It should be emphasized that this type of stock does not have to belong to a fast-growing industry, as room to continue developing is more decisive for the growth of a company. For example, the hotel industry has an annual growth of almost 2%, while Marriott has developed strongly over the last few years, increasing its market share to 20%.
It is also useful to look at whether the company has been able to replicate its success in other cities or countries, thereby demonstrating its capacity for expansion.
However, if this stock becomes too important, its growth capacity will be limited. So it is best to look for companies with high growth potential, and sell them before this potential is exhausted.
A cyclical stock is a company in which sales and profits rise and fall regularly and in a somewhat predictable pattern. In a cyclical industry, business grows, then slows and grows again, then slows once more and so on. At the end of a recession and in a vigorous economy, these are the stocks that appreciate.
Inventories and the relationship between supply and demand for the products the company sells are the decisive factors in achieving adequate positioning in the business cycle in question.
Automotive companies, airlines, tire manufacturers, steel producers, and chemical companies are cyclical stocks. As most of these companies are reputed multinationals, we often tend to put them in the stalwart category, but the cyclical character of the industry is critical.
These companies are not growing, but in the event of a recovery, they can move back up very quickly. Lynch distinguishes four types of turnarounds. First of all, there are those that are subsidized, whose future depends entirely on a loan guaranteed by the government.
Then there are those that must resolve one or more unanticipated problems, such as operational accidents that will take time to repair. The extent of such a company's losses and debts must be carefully studied.
Next, there are perfectly good companies within bankrupt companies that will be able, after separation, to take off on their own to the delight of investors. There is also restructuring, which lets the company rid itself of unprofitable subsidiaries in order to concentrate on its core business.
Whatever the type of company in difficulty, the number of its liquid assets and its debt level are the essential factors in analyzing its future capacity for recovery. The way in which the company intends to go about this must also be examined, taking into account the outlook for the sector.
The Asset Plays
By “asset plays”, Lynch means a company that's sitting on a treasure that you know about, but that Wall Street has overlooked. The assets may be in the form of a large pile of cash (the famous “war chest”) or real estate, such as land or housing stock managed in parallel with the company's business.
You also find these asset plays in companies operating in the metal, oil, newspaper and pharmaceutical industries and television stations. Companies' losses may also represent value. Indeed, a company in serious financial trouble may, for example, benefit from a tax credit, meaning that future profits will be exempt from taxation.
The aim is, therefore, to identify the existence of these hidden assets and then try to estimate their value, taking the company's debt into account. Finally, investors must consider whether the company is vulnerable to takeover by a third party.
The Perfect Company According to Lynch
Above all, Peter Lynch appreciates the simplicity and always asks himself if “any idiot can run this business”. He also looks for other characteristics in a company and has compiled a list of 13 factors to help select them.
a) The Perfect Company has a Dull, or Even Better, Ridiculous Name For Lynch, the more boring the name, the better.
b) The Perfect Company Does Something Dull In his opinion, “[a] company that does boring things is almost as good as a company that has a boring name, and both together is terrific”.
c) The Perfect Company Does Something Disagreeable
The ideal business is one that makes people shrug, retch or turn away in disgust. He gives the example of a company engaged in washing greasy auto parts.
d) The Perfect Company is a Spin-Off
The result of the separation of a division or business unit from a parent company, that then takes its independence, often offers investors exciting and lucrative opportunities. As Lynch rightly notes, parent companies do not want to let their subsidiaries go just to see them getting into trouble, as this may bring them negative publicity.
Spin-offs usually have strong balance sheets and are well prepared to deal successfully with their new independence.
e) The Institutions Don't Own It, and the Analysts Don't Follow It
For Lynch, the lower the percentage of shares held by institutions, the better. The idea is to find a company that no analyst has visited, or that they admit knowing nothing about. As we said earlier, the goal is to discover the company before Wall Street does.
f) Look Out for Toxic Waste and/or the Mafia
According to Lynch, there is no more perfect industry than waste management, and some others such as hotel and casino management reputed to be “influenced” by the Mafia, which may have great prospects.
Rumors about the Mafia allegedly controlling these industries have kept many investors at bay, but Lynch suggests keeping things in perspective; the fact is that hotels and casinos usually appear on recommendation lists.
g) There is Something Depressing About the Perfect Company
Besides the boring or disagreeable nature of a business, being depressing is another key factor for Lynch. He gives the example of Service Corporation International, which is in the funeral business.
The company became a “20-bagger” (twenty times the initial investment) before Wall Street even began to pay it any attention. Since then, it has performed worse than the market.
h) The Perfect Company Operates in a No-Growth Industry
Investors usually prefer to invest in a high growth industry, where there is noise and movement, but Lynch far prefers a no-growth (or low-growth) industry where there will be little competition.
There is no need to worry about potential rivals or to enter a price war because nobody else is interested. The company has a free rein to continue to grow and gain market share.
i) The Perfect Company has a Niche
An exclusive license is obviously the ideal situation, as the company that enjoys these rights can freely increase its prices and, consequently, its profits. Managing a quarry is one example of such a license, as are pharmaceutical and chemical companies that hold a patent giving them the right to manufacture and sell a unique drug for a given period.
j) People have to Keep Buying the Perfect Company's Product
As Lynch puts it, it is better to invest in a company that makes medicines, soft drinks, razor blades or cigarettes than in a toy manufacturer whose products are often only bought once. Regular sales are essential for ensuring stability, if not growth, of profits in the future.
However, there are also companies that Lynch recommends avoiding, such as hot stocks in a hot industry, those with the best advertising or those that all investors hear about and end up buying simply because everyone else does.
k) The Perfect Company is a User of Technology
It is better to invest in companies that use technology (scanners, for example) to reduce their costs and increase their profits, than in companies that make that technology (scanner manufacturers) and whose products are likely to be made obsolete or outdated by competing products.
l) The Insiders are Buying the Perfect Company's Stock
The best sign of a company's success is to see its executives and managers investing in its equity.
However, it should be emphasized that sales of stock are not necessarily revealing and investors should be very cautious about attempting to draw conclusions. Managers may sell their shares simply to generate the cash to buy a house or send their children to university.
Therefore, it is more representative to see insiders buying shares—driven by the desire to participate in the company's growth—than selling, which can be motivated by any number of reasons. There is only one reason for managers to invest in their company: the feeling that the stock is undervalued relative to the company's growth potential.
M) The Perfect Company is Buying Back Shares
Finally, a company buying back its own shares is a positive sign for Lynch and, more importantly, for investors, because it represents the reward offered by the company to its shareholders.
However, instead of undertaking this kind of buyback or a dividend payout, sometimes companies decide to make often expensive acquisitions unrelated to their core business, which then weighs heavily on their balance sheets and their ability to generate earnings growth.
As Lynch says, “If a company must acquire something, I'd prefer it to be a related business, but acquisitions, in general, make me nervous.
There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I'd rather see a vigorous buyback of shares, which is the purest synergy of all.”
Earnings and Earnings Growth
When buying a company's shares, investors are actually buying the growth of future earnings. For Lynch, as part of security analysis, it is essential to begin by comparing the earnings line to the price line. These two lines usually move in tandem and although one may seem to stray from the other a little, they always end up coming back together.
Therefore, comparing the price line with the earnings line helps quickly determine whether a stock is overpriced. Comparing the P/E of the stock with that of its industry is the next step, making it possible to rule out stock with a very high P/E ratio. The P/E can also be regarded as a measure of the number of years necessary to recover the amount initially invested.
The problem, however, is that present earnings only help to evaluate the current stock price, but it is information about future earnings that investors seek.
According to Lynch, although it is impossible to predict future earnings, it is possible to determine whether a company can make them grow. It has five ways of doing this:
1. reducing costs;
2. raising prices;
3. if possible, expanding into new markets (but will it work elsewhere?);
4. selling more products in old markets;
5. closing or getting rid of a losing operation.
Investors should focus on these factors to evaluate the company's ability to grow their earnings in the future. They should also find as much information as possible about the company, to understand exactly how it goes about generating profits and thereby analyze its potential success.
For a slow growing stock, dividend stability and growth over time are the essential factors in determining attractiveness. For a stalwart, the analysis of the P/E ratio and the stock price will be decisive. It is also worth considering whether an event may accelerate growth, and if so, which event.
When looking at a fast grower, the question is obviously for how long and by what means the company can continue to grow at this speed. The number of new shops opened, for example, and the development of market share are relevant factors for analysis.
When considering a cyclical stock, industry conditions, inventories, prices and the capacity of production facilities are decisive factors. In the case of an asset play, you need to find out the value of the assets.
Finally, for turnarounds, investors should consider how the company is going to go about improving its situation, and if the measures envisaged are likely to pay off in the future.
It is also useful to recall that stockholders are able to get information directly from companies and their head office. As such, Lynch believes that “nice earnings and a cheap head office are a good combination. […] Other unfavorable signs include fine old furniture, tapestries, and wood paneling.”
Finally, it is possible to analyze an industry simply by looking around you. A (partial) analysis of the automobile industry can be carried out, for example, in parking lots of ski resorts, malls or other leisure spots.
Most of this information can be found in companies' annual reports. However, Lynch recommends spending no more than a few minutes reading them. In his opinion, “the cheaper the paper, the more valuable the information”.8 He recommends focusing instead on the following criteria.
The Sales Percentage
When we examine a company, the first thing we observe is the products and services it offers. Independently of the profitability itself of a product, it is essential to determine the impact of the product in question on the company's sales and earnings.
For example, a product may sell very well but represent a negligible share in the company's sales and, therefore, have little impact on its earnings.
The P/E Ratio
For Lynch, the P/E ratio of a company valued at its fair price is equivalent to its growth rate. It is, therefore, necessary to find out the growth rate and compare it to the P/E ratio. If the P/E ratio is lower than the growth rate, the investor may have found a good stock.
According to Lynch, book value often has little to do with the true value of a company. Moreover, the closer an investor is to a finished product, the harder it is to predict its resale value.
Examination of a company's balance sheet will show the amount of cash as well as a figure which includes its marketable securities, which together give the overall cash position. The higher this is, the more prosperous the company. It is essential for a potential investor to know whether or not a company has considerable liquid assets.
Subtracting long-term debt from cash and cash equivalents gives the company's net cash position. By then dividing this value by the number of shares in circulation, we get net cash per share.
By comparing this number to the market share price, investors can determine the value of the company's growth potential and of the “true” P/E ratio. In addition, this value can also be interpreted as the lower threshold of the share.
Lynch uses Ford as an example. He estimated net cash per share at US$16.30. With a market price at the time (early 1988) of US$38, Lynch considered the share to be worth US$21.70 (38 − 16.30). The P/E ratio of 5.4 (US$38/7 per share) given initially, in fact, came down to 3.1 (21.70/7).
The balance sheet gives us the amount of short-term and long-term debt. When long-term debt is higher than cash and equivalents, the financial the situation of the company is deteriorating.
Conversely, the reduction of debt and an increase in cash and equivalents is a good sign. It is interesting to note that Lynch ignores the short-term debt, considering that the value of the company's other assets is enough to cover this debt.
This factor is crucial for companies in recovery or in the start-up phase, as it will determine which ones will survive and which will go bankrupt. Furthermore, the kind of debt is also important. Bank debt, which is due on demand of the bank, puts the company in a worse position than funded debt, which is not due as long as the interest is being paid.
As mentioned previously, stability, that is, the existence itself of a dividend over time, as well as its growth, is an important criterion for stock selection. The dividend is the first part of a stock's return.
For Lynch, share repurchases by the company are positive, while acquisitions made by forgoing dividend payments to shareholders generally have a negative impact on share price movement.
However, for companies seeking fast growth, dividends are often reinvested, and it is better to favor these stocks above traditionally generous companies without any real growth prospects or outlook.
Companies that own natural resources such as land, forests, oil or precious metals often present assets in their balance sheets at their purchase price although they are worth much more on the market. Moreover, some assets amortized over time disappear from the balance sheet. Investors must take these undervaluations into account.
In general, cash flow is the money a company makes by selling its products or services (revenues), taking account of costs incurred in its activities. Lynch prefers companies that have little or no investment expenses, i.e., those that have a high free cash flow (cash flow after deduction of capital expenditures).
It is also important to analyze inventories and to find out if they are piling up. Growing inventories can lead companies to lower their prices to liquidate them (not to mention the price of storage), which implies a drop in profits. On the other hand, the depletion of inventories is a good sign for the company and consequently for investors.
For Lynch, as noted earlier, a company's earnings growth rate is the most relevant rate in terms of investment and should be compared to price movement.
Finally, Lynch examines gross profits, which represent the company's profit minus costs, including interest but before taxes. By dividing the company's sales by its gross profit, we get the profit margin before taxes that should be compared to that of the industry in question.
Conclusion on Peter Lynch's Approach
Peter Lynch believes that the end of the year usually provides the best opportunities to buy. Opportunities also present themselves during the drops and freefall that occur every two, three or four years, but buying at these times is not for the faint-hearted.
A very interesting approach to stock valuation is suggested above, which will be incorporated into the discussion that is to follow.
It is worth bearing in mind that “the market, like stocks, can, in the short term, move in the opposite direction from the fundamentals”, but “in the long term, the direction and sustainability of profits will prevail”. Moreover, he believes it is impossible to predict market movements over one or two years.
Lynch criticizes all those experts who recommend that their clients systematically sell their positions as soon as they have doubled their initial investment.
The problem is that they will never find a “ten bagger” that way. He indicates that he has never been able to predict which stocks would see their price growing five- or ten-fold, but he held on to them for as long as their story remained intact.
Finally, valuation models are very sensitive to parameters and ultimately only provide estimates. Furthermore, as Lynch reveals, “we all read the same papers and listen to the same economists.
We all come from the same homogeneous mold. Few of us have left the beaten track.” The right direction is therefore off this beaten track and lies in adopting a new, unconventional and even surprising approach.
The idea of value advocated by Buffett and Lynch should be definitively assimilated by any investor, as the selection itself of value is essential in any investment decision.
Theories based on the Capital Asset Pricing Model (CAPM) and on the efficient market hypothesis assume that individuals act rationally and predictably. Whereas in reality, they often seem to behave irrationally.
We human beings think that we are logical, but research has shown that information is systematically analyzed unconsciously in the parts of the brain related to emotion. It would, therefore, seem that decisions are based on emotion.
As Taleb justly points out, “we react to a piece of information not on its logical merit, but on the basis of which framework surrounds it, and how it registers with our social-emotional system”. Lynch is also shocked “to see the speed at which an investor's feeling can change when the reality hasn't”.
Each individual perceives risk differently. Individual risk preferences are not solely determined by deviations from the mean but depend significantly on the objectives set or on gains and losses made in relation to a certain benchmark or reference point.
Investors in Behavioural Finance
“Prospect theory”, developed by Kahneman and Tversky, defines a value function to describe the irrational behavior of investors. Investors use gains and losses, i.e., variations in their wealth over time, as a reference. This function has the following three characteristics.
Firstly, investors are risk-averse when it comes to gains and more open to risk when pertaining to losses. This is often reflected in investors' tendency to sell winning securities (to book and secure the profit) and to hold losing securities (to try to “redeem” themselves and recover their loss as quickly as possible).
Recent examples of traders such as Nick Leeson (from the bankrupt Barings Bank) or Jérôme Kerviel (Société Générale) illustrate this willingness to take more risks to try to recover losses sustained on a position as quickly as possible—positions which were highly speculative in these two cases.
Secondly, investors hate losses more than they love gains. In other words, these researchers have shown that the aversion to losses is much stronger than the satisfaction derived from gains. Losing one dollar is two and a half times more painful than the satisfaction derived from a dollar.
Thirdly, investors perceive gains and losses in relation to their subjective reference points, such as the 0% threshold, the inflation rate or a defined minimum return.
Moreover, it seems that investors deform probabilities, that is, they overestimate low probabilities (distribution tails) and underestimate high probabilities, biasing their perception of the risks associated with the decisions they make. The occurrence of highly improbable events is frequently overestimated, often based on personal experiences.
Furthermore, as Taleb notes, “what we see is not necessarily all that is there. History hides Black Swans from us and gives us a mistaken idea about the odds of these events.” So as we can see, investors do not always act rationally and various aspects of human nature influence the way we invest.
It is essential to understand these irrational mechanisms because, as Malkiel states, “we are often our own worst enemy when it comes to investing”.
Investors are not always conscious of the risks taken when they make investment decisions, and can, therefore, act in an irrational manner. There are several psychological biases that can lead investors to select and treat information with bias, and particularly to under- or overestimate the risks taken.
Heuristics and Cognitive Biases
In order to facilitate analysis and information processing, individuals use practical, simple rules, often drawn from experience or analogies, called heuristics or “rules of thumb”.
These rules help us to make choices and decisions. However, they can be subject to errors of judgment called cognitive biases. We would now like to take a look at these heuristics and cognitive biases, which we have classified into three categories.
The first category concerns biases in the selection of information, demonstrating that individuals prefer information that is readily available, precise, chosen by those we believe are well informed and, finally, that is consistent with our view.
This bias describes the tendency of individuals to judge the relevance of a piece of information by its availability. It also represents the strength of association that can influence investor decisions.
The more we read comments on a subject, the more we believe them. So, from an individual's standpoint, the fact that a certain piece of information is more readily available increases the probability that it will happen. Moreover, this bias often causes investors to overreact to news.
This concept relates to investors' tendency to be influenced by what the crowd says and thinks. In a context of uncertainty, when information is asymmetrical, they tend to believe that others are better informed, which causes mimicry.
Furthermore, as it can cost time and money to acquire and analyze information, it is both tempting and easy to follow others, or those we believe know best.
Investors prefer precise information too vague information (Ellsberg Paradox) and they do not like situations where they are uncertain of the probability distribution of future returns.
However, this bias is reduced by experience. Inexperienced investors see a lot of ambiguity in risky investments whereas experienced investors have more precise convictions.
This way of thinking leads to interpreting things as we would like them to be, rather than as they really are. Investors' convictions can, therefore, justify their investment decisions. They make their choices according to their perception of reality, retaining certain information and excluding other information.
The second category concerns the biases related to information processing, which lead individuals to allocate probabilities of different scenarios being realized according to a certain value system.
This is usually based on generalities, similarities, models or processes, or excessive confidence. These biases particularly affect investors' consciousness of risk.
This is a bias that may lead investors to estimate probabilities based on their pre-existing beliefs, for example, by applying a given probability to a situation they believe to be similar but which in reality is not.
This can also lead them to believe that the results reached within small samples are representative of results that would be obtained in an entire population.
Investors tend to look for similarities, or what they believe is most representative when making a decision, which causes a risk of underestimating the probability that this is not the case.
We often establish generalities based on observed facts. For example, the fact of seeing white swans does not confirm that black swans don't exist. However, in seeing a black swan, it is possible to assert that all swans are not white. “We have a natural tendency to look for instances that confirm our story and our vision of the world.”
Human nature tends to try to establish causal relationships in events it observes, seeking explanations and logical links at any cost. In other words, we often look for a relationship of cause and effect in events that we observe, even though the cause is perhaps fortuitous in many cases.
Individuals maintain the illusion of having control over situations over which they, in fact, have no influence whatsoever. They tend to look for logical sequences in random processes.
They believe that a random walk process, such as tossing a coin, is, in fact, subject to mean reversion, i.e., that it will follow a cycle. For example, once we are “at the top”, we will have to “come back down”; or, after landing on “tails” 10 times, “heads” should turn up, while the probabilities are actually the same for each throw.
They, therefore, underestimate the frequency of repetitions. Studies have shown that the movement of stock prices does not follow mean reversion. Similarly, they are likely to overvalue losing security which “should come back up” and to observe trends when there aren't any.
Anchoring is the tendency to be influenced by an arbitrary reference when evaluating a quantity. For example, mentioning a figure will lead an individual to use that figure as a reference when giving a reply. Expert opinions and forecasts constitute such “anchors” for investors, who are likely to refer to them when making decisions.
The way information is presented influences decision-making, causing biased decisions (splitting bias) and allocation that disregards risk.
A factor is given more weight in decision-making simply because it is presented in more detail. Investors may decide only to consider the total (aggregation effect) or to look at each part separately (segregation effect).
For typically binary choices (buy or sell), investors tend to decide according to the probabilities they associate with each scenario, looking for patterns in random processes. They make decisions based on probabilities they assign to the different results, but which do not always correspond in reality.
For example, for ten throws of a coin, if heads appear 6 times (60%) and tails 4 times (40%), an investor will decide to bet on heads, believing that heads have a greater chance of appearing, even though the probabilities for each new throw are identical.
“We focus on a few well-defined sources of uncertainty, on too specific a list of Black Swans (at the expense of the others that do not easily come to mind).”
In other words, we often tend to concentrate on scenarios with variable probabilities, but without thinking of improbable events that may indeed occur. Human nature is somehow not programmed for these highly improbable events (the “never”) that are therefore often discounted.
To illustrate this, it is interesting to look at the difference between the risks that had been anticipated by a Las Vegas casino and the unexpected losses that actually occurred.
First of all, the casino lost about 100 million dollars when an irreplaceable performer from its main show was attacked by a tiger (the show, Siegfried and Roy, had been a major Las Vegas attraction).
The tiger had been reared by this trainer and even slept in his bedroom. Until the attack, no one suspected that it would turn against its master. In scenario analyses, the casino had even conceived of the animal jumping into the crowd, but nobody had imagined an eventual tiger attack on its trainer.
Second, a disgruntled contractor was injured during the construction of a hotel annex and attempted to blow up the casino by placing dynamite around the underground foundations. Fortunately, he was discovered in time, but the casino was only insured against construction problems.
Third, for years an employee hid the forms that he was supposed to send to the Internal Revenue Service declaring any gambler's profit which exceeded a given amount.
The casino, accused of tax fraud, almost lost its license and ended up having to pay a colossal fine, and this, despite the surveillance systems and procedures intended to monitor employees.
Fourth, the casino owner's daughter was kidnapped, which caused him to dip into the casino coffers in order to pay the ransom, a risk which obviously had not been anticipated.
The casino had spent hundreds of millions of dollars on gambling theory and high-tech surveillance systems while the bulk of their risks came from outside these models.
This bias describes investors' tendency to be overconfident in terms of their predictions and their own judgments. Individuals are willing to take more risks than they can in fact withstand. So, the risk of being on the wrong side—“Miscalibration bias”—is often underestimated because of overconfidence.
This also results in their underreaction to market news. Investors tend to exaggerate their own skills and to reject the role of luck, thereby exaggerating their ability to control events.
As Taleb summarises, “we attribute our successes to our skills, and our failures to external events outside our control, namely to randomness”. Investors are also convinced they can beat the market. They speculate more than they should and carry out too many transactions.
Furthermore, we often believe we have better knowledge when we have access to more information, but more information does not necessarily mean more knowledge. Investors also have a selective memory of success. They remember successful investments and forget mediocre results, thereby reinforcing their overconfidence.
Illusion of Control
When a situation involving chance replicates a situation requiring skill, individuals behave as if they could control the outcome of an uncontrollable event. For instance, when they invest in the stock market for themselves online, investors feel as if they are in control of their assets, while the market, in fact, remains unpredictable.
We might well wonder if an investor ultimately controls anything by holding a company's stock in his or her portfolio. We will leave the question open but, in our opinion, the only way of retaining a considerable level of control, and perhaps the only way of making money, is by owning the production facilities. There is no denying that most of the wealthy people in this world own their own company.
Supporters of a team bet more money on that team. Similarly, employees who hold stock in the company they work for have a more optimistic vision of the stock price. This optimism bias belongs to the same family of biases as the illusion of control.
The Use of Assets
The third category covers various irrational human behaviors in terms of the use of assets, which can affect the process of portfolio construction and security selection.
Investors tend to divide their assets into different categories, and they allocate different degrees of utility to each class. They then make separate choices for each of their mental accounts.
This approach has the advantage of simplifying decision-making. However, by separating the different assets, we lose sight of the whole and the potential benefits of diversification (positive effect of a weak correlation between different asset classes, etc.).
As we noted earlier, investors often hold onto their losing assets for too long due to their lower risk aversion regarding losses. But in doing so, they lose the opportunity of a potential gain in selling losing security and investing in another which may make a significant gain.
Because for the moment it is only a paper loss and hasn't yet been realized, investors prefer keeping the security in the hope of a price rebound, although they could sell and reinvest in something more profitable.
On the other hand, investors tend to sell assets that have made again too quickly due to their greater aversion to risk as far as gains are concerned.
This tendency can be explained by the fear of regretting one's choice in the future (“I should have sold”), or by the belief in a mean reversion process that would push the price back down once arise has been registered.
House Money Effect
This effect, which is the opposite of the disposition effect, describes the tendency for investors to increase the proportion of risky assets in the event of again. They consider the gain already realized as a safety cushion allowing them to take more risks. The dominant effect will depend essentially on the individual's aversion to losses and risk.
This is the difficulty of parting with an asset that was pleasant to buy and hold. The maximum price paid by an individual to acquire an asset will be lower than the minimum compensation that will motivate him or her to part with this asset. The difficulty of parting with losing securities is a similar bias.
Investors often prefer investing in assets from their country of residence rather than in foreign assets. They have a preference for familiar situations because they feel better informed.
Investors sometimes have individual, ethical and religious preferences that limit their investment universe, such as, for instance, an unwillingness to invest in the tobacco or arms industries.
Investors are sometimes attached to past investments and, because they don't like to admit they're bad investments, they may keep them for too long at a loss. This reflects the disposition effect we mentioned earlier.
Lack of Control
Investors don't like assets they have no control over. This bias may explain the reticence of some clients to invest in hedge funds, as they can't imagine investing in a kind of “black box” they don't understand and, more importantly, cannot control. However, it is debatable whether buying stock in a large multinational gives them any greater control.
Pride and Regret
Depending on past decisions and the success or otherwise of buying a given asset, regret can play an important role in future decision-making. A bad investment experience in an asset can lead to it no longer being considered in the future.
In the specific case of the relationship between a client and advisor, if the investment decision seems positive, the client will attribute it to his or her own skills, whereas if it turns out negative, the client will protect his or her ego by blaming the advisor.
It is well and truly worth being conscious of these different behavioral biases that can be involved in decision-making, both in terms of the selection and processing of information.
It is necessary to format our brains, which are used to reasoning rationally so that they also take these irrational components into account.
A better understanding of these biases helps to keep things in perspective and reduces our dependence on them.
Investment Approach Based on Behavioural Finance
Psychological biases are certainly interesting opportunities to consider, but the exploitation of an anomaly which has started to be widely recognized is likely, bit by bit, to self-destruct over time. We are now going to look at a particular investment strategy that specifically aims to exploit these biases.
We mentioned earlier that investors seek above all to know whether it is better at a given moment to stay out of the market, or better to invest. The key word in this sentence gives a clue to one solution: moment.
The so-called momentum strategy is worth looking into here. Richard Driehaus, regarded as the father of this strategy, believes that we can make the maximum amount of money by buying high and selling even higher.
Momentum, or the relative continuity in returns from securities, is the tendency for securities having performed well (badly) in the past to perform well (badly) in the future.
Momentum strategy involves buying stocks that have generated high positive returns over the last three to 12 months and selling those that generated a negative return over the same period.
In 2001, Narasimhan Jegadeesh and Sheridan Titman assessed the profitability of momentum strategies for various sample periods (1965–1989, 1965–1997, 1990–1997).
The study showed that these strategies maintained a consistent level of profitability. They also demonstrated that this strategy generates a return of 1% per month for the following three to 12 months.
Winning stocks for the last three to 12 months have a strong chance of still being winning stocks over the subsequent three to 12 months. The effectiveness of this selection rule, obtained using American market data, has been validated on other international financial markets, particularly by Professor Rouwenhorst who came to the same conclusion.
This investment strategy consists in buying, at the start of each period, portfolios of the best performing securities and selling the worst performing, with the position being held for k months (k = 3, 6, 9, 12). The momentum effect reaches its maximum when the formation period of the portfolios equals 12 months and the holding period six months.
Portfolios with the best performance histories generate the best actual performances, whether the historical performance is calculated over the last six or 12 months. The best strategy is, therefore, to use the historical performances for the last six or 12 months with a holding period of between six and nine months maximum.
Performances generated by momentum strategies have obviously piqued the curiosity of researchers, and two approaches have been developed in an attempt to justify this phenomenon.
The first is the rational approach, which considers that momentum investors bear a high risk by adopting this strategy and the high returns represent the appropriate compensation for this risk.
Seasonal effects may also explain the strategy's success. If a stock has performed averagely and the end of the year is near, investors may well decide to sell it for tax reasons, causing its price to fall. Once the tax incentive has passed, the price moves back up.
The second is the behavioral approach, which holds that investors adopting this strategy are in fact exploiting behavioral biases in the interpretation of information, such as mimicry, under- an overreaction to news, and the overestimation of oneself and one's own judgment.
In a study carried out in 2006 on momentum strategy profits, it was shown that profits are predominantly due to investors' underreaction to information. The study also showed that these profits can be attributed to delayed overreaction and not to compensate for a high level of risk.
This phenomenon can, therefore, be explained by certain behavioral biases, namely: conservative bias, representativeness bias, and self-attribution bias.
The conservative bias results from investor tendency to under-weight recent information compared to prior information. In addition, the representativeness bias incites individuals to perceive trends where there are none.
Individuals tend, for events that occur infrequently, such as stock transactions, to overestimate the probability that the event will reoccur in the future, especially when they have observed it recently.
Because of the self-attribution bias, investors overweight information that confirms their first evaluation and underweight information that is inconsistent with it. Consequently, their estimations increase in strength with time, which produces a momentum effect, like a kind of delayed overreaction.
Assuming that small firms have a slower information diffusion process, the authors conclude that profits from using the momentum strategy are larger for these small firms. By picking stocks according to their historical performance, it is possible to generate abnormal profitability.
The actual performances decrease logically with the holding period. Holding these stocks for over nine months reduces the profitability we can gain from this strategy.
In conclusion, it would seem that the returns from the momentum strategy are not due to compensation for higher risk. In the end, the results obtained confirm the delayed overreaction of investors to information.
If we observe a momentum effect on the stock market in the short term (one to two years), there is, on the other hand, a reversal effect in the long term (three to five years), because the securities that made significant gains over the last three to five years tend to produce lower than average returns over the subsequent three to five years.
So it is dangerous to choose securities that have been performing very well for the last five years. The wisest bet is stock that has produced excellent returns over the last 12 months (when kept for only one year), but that has experienced the worst results in its group over a longer horizon (at least three years). Investors should be aware of some mean reversion over time.
The momentum approach would appear to be advantageous and is simple to implement, as it uses little data. However, the exploitation of this anomaly has started to be used excessively by the financial industry, as are all anomalies in the financial markets that result in higher than normal returns.
In our opinion, it is too early to judge the relevance of this approach, but it is worth retaining the idea of a holding period and an observation period.
Criticism of Behavioural Finance
Professor Fama suggests that even though there are anomalies that can't be explained by the modern (traditional) financial theory, market efficiency should not be totally abandoned in favor of behavioral finance. He notes that most anomalies can be regarded as short-term events due to chance that is corrected over time.
So the markets can be efficient even if many market players are irrational. Furthermore, the behaviors described are typically observed in individuals, while there are other players on the markets who are more rational and perhaps more important (in terms of size), such as institutional investors. We might wonder which group has a bigger impact on prices.
Nonetheless, it is important to be conscious of these psychological biases and of the irrational behavior of investors. Malkiel recommends resisting the temptation to make too many transactions, and considers the buy and hold strategy with a diversified market portfolio to be the most suitable approach.
However, he also says that the ideal holding period for securities is forever, while this is not necessarily the case for most investors.
Forecasting Market Movements
It is hard enough to forecast the weather, with few parameters to take into account. Considering the extensive number of variables acting on the markets, it is even more difficult to make forecasts.
As S. Goldwyn justly states, “Forecasts are difficult to make, especially those about future.” Many analysts try to predict market movements, but none manages to get it right consistently.
A random movement is a movement that is not predefined or programmed, whose future development is utterly unrelated to its past or present position. It has no memory and changes entirely at random.
But perhaps there is a certain “structured” order in such an apparently random process which, ideally, could be modeled? A statistical approach based on probabilities is the first path to explore.
Investment Approach Based on Probabilities
We can roughly summarise market movements by saying that they represent a succession of upturns and downturns over time, although the size of these movements will vary.
The probabilities of an upwards or downwards movement are not always equal and, depending on the context, the probability of an upturn can be higher or lower than that of a downturn. Furthermore, the size of upwards movements can differ from the size of downward movements, which has a significant impact on profit.
Profit, of course, depends not only on the occurrence of a rise or fall but also on the size of the rise. The size of an upturn or downturn will necessarily have a direct impact on results.
For the reasons outlined in the first part of this blog, we do not believe that the use of probabilities to determine the possibilities and size of an upturn or downturn is an appropriate means of forecasting future prices.
Different scenarios are possible to estimate by probabilities, but there is no way of asserting which scenario will occur because all the others, due simply to the fact they exist, may also occur. The estimated probabilities themselves are based on historical data.
So the financial models developed by Markowitz, Sharpe, and Black-Scholes are not really suitable; not only do they use the concept of volatility as a measure of risk, but they also assume that price changes are practically continuous. However, as we have already pointed out, prices jump, soar suddenly or collapse, thereby discrediting the assumptions underlying these models.
Mathematics is supposed to provide precise answers but, in our opinion, the usefulness of this discipline in stock market investing is limited. We believe that investments depend more on convictions than on the application of elaborate formulas.
We believe that forecasting future market movements on a statistical basis should be avoided. Although there are, admittedly, different probabilities associated with the various scenarios that we expect, any of these may occur, not to mention those we haven't thought of but may also occur. Therefore, this approach does not appear suitable for forecasting market movements.
Random Walk Theory
Does this mean that the markets follow a purely random movement?
The academic world holds that past prices cannot reliably indicate their future movements. Prices change randomly and are therefore unpredictable.
As we stated earlier, random walk theory is based on the efficient market hypothesis, and the best investment strategy under this approach is the buy and hold. Any attempt at beating the market in the long term is doomed.
In light of all the conclusions we've come to in the previous blogs, it would seem difficult to forecast market movements and, consequently, to make higher returns than the market.
However, the rather limiting buy and hold strategy neglect an important point: prices follow trends, they do not follow a random walk. According to Mandelbrot, they even have a kind of memory.
In which case, the objective is not to beat the market but simply to perform at least as well as the market in the periods where investors should invest, i.e., in bull markets. This obviously implies that there are periods in which investors shouldn't invest. Which brings us to the idea of market timing.
We believe that the markets do not follow a random walk, that instead, they move in trends. Therefore, a so-called buy and hold strategy that involves keeping positions in a portfolio “for life” is unsuitable for private investors.
Market timing involves investing, or being invested, in bull markets and getting out or staying out of bear markets, which obviously assumes that investors have correctly predicted these movements.
It is true that “with market timing, you run the risk of not being invested on the stock market's best days. Although the trading days that contribute strongly to an increase in returns are rare, they do play a major role in overall performance. Which should make us wary of market timing.”
However, the days of severe market decline contribute perhaps more significantly to overall performance, and it is specifically these declines that should be avoided.
According to a study of daily returns on different stock markets between 1990 and 2006, the average annual performance of the Swiss market was 9.4%. Someone who had not been invested on only the 20 worst days would have made an average annual return of 15.9%.
On the other hand, someone who had not been invested on only the 20 best trading days would have made the meager return of 3.6%. Over an observation period of 17 years, 20 days corresponds to 0.004% of all trading days.
Market timing might seem practically impossible to carry out, but the main thing this study teaches us is that it is better to avoid the bad trading days (15.9% performance, or an annual performance 69% higher than average) than to endure them (3.6% performance only, or an annual performance of 161% below average).
The difficulty of applying a market timing strategy should not, however, lead us to adopt a simple buy and hold approach. The goal is not to “buy as low as possible and sell at the top of the market, but to buy and sell at the right time”.3 Investors would then be likely to suffer market fluctuations over time, and these can be very violent with extended recovery periods.
Over a 10-year period from the start of 1999 to the end of 2008, someone who invested their capital in stocks would have lost money and ended the period worse off than someone who had invested in government bonds. Therefore, they were not remunerated for the risks taken.
Although exceptional returns did occur over short periods, considering the period overall, the result is fairly disappointing—worrying even—especially for investors with a relatively long time horizon.
Turning to the European market, the return on the DJ EuroStoxx50 index for this period was −26.77%, while the government bonds index reached +58.76%. You can imagine the return that could have been made by carefully choosing when to invest in stocks and, more importantly, avoiding strong correction phases.
It is also apparent that the recovery periods are very long, lasting years, while the correction periods are shorter and much more violent. In our view, it is better to avoid the worst trading days than to endure them while benefiting from the best days. Active management is crucial.
However, as Malkiel notes regarding the American market, his observation period of 54 years included 36 bull years, three years where the market did nothing and 15 bear years.
In his opinion, the buy and hold approach is the one that works the best, but how many investors can allow themselves such a long time horizon? Pension funds probably, but even some of these were required to take corrective measures after the large market decline of 2008.
It is worth noting that Malkiel himself says that for a time horizon of 10 years or less, it is impossible to predict returns. Investors must, therefore, be willing to accept market fluctuations, and potentially to lose capital.
In terms of institutional management, Swensen believes that market timing “voluntarily deviates the portfolio from the objectives of its long-term policy, exposing the institution to risks that it could easily avoid.
Because the asset allocation policy is the principal means by which investors express their risk and return preferences, a good manager will try to minimize deviations from these objectives.”
Before continuing our analysis, it is again worth demonstrating the impact of seasonality on performance according to the holding period or, in a way, to market timing.
An investor who systematically buys the Dow Jones index on 31 October and sells it on 30 April—following the old adage “sell in May and go away”— achieves a much better performance than an investor who buys on 30 April and sells on 31 October.
The former achieves a performance of 6000% for the period 1945–2008, while the latter has to be content with a performance of 9%.
So is it possible to forecast market movements by any means whatsoever, even if we can't achieve perfect market timing? We saw in an earlier blog that neither technical analysis nor fundamental analysis allows market movements to be predicted perfectly.
Therefore, the solution has to be sought elsewhere; we suggest taking at look at an approach based on macroeconomic factors.
A buy and hold strategy is unsuitable for private investors. It can, however, be justified for pension funds with very long investment horizons.
Markets move in trends and the most important thing is to avoid (strong) bear phases rather than enduring them over time.
Although the perfect market timing is impossible, active management or ideally proactive management should be considered.
Macroeconomic Investment Approach
The pertinence of a macroeconomic approach may be studied by looking in particular at the model proposed by Peter Navarro—namely, microwave investing.
According to Navarro, by adopting this approach investors can better anticipate market trends, and they must never invest against a trend. It is therefore essential to study general market conditions before buying a position because it is the large market movements that will make the difference.
The sectors to favor and those to avoid can be determined using various macroeconomic news and indicators. In his view, even natural disasters and wars represent macroeconomic opportunities.
Before we start presenting Navarro's analysis, we first need to look at the main macroeconomic forces in the market and the various indicators used to measure them. It is recommended to follow the development of these indicators to determine the real improvement or deterioration of the economy.
Sometimes, no precise conclusion may be reached. In this situation, it is better to wait for more clarity and certainty about the direction the market will take. A data publication alone is insufficient and it must always be examined in context.
Furthermore, it is preferable to focus on leading indicators (see below) that provide signs as to what is to come, rather than lagging indicators, which only change direction once economic conditions have already changed. Below is a list of these leading indicators and their meaning for investors. There is also an index of leading economic indicators that are worth following.
New orders for industrial investment
The money supply
Historically, the market peaks months before a recession and troughs before the recovery begins.
More money means lower interest rates and therefore more investments.
The interest rate spread (10-year bond less Fed funds rate)
When short-term interest rates exceed long-term interest rates, this inverted yield curve signals recession. This index includes several economic components whose variations can be used to predict changes in the economy for the coming months.
According to the definition given by the OECD, the leading indicators help forecast turning points (peaks and troughs) between expansions and slowdowns of economic activity.
In the United States, the Leading Economic Index (LEI) is published monthly by the Conference Board and may be found at www.conference-board.org. The various components of the index can be found here. Index calculations are also performed for other countries or regions, such as the LEI for the euro area.
The OECD also establishes composite leading indicators for its member countries and groups of countries, such as the euro area (www.oecd.org—statistics, leading indicators). An increase of over 100 indicates expansion and a decrease of over 100 a slowdown.
In the United States, the Fed reports (Federal Reserve Bank—American central bank) are also an important source of information. The Beige Book, which is published eight times a year, reflects discussions on regional economic conditions prepared by each Federal Reserve Bank. It contains comments that tend to predict and forecast changes over the subsequent months or quarters.
There are also two documents prepared for the members of the Federal Open Market Committee (FOCM), namely the Green Book, which provides forecasts on the American economy, and the Blue Book, which undertakes an analysis of national monetary policy.
In Europe, the European Central Bank (ECB) also publishes monthly reports (the Statistics Pocket Book and the Monthly Bulletin) containing a selection of macroeconomic indicators for the members of the European Union, as well as comparisons between the euro area, the United States and Japan.
The type of state intervention will depend first of all on the political affiliation of the ruling party and the dominant school of thought in terms of macroeconomics. For example, in the United States, the Democrats are generally Keynesian and favor an active fiscal and monetary policy.
On the other hand, the Republicans are more divided and tend to discourage this kind of intervention. Now let's examine the various approaches, focusing essentially on what has happened historically in the United States.
The classical, so-called non-interventionist economic approach, influenced predominantly by the economist Adam Smith, considers the problem of unemployment to be a natural part of the economic cycle.
According to this approach, unemployment self-corrects over time and therefore there is no call for the government to intervene in the free market to correct it.
The 1929 financial crisis and the subsequent Great Depression in the United States led John Maynard Keynes to reject the notion of self-correction. He asserted that the only means of recovering from this severe recession and revitalizing the economy was state intervention in the form of an appropriate tax or fiscal policy.
This approach implies a fiscal policy that aims to reduce taxes and increase public spending. Keynes' approach was adopted by President Roosevelt, particularly through his ambitious public works programme of the 1930s, subsequently supported by the boom of the 1940s with the Second World War.
The 1964 tax cut was also based on this approach and contributed to the strong prosperity the US experienced in the decades that followed.
However, in the 1970s, the United States experienced stagflation—a period of recession or economic stagnation combined with inflation. Keynes' interventionism to reduce unemployment in fact created inflation, and the actions to reduce inflation had a negative effect on growth, thereby aggravating the recession.
According to monetarism, the approach defended by Milton Friedman, inflation and recession actually depend on the growth rate of the money supply.
The government printing too much money causes inflation, and not enough leads to recession. There is a so-called “natural” rate of unemployment according to this approach and the only way to curb inflation is to increase the rate of unemployment above the natural rate, which amounts to creating a recession.
From 1979, former Fed president Paul Volcker adopted a contractionary monetary policy, raising interest rates to over 20% to control the double-figure inflation rates that the country had been experiencing for the last few years.
In 1980, Ronald Reagan proposed a simultaneous tax cut, an increase in tax revenues and the acceleration of economic growth. He believed that by adopting an approach based on supply, the tax cuts would allow citizens to work more and invest more, thereby generating stronger growth and more tax revenues for the State. Unfortunately, this did not happen and the American deficit worsened.
During the Bush presidency, a new approach emerged: so-called neoclassical economics, which is based on rational expectations. If expectations are formulated rationally, then all available information—including the effects of an active fiscal policy—is taken into account, and government measures may become ineffective specifically because they are anticipated by market players.
More stable policies focused on the long-term are therefore preferable, instead of considering short-term reactions.
As we noted earlier, the chosen approach depends heavily on the government in power and the school of thought it decides to follow. However, it is essential for investors to be familiar with the type of intervention that will be chosen as its consequences will vary for each industry. We will now look in more depth at tax and fiscal policy, then monetary policy.
Tax and Fiscal Policy
There are two means for a government to stimulate its country's economic activity and seek full employment. First, it may envisage an increase in public spending, allowing the State to make investments in order to support private companies and promote their competitiveness.
State support for education, training, and technological development allows companies to create greater added value on the products and services offered, and therefore become more competitive internationally.
This tool is most appropriate in the event of a crisis in supply, i.e., on the corporate side. In a way, in times of economic crisis, government spending is substituted for the decline in household consumption and private investment, thereby ensuring a sufficient level of growth.
Second, a tax cut may be considered by the State to revive household consumption. This tax stimulus is intended to increase consumers' disposable income, inciting them to step up their consumption.
However, depending on the extent of the economic crisis, the unemployment rate and the expectations of the various players involved, consumers may simply save their disposable income and postpone their purchases.
Furthermore, depending on the level of competitiveness of their products and services and of their currency, consumers may look increasingly to cheaper foreign products. This approach is best suited to a crisis in demand, the State hoping to stimulate consumer spending, but the disadvantages just outlined cannot be discounted.
In both cases, these government actions lead to an increase in the public deficit. Careful policy-making is therefore required to reduce debt if the economic conditions are favorable or increase it in the event of a recession.
In theory, of course, an increase in the public deficit should be temporary, because if the measure is effective, economic activity should increase—as should the tax base —even with lower tax rates. Often, however, this effect remains theoretical. In addition, a high level of public debt in some States can limit the possibilities of taking on debt in the future.
In general, the government has two tools available to finance its deficit. It can issue bonds to raise capital on the market, or it can print money. In practice, the Central Bank will buy government bonds before they arrive on the market, following what is known as an accommodative policy.
This approach is fairly positive in the short term for stocks and negative for the currency. For bonds, it has an adverse effect in that the probable return of inflation is likely to impact negatively on prices.
Monetary policy is usually conducted by the Central Bank, which controls the amount of money in circulation. As we mentioned earlier, it can either follow an expansionary monetary policy to stimulate the economy or a contractionary monetary policy to avoid an overheated economy and excessive inflation.
It has two main means of doing this. There are also other kinds of intervention possible for central banks but we won't go into further detail on these here.
Firstly, it can perform open market operations by buying government securities for an expansionary policy (an intended fall in interest rates) and selling government securities for a contractionary policy (an intended rise in interest rates).
It can also set interest rates. In practice, in the United States, for instance, there are two distinct rates: the discount rate, which is the interest rate that the Fed applies to banks that want to lend it money, and the Federal funds rate, which is the rate that banks use among themselves when lending each other money.
A drop in these rates allows banks to borrow money at a lower cost, creating an expansion of the money supply. Conversely, a rise in these rates makes it more expensive for banks to borrow, causing a contraction in the money supply.
The Appropriate Policy
In general, fiscal policy is the preferred instrument when the economy has fallen into a strong recession or a depression. Monetary policy is preferable when the government is trying to fight inflation or a slight recession.
The Major Macroeconomic Forces
For the first three of these forces, we recommend above all following the calendar of macroeconomic events and publications, which can usually be found in the business and finance section of the major daily newspapers and on the websites of governmental organizations.
There are other websites that provide the macroeconomic calendar for the week or months to come, some of which are more focused on one country or region in particular:
As we indicated at the start of this book, inflation can be defined as a rise in the general level of prices, with the essential consequence of a decrease in consumer purchasing power in the future. Conversely, deflation can be defined as the fall in the general level of prices.
It is referred to as monetary inflation when too much money is issued by the State, leading to a price rise. According to the quantity theory of money modeled by Irving Fisher, any increase in money supply which exceeds the increase in gross domestic product (GDP hereafter) mechanically drives up the general level of prices in the medium term.
Too weak a demand for money, due, for example, to high savings, can lead to the same result. This assertion is based on the following equation and assumes that the velocity of money, which measures the tendency to spend money, is stable over time:
However, it seems that the velocity of money is not always stable, that it actually changes over time. Furthermore, a rise in the household savings rate reflects a tendency to spend less, which has the effect of lowering this velocity. Lower velocity, therefore, makes it possible to limit price rises.
Consequently, monetary growth is not in itself sufficient to cause inflation, which will depend on changes in velocity and GDP growth. Finally, when a central bank increases the money supply, the final destination of the money is key in determining whether it has indeed been integrated into the system.
Following the subprime crisis and the intervention of the Fed—which injected colossal amounts of money—it became apparent that a very large part of the sums made available to banks had not been “redistributed” to companies and private individuals, but had rather been kept by the banks.
Furthermore, if we include the demographic component, growth is likely to be much more modest than in the past because of the expected growth of the inactive population (the elderly) and the attendant decrease in the working population.
However, if growth remains sufficient in the future to “absorb” this aging population, the problem will become more political than economic.
In the event of strong economic growth (where demand for products or services exceeds supply), inflation can also be stimulated by demand, in turn causing prices to rise and creating demand-pull inflation. It can also be caused by wage increases when wages rise too quickly relative to economic growth.
When the production costs of products or services, especially related to raw materials, increase significantly, this is reflected in the final price paid by consumers. This is referred to as cost-push inflation.
The type of inflation is critical, as it will determine the policy adopted by the Central Bank. This will be more reactive (interest rate hike) when faced with demand-pull inflation, which carries a risk of overheating, and more reserved in the case of inflation related to increases in energy or commodity prices, for example.
In the event of cost-push inflation appearing in a context of (pre-)recession, an interest rate hike would exacerbate the slowdown, further reducing a consumer demand already weakened by rising energy or raw material prices.
When faced with the last type of inflation, namely that related to wage increases, the Central Bank will undertake strong measures to fight it. This form of inflation may take longer to bring under control than demand-pull inflation.
When inflation starts to rise or is likely to rise in the future, the Central Bank can adopt a so-called monetary tightening policy, which involves a rise in short-term interest rates.
This aims to “slow down” growth to avoid the economy overheating, i.e., excessively fast growth with no control over price increases or, consequently, inflation. However, this interest rate rise is likely to reduce both consumptions and, in the event of currency appreciation, exports.
In general, rising inflation can be controlled by an interest rate hike, but this incurs the risk of a future economic slowdown. As we mentioned earlier, an increase in interest rates is negative for stocks.
For bonds, such a rise will push prices down, but as investors will shy away from stocks, the attractiveness of this asset class will help raise prices. The final net effect is therefore difficult to determine.
Conversely, when inflation is under control or growth slows down, the Central Bank must follow this trend. If the risk of economic slowdown is significant, a drop in interest rates may be considered to stimulate the economy. As such, it can adopt a so-called expansionary monetary policy, which involves a drop in short-term interest rates.
This measure aims to promote growth to boost the economy, but carries the risk of higher prices and therefore inflation in the future. At this stage, it is worth noting that the objectives of central banks differ according to the country. For instance, the objective of sustainable growth is much more important in the United States than in Europe.
These short-term interest rates, reflected by the money market, are therefore influenced by the Central Bank's policy in terms of inflation, as well as expected growth.
Long-term interest rates, usually represented by 10-year or even 30-year government bond yields, are influenced by the future financing needs and capacities of public and private agents.
So if these long-term financing needs are expected to rise, long-term rates will also rise, and if these needs are expected to decrease, long-term rates will fall.
The presence of moderate inflation is not a negative factor, as long as the economy is enjoying a reasonable level of growth. The worst-case scenario that any Central Bank seeks to avoid is stagflation, i.e., inflation without economic growth.
A little short-term deflation is not negative either, but prolonged deflation such as that experienced in Japan can have severe consequences on the economy.
As deflation leads to further deflation, consumers seeing prices fall tend to postpone their consumption in anticipation of further price reductions. This phenomenon obviously does nothing to help economic recovery, rather aggravating the recession.
This is why central banks with the sole objective of price stability have a positive inflation objective. As inflation rates may vary, an objective of 0% would be too risky as a situation of deflation could occur frequently.
There are various indicators for measuring inflation.
a) Consumer Price Index—CPI
This measures inflation at the consumer level, but some indexes, like the core CPI, disregard food and energy prices in order to evaluate the type of inflation more accurately (demand-pull or cost-push). This is an important indicator for bonds and stocks.
b) Producer Price Index—PPI
This indicator reflects production costs, especially for finished products. The core PPI index does not include food and energy, and is best suited for evaluating the type of inflation.
However, it is important to consider the effects of seasonality. This is often considered as a leading indicator of the CPI, and therefore of expected inflation.
c) Employment Cost Index—ECI
This index measures the third form of inflation, namely wage inflation, and tracks wage development. The existence of wage inflation can provoke a future rise in interest rates.
d) Average Hourly Earnings
This index is also used to measure the third form of inflation, but we must be careful not to draw premature conclusions from it. An increase may simply be the result of an increase in overtime, while base wages remain the same.
Or, the increase may be explained by a change in the composition of the workforce, which has become better qualified and therefore better paid.
Finally, the various job-related benefits are not taken into account; only the nominal increase is considered. The previous indicator is more reliable because it takes into account both the nominal increase and the various workers' benefits and compensation.
As we have seen, economic growth is essential for a country to ensure its prosperity, an optimal level of production and full employment. It is measured by the growth of the Gross Domestic Product (GDP), which changes over time and is one of the most closely followed indicators. Other types of indicator do exist for evaluating growth.
It is important to compare growth rates between countries, as a country's demand for imports depends essentially on its revenues. For example, if growth is stronger in the United States than in Germany, the demand for imports of German products will grow, at the same time creating an increase in the US balance of trade deficit.
a) GDP Growth
GDP measures the total value of wealth produced by a country over a given period, i.e., the total value of goods and services produced domestically.
Practically, this value is calculated by adding all the expenditures made by different production factors: private consumption (C), gross investment (I), government spending (G) and the balance of trade (eX-i), i.e., the difference between exports (eX) and imports (i). This gives the following formula:
As such, the Investments/GDP ratio constitutes an indicator of future growth potential. Meanwhile, the Debt to GDP ratio indicates a country's level of debt. As we have already pointed out, growth brings with it the risk of inflation, which can lead to possible interest rate hikes to curb inflation.
Conversely, low growth indicates a risk of economic slowdown or even recession. This may lead to an interest rate cut to stimulate the economy, which in turn carries the risk of inflation in the medium or long term.
GDP indicates the growth of a country and is published quarterly. Two consecutive quarters of negative growth correspond to the economic definition of a recession. Real GDP is more pertinent as it measures growth while excluding the influence of inflation, i.e., it is adjusted for price changes.
As it appears quarterly, the GDP report is quite volatile and subject to revision. It comes out later than other indicators, so it is better to focus on consumption and investments, two of its major components. However, it completely ignores undeclared work, thereby underestimating a country's real level of activity.
When examining GDP, it is also interesting to study two types of the deficit that may occur, as well as the current account balance.
i) The Current Account Balance and the Trade Deficit
The Gross National Product (GNP) represents the total value of goods and services produced by the citizens of the country in question. The formula is virtually identical to the one described above, the difference being the addition of net income from abroad (income receipts from the rest of the world—income payments to the rest of the world).
The current account balance is obtained by adding the balance of trade for goods and services (eX-i) and the net income from abroad. The current account balance (CA) is also obtained by adding net private savings (S—I) and net public savings or fiscal balance (T—G). A current account surplus means that the country invests abroad and it can consequently lend to other countries. The domestic currency is usually strong and interest rates low.
A current account deficit means that the country spends more than it produces and it may finance its consumption by borrowing abroad. In this case, there is a risk of currency devaluation.
A negative domestic savings rate also implies a current account deficit. Unfortunately, an interest rate hike to stimulate savings or attract foreign investors is likely to have a negative impact on stocks and bonds.
As we saw above, the balance of trade (eX-i) is a component of the GDP calculation.
A trade surplus means that exports exceed imports, with a positive impact on growth.
The reverse is true of a trade deficit (imports exceed exports). A trade deficit may lead to a weakening of the domestic currency to stimulate exports, but as foreign holders of securities denominated in that currency will seek to avoid depreciation of their investments, they may sell these assets, pushing the stock market down.
This will result in increased pressure on the currency. Investors in the domestic market are likely to follow the movement, and if the Central Bank decides to sustain its currency through an interest rate hike it risks worsening the situation even further. The Trade Balance Report provides the level of imports and exports for a country and indicates whether there is a trade surplus or deficit.
The total deficit is somewhat secondary to changes in exports or imports. Import and export prices are also an important source of information on this point. Depending on the cause of increases or decreases in imports and exports, market reactions will differ.
The deficit may be explained by an increase in imports due to strong domestic growth compared to other countries. In this case, such a scenario will have little impact on the stock market. Depending on the outlook for inflation, however, the bond market may suffer.
On the other hand, the deficit may come from a decrease in exports due to a recession in other countries. In this case, the stock market is likely to suffer, especially in export-oriented industries. Meanwhile, the bond market prefers this scenario, which puts downward pressure on interest rates to stimulate exports.
When the deficit results from a decline in exports due to an interest rate hike initiated by the Central Bank, neither the stock market nor the bond market will react favorably. However, the final reaction will depend on measures taken by foreign governments to maintain their currency or otherwise.
ii) Budget Deficit
We spoke in the first section of the consequences of fiscal policy on the budget, particularly on the increase in its deficit. This deficit should be compared to GDP to measure the country's capacity to produce and thereby pay off its debt.
It is, therefore, a relative measure, which should be compared with other countries. Note that a chronic budget deficit is dangerous for the economy and is not encouraging to the stock and bond markets.
To finance its expenditure, a State has three options. First, it can raise taxes, but this measure is often unpopular, especially during an election campaign period.
Second, it can borrow on the market by issuing bonds. The quality of public finances will essentially determine the rate it can offer on the market. Occasionally, this rate may be equal or even superior to that offered by corporate bonds, showing, in fact, a government issue of poorer quality.
Finally, the State can obtain funds from the Central Bank, which can intervene by adopting a so-called “accommodative” policy, i.e., buying the government bonds before they hit the market.
In a way, this kind of operation amounts to creating money, but the increase in supply can cause inflation. Once again, a potential interest rate rise is never well received by the stock and bond markets.
So attention should be paid to the development of the deficit; it's important to study the budget report showing the level of budget deficit. This appears every month, but suffers from effects of seasonality due, for instance, to quarterly payments by taxpayers. As monthly fluctuations can be considerable, it is better to examine a given month compared to the same month of the previous year.
The so-called “structural” deficit, which exists even in a context of full employment, is distinct from the “cyclical” deficit, which is linked to a situation of recession and is easier to fight using appropriate monetary or fiscal policies.
b) Consumption Indicators
Household consumption represents nearly two-thirds of GDP. Its development is, therefore, a strong determinant of GDP growth. As such, three indicators are worth examining.
i) Retail Sales Report
This is one of the most important monthly indicators and can have a strong impact on the markets. It reflects the level of consumer spending (sales of all retail goods) and influences economic growth.
Increased sales are therefore a positive sign, but with a potential inflation risk that may be controlled by future interest rate hikes. Conversely, if sales are down, there is a risk of economic slowdown or recession which must be monitored.
This is one of the most important leading indicators, which falls when the economy starts to enter a recession, and is the first to rise when the economy takes off again.
It is also important to examine whether the changes in consumption affect all industries or certain sectors in particular. It is better to evaluate this indicator excluding car sales, which usually represent a large percentage of sales and can suffer from considerable seasonal fluctuations.
This indicator can also be very volatile and does not include spending on services.
ii) Personal Income and Expenditures
Changes in disposable income and household consumption will determine future consumer demand, and therefore have an impact on growth. If disposable income is rising, people will usually spend more money. If it's falling, they tend to save.
In the past, the United States had a very low savings rate (between 1% and 2% over the last three years), but this rate is currently rising for American households. In 2009, it sat at almost 4%—high for the US but relatively low when compared to 17% in France,8 the rate calculated for the third quarter of 2009.
iii) Consumer Confidence Index—CCI
The confidence indices evaluate the expectations and feelings of households vis-à-vis their future consumption, thereby constituting a leading indicator on growth, as long as the changes are significant. As we noted earlier, there is a link between consumer confidence and actual consumption.
If confidence is high, consumption is very likely to increase, thereby generating growth. Conversely, if confidence is weak, consumption is likely to be limited or postponed, causing an economic slowdown.
c) Corporate Indicators
Investments represent nearly 20% of GDP and, as with consumption, an increase in investments contributes to GDP growth.
i) Purchasing Managers' Index—PMI
In the United States, the Institute of Supply Management (ISM) publishes a monthly report on manufacturing (ISM Manufacturing Report on Business) and another on services (ISM Non-Manufacturing Report on Business). The latter is more recent, having been created in 1998, and is consequently less closely followed by the markets.
The most important indicator to reflect the condition of the United States' manufacturing industry is the composite Purchasing Managers' Index (PMI), which is organized into five categories (each worth 20%):
When it falls under 50, the index indicates a recession, especially if the trend continues over several months. A level of above 50 shows economic growth.
ii) Factory Orders and Durable Goods Report
This indicator helps measure the level of factory orders and durable goods, and therefore corporate demand, which in principle will have a subsequent impact on sales and corporate earnings.
iii) Industrial Production and Capacity Utilisation
This report gives an overview of the country's industrial production, particularly the capacity utilization of factories. Levels of above 82–85% tend to predict future price hikes and shortages on the supply side. A level of below 80% tends to indicate a slowdown of the economy and a possible recession.
d) Other Indicators
It is also worth studying the international trade situation, by examining the development of the Baltic Dry Index (BDI), which is an index of shipping prices for various dry bulk cargoes such as grains, ores or metals. It is calculated on an average of prices for 24 global shipping routes.
By definition, a country has entered a recession when it has undergone two consecutive quarters of negative growth. It is important to detect the signs of a major economic slowdown as early as possible.
When a recession is expected or is taking place, and there are no inflationary pressures, bond prices may rise in anticipation of rate cuts to combat them. Stocks will tend to weaken in anticipation of a decline in future results, but it is important to select industries carefully, choosing those best prepared to withstand or even take advantage of the crisis.
Besides the indicators related to growth presented above, there are several indicators used to determine whether or not the economy is entering a recession.
a) Initial Jobless Claims Report and Employment Situation
The Initial Jobless Claims Report indicates the number of newly unemployed on a weekly basis. The Employment Situation, published monthly, gives the unemployment rate, the number of jobs created on nonfarm payrolls (manufacturing, business, government agencies), and other factors such as the average work week.
An increase in overtime is often a preliminary stage before hiring new workers. On the contrary, a reduction in overtime may presage future redundancies.
The total number of unemployed persons represents the country's unemployment rate and therefore the level of economic activity. It is closely monitored by politicians, especially at election time.
If the unemployment is rising, the risk of economic slowdown, or even recession, is significant. Consequently, an interest rate cut is possible to stimulate the economy. A high figure may be positive in that it can sometimes mark the end of a crisis.
Waning unemployment points to growth, but this can carry a risk of overheating and inflation. An increase in interest rates to control inflation is therefore possible.
To assess the risks of inflation and recession accurately, it is nonetheless important to compare this rate with the so-called “natural” unemployment rate.
Investors should also carefully examine whether the job creation or losses are affecting the economy in general or only certain sectors. In the United States, a variation of less than 30 000 in the number of jobless is regarded as statistically insignificant.
b) Existing Home Sales Report and New Home Sales Report
The Existing Home Sales Report appears at the end of every month for the developments of the previous month. It is strongly related to mortgage interest rates and therefore reacts quickly to any changes in these rates.
The report also gives the housing inventory and median prices but includes no detailed information on the type of housing. A low inventory can be an early sign that construction is likely to increase.
The New Home Sales Report depends on demand and usually starts to rise when the economy is coming out of a recession. This indicator also helps measure growth. This is because individuals who buy land to build their house on will subsequently spend money to furnish it, landscape the garden, etc., generating private consumption expenditure with a positive effect on growth.
So both these reports provide information on the level of growth or economic slowdown in the country, but because their publication is delayed relative to the construction of new homes, they cannot be considered as leading indicators. Although more focused on the housing market, they also help determine the overall macroeconomic perspective.
Increased sales or high figures are positive for the economy and indicate growth. Furthermore, if housing prices rise, homeowners and landlords can take on more debt to consume (buy) more. However, this situation brings with it the risk of inflation, which can lead to possible interest rate hikes to curb inflation.
Conversely, if sales are down or the figures are low, there is a risk of economic slowdown or recession. A lowering of interest rates is possible in the future, but this will also depend on inflation. If prices drop, homeowners and landlords will take on less debt and therefore consume less.
c) Housing Starts and Building Permits
This monthly indicator is also regarded as one of the important leading indicators, as it usually falls when the economy starts to enter a recession, and is the first to climb when the economy takes off.
However, the impact on the markets will depend on the condition the economy is in when the monthly report is published. If the economy is expanding and inflation is a concern, an increase in construction will be seen as fairly negative because of this inflation risk. On the other hand, in a context of economic slowdown or recession, such an increase will be greeted as positive.
d) Confidence Indices
Confidence indices such as the Consumer Confidence Index (CCI) or the index provided by the University of Michigan give an indication of consumer expectations and sentiment about their consumption.
There is a strong link between consumer confidence and actual consumption. If confidence is high, consumption is very likely to increase, thereby generating growth. However, as we stated earlier, this can create a risk of inflation, making an interest rate hike possible in the future.
Conversely, if confidence is weak, consumption is likely to be limited or postponed, causing an economic slowdown. Consequently, an interest rate cut is possible to stimulate growth. Other confidence indices also exist, such as the ZEW index, which gauges the sentiment of German investors.
It measures the confidence of financial analysts and investors about the outlook for inflation, interest rates, stock indexes, currencies, oil and corporate profits over the next six months. A positive index means that sentiment is improving, while an index of below zero indicates a deterioration.
There are also confidence indices for the industry—the German Ifo index, for example—that give an idea of expectations and sentiment about the development of the business climate and future growth.
Productivity and Technological Change
Another of the market's most closely followed indices is the increase in worker productivity. By productivity, we mean the relation between production and the resources used to achieve it.
An increase in productivity makes it possible to produce more for less, which can lead companies to lower their prices and become more competitive on the market. This will stimulate consumer demand for the goods that have become cheaper (improved purchasing power).
Improved productivity also leads to lower unit labor costs and a consequent increase in company profits. Companies can, therefore, make new investments to ensure their development, stimulating demand for goods and services. The same is true for the State which, due to increased tax revenues, can increase public spending and particularly investments.
Finally, companies may decide to distribute this surplus to their employees by raising wages. This will result in an increase in their purchasing power and a boost to consumption of goods and services. As we can see, increased productivity has a positive impact on growth.
However, greater efficiency does not necessarily lead to new jobs. The immediate impact is difficult to estimate, but in the long term, increased productivity is usually positive for employment. The report on productivity and costs only appears on a quarterly basis and is published later than GDP.
Besides the economic calendars, reports on productivity are available on the Bureau of Labor Statistics and OECD websites:
Furthermore, the technology used by a company influences its productivity. As such, technological change is one of the most important factors influencing long-term stock prices. A company that has missed a technological shift is doomed to disappear, as it will be unable to adapt to the new market conditions.
These can be linked to the incorporation of new technologies that lower production costs or that favor the use of cheaper raw materials. Companies that manage to become less dependent on crude oil in a given sector will, therefore, be better positioned.
If we look at transport, for example, the sector to benefit the most from the context of rising oil prices will be rail. This sector already enjoyed strong growth in 2008 when oil prices reached historic highs.
Thus, it is crucial for investors to keep track of technological advances and to examine how they are integrated by companies, which must offer products and services adapted to their time and their customers. For example, the last company to manufacture typewriters (Smith-Corona) went bankrupt, its products have become obsolete.
Regulations and Taxes
Finally, government statements or decisions can have a devastating impact on securities. Decisions to liberalize or privatize, to regulate, control or subsidize, can affect industries and especially companies.
Regularly reading the newspapers (paper or online) is a good way to stay informed and be better able to anticipate changes of potential significance for certain sectors, or those that may affect businesses.
It is important to know the various sectors and industries well in order to determine the impact that macroeconomic events can have on them. Different industrial sectors react to differing degrees—and sometimes in opposite ways—to good and bad macroeconomic news.
According to Navarro, you have to think in terms of sectors to profit from the opportunities these events provide. The same goes for the stock, bond and money markets, which react differently to macroeconomic news and can, therefore, develop in opposite directions.
So investors should first ensure they are familiar with the main sectors of the economy, then identify the strongest and weakest companies within these sectors. Then they need to reflect on how each sector reacts to different types of macroeconomic news.
To begin with, it is necessary to examine the type of customer by sector, namely consumers (households), companies or the government. In general, the computer and leisure sectors depend on sales to consumers. The consumer confidence index, retail sales, and personal income are the indicators to follow.
The chemical and paper sectors depend more on industrial buyers. An indicator like the industrial production and capacity utilization rate is more relevant here.
Finally, the main customers of the defence and aerospace sectors are governments, meaning that any news on the State budget must be scrutinized with great care. Next, it is necessary to find out if, in the production process, the sector tends to use workers, machines or oil, or a combination of two or all of these.
In this respect, the retail sales sector is regarded as labor-intensive, which means it is more sensitive to the rise and fall of unemployment rates and to wage inflation.
Utilities—companies providing public services such as water, electricity, and gas—are seen as capital intensive and are very sensitive to interest rate fluctuations. Finally, the transport sector is fuel intensive and reacts to fluctuations in energy and oil prices.
Some sectors are “cyclical”, such as the auto industry, construction, and transport, which react more strongly to economic slowdowns or recessions than so-called “non-cyclical” sectors such as health, pharmaceuticals or food. For macroeconomic investors, this distinction helps determine which sectors to sell or avoid in the event of a slowdown and which to buy when the economy is taking off.
Finally, the agricultural, electronics, industrial equipment, computer, and pharmaceutical industries are export-oriented, while financial services and healthcare are less dependent on exports. Export-dependent sectors react more strongly to the balance of trade and currency fluctuations.
As we noted above, it is also necessary to keep up to date politically to determine the risks related to new regulations as early as possible, especially in sectors such as energy, pharmaceuticals, or the chemical and defense industries.
The climate can also influence sales and therefore corporate margins. The return of rain to Brazil after a period of drought will help lower coffee prices, allowing a company like Starbucks to increase its margins. On the other hand, a flood can destroy crops, this time pushing prices up.
Peter Navarro's Approach
For Navarro, market risk represents the purest kind of macroeconomic risk. In order to minimize this risk, macroeconomic investors must be capable of going long, short or flat, i.e., knowing whether to be a buyer, seller, or neutral, and must never go against a trend. With regard to sector risk or company risk, it is useful to follow the events likely to affect them.
According to Navarro, sector risk represents 50% to 80% of the price movement of a security and depends specifically on the macro and micro-economic forces acting on a given sector.
Company risk, or specific risk, can be related to management, unfavorable regulations or bad news. Risk related to regulations is particularly marked in the drug, tobacco and agriculture sectors. Diversification, particularly using a tracker fund, help minimize this risk.
A study of the fundamentals, such as growth in per-share earnings, the P/E ratio or technical levels (near to a support or resistance), helps limit it. It is also important to examine the calendar of earnings announcements, which is often a risky period for trading a stock.
Stock Picking and trends
Although it is certainly important to be familiar with the different industries and sectors of the economy, this is not enough. Investors must be able to determine, using various indicators, the general market trend and that of the individual sectors, in order to identify the strong and weak sectors and those which may soon gain in strength or deteriorate.
As we pointed out earlier, “Trend is your friend” and you should never invest against a trend. In order to determine the market trend, the following indicators can be used (the example refers to the American market).
a) S&P Futures
These are an excellent indicator of the market direction. If they are rising, the markets are usually rising, and vice versa.
b) TICK and TRIN
In the case of the US market, TICK gives the difference between the number of stocks rising (upticking) and those falling (downtick). So a positive TICK indicates a bull market. The TRIN incorporates the relative volume of advancing issues and the relative volume of declining issues, using the following calculation.
A TRIN lower than 1 is a sign of a bull market. TICK and TRIN must be pointing in the same direction to confirm a market trend, as mixed signals don't really allow a trend to be ascertained clearly.
Next, trends for the different sectors should be established. A study of the sector indices and trackers helps detect which sectors are advancing and which are declining.
Before trading stock, it is essential to examine the sector's situation, as the price movement of an individual stock depends for over 50% on the movement of the sector it belongs to.
Simply investing in a market index certainly reduces risks thanks to large diversification, but it also limits potential gain. Investment in a particular sector helps avoid excessive concentration, but a part of the capital invested will suffer fluctuations due to the weak companies in the sector, thereby affecting the potential profit. So it is more appropriate to favor strong, solid stocks in the chosen sector during a bullish trend.
Finally, when evaluating the trend, it is also important to follow the news and the calendar of macroeconomic indicators. Reading the newspapers regularly and attentively helps minimize the risk associated with fluctuations due to announcements or political decisions affecting the sector.
It can be useful to construct different scenarios according to the level of the indicator, which can then be compared to the estimates, and to evaluate the potential consequences on different sectors.
Regarding individual stocks, fundamental analysis is carried out first, followed by a technical analysis to refine the market timing.11 Stocks that successfully pass the fundamental and technical analysis tests are finally selected to make up the stock basket for the sector in question.
It is advisable to proceed in this way, as even a stock which seems attractive from a technical or fundamental point of view won't be able to do much in a generally bearish market or sector. So the technical and fundamental analysis must be taken into account, along with the macroeconomic context.
Peter Navarro also suggests looking at economic cycles and investing in different sectors according to the phase in which we find ourselves in the cycle. The choice of the sector is the easy part; determining the phase of the cycle is more complicated. To understand this table better, it is worth starting from the top market situation—phase 5, and then studying the cycle's development.
In a top market situation, the economy is growing strongly but runs the risk of overheating. The Central Bank has already raised interest rates several times to bring it under control and avoid excessive inflation.
The unemployment rate is usually very low, retail sales are exploding and consumer confidence is in great shape. Energy prices continue to rise. At this stage, inflation is a major worry and this is the moment (early bear) for investors to start turning to more defensive and non-cyclical sectors.
As interest rates are too high, the economy slows down and starts entering a recession, with a drop in production and confidence and rising unemployment.
The Central Bank starts to lower interest rates, investments decline and industry is waiting for better days to start investing again. Investors first begin (approaching late bear) moving toward the utility sector, which is capital intensive and sensitive to interest rates. Falling energy prices also benefit this sector.
When interest rates are at their lowest, the cyclical and financial sectors will be favored (late bear) as they benefit particularly from low-interest rates.
The economy will then start to take off and the transport sector will become attractive in this new phase (early bull). Production will start to increase, as will sales. Investments in new factories or equipment won't be made until the following phase (early to middle bull) with an increase in new orders.
The technology sector will benefit first, then (middle to late bull) the sectors that will take advantage of the increase in demand for machines and equipment.
The economy is now working at full speed, with virtually full employment and many hours of overtime being worked. This phase (late bull) is the moment to turn to the industrial sector, which benefits from increased demand for aluminum, steel, chemicals, and paper.
The Central Bank is starting to raise interest rates to avoid excessive inflation, and it is usually at this point (late bull to market top) that demand for energy explodes. The energy sector is, therefore, to be favored.
The Central Bank continues to raise interest rates and energy prices keep climbing, which is beginning to weigh on the economy. The market reaches its summit (market top). The indicators start to deteriorate and the cycle comes to an end.
Criticism of the Macroeconomic Approach
By anticipating certain factors, based on current, historical and estimated data, analysts propose forecasts for the development of securities, markets, and currencies. This approach only considers objective data and disregards the psychology of the individuals behind each of these factors.
An analysis that takes behavioral aspects into account would be desirable, but we understand that this is a difficult exercise as its role is precisely to focus on the fundamentals, i.e., the tangible aspects.
Peter Lynch, the guru of the Magellan fund, one day declared: “If you spend more than 14 minutes a year worrying about the market, you've wasted 12 minutes”, underlining the lack of reliability of macroeconomic forecasts.
Indeed, in practice, analysts often make mistakes, or rather the results that occur differ from the suggested scenario. Not because their analyses were wrong in substance, but simply because they fail to take into account other factors, particularly the current market trend in the broadest sense of the term, which includes investor psychology.
We believe that the macroeconomic context must be considered and that it is essential to keep a close eye on the various indicators we have presented above. We favor a so-called top-down approach, i.e., determining first of all the general market trend, then the trend of the different sectors and industries, before finally selecting individual securities.
A combination of fundamental and technical analyses is then necessary. However, human psychology is complex and macroeconomic, fundamental or technical analyses are not enough on their own.
Modeling Market Movements
We turn now to the modeling of market movements. How relevant is this modeling? Is it possible to implement a model to forecast these movements? We mentioned earlier the possibility of order appearing in the midst of apparent disorder. This is the view advanced by mathematician Benoit Mandelbrot, the father of the fractal approach.
A fractal is a geometric shape that can be divided into several parts, each of which is a reduced-size copy of the whole. In other words, a fractal object is an object in which each part is also a fractal object.
The whole can, therefore, be “deduced” from each of the parts of which it is composed. As such, order emerges from what seems initially to be a disorder, implying the non-existence of random movement. The idea is to try to identify regularity within irregularity.
An analysis of each fractal and its development will, therefore, help understand and, in a way, anticipate the following fractal object or even the whole. In finance, if we break down market movements, we can see that they represent a series of upswings and downturns.
Each movement is a fractal and together these upwards and downwards movements give the general movement of the whole or the market.
Each movement should, therefore, make it possible to explain the following movement, or even to infer the movement of the whole.
According to Mandelbrot, the traditional tools currently used in the finance industry do not work and their underlying assumptions are incorrect. Indeed, in his opinion, price variations are practically never continuous but make trivial or substantial jumps.
They are neither independent nor stationary, nor do they marry the proportions of the famous bell curve of normal distribution. Finally, he does not believe that the efficient market hypothesis has been verified in practice.
In his study on cotton prices, Mandelbrot observed obvious correlations between past and future prices and asserted that there are also long-term correlations. Based on the analysis of the growth rings of trees, he established that correlations fall more slowly than expected, so slowly in fact that they never seem to disappear completely.
A new path he explored is that of the multifractal model. This model, in the scholar's view, uses little data to provide a large amount of information, unlike other financial models.
It is based on fundamental, long-lasting facts about how the market works. This model is economic and imitates the market.
Examining price fluctuations, he noted that they develop in irregular trends. Price variations are clearly concentrated according to their size. He distinguished first the big variations, which are concentrated and quick, followed by smaller, slower variations. So, over shorter periods, prices fluctuate more strongly, while over longer periods they tend to stabilize.
According to Mandelbrot, market timing is essential, as large gains and losses are concentrated in short intervals of time. This concentration can be extremely useful for avoiding the risk of loss or, on the contrary, profiting from market movements depending on the type of variation.
It would, therefore, be worth designing an index to predict stock market storms with a time horizon long enough to prepare for them, similar to seismic warning centers. “You cannot beat the market […] but you can sidestep its worst punches”,2 and it is stock market crashes that destroy the investor, not the small downturns.
Given our previous conclusions, we cannot but share this approach and agree with his analysis, but in a somewhat adapted form.
Each movement is the result of a multitude of factors that produce increases or decreases. The number of factors is very high, and also extremely varied (interest rates, inflation, political decisions, indicators, corporate earnings announcements, human behavior, and psychological factors, etc.).
Faced with this large variety of factors, we could first consider conducting a multiple linear regression to determine which of these significantly influence price developments.
Thus, using data on each of these so-called explicative factors, the model would indicate an increase or decrease. Besides the very large number of explicative factors, conducting such a regression would involve a gargantuan database, supercomputers and, most importantly, a very strong assumption: the explicative factors found would be the only ones to explain the model.
However, it would seem that these factors develop randomly, and their occurrence comes as a surprise to the market, which must then immediately incorporate the newly available information, eventually leading to an increase or decrease.
Furthermore, the model—which would only obtain data on a given explicative factor at the last moment—would have to be able to provide the direction of the movement in a fraction of a second in order to allow proper positioning on the market.
Finally, we could consider entering expected data for the factors with different probability scenarios, but this brings us back to the debate over whether using a probability distribution is coherent.
Unless of course, these expected data are unbiased data on future values. In other words, insider trading on the whole range of factors would be the only way to predict the market's development before it happened. On the individual, national or even worldwide scale, this approach is hardly conceivable.
By applying the fractal approach to these different factors, we can consider that each of these, in fact, follows a certain order, and does not develop randomly. Each factor would be a fractal of the “final” fractal object that is the market. Determining a trend per factor would, therefore, be the way to go.
Furthermore, we said earlier that an upswing or downturn is the result of the market integrating a newly available piece of information (or factor). But is the factor integrated immediately? In other words, is the market efficient? We have already concluded in the negative.
Mandelbrot does not believe in market efficiency either, and many empirical studies demonstrate the existence of biases that result in each new piece of information taking some time to be reflected in prices. We obviously agree.
At this stage of our analysis, it is worth recalling that the bulk of our reasoning applies to the individual. All the financial theories that are based on an overly mathematical or probabilistic approach forget that behind the market, behind each factor and company and finally each investor, lie human beings.
Unfortunately, the crisis of 1929 failed to teach us enough lessons from the past; history does tend to repeat and human greed has changed little—if at all— over the centuries. Human psychology remains constant.
Already at the time, trader Jesse Livermore said in relation to the crisis of 1929 that man tends to forget the past, and therefore to lose his memory of past financial crises. The generation that has lived through the crises of 2001 and 2008 should fear that this memory is lost with the next generations.
Fortunately, we have been studying human behavior for much longer than finance, so it's not surprising that we are led to look for a solution in the realm of behavioral finance. We believe the ideal model to be a “human” one, which is both simple and comprehensive.
We need to find a model or approach that provides the investor with an answer to a simple question: should I enter (stay in) or exit the market? The answer to this question must be independent of the expected return. Indeed, we have already established that the final return will depend specifically on the moment at which the investor enters and exits the market.
So despite an attractive historical—and therefore expected—return, there are times at which it is appropriate to invest in order to participate in bull trends and other times at which it is better not to be involved in the market.
A good manager should know when it's time to invest and when it's preferable to stay in cash or bonds. As such, portfolio management consists in managing risks, not expected returns.
Depending on the chosen degree of risk, it is ultimately the decision to enter or exit the market at a given moment that constitutes the risk taken by the investor. Investors also appreciate simplicity and ease of use, making the concept of entry and exit attractive.
Let's make an amusing analogy with a lover of barbecued sausages. Despite the delicious taste of barbecued sausages, this person is not going to have a barbecue if it's raining or looks like rain. You would have to be stupid to have a barbecue in the rain on the pretext that the sausages are delicious.
Similarly, you have to wonder what could justify staying in an established or expected bear market, even if the expected returns on stocks are high when it would be so much wiser to avoid the stock market for a while and stay in cash.
Each movement takes into account a range of different information at a given time. This includes not only so-called “objective” information but also “subjective” information: the psychology of financial players. The suggested approach has to identify trends for investors and, especially, take into consideration both objective and subjective factors (the psychology of individuals).
Suggested Investment Approach
In the light of all the preceding analyses and our conclusions, we are now going to outline an investment approach capable of helping investors identify trends and, more importantly, define the moments at which it is wise to enter (stay in) or exit the market.
The approach presented below was devised after reading the following introductory lines from the Theory of Speculation by Louis Jean-Baptiste Bach lier: “The determination of these movements is subordinated to an infinite number of factors:
it is, therefore, impossible to hope for mathematical forecasts. Conflicting opinions about these variations are such that any one time, buyers believe in an upswing and sellers in a downturn.”
The second half of this statement forms an important part of our approach because it indicates how price movement will be determined by the degree of conviction of one category of investors compared to another. If there are more investors who believe in an upswing, prices will be pushed up rather than down, as those who expect a downturn will exert less influence.
Mandelbrot proposed a multifractal model, and the term “multi” is essential here too as it will form the basis of the approach we suggest: the multi-force approach. The price of a stock can move upwards, downwards, or remain stable. Various “elements” will influence the price in a given environment, which itself is constantly changing.
Given that strong correction periods tend to be concentrated, the first step is to design a sort of stock market thermometer, or concentration of activity indicator, equivalent to a Richter scale of stock market activity. The idea is to examine current volatility and compare it to historical volatility.
The second step will be to determine the forces that push prices up, those that push them down and those that have no influence on prices. The resulting force will be the decisive one, which will exert pressure in the final direction.
In our opinion, it is worth distinguishing major trends from “waves”, or short-term bullish or bearish movements, which do not help work out the general direction of the market.
Amongst the various forces, and in the light of all that we have discussed so far, we will include:
The Macroeconomic Force
Investors must consider, using a series of indicators, if the macroeconomic environment is conducive to investment or not. Taking fundamental analysis into account may seem surprising for some, but as we have noted, the market represents a whole range of individuals following different objectives and buying and selling securities for different reasons.
Price movements therefore also depend on a Fundamental Force. The fundamentals of a particular sector, the search for intrinsic value and the analysis of the various relevant ratios will help determine this force.
The Technical Force
For the reasons mentioned above, technical analysis should also be taken into account. Its results will determine the Technical Force. Some investors or traders act solely on the basis of expected trends or patterns, such as the “head and shoulders”, “cup”, or “double tops” and “double bottoms”. This aspect cannot be ignored and must be incorporated into the model.
Others believe that prices follow a mean regression process, and invest accordingly. In practice, therefore, moving averages are extremely commonly used technical indicators. We believe that speculation, which is mainly present in the short term, is essentially accounted for in this force.
The Behavioural Force
Psychological biases obviously must be included, and are perhaps the model's main force. As we have already stated several times, behind the market and prices lie human beings, who are usually irrational and are subject to various emotions;
they make subjective decisions that must be integrated into the process of price formation and development. An investor's experience and sensitivity to the different forces will obviously play a part in the process of analysis.
The Luck Force
This force does exist and will always exist, but it can never be determined. In our view, it is not a major force, but it does exert an immeasurable pressure on prices. Investors must be conscious of this; as Louis Pasteur said, “chance favors only the prepared mind”.
To begin with, it is necessary to study each of these forces and then their potential strength. The resulting final force can then be determined, which will allow investors to make their choice: buy, sell or hold their security or position in a particular asset class.
It is obviously possible that for a given situation, certain forces produce opposite pressures. Therefore, it is important to determine which has a dominant effect on the others. It is also possible that no dominant force can be determined. In this case, it is better to wait for more clarity or visibility of the markets before making an investment decision.
The Beauty of the Approach
An analysis of the different forces can be carried out using indicators or indices that we might qualify as objective, but with a subjective impact in terms of the conclusions they give.
On the other hand, calculating the strength of a force requires a far greater dose of subjectivity, as there is ultimately no rule of measurement. An investor's experience will help determine this strength, as will discussions and exchanging ideas with peers.
The beauty of the suggested approach lies precisely in the fact that it is ultimately human: it doesn't rely on a black box where figures are entered in one side so it can spit a numerical result out the other. In this sense, this new investment approach provides a truly simple and comprehensive analysis framework.
To reach conclusions, our “model” employs the financial reflection of the human brain to the highest degree. Indeed, there is no better filter for the analysis of irrational behavioral factors than a brain that can adopt both a rational and an irrational mode of thinking. Machines do not have this ability, and any attempt to model or rationalize the irrational will only produce an imperfect model of the human brain.
Ac the Copernicus noted long ago, “mathematics is for mathematicians”. At the beginning of our analysis, we asserted that statistical laws are not really adapted to finance. It may be time to assert that the laws of human nature necessarily apply to that which man has created: the financial markets.