No one can take the ultimate weight of decision-making off your shoulders. But the more you know about how things really are, the lighter the burden will be. -- from an old IBM ad
[ Home | Daily Column | Blog | Books | Top-50 Tech Stocks | S&P 500 Tech Stocks | Resources | Charts | Adages | Glossary | Search | Payment | Contact ]
| Are you looking to get started with investing in the stock market? If so, please read our "Getting Started Investing with Stocks" page. Click here. |
There are any number of investment 'gurus' and investment newsletters which purport to advise you on when to get into and out of the stock market, sectors of the market, individual stocks, bonds, gold, commodities, etc. This is known as market timing or sometimes asset allocation. There are two camps: those who believe that market timing is hogwash and those who believe that it is not only practical, but essential. My view is that it is up to every individual investor to decide their own view on this issue.
I will neither advise you to time the market nor to avoid timing the market, but I will advise you to be careful, be deliberate, and be thoughtful. Ultimately, I believe that the market works best when each individual investor decides for themselves whether or when or how deeply into jump into the market.
Jumping into the market should never be an all or nothing proposition. In fact, 'jumping' is a poor metaphor. As with many things in life, it is frequently better to start with a modest "toe in the water" and gradually ease in as you feel more comfortable.
Never jump into anything because you feel obligated or under pressure. If you feel pressured, simply back off and wait a day, a week, a month, or even a year (or two or three as in the case of the recent bear market) and make a more thoughtful, dispassionate, more informed decision that is yours and your alone. Other people can certainly give you advice, but the decision and the responsibility is yours.
Be very careful about advise from brokerage firms telling you that "now is the time" to get in or out of the market or a sector or individual stocks. Brokerage firms have an inherent conflict of interest: they live on the commissions and transaction fees they collect as a result of your buying or selling stocks. Sometimes they might encourage you to "take a little money off the table", which is fine if that's what you were thinking of doing anyway, but their motivation is to collect the extra commissions and transaction fees.
Here's a checklist to review for deciding whether and when to "jump into the market":
Realize that by making your own decision you are making the most significant possible contribution that any one person can make towards making the stock market work. The stock market (as well as the economy and even our society) is simply the sum of all of our individual decisions. We won't have a very vibrant and robust stock market (or economy or society) if we all make the same decisions at the same time. The stock market simply would not work if we all decided to buy or sell at the same time. By making your own decisions at your own pace, you are doing the right thing.
If you do decide to "jump into the market", keep a few points in mind:
I've tried to come up with the simplest possible plan for people who have decided to start putting some money into the market. Click here for Getting Started plan.
We have our own Tech Stock 'Safe' Indicator which should tell us when tech stocks really are 'safe' again. See our daily column for the current reading on this indicator.
I've kept a list of every investment book I've either read or browsed through that seemed to have at least some value. Click here to check out my Book List.
There are many witty (and some not so witty) "pearls of wisdom" that are used by "people in the business" to explain the way the market works or at least seems to be working. Click here for our collection of these sayings.
You won't get very far as an investor unless you are able to cope with the wide range of terms that are used to refer to the many aspects of the investment process. Click here for our list of links to the various online glossaries as well as the important offline dictionaries.
This is the process by which an analyst (or someone posing as one) calculates a value for a stock. Some people assert that the current price is the best estimate of a stock's value. Despite the impression given by 'professionals' on (and off) Wall Street, valuation is not a science. It involves a lot of judgment and making assumptions. Some of the techniques for arriving at a valuation for a stock are:
There is simply no such thing as a single valuation for a stock even at a single point in time. Nobody buys a stock for today. Everybody has a time horizon for their investment, whether it be six months, 5 years, or 50 years. Even a single, well-defined valuation strategy will come up with different current valuations when different time horizons are plugged into the calculations. Remember that interest rates, inflation, and foreign exchange rates vary over time.
Most valuation methodologies don't do a very good job of appropriately valuing intangible assets such as:
A valuation needs to reflect the net of positive value components (valuable assets) minus negative value components (mostly liabilities). One of the difficulties is that many of the potential liabilities are simply not known in advance. Future lawsuits, future competition, future regulation, etc. are inherently unknowable, and hence don't show up in a quantitative valuation of a stock. Similarly, positive future developments are unknowable and hence do not show up in any quantitative valuation. For example, back in the 1920's (the Roaring 20's, before the Crash), Ben Graham's boss convinced young Graham to stay away from putting money in a 'technology' company called CTR, after all, who can predict the future of such a company. In 1924 CTR changed their name to IBM, the Great Depression and New Deal created a huge demand for technology to manage information, and Graham missed out on a true investment opportunity of a lifetime, all because he didn't have a decent valuation methodology to deal with "one of those 'technology' companies.
The PEG ratio of a stock (P/E ratio divided by the expected annual growth rate) has some appeal, but assumes that both the P/E and the expected growth rate are valid. P/E can be either historic or prospective (e.g., coming year), but even earnings are subject to interpretation. After all even with 'standard' GAAP, earning include 'one-time' balance sheet adjustments that don't reflect the true, long-term earnings potential of the company. And the expected growth rate for any time horizon is pure judgment. The range of annual growth rates (and profit margins) that a company will experience over the next 5 years are truly unpredictable. The best example was Coca Cola, which was known as a 'ruler stock' since earnings grew at a very consistent (straight line) rate. So, the basic problem is that the growth rate will vary and your selected time horizon and 'smoothing function' will determine your growth rate estimate and hence your valuation. Even Warren Buffett has this problem with his intrinsic value.
Risk is an important component of valuation. Ben Graham used to talk of the importance of a "margin of safety". There are lots of different kinds of risk. There is the risk that you don't fully know all the negatives or positives. There is the risk of exogenous events such as wars, weather, civil unrest, etc. There is the risk of fraud. There is the risk of a change in the regulatory or tax environment. There is the risk of the emergence of a new competitor or a replacement technology. Consumer interests can change. Markets can become saturated. The 'value' of a competent, flexible, bold management team should not be underestimated and cannot easily be overestimated.
There is something called relative valuation which is simply concocting a premium between two companies and then arguing that one company should go up of down based on the price movement of the other company. Wall Street loves to use this technique to "broaden the market" rather than allow investors to focus on the leaders. If Intel moves up too far, then analysts will lobby that AMD should move up as well. And if AMD moves up too fast, people will argue that Intel should move up higher to maintain its premium. The process works in reverse on the downside.
Even something as simple as valuing cash is problematic. After all, the issue is not the liquidation value of the company, but how they will use their resources and assets to fuel future earnings growth. Company A may simply collect interest on their cash. In that case, the cash portion should have the same value as buying treasuries. Company B may squander its cash ill-conceived products, acquisitions, joint ventures, share buybacks, excessive dividends, etc. You might as well value their cash as zero or even negative since it gives management and investors a false sense of security. Even Microsoft has squandered a lot of money on things like investments in cable companies. Company C uses their cash to fund new blockbuster products, to beef up customer service, and to buy back stock on irrational stock market dips. Those 'expenses' are worth more than their weight in gold. If company A paid that excess cash as a special dividend, you the investor might have a better use (real estate) than having it sit in treasuries. If Company B didn't have the cash cushion maybe management would have been forced out and the company radically restructured (I'm thinking of Apple and Gateway). If Company C didn't have the cash, they'd either have to take on debt or pass up on some great opportunities that would have given their investors dramatic gains. Oh, and then there is interest rate risk, inflation, and foreign exchange rates which can all dramatically effect the future value (and hence the discounted present value) of that cash, depending on your choice of time horizon and macro variables. So, how do you value that cash?
Some people claim that timing the market cannot be done. Others claim to do it all the time. At best, it's tricky and error-prone. There are numerous newsletters that attempt to time the market for you. I'm not going to recommend market timing, but you'll have to decide for yourself. I myself prefer long-term buy-and-hold coupled with dollar-cost-averaging. One problem with market timing is that even one small error can result in a 'miss' that more than completely wipes out all the gains from any number of 'hits' on your market timing.
Catalysts, or events that move the market, are mainly of interest to traders rather than long-term investors. The only concerns of investors should be the overall pace of the economy and the pace of corporate revenue and profits. Whether a company beats or misses the consensus for quarterly earnings by a few pennies in inconsequential.
Every market has a hot money flowing in and out on any given day. The level of 'froth' will vary, primarily based on the trend of the market. Each bit of froth has its own time horizon and tolerance for pain desire for gain. As the market rises, more froth accumulates (due to hot money flowing into the market) and its proportion of the market accelerates as a rally continues. As a market falls, more of the froth burns away (due to hot money leaving the market) and its proportion of the market decelerates as the market corrects. After a strong rally, the froth level is quite deep. After a strong correction, the froth level becomes quite shallow. An advancing market will also attract 'real' money that will stay in the market despite even a moderate correction. If a market corrects strongly enough, even long-term 'real' money will begin to feel enough pain to sell. At any given moment, the froth depth may be 1% to 20% of the total market. 3% to 7% may be typical.
Traders and hedge funds can enter and leave the market at a fairly rapid pace. I call this hot money. True investors, who intend to stay in the market for an extended period of time, are what I call real money. When real money is flowing into the market (e.g., substantial amounts are flowing into stock mutual funds), I call that real buying. When real money is flowing out of the market (e.g., money is flowing out of stock mutual funds), I call that real selling. The significance is that real buyers tend to stay in the market and form a foundation for a sustainable market advance and real sellers tend to stay away from the market and help fuel a bear market.
Nasdaq is usually associated with tech stocks. In fact, only a portion of the many Nasdaq stocks are technology companies. The Nasdaq-100 and the Nasdaq-100 Tracking Stock (QQQ) are also usually associated with technology stocks even though there are numerous non-tech stocks in the index. And finally, there are quite a number of tech stocks that trade on the New York or American Stock Exchanges (anything with less than 4 letters in its symbol), so they are not included in the Nasdaq index of the Nasdaq-100 index.
If you want pure technology, check out the S&P 500 Tech Sector 'Spider' (XLK). It consists of the 95 'technology' (Information Technology and Telecommunications Services) companies from the S&P 500 Index. It includes both Nasdaq and NYSE stocks. There are some oddities, such as the inclusion of Yahoo (YHOO), but the exclusion of Amazon (AMZN) and eBay (EBAY) (Amazon was in but was dropped from the S&P 500 and eBay was added to the Consumer Discretionary sector). So, if your want eBay, go with Nasdaq or QQQ, but if you want HP (HPQ) and Texas Instruments (TXN) go with the Tech Sector 'Spider'. Nasdaq and QQQ also include the bio-tech stocks. Unfortunately, there is no tracking stock for the overall Nasdaq.
Although a lot has already been said and written about the Nasdaq boom and bust of 2000, I feel that a truly accurate characterization of that time has yet to be written. Sure, there were a lot of excesses, a lot of fraud, a lot of greed on Wall Street, and a lot of stupid behavior on the part of investors, but there's more to it.
As a start, my feeling is that the boom occurred because of a "perfect storm" confluence of factors that synchronized a lot of economic growth (demand) into a relatively small number of years:
- Demand for infrastructure (networks, routers, servers)
- Demand for personal computers to access the net.
- Access to the internet by company employees
- Companies publishing information on the web
- The rise of dot-com ecommerce companies
- Non-dot-com companies offering e-commerce
The stock market critically failed in one of its central 'purposes': to predict the future pace of the economy. There was so much 'extra' money flowing into the market that the market simply could not respond quickly enough. There was too much money chasing too few stocks (even though now we face the problem of too little money chasing too many stocks). It's all about supply and demand. Also, short-selling actually encouraged the stock boom since too many people were desperately trying to short the market, creating what seemed to be buyable dips, causing additional buying, causing the shorts to cover, causing a further price rise, causing further momentum buying, causing stocks to look even more attractive to shorts, and so on. That upwards spiral ended only as mutual fund inflows finally petered out. We would have had a boom and bust without the shorts, but the shorts made it far worse.
One of the lingering problems is that we still don't live in a market where 'research' lives up to its name. Even when research is bearish, it's still not truly objective and is mostly designed to further somebody's agenda. The main current problem is that too many research firms benefit from transaction volume caused by their periodic rating changes.
Another problem is that too many people have mistakenly been led to believe that buy-and-hold is "dead".
Different stock market participants have different financial goals and different time horizons. Some (traders) care very much about the latest news and events, others care about cyclical factors, and others are "in for the long haul". The various layers of the market are roughly:
We can also categorize participants by the reason they will close a position:
Sure, there are bullish traders as well, but there is a strong tendency towards cynicism and bearishness among traders. It's simply based on the fact that one of the reasons why people lean towards trading is that they don't see longer-term holding of stocks as being attractive, sound, and risk-free, whereas in trading you are focused on the solid facts of the here and now. Analyzing and understanding a company is difficult. But analyzing a chart and watching for changes in price and volume is much more mechanical and predictable, even if the results of trading are quite unpredictable. With trading, the facts can be readily grasped and understood. With longer-term investment in companies, everything gets squishy and subjective. My suspicion is that most traders are simply scared away from trying to fully understand a company, its products, its markets, its customers, its management, etc. With a long-term bet you're betting that there is no fraud, but with trading you either don't care if there is fraud or you are more than happy to exploit it.
Back in the old days (before the internet/web), I did read the Wall Street Journal regularly. But now I find little reason to read it, ever. Here are my reasons:
Put simply, I don't read the Journal anymore because it delivers no value to me.
I first started reading Barron's intensively back in 1998. I learned a lot and found it very useful. But after about two and a half years it outlived its usefulness. I learned a lot more doing my own reading of books, reading financial news stories in greater depth on the web, and diving deep into the many economic data reports that are on the web. I evntually found their economic commentary to be not only relatively useless, but even worse than useless. Basically, I eventually found that I was gaining very little from reading it regularly, and gaining far less than from reading material freely available on the web. I also began to find their extremely critical and negative tone to be what I consider unprofessional, far worse than the Wall Street Journal. The seem to go out of their way to appeal to people who have a cynical and bearish nature. I found their editorial commentary not only useless, but offensive in its tone. As with the Journal, I recognize that their readership loves that slant and tone, which is fine for them, but means that I will not be a reader. It also annoyed me greatly when they raised their price from $2.50 to $3.50 with no commensurate improvement in quality. Now of course it is available more cheaply on the web, so it was really the lack of benefit that bothered me much more than the cost. Briefing.com and CBS.MarketWatch.com will occasionally highlight the gist of important stories that do appear in Barron's.
I do know a fair amount about treasuries and do follow a lot of the developments in the treasuries market, but I don't cover the treasuries market in my regular column for a number of reasons:
I keep meaning to try to cover TIPS (Treasury Inflation-Protected Securities or actually more properly called TIIS for Treasury Inflation-Indexed Securities) and the difference in their yield from non inflation-index treasuries. That difference in yield should in theory be an expected inflation rate, but other factors in the economy can cause either TIPS or non-TIPS to have a greater or lesser demand. But alas, there is not enough easily accessible information on the web for me to do the desired coverage.
Market participants look at a combination of technical factors and fundamental factors. The concepts of being overbought and oversold relate purely to technical considerations and have nothing to do with fundamentals. The concepts of overvalued and undervalued relate purely to fundamental considerations having nothing to do with technical analysis. In fact, it is possible for a stock to be overbought and undervalued or overbought and overvalued or oversold and undervalued or oversold and overvalued. The meanings of these two pairs of terms are as follows:
Yes and No. It all depends on the valuation methods and your forecasting ability. In general, stocks are overvalued, but they have almost always been overvalued and most likely always will be overvalued. Even at the depths of the Great Depression, stocks were overvalued by some methods and undervalued by others. It all depends on your ability to forecast the future.
Sometimes stocks are in fact undervalued, but that's typically because there is great uncertainty about the future.
Ultimately, you have to discount the calculated value of a stock by its perceived risk and compare that to the price.
The only think about a Treasury that is risk free is that the U.S. government guarantees that you'll get your interest payments on time and the principle will be returned at maturity. But all the other risks of investing in bonds remain:
There are really three types of market turning points. The same is true for individual stocks and sectors indices as well. The three types are:
A turning point has four distinct phases:
Note that market turning points can occur at any time scale. Besides the transitions between major bull and bear markets, you have turning points for bull market corrections and bear market rallies. There can even be turning points within corrections and rallies. And the same process works within a day, even down to the tick level, as any day trader can attest. But for the purposes of the interests of this web site, we use the term market turning point to mean either the transition between a bull and bear market or major corrections and rallies within bull and bear markets. Basically, we're focused on identifying the starting point of an up-leg or a down-leg, where a leg lasts for at least several weeks. Anything less than that is simply a fluctuation.
My 'method' is derived from the techniques described on pages 64-68 of William J. O'Neil's How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition. My tuning is designed to work well for the Nasdaq index. This technique recognizes both the transition the transition from a bear market to a bull market, the start of a rally in a bear market, or the end of a correction in a bear market (or a continuation or a recovery of an up-leg after a pause). The steps are:
You can't be certain the day that the market bottoms, but the confirmation step gives you the confidence to relatively quickly go back and say with certainty when the new advance started.
TBD
I still haven't figured this out to my satisfaction, even after reading the excellent discussion in William J. O'Neil's How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition. You can read his discussion yourself on pages 56-64. I keep working on this. I suspect that what is needed is a technique for distinguishing market inflection points from true tops.
Bearish traders like to set up the market for a fall, or at least to set expectations overly high and then say "See! We missed expectations, so the market needs to pull back!". Here's how it works... Suppose X is good level of performance (of anything, whether an economic data index or earnings or revenues of a company) and is quite achievable. Obviously, X+k is even better. So, the traders (at least the ones try to set unrealistic expectations in order to incite a market decline) pick a value of k that is clearly unachievable but still within the realm of belief. Then these traders start chattering about how the market 'expects' X+k, irregardless of what the general consensus of market participants might actually be. This is the false strawman. Sometimes this might masquerade as a whisper number. Low and behold, X does in fact happen and maybe the actual news is even better than X, but is is below X+k. The traders then raise their level of chatter and go on about how the report missed the X+k number. In other words, these traders then knock down the false strawman that they had themselves put up. Now this kind of tactic does not work with the many rational market participants, but there are enough traders plying the market at any given time that this technique will frequently work, at least for a short time, before the market returns to prices that reflect the non-trading market participants expectations of X.
Every year Warren Buffett writes a detailed letter in the annual report to shareholders of Berkshire Hathaway. They are always insightful, educational, and even amusing. No investor's education can be complete with careful study of these letters. Click here to view the latest or the archive of letters back to 1977.
The Market Volatility Index (VIX) is sometimes known as the "Investor Fear Gauge" since it seems to spike up whenever investor anxiety is high and tends to drop off as investor anxiety drops off. See our daily column for the current reading of investor anxiety. Click here for a more in-depth description.
Some people (actually, a lot of people) say that buy-and-hold is dead. I disagree. Sure, you can buy and sell and buy and sell if you like being an active trader, but that is not to say that buy-and-hold itself is a bad thing. Sure, it is difficult to identify stocks for the long-run, but nobody said that investing wasn't a lot of diligent work. Besides, there are always ETFs such as the S&P 500 Spider, the Dow Diamonds, and the Nasdaq-100 Qubes for those who are lazy.
My compromise for the people who got burned by dot-coms, Enron, WorldCom, Global Crossing, Qwest, et al, is to modify simple buy-and-hold to be buy-and-hold-until, meaning that you pick stocks that you really do want to hold for the long-term assuming that they stay attractive, and then monitor them semi-closely for any warning signs that the company may no longer be what it seems. Sure, you should have dumped Enron and eToys, but you should hang onto Microsoft, eBay, Amazon, and Berkshire Hathaway though the turbulence. Speculators like to try to time the market and move out of a stock for the down portion of a cycle, but that's not really necessary. The bottom line for a buy-and-hold-until portfolio strategy is that you decide up-front what qualities make a company attractive and are necessary for their long-term health and they simply stay the course until those qualities begin to deteriorate excessively, ignoring temporary setbacks which are likely to be reversed soon enough.
The warning signs for dumping a stock are not cut and dry and require a lot of judgment. I recall a number of times that Intel and AOL has significant setbacks, but bounced back even stronger. In the case of AOL, the merger with TimeWarner was a clear sign (using our 20/20 hindsight) that AOL was making a big misstep. WorldCom trying to buy Sprint (or even when it did buy MCI) was another such sign. AT&T's purchase of NCR was their big warning sign.
Everybody talks about U.S. Treasuries as being 'risk-free', but that does not mean there are no risks with Treasuries. What people really mean is that there is no risk of losing your nominal principle if the Treasury is held to maturity. So, if you buy $10,000 of 10-year Treasury notes from the U.S. Treasury and hold them for 10 years, then the U.S. government is guaranteed to pay you your full $10,000 after 10 years, as well as interest payments during those 10 years.
But, there is a caveat on even that 'risk-free' proposition: if you buy Treasuries on the open market, you usually pay an amount more or less than $10,000 for those Treasuries (a premium or a discount) and the U.S. government guarantees to pay you exactly $10,000 at maturity. So, if you had bought at a discount because interest rates had risen, you get more than your $10,000 at maturity and if you had bought at a premium because interest rates had fallen, then you will get less than your $10,000 at maturity.
That's the 'risk-free guarantee' for U.S. Treasuries.
Now here are the main risks of these 'risk-free' Treasuries:
Of course, each of those risks has a flip side, allowing clever (and nimble) speculators to profit handsomely at times when: interest rates are declining, inflation is declining, the dollar is strengthening, when stocks are stumbling, or when geopolitical tensions are shifting.
Note: You can evade the inflation risk by purchasing Treasury Inflation-Indexed Securities (or TIIS, usually improperly referred to as TIPS or Treasury Inflation-Protected Securities, but the U.S. Treasury renamed them quite a while ago). But all the other risks are present. But be aware that while TIPS do protect you from inflation, they do not protect you from loss of principle as inflation expectations decline. The flip side is that the market value of TIPS can rise as inflation expectations rise. The bottom line for TIPS is that their market value rises and falls according to the law of supply and demand. If you're going to buy TIPS, buy them when nobody else wants them (when inflation expectations are low or declining) and sell them when everybody has bought their fill of them (when inflation expectations have peaked).
The bottom line is that you have three choices:
Unlike the S&P 500 and other "indexes", the Dow Jones Industrial Average (DJIA) (as well as the transportation and utilities averages) does not use weighting factors for each stock. Originally, as the name implies, the DJIA was designed to be an average price, but as stocks were replaced and splits occurred, Dow Jones simply revised the divisor from the original 30 (actually, it was 20 for 20 stocks) so that the DJIA index value would not change merely because of a replacement of a stock. Over the years, that has resulted in the divisor becoming less than one so that it is now actually a multiplier (see below).
Here's the official Dow Jones page that describes this process.
And here's the relevant text:
The Dow Jones averages are unique in that they are price weighted rather than market capitalization weighted. Their component weightings are therefore affected only by changes in the stocks' prices, in contrast with other indexes' weightings that are affected by both price changes and changes in the number of shares outstanding.
When the averages were initially created, their values were calculated by simply adding up the component stocks' prices and dividing by the number of components. Later, the practice of adjusting the divisor was initiated to smooth out the effects of stock splits and other corporate actions.
The current divisor values are as follows: DJIA 0.13532775, DJTA 0.22477839, and DJUA 1.5940823.
Just to recap: Take the 30 Dow Industrials stock prices, add them up (no "weighting") and divide by the "divisor" (0.13532775). That gives you the DJIA.
Contrary to the claims of some, there is no "weighting" for each stock. Sure, you can take the DJIA and divide by 30 and then divide by the stock price to get this so-called "weighting", but it doesn't really have any significant investment value and is not used in calculating the DJIA as stock prices change.
What is true and interesting is that a $1 change in any Dow Industrials stock has the same impact on the DJIA, regardless of whether it was a $101 stock or a $24 stock. In that sense, the DJIA is rather democratic.
Different asset classes tend to outperform during the various stages of the classic business cycle. Allocating your assets according to these phases is referred to as using the asset allocation clock.
Oversimplifying, growth stocks do well during the early portion of the growth phase of the business cycle. Commodities then tend to outperform as the business cycle matures and commodity prices zoom up due to inflation. Money market funds tend to outperform as a recession starts to kick in. Bonds do well as inflation evaporates and becomes disinflation or even a little deflation. This model is not guaranteed to work and every business cycle has its own quirky characteristics, but does help to explain some of the investment and speculative behavior we see in the markets.
Here is another variation of the asset allocation clock that I found on the Web:
Updated: February 18, 2007 08:55:15 PM -0500
Copyright © 2006 John W. Krupansky d/b/a Base Technology
