Learn to read the market signs

Guarding Wealth: Two distinct schools of stock market price prediction are taken on faith

It is said that the future is written in the past. For investors, that means looking backward to see where the future lies. On the one hand, it seems silly. After all, if you are driving down the road, looking backward is downright hazardous. But if you are an investor, you have to look to the past to see what you may buy or sell. Any other technique is sheer gambling.

There are several ways to read the past. Some investors like to examine the income a company may earn. That means looking at sales, costs of production, profit margins, competitors’ products, industry trends, ratios of price to earnings, price to sales, etc. This is the fundamental analysis most often practiced by investment analysts. It gets a lot of respect.

Another form of fundamental analysis ignores sales and costs and instead looks at the balance sheet of a company to determine its present worth. The basic measure is share price to book value with variations that include price to various measures of assets and debt to equity ratios. Ben Graham, the founder of fundamental analysis and the teacher of famed investor Warren Buffet, focused on balance sheet analysis to show what an investor would get for his or her money.

An alternative school of investing is so-called technical analysis. Its practitioners claim that everything that is known about a stock or bond is already contained in the stock price. They plot daily prices and look for patterns such as “head and shoulders” to identify trends. Academic analysis of technical analysis has found that it gives useful trading signals. However trading costs wipe out the small advantage, studies show.

The problem in each of these three schools of investment analysis is to identify the right measurement period. Where you set the start and stop markers predetermines much of the gain or loss. In fundamental analysis, analysts tend to look at quarters of a year and years. In technical analysis, analysts use daily price moves to find trend lines. A daily plot that rises over a longer-term average is seen as a buy signal. If the plot goes below the moving average, it’s sell signal. Persistence of trend is supposed to rule out randomness.

The problem with each school is to find the true trend. Let me illustrate the point. If one studies stock prices minute by minute, statistical noise obscures direction. Hourly data has the same problem. Just as a matter of interest, many investors like to look at daily moves. It means little. Weekly and monthly and quarterly data is also interesting. It means more. The longer the period, the smoother the data becomes. If you use a moving average such as 52 weeks to that each successive week you divide share price by the price average of the preceding 52 weeks (the sum of 52 average weekly prices divided by 52) to smooth out the wobbles, noise and clutter disappear and the trend becomes evident. If you carry the smoothing process out to 10 years, 520 weeks, or 20 years, 1,040 weeks, all that is left is a straight, upward sloping line. A price above or below the line will be sucked into the trend or, if an outlier, ignored. History takes over and short-term trading signals from fundamental or technical analysis no longer matter.

Long-run returns

Using long run returns, Wharton School of Finance Professor Jeremy Siegel has shown in his book, Stocks for the Long Run (McGraw-Hill; 5th ed.; 2014), that in the period 1926 to 2012, U.S. stocks had a 6.4 per cent average annual return after inflation. In the same period, bonds had an average annual real return after inflation of 2.6 per cent. In periods shorter than these 86 years, returns deviated from the long run average. In the period 2000 to 2012, starting from before the dot com bubble broke to a time during the recovery from the 2008 recession, stocks had a real return of just 0.3 per cent and bonds of an astounding 6.5 per cent. If we move to still shorter periods, there will be more deviation from long run values.

It comes down to trying to beat the averages and that takes more than an MBA. The largest gains and losses happen when investors are unprepared for an event or a change of trend. Very few people predicted the 2008 crisis driven by a meltdown of the U.S. subprime mortgage market. Almost no one would have predicted the extraordinary and unprecedented period of bond price gains that started in 1983 and is still running. There has not been such a bond bull market since the end of the Napoleonic Wars in the early 19th century.

It follows that looking backward at lines traced by wobbly stock or bond prices or trying to divine from income statements what the future will bring is not enough to predict the future. Sure, some trends do emerge when you see a stock’s price line swan diving toward zero or, the reverse case, a stock price rocketing upward without any apparent limit. The investor who wants to avoid risk will not jump onto a stock that seems near death at a zero value. It could deserve to die Nor will the risk-avoiding investor buy into stocks trading on momentum on the theory that what goes up continues to go up. If it did, the company would own the world one day. Yet there are exceptions such as Apple Inc., the most valuable company in the S&P 500 Composite. And a few companies periodically have near death experiences and then recover, especially in mining. Teck Resources Inc. was at $50 in 2011 and is trading near $5 today. Beaten is not dead and this coal and copper miner will probably rise again. But it’s risky and owning it is no way to get a good night’s sleep.

It comes down to a problem of observing volatility and then having the fortitude to do nothing. French geophysicist Didier Sornette, whose book, Why Stock Markets Crash (Princeton University Press, 2004) made major contributions to understanding investment trends, points out that huge selloffs in stocks that should happen once in a hundred thousand years if they are viewed merely as statistical probabilities actually happen a few times a decade. Major market corrections occurred Oct. 19, 1987 when the Dow Jones Industrial Average dropped 22.6 per cent in a day. Other big corrections happened in 1991 when interest rates spiked, 1998 when hedge fund Long-Term Capital Management failed threatening to wipe out a few investment banks, 2000 when the dot com mania collapsed, 2001 when the twin towers were destroyed, and 2008 in the subprime mortgage meltdown. The words “stock” and “crisis” are almost inseparable.

What to do? Spread your money into many asset classes from stocks to bonds, domestic urban real estate, farmland, foreign stocks and foreign real estate. There are low fee exchange traded funds for every strategy and every market. Do not chase winners. If anything, short-term data show that this year’s losers are often next year’s winners and vice versa. It’s not that industries’ prospects change so drastically year to year, it’s rather that winners get overpriced and crash while losers appear to be bargains and get bought up. It does not always work, but for an investor, the right balance of faith in the long run and cynicism for the short run is the basis for survival and profit in capital markets.

About the author

Columnist

Andrew Allentuck is the author of 'When Can I Retire? Planning Your Financial Future After Work' (Penguin, 2011).

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