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share. Under the system used by most financial news sources, the significance of these two reports is equal. Both rose four points. In reality, however, the day’s change for the $30 stock represents a 13.3 percent increase, and the day’s change for the $60 stock was only 6.7 percent. In other words, the reporting itself emphasizes points of change rather than percentage change in value per share. The reporting of price is emphasized because it is easily understood and readily available. The change in price per share is important to current stock- holders, so the perception is that the same level of importance applies to would-be buyers, as well. The reporting method is inaccurate and misleading. It also does not reveal the more significant information about a company; in other words, the comparative fundamental information. The financial press, of course, is like the rest of the press. It wants to convey information in a simple manner to report what is thought to be newsworthy. Every serious investor, however, has to be aware not only of the inaccuracies in reported information, but also of the fact that a daily change in a stock’s price means absolutely noth- ing in terms of a company’s value as an investment. It is only scorekeeping, and the game being reported—changes in stock prices—means nothing in the long term. The financial press identifies “winners” as those whose stock rose today and “losers” as those whose stock value fell. So that is the game. It has no rel- evance to the selection of stocks based on underlying, fundamental value, but it is misleading because so many investors make their decisions based not on a study of the company and its fundamentals, but on what they read and hear in the news. Beliefs about Future Price Movement Among the ideas that have caught on among investors is a primary belief that future price movement can be predicted. Certainly, the future value of a com- pany as a sensible investment can be predicted with great reliability, using fun- damental information to identify worthy buy and hold candidates. The very idea that price movement can be predicted is inherently flawed, however. Considering the mechanism that creates changes in price—perceptions of future value tempered by institutional holdings—it is troubling that any belief in price level prediction can be as widespread, and yet it is. This belief demon- strates the illogic of the stock market. Short-term price movement in the mar- ket is recognized as unreliable by proponents of all major theories. The Dow Theory discounts short-term change entirely. According to the efficient market theory, prices reflect all of the knowledge about a stock at any given time, which means that the chances of a stock going up or down is 50-50—that is, if one accepts the efficient market theory in a pure form. Finally, under the ran- dom walk hypothesis, it makes no real difference whether a company’s fortunes are positive or negative, because short-term price movement will be random in either event. BELIEFS ABOUT FUTURE PRICE MOVEMENT 9 You will not find a theory about the market supporting the premise that short-term price movements can be predicted. Even so, a very popular belief is that price can be predicted by studying recent price patterns and trends. The chartist watches price charts of stocks to identify the direction that prices will move in the future. An entire industry has grown around the idea that patterns are established in price movements, almost as though prices had conscious will and would act according to statistical laws. The fact is that short-term price movement is entirely random. There is a degree of value in identifying certain characteristics of market prices for a stock, and those can be found in a study of charts. Beyond a few basic observations, however, it simply is untrue that price charts predict short-term price movements. Fallacy: Future prices of stocks can be predicted by studying price charts. You can gain value from the study of stock charts in a few limited ways. Virtually all online trading sites offer free quotes and charts for all listed com- panies, and this free service is invaluable in getting basic market informa- tion—either on stocks you own or on those you are thinking about buying. It is important to recognize that charts reveal very limited information about what is likely to take place in the future, however. The true believers in charting con- tend that trading patterns signal the next direction a stock’s price will move, and they take great pains to prove their point. Like all belief systems requiring constant efforts to prove something, however, the thinking of these chartists is flawed. A chartist holds a more balanced view and recognizes the value of studying price trends. This individual knows that the information to be found on a chart is statistically valuable, however, but only insofar as it supports inde- pendently verified likely outcomes. In other words, if you believe that a stock’s price is likely to rise over the next year based on what you see in a chart, that is useful information when it is also confirmed by other analysis performed using different means. The basic premise of charting is that many stocks tend to trade within a pre- dictable range, at least for a period of time (which, of course, is unknown). This trading range is further defined as having a top, the price above which a stock’s price is not likely to move; this price is called the resistance level. It also has a bottom, the price below which a stock’s price is not likely to move; this price is referred to as the support level. Resistance and support are valuable ideas because they help the analyst to identify when a stock’s market price is likely to move above or below that range. Such an event is called a breakout. Support and resistance levels are illustrated in Figure 1.1. In this example, the trading range is progressing. That is to say, over time the resistance level and support level gradually move upward. This situation would indicate that the stock’s price is likely to remain within the trading range, 10 THE PRICING OF STOCKS given its upward trend. Eventually, however, the price will move above or below the predetermined trading range pattern. Whether this event occurs due to random change or in response to rumor or financial news, the fact remains that when the pattern changes, the trading range is disrupted and has to be rede- fined. This breakout is illustrated in Figure 1.2. In this example, the breakout takes place on the down side. Support level gives way as the price falls. The astute analyst would look for an underlying cause. For example, has the company released financial information recently? Was it disappointing? Is there a rumor or any news affecting the company? Any number of valid factors could affect a stock’s price immediately, including eco- nomic factors like changes in interest rates, labor problems, lawsuits, new product introduction or problems with existing products, or changes in man- agement to name a few. BELIEFS ABOUT FUTURE PRICE MOVEMENT 11 FIGURE 1.1 Support and resistance. FIGURE 1.2 Breakout. To some investors, a breakout signals that it is time to change positions. An owner of shares could see the sudden decline in market value as a sell signal, assuming that the news causing the fall justified that decision. A contrarian might look at the lowered market price as a buying opportunity, again based on the underlying cause of the change in price. It is not accurate to say that a change in direction or any other chart indication always signals a particular deci- sion. You need to study the reasons for price changes while also understanding that some price movement is going to be unexplainable and truly random. Chartists use a series of indicators in an attempt to identify when support or resistance are likely to be violated. Spikes and tests, for example, are analyzed in patterns. These have various names like “head and shoulders,” and some chartists give great significance to the emerging patterns visible on charts. For chartists as with all investors, however, hindsight is always superior to fore- sight. Chartists can point to past price movement and explain what signals were clear; however, the record for predicting future price trends based on the same patterns is far more elusive. You can gain insight by studying chart patterns. For example, it will become apparent that some stocks exhibit a relatively narrow trading range, whereas others demonstrate far more volatile trading patterns. This difference occurs for a reason, and a study of resistance and support levels for stocks is a useful comparative tool for the study of price volatility (see Chapter 7 for more infor- mation about the topic of volatility). As a short-term observation, trading pat- terns can be used to augment your personal program for stock analysis. At the same time, however, it’s important to recognize that stock prices do not behave in a natural manner, and statistically they are not going to move in adherence with any rules or predetermined patterns. The random nature of short-term price movement makes the attempt to predict the short-term future a troubling endeavor. Rather than believing that charting can be used to pre- dict price movement, a more sensible conclusion should be: Charting is useful for comparing price volatility among stocks, but short-term price movement cannot be predicted reliably using any method. Reckless Optimism The chartist continuously looks to the recent past in an attempt to estimate what will happen next. In the same way, many other investors make their deci- sions based not upon any science, analysis, nor formula, but on the premise of reckless optimism. It’s the nature of risk-takers, including investors, to view matters with opti- mism. The future will always work out better than the past in this world view, and so the market has more than its share of reckless optimists. They view the future as “that period of time in which our affairs prosper, our friends are true and our happiness is assured.” 1 12 THE PRICING OF STOCKS Optimism about investments is certainly no flaw as long as you also recog- nize that mistakes can be made and that situations change. Obviously, you would not purchase shares of stock unless you were optimistic about the com- pany’s future. A reckless optimism, on the other hand, enables you to delude yourself about the reality of the situation. Many decisions are made based on the idea that, in some way, a stock’s market value will rise as long as the investor owns shares. In practice, everyone knows how difficult it is to judge the market in terms of timing. You might be right about the overall direction of a stock’s price but wrong in the timing of your decisions. This reckless optimism is encouraged in the financial press. For example, an overall rise in prices is referred to in glowing terms as “robust” or “a sign of renewed faith” in the economy, for example. When prices fall, however, the news is softened with descriptions of “profit taking” or “consolidation.” Why does the financial press encourage this approach, rather than reporting the news in a more forthright manner? The answer is found in a study of the advertisements seen in newspapers, in magazines, on radio and television, and on the Internet. Financial reporting is supported by financial institutions— brokerage firms, analysts, and information services related to the ownership of stocks. The majority of reporting, financial and otherwise, is supported by sell- ing advertising space, so at least to some degree reporting is affected by the mix of advertisers. If the public becomes disenchanted with investing, sub- scriptions fall and ad sales follow. More to the point, if advertisers believe that news reports are contrary to the message that they want to send out, then their advertising dollars might go elsewhere. Every investor faces the problem of bias in getting information. News as reported often presents a simplistic summary of the facts and often emphasizes the wrong points. A financial reporter might be able to write interesting copy, but this fact does not necessarily mean that the same person grasps the signif- icance of the news itself. For example, when the market falls as measured by the popular index levels, it is possible to report that in more than one way. Consider the following two slants on the same story: Example # 1 The Dow fell yesterday more than 450 points, the biggest drop in three months. This drop followed warnings by the Fed that interest rates could be increasing in the near future, which took the market by surprise. High sales volume in late trading yesterday shows that reaction is negative and widespread, and most experts expect further drops today. Example # 2 The Dow corrected yesterday following a three-month price run-up. Index level retreated 450 points in late trading. While the Fed announced possible adjust- ments in interest rates, the change in the Dow level was the result of profit-tak- ing and is not seen to signal a change in the market’s direction. High trading volume in the late session shows continued interest among investors. RECKLESS OPTIMISM 13 These treatments of the same news demonstrate that a vastly different tone can be put on the news. Investors should be aware of how easily this process can be done; it might even be unconscious on the part of the reporter. The ten- dency in financial reporting is to augment good news and to downplay bad news. This tendency permeates Wall Street, not only among reporters but among investors and analysts as well. Consider the case of brokerage firm rec- ommendations. The majority of them are “buy” recommendations, and a down- grade usually suggests reverting to a “hold” or “accumulate” recommendation. In a story about the problem of investment bankers and a conflict of interest, CBS reported that at the time of their initial report, out of more than 8,000 ana- lyst stock recommendations to the public, only 29 were to “sell.” 2 The problem arises when a brokerage firm also acts as investment banker, a role in which the firm markets an Initial Public Offering (IPO). The glaring conflict of interest in this situation is that the firm stands to make a big profit by selling shares of the newly issued stock while also in the position of advising clients which stocks to buy. This topic is explored in more detail later (see Chapter 10). The point to remember here, however, is that recommendations made by brokers of firms that also underwrite the IPO of a company are, by nature, problematical. This serious problem is widespread, but it continues for several reasons, including three primary ones: 1. Reckless optimism as a characteristic of the entire culture. It is not just the conflict of interest that has created the problem. That is only half of it; the other half is that investors practice reckless optimism daily. In other words, they would prefer hearing “buy” recommendations. That is good news. A “sell” recommendation is bad news, often a reversal of a previous suggestion from the same broker. So while the broker does not want to contradict previous recommendations, investors do not want to hear bad news. This culture of optimism clouds the facts and enables everyone—analysts, brokers, and investors—to proceed with the most optimistic point of view possible. 2. Trust, perhaps too much, in the brokerage industry. Investors like to believe in their advisors. Unfortunately, they probably give brokers too much trust, especially in the situation where a broker’s firm is also the investment banker for the stock being recommended. The profit incen- tive for the brokerage firm and for the broker is on the side of making “buy” recommendations, so as a natural consequence investors are encouraged to buy and hold—even when the fundamentals contradict this advice. A related problem comes from the idea that brokers have more information than the average investor. Brokers are licensed and have to possess information about the securities they market; however, this situation does not mean that they understand the fundamentals better than the typical experienced 14 THE PRICING OF STOCKS investor. In fact, because brokers in so-called full-service firms are compen- sated by way of commission, they are salespeople more than professional advi- sors. The idea that investors are paying for professional advice often is misplaced, and a study of outcomes as a result of broker recommendations makes this point over and over again. A four-year study conducted by Investars.com con- cluded that investors lost an average of more than 53 percent when they took the advice of their broker and that broker’s firm led or co-managed the IPO. Even when the brokerage firm did not manage the related IPO, investors still lost money (4.24 percent on average). 3 The big difference between these results makes the point that when broker- age firms underwrite an IPO, they do not give sound advice to their commis- sion-paying customers. And even in cases where that relationship does not exist, customers still lose money. Chances are, those investors would have seen better results investing without the advice of a broker. The problem of trust is probably one factor in the growing trend toward the use of discounted trading services—notably, those online. In these cases, trades are made for a small fee, but no advice is given. More and more, investors are realizing that advice from brokers can be costly. Perhaps the biggest problem in the obvious conflict of interest and poor track record of investment banking is the fact that there is no legal ramifica- tion for giving poor advice to customers. Although it might be difficult to iden- tify an abuse in the many instances where poor advice is given, there certainly should be a distinction between underwriting and investment recommenda- tions given by the same firm. The official position on the part of Wall Street firms is that their brokers give advice independent of the investment banking side of the business. The consistency of outcomes shows that a problem per- sists, however. The Securities and Exchange Commission (SEC) regulates the industry, and the SEC would be the proper agency to enact changes in this area. In order to protect the investing public from abuses arising from conflict of interest, better-defined rules of conduct and due diligence on the part of the firm engag- ing in investment banking would go a long way toward solving this problem. Meanwhile, the unwary investor who continues to trust in a broker’s recom- mendations takes his or her chances. 4 To what extent does reckless optimism affect stock prices? In theory, opti- mism itself should not be a factor in the supply and demand for stocks. In prac- tice, however, the degree of optimism has everything to do with price run-up, even when it is not justified. The late ’90’s dot.com industry and the run-up of stock price values makes this point, followed of course by the severe and rather fast turnaround in which values fell even more quickly than they rose. The run-up of stocks like Amazon.com was typical of the reckless optimism and its effect on prices. Amazon had never shown a profit, meaning there was absolutely no fundamental information upon which to base an investment in RECKLESS OPTIMISM 15 the company—unless investors had some specific reason to believe that the high-moving price was justified on some basis. Such a justification is not known, given the lack of any net profits. Accompanying the run-up, however, was a prediction by an analyst named Henry Blodget that the price would rise. When Amazon’s stock was at $243 per share, he predicted that it would go to $400, which it did. Blodget claimed that his prediction was based on sound analysis, but it is difficult to imagine how sound that process can be without any profits for the company. Unfortunately for the investors who believed in this prediction, the stock subsequently lost three-quarters of its value. The point to this example is that reckless optimism can cause a stock’s price to rise. If that rise is based only on prediction, however, that means that the frenzy of demand created as a result is itself the cause of the run-up. Ultimately, such situations will reverse themselves and many people will lose money. The case of Amazon.com is right on point, because there were no prof- its to support any optimistic prediction whatsoever. The effect of reckless optimism has some historical references, as well. In the 1630s, Holland was caught up in a frenzy of investing in tulip bulbs. Unbelievably, bulbs sold for as much as 60,000 florins (about $44,000) until, in 1637, the whole market crashed. Until that point, speculators saw no reason to believe that the demand would fall and put their capital at risk in the belief that prices would only continue to rise. The reckless optimism of 17 th -century Holland did not die with so-called tulipmania. It is only human nature to believe that a rising price trend will continue indefinitely. The frenzy of reck- less optimism does affect price, but only for a while. Eventually, those with the most at risk lose their money, whether it is invested in tulip bulbs or the stock of companies that have never earned a profit. Fundamentals and Stock Prices The fundamentals—the financial and managerial information about a company—are the basis for selecting valuable and well-priced long-term stocks. Once stocks are held in your portfolio, the fundamentals also are most useful for monitoring the company to ensure that a ‘hold’ decision is justified. When the fundamentals change, the ‘hold’ might also change to the decision to sell. This basic information is well known to most investors, whether acted upon or not. A popular fallacy, however, is the belief that price change of stocks is a direct reflection of the fundamentals. In fact, the fundamentals have very little effect on price movement. The market tends to batter stock prices around, usu- ally overreacting to all news and rumor, so that price changes tend to make lit- tle sense in the immediate analysis. A rise or fall of many points often is not justified by the known news about a stock at the time. The immediate market is highly chaotic and makes no sense. In fact, sensibility does come into play, 16 THE PRICING OF STOCKS but it is seen not in day-to-day price changes, but rather in the long-term trends and price movements of stocks. The fallacy, then, is the belief that short-term pricing of stocks is logical and can be followed; and more to the point, investors can gain some insight by watching a stock closely. In truth, watching daily changes in stock prices tends to confuse rather than enlighten. It makes more sense to study the fundamen- tals and largely ignore the small daily movements in a stock’s price or to rec- ognize that momentary change in market value has little or no meaning to you if you are holding an investment for the long term. Of course, while watching the fundamentals, remember that the purpose is to identify prospects for long- term holding, and once they are owned, to ensure that the hold decision remains valid. Don’t expect the fundamentals to signal immediate changes in stock price. Even when prices do react to financial news, the reaction itself has little meaning. What counts is how the fundamentals support the contention that a stock’s value will grow over many years; in the market, the tendency is to hope for price increases over many hours, and that is a mistake. Fallacy: Prices of stocks change due to changes in the fundamentals. It would be nice and orderly to invest in a market where this scenario was true. In the short term, it is not; however, the simple truth is that strong fun- damentals do identify strong long-term investments, so those companies whose sales, earnings, and other fundamentals remain strong from one period to another also tend to work well as long-term investments. The market rewards patience, so truly following the fundamentals is a wise choice. So how does the market work from day to day or hour to hour? Remembering that this environment is chaotic, it also makes sense that all momentary changes in price are the result of chaos. In that environment, we cannot expect order. The market is set up to provide some semblance of order even in the chaos, however. The way that buyers and sellers are brought together and their trades are exe- cuted is quite complex, but the market facilitates millions of trades daily with lit- tle error or misunderstanding. The pricing of stocks within this fast-moving, high-volume market is complex and as far removed from the fundamentals as pos- sible. The complex forces of supply and demand react to all news, so any financial news just goes into the mix. An increase in declared dividend will likely cause a rise in price. The actual payment of a dividend will cause a corresponding fall in the price. If earnings are better than projected, the stock’s price will rise in response. If lower than expected, the price is going to fall. Of course, far more information than the purely financial will also affect the pricing of stocks, often in ways that do not make sense to the analytical and financially oriented observer. For example, a stock in an interest-sensitive industry like public utilities is likely to react to any news or speculation about interest rates. So, even an opinion FUNDAMENTALS AND STOCK PRICES 17 expressed in a news piece can have an immediate effect on the stock’s price. For example, the news might say, “The Fed meets this week to discuss interest rates, but no reduction in those rates is expected.” This non-news could be seen as neg- ative news in the utilities industry, so some utility stocks could lose some steam as a consequence. The statement might not be true, however. And if true, it might only confirm what was already know—that no reduction in rates is expected. In other words, the market is going to react and overreact to every piece of news, opinion, rumor, and change. So, it is a mistake to pay too much attention to the hourly and daily changes in a stock’s market price. There is simply too much going on to make momentary changes worth paying attention to, and in addition, those changes in price are the results of the chaotic environment. So, a small rise or fall in the price does not reveal anything of interest nor impor- tance to you. An alternative point of view about pricing of stocks and the fundamentals might be as follows: The fundamentals point the way to worthwhile long-term investments, but short-term price changes do not reflect the fundamental con- dition of the company. The fundamentals are an historical body of information, so a quarterly or annual report tells you the status of the company over the past quarter or year and summarizes assets and liabilities as of the reported date. Price, on the other hand, is a projection of the market’s perceptions of future value of that stock. Because the market overreacts as a whole, price is a poor indicator of what is really going to happen to a stock. As a relative measurement of the stock’s value, performed through the PE ratio, for example, the price side is not reliable. Many investors make the mistake of describing themselves as believers in the fundamentals, and in fact, the majority of investors describe themselves in this way. The majority also follows some very technical indicators, however. The market price of a stock is a technical indicator because it is based only partially on any fundamental information. Remember what the price of a stock reveals: It is the current level of perception about the future value of the company. The price, representing the highest price that buyers are willing to pay and the low- est price at which sellers will sell, is an illogical settling point in the chaotic market. It is a technical indicator. It provides the fundamentalist with nothing of value, but it can distract you if you pay too much attention to the alleged sig- nificance of price as reported in the financial press, where emphasis is on the point change during a trading day. Many self-described fundamental investors also follow market indices like the Dow Jones Industrial Average (DJIA), which is based solely on prices of stocks. Because stocks that split hold greater weight in the DJIA than those that have not split, however, the index itself is a distortion. The level of the DJIA, considered by many as “the market,” is a highly technical and inaccurate method for measuring the health of your stocks. It is scorekeeping in the most 18 THE PRICING OF STOCKS [...]... be monitoring instead It makes far more sense to view an analyst’s predictions as one of many sources for information Your final decision to buy, sell, or hold a particular stock should be based on the fundamental outcome—performance of the company—rather than the accuracy of mere predictions Any accountant will tell you that forecasting and budgeting is a means for setting internal standards but that... private-sector organization that sets standards for accounting practices in the United States FASB develops the rules and guidelines for reporting by accountants and auditors in an attempt to standardize the methods used for evaluating companies during audits and ensuring fair and accurate reporting 27 28 F U N D A M E N TA L A N D T E C H N I C A L A N A LY S I S TIP The FASB Web site provides information... customer/client service The management functions performed in the corporation are far different than the public relations functions that executives and the board have to perform in order to maintain the stock’s price 1 Market share is constantly on the minds of corporate executives In each industry, a finite amount of demand for goods or services means that each member of the sector has to fight to gain and maintain... fundamental information Perhaps the problem is that investors want to be told which stocks to buy, sell, or hold This position would be entirely logical if the experts were usually right But history shows again and again that analysts’ recommendations— based on their own estimates—are wrong more often than they are right So, giving any weight whatsoever to corporate earnings reports as they stack up against... grow forever, and it often is not only acceptable but also superior for a company to hold its net profit levels from one year to the next This idea, however, is not only difficult to convey in a short news report; it is also relatively uninteresting Remember, the financial journalist has the task of reporting information and making it interesting for the reader That does not always mean that the report... News, 60 Minutes II, reported June 26 , 20 01 (http://cbsnews.com) 3 “Analysts’ Links to IPOs Mean Losses for Investors, Study Finds,” The Wall Street Journal, June 12, 20 01 4 To see a summary of new or pending rule changes or to write to the SEC, check their Web site at www.sec.gov/ 2 CHAPTER 2 Fundamental and Technical Analysis o you follow the fundamentals? If you do, then you base your investment decisions... and popular modes for understanding what is going on in the market The opportunity lies in recognizing the inaccuracy of the popularly reported market news so that you can look for information elsewhere Because the majority is content with being told about the health of the market by way of point rise and fall in the index of a few stocks, you can find more important and valuable information, either... results derive from different forces Because investors approach their portfolio from an investment orientation, they often misunderstand how corporate profits come about It’s not a matter of ignorance; it is, however, a mistake to think that corporate management takes the same approach as investors From the corporate point of view, management does involve keeping the stock price up and hopefully making... two forms of information are merged by the financial press, so it is easy to forget which is which So, as a result, the investor who believes in the fundamentals ends up making decisions based on reports of purely technical indicators Most popular are changes in the price of stocks and changes in the level of an index, such as the DJIA How does the news you hear today affect your decision to buy, sell,. .. foundation of a pyramid erodes, the top can still be supported on nothing but money.”1 The belief persists, however, in spite of logic or proof, that technical analysis is the best tool for identifying good investments Because it is forwardlooking rather than historical, the technical indicators enjoy popularity among many investors who see the potential for price growth as the key to market success It is . managerial information about a company—are the basis for selecting valuable and well-priced long-term stocks. Once stocks are held in your portfolio, the fundamentals also are most useful for monitoring. what you should be mon- itoring instead. It makes far more sense to view an analyst’s predictions as one of many sources for information. Your final decision to buy, sell, or hold a particular stock. II, reported June 26 , 20 01 (http://cbsnews.com). 3 “Analysts’ Links to IPOs Mean Losses for Investors, Study Finds,” The Wall Street Journal, June 12, 20 01. 4 To see a summary of new or pending