Market Monkeys Drown Out Investment Message
By Brady Willett
The problem with the markets today is not 'high' valuations, crazy Wall Street analysts, or the threat of an entrenched recession. No, the real problem is with the investing public: or
the unenlightened mass that call themselves 'investors' because they can align a mouse pointer over the word 'buy'. It is these new investors that remain unacquainted with sound investment logic, that have raised the risk
premiums on stocks, and that have changed the investor's focus from corporate fundamentals to that of macro speculations. As a result, the logical framework that binds the markets to the investor has been re-spun: the purpose
and principles of the markets have been altered.
To begin with, today's market has been formed from the tutelage of herd investing 101: or the 'monkey see monkey do' analogy that is often used to describe the 1990s
bull market. Perhaps the more accurate description would be that of 'a million monkeys typing on a million terminals eventually combining to write the phrase 'buy stocks for the long term''? Nevertheless, the reason why any
such analogy is important is because it is the only explanation one can offer as to why a clueless public enters the stock markets. By 'clueless' this is to say that many investors today readily hand money over to fund
managers, and buy and sell funds based on rumors, tips, and past performance: these are clueless investment initiatives because the information on which the investment decision is made is always at least two steps away from the
actual source of the value - company fundamentals. It is a speculation on a speculation, incomplete information extracted from incomplete information. As anyone who has ever played the child's game of telephone will attest,
the message that results soon has little resemblance to its source.
To be sure, the information deficient character of the marketplace has grown over the last
decade. Evidence of this is seen in the fact that an ever increasing volume of capital embraces risk and uncertainty based upon market criteria which completely ignore the company valuation premiums suggested by
traditional investment rationales. As an example, risk premiums such as price-to-earnings, price-to-book, and debt/equity have all reached levels never seen before, yet the median shareholder expectations for next year stands at
11%.1 To state it more bluntly, valuations are expected to increase even while company performance is declining! Clearly the logical investment message is being garbled somewhere along the line. Not
coincidentally, this has happened as the amount of capital thrown into mutual funds has exponentially grown. Remember, all it takes is one primate – monkey see monkey do.
Unfortunately, the average herd investor does
not seem to recognize that they are nothing more than a monkey. Rather, these investors claim that they are in stocks for the 'long term', because the current 'correction' will eventually 'bottom', and form a 'rebound'.
Yes, the herd has absorbed and put the popular mantras to memory, and they can readily flip any one of a hundred slogans to justify being in the stock market at all times. However, the last thing these investors would do, god
forbid, is actually look at a company.
Which brings us back to the real problem with the markets: no one is investing in companies! In fact, what has happened is a curious inversion. While the nominal
purpose of the stock market is to provide funding for corporations and thereby value for the investor in the form of a share in a better-positioned corporation, today a strange twist has occurred. Now the purpose of the
markets, indeed the fulcrum upon which governments currently construct legislation, is to provide funding for the investor for retirement: investment growth through investment growth is what dominates investment strategy, while the
companies upon which that growth is to take place are mere afterthoughts. Of course it doesn't help matters that the government benefits from the temporary bull market effect that such a focus produces: increased
capital gains taxes, an up-tick in economic growth due to the increased wealth effect, and decreased attention accorded to the retirement burdens soon to be facing government coffers. However, such "investment" strategies are
unsustainable where the productive potential of the "real" economy fails to keep pace with market growth. The consequences are predictable and violent decreases in share price when the "real" economy fails to produce the
necessary increase in capital to sustain the momentum effect. It is a consequence produced from investors neglecting to look objectively at corporate fundamentals.
It is this 'absentee shareholder' that stands for
everything that is wrong with the markets today. These stock market investors are too busy focusing on the expected macro implications for the economy and trying to figure out which direction the major markets might break next,
while not paying enough attention to the companies that they have a stake in. As such, valuations have been rendered temporarily meaningless: the focus is no longer on corporate debt levels, consumer debt, and looming
government deficits, because until a fortuitous crack is exposed in the monkeys logic there is enough speculative money still in play to keep junk rated shares afloat, the consumer unwisely optimistic, and an oversight in
governmental responsibilities seen in the best light. Quite simply, no one cares about investing since they are too busy counting their eggs for retirement, trying to diversify because some Wall Street head told them to, and
wishing they had of bailed out of their tech fund before it tanked. They are still speculating, not investing…
To illuminate this opinion take a look at IBM. Remember, supposedly bear hardened 'savvy investors' are in
these markets:
IBM
As of September 10, 2001
2002 EPS Estimates: $5.05
Share Price: $96
As of November 9, 2001
2002 EPS Estimates: $4.80
Share Price $115
How does one begin to describe what
investors have been looking at with a company like IBM? Since September 10 earnings estimates have been slashed, terrorism has become a real threat and cost to America, and IBM is soaring? How can anyone argue that the
outlook for IBM is better today than it was on September 10? Not even the Wall Street faithful own such an opinion, yet the share price keeps rising…
Herein rests the kicker: IBM's latest rally wasn't even sparked
by optimistic investors but by those with a negative prognosis on the company.
What has actually happened is that short sellers began to cover profitable positions sending the share price higher. Then institutions and mutual funds, needing a place to park their money to try and boost returns, began to peck at IBM's improving stock price. As a consequence, IBM's share price began to rocket up. Unfortunately, the problem for the casual "investor" is that funds will flip the stock the second momentum fades, and short sellers (if they are willing) will begin to pummel the stock price lower in unison. Ironically, commenting on the action (and right before the price drops) the media will claim that the investing public is growing increasingly confident on IBM, Wall Street analysts will scramble to justify the situation by claiming the 'bottom' is in on IBM, and the monkeys will lap it up. But remember, most of the monkeys didn't do anything except leave their capital in a managers hand…
While IBM is a quick example of how this type of market can act, there are many other stocks that done the same thing since September 11.
Nevertheless, interested parties have offered other explanations for the
price rise: capital feels more confident about a pending economic turnaround, the Fed will continue to cut interest rates, government stimulus packages loom, inflationary pressures are lacking. However, such speculations only
harden the initial point of this article that there has been a disconnect from investing to speculation. Remember no one, and this includes Wall Street, thinks that IBM is a better investment today than on September 10 based upon
any set of economic statistics. Rather, the fundamental outlook for IBM has weakened on all counts.
The obvious prediction to be made is that the herd will dissipate, prices will fall, and the ponzi-like scheme will be
exposed. However, trying to elaborate a macro contrarian strategy is not a road easily followed. While some would argue that "too many bulls implies a bearish strategy", and vice versa, the situation today warrants a
different take on the market: there are too many 'investors' period! In this regard, whether the markets' current tone is said to be bearish, or bullish, the outcome to those applying such macro strategies is much the same: too
many eyes on the prize means that the market taken as a whole does not play by predictable rules. As an example, it was certainly the case that bearishness was very pronounced in late September, but money did not leave en masse
(only $29.5 billion in equity outflows) and market prices have rebounded strongly. Most of capital thrown back into stocks during the latest run-up was sitting in mutual fund coffers with no sentiment label controlling its
movements. Furthermore, the vast amount of capital helping IBM and the markets rally since late September did not take into consideration long-term corporate earnings, and related risk premiums, but bought the momentum, or other
various reasons. It does not pay to respond to optimistic speculation with pessimistic speculation. This is still not investing.
The markets, in a macro sense, can only be understood when the bulk of capital
moving stocks is guided by investment rather than speculation considerations. When most of the capital in the markets is from mantra loving monkeys, the action in stocks becomes entirely unpredictable and value becomes almost
non-existent. Yes, stocks perform better than cash, and bonds over the longest of terms. However, if this makes you want to run out and buy stock, just remember what happened in Japan: For those of you counting on an increasing
equity portfolio to fund your retirement, 17 years and counting is a long time to wait.
With these things in mind there are three things that we think every investor
in securities should instinctively do when looking at stocks today:
The Check List
1) Shareholders Equity (assets minus liabilities)
If return-on-equity (ROE) is in free fall you must understand
the company/industry completely or you are buying a lottery ticket. If you did not correctly predict the onset of terrific asset devaluation, then how can you be confident that you can predict the exact date such devaluation
will end? Those companies that are well managed and/or possess pricing power during economic slowdowns will, in most cases, now be posting positive ROE.
Of the eight companies in the 2001 Wall Street Wish List six had
excellent ROE. Barrick's ROE began to slip as its stock price rose so we liquidated our position, and Stewart was an asset play (different story) that rose by $165%. The exceptions to this rule are rare, especially if your timing
in predicting an ROE turnaround is off by a few quarters/years, and/or you are impatient.
2) Current Assets
Back out inventories, and chop 10% off investments. Does this total cover current liabilities? If it does not the company may require additional funds within the next 12
months. Using this simple formula the keen observer knew that Polaroid, Enron, SunBeam, and Xerox were due to encounter financial troubles well before such woes arrived. Point being, if a company is planning assets sales, share
offerings, or new debt configurations the investor should do everything possible to know this beforehand. Furthermore, if a company is planning any such financing in the future and they are not profitable the level of risk sharply
rises.
If under current assets there is a string of listings ('investment', 'other', etc) call the company and try and pin down how much liquidity they have. While 'current liabilities' typically describe the next 12
months of debt payments, 'long term liabilities' must also be considered.
3) Do not look at stock price
This is the most difficult principle to follow. Especially considering that no matter where you go online stock price is undoubtedly the first thing you will see. However,
the investor has no need to know what the stock price is before their research is complete. If you look at the stock price first you have already lost an important battle; your mind may wonder and begin to think about double
bottoms, trend lines, 200 DMA, etc. How can you think about technicals before you completely understand a company? This is not to say that these technical considerations should not play a small part in deciding the
timing of your equity purchases, but they should only be looked at when you understand the company, its fundamentals, the industry it is in, and its competitors. Technical traders should ask themselves one question: would you
buy a tulip just because the market in bulbs is forming a double bottom, there is 200-day support, and a channel is forming? Surprisingly, given the lessons of the Dutch case, some would probably say yes if there was enough
liquidity…
Nowhere on a balance sheet is stock price listed.
Nowhere on an income statement is stock price listed.
Nowhere on a cash-flow statement is stock price listed.
Do not look at stock price!
Yes, following this last step can be hard work – its called investing.
By no means is this checklist complete. However, it is a good place for an investor to start, and could help you to avoid some serious
pitfalls. Those looking for a more thorough demonstration of just what this entails may find the 2002 Wall Street Wish List of some utility.
Conclusion
The Monkeys in the herd worry about stock price because it is easier for them to align their mouse pointers over the word 'buy' than to work hard at
becoming a better investor. However, as lemmings aptly demonstrate, herd behavior does not always produce the most fortuitous outcome.
November 14, 2001
http://www.wallstreetwishlist.com
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