Any (short) answer requires broad generalizations. I’ve narrowed the literally millions of variables down to four: company earnings prospects, supply/demand factors, current news releases, and a broad category of “alternative investment choices.”
On a daily basis, the company news reports and current economic statistic releases do have an impact – but it’s generally a short-term impact, most useful for making sound “trading decisions.” Internet era day-traders are rare; most busted in 2001. Big investment firms take short-term positions in stocks into “inventory” and trade around these positions. These folks are called “information traders” and may live or die by paying attention to daily news briefs. Sometimes “good news” was actually anticipated to be “great news” and a stock will go down if only good news gets reported. This sort of price activity confuses lay investors, who shouldn’t be trying to out-trade Wall Street anyway.
Every stock has both potential, and risk. Buyers focus on the potential while the sellers are reducing their risk. On most days, both good news and bad news is released – or at least news that could be interpreted both positively and negatively, depending on the listener’s bias, much like news in a political election can be spun either way. Journalists will typically report the side of the story which matches the direction of the stock’s move. If the stock rises on the day, the media will report the increase and ascribe the move to the positive spin du jour.
Stocks move for a lot of reasons. I have made mistakes that cost a stock a couple of points when Wall Street spread the word that my firm absolutely, positively had to sell a big block of shares by the end of the day. News isn’t always responsible for either the size or direction of a stock move, and media attempts to link cause and effect may be a work of fiction.
In the long run, earnings prospects determine prices, though not precisely. I talk about the “intrinsic value” of a particular company. That value can never be found, or proven, but as earnings prospects increase, so does a company’s intrinsic value. Other factors cause the stock to trade above and below its real value, but in the long run the intrinsic value determines where a stock is headed. So what about the big sell-off in September/October?
The horrific decline was more than just normal volatility. It tells me that in August we had a functioning banking system and bond market, but by mid-September we didn’t. Without working capital markets and trustworthy banks, the ability of companies to conduct business and the willingness of consumers to continue spending is severely hampered.
Back in 1987, when the market fell over 20% in a day, that was mostly normal volatility, exaggerated a bit by some supply/demand factors. In a single day, the market went from overvalued to undervalued, but soon recovered because the intrinsic value for the underlying companies was little changed.
We have now entered an age of de-leveraging across the globe due to our severely injured banking system and capital markets that are still closed to lower quality credits. Intrinsic values of certain companies have plunged. Charles Prince, the idiot ex-CEO of Citigroup, told the Financial Times in July 2007 that, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” He was right about the fact that once the music stops playing, it will be a completely different world. Shearson folded, bonds (not just stocks) became worthless, the banking panic froze the capital markets and we now live in a very different, trust-starved world. It will take years to rebuild trust, and companies which require trusting creditors to survive no longer have a viable business model. For those companies, the de-leveraging process is a death sentence that results in a dramatic plunge in intrinsic values, probably worldwide.
The financial industry usually makes things worse by manufacturing too much of a bad thing (increasing supply) just as investor interest in a particular fad peaks (demand declines). Bob Clark, an industry writer, observes that the job of a good financial advisor is to protect his clients from the financial services industry, and I think there’s a lot of wisdom (experience?) in that statement.
The sub-prime debacle kicked off this particular panic in January of 2007. After years of packaging toxic loans and selling them to brokerage clients, the heavily regulated banks and other investors found themselves with a need to sell sub-prime securities but suddenly no one was willing to buy them. This created a huge supply/demand mismatch. Some brokers will say that supply/demand imbalances never occur because for every buyer there is a seller, but that’s hogwash because in order to flush buyers off the sidelines, prices have to change. At 10 cents on the dollar, the sub-prime mortgage supply/demand balance was restored. But in the process we wiped out a couple of trillion dollars of shareholder wealth.
Supply/demand disequilibrium is usually a temporary phenomenon. It is part of what causes stocks to be volatile, moving above and below intrinsic value. Eventually, however, prices adjust and buyers and sellers pair off against each other at, or at least near, true value.
Supply/demand imbalances often create opportunities. Some writers have observed that “diversification failed” in 2008. In other words, everything went down. Investing in foreign stocks, and small-cap stocks, and mid-cap stocks, and large-cap stocks, and real estate oriented stocks, and leveraged stocks and non-leveraged stocks, and junk bonds and even high quality bonds…everything sold off. Instead of just selling the bad apples, the demand for fund redemptions was so great that funds sold off good assets, too, because on some days those were the only assets for which a bid was available. It has been a classic “throw the baby out with the bath water” sort of market, which creates opportunities in non-cyclical non-leveraged companies, and in fixed income securities as well.
Many people are saying that financial stocks have to lead us out of this decline, but I disagree. The intrinsic values in the financial sector are, in some cases, disappearing! Why should those stocks rally when they’re still in the process of declining to their true value, of zero. The leveraged and very cyclical companies may well see their stock prices continue to decline as intrinsic value evaporates, probably when the next bond comes due and creditors need to be paid. In the coming months, however, the stocks of good companies which were routed but whose intrinsic values did not decline much will rise toward intrinsic value. Those companies will lead us out of the darkness. It may include some financials, but the very fact that those companies are all leveraged, by definition, makes the sector suspect.
The final factor that drives stock prices are events in other markets. Alternative investment choices have an impact, just as (Warren Buffet has noted) you can’t understand Coca-Cola stock unless you understand Pepsi and Cott Corporation as well. These sectors all compete for your money.
The bond market, especially, can trigger a sell-off or rally. But money flows from one asset class to the next, so you can’t limit this factor just to bonds and what interest rates are doing.
In 1987, bond prices were falling (interest rates were on the rise). Once the long-term bonds began selling at a 10% yield, stock investors shifted money out of an over-valued stock market toward a much less risky bond alternative, preferring a “safe” 10% to a very risky…whatever. The asset re-allocation started in August, became more popular in September, and surged in October when yields went above 10%. What happened in bond land helped torpedo the stock market. And, subsequently, when interest rates declined rapidly during the crash, some investors were able to reverse the allocation after the market crash and the bond market provided a nice source of funds for investors to shift money back into stocks almost immediately after the crash.
I fear that, given the massive government intervention we’ve seen, once the bailout starts working the Treasury will have to issue billions of new bonds and the resulting supply/demand imbalance (lots of treasuries for sale, but where are the buyers?) will find an equilibrium at significantly higher yield levels. If today’s 10-year Treasury were to rise from 2.6% to 5.5% or 6%, I think you could fund these bailouts, but at a much higher cost to the taxpayer and at yield levels high enough to draw investors out of stocks, causing stock prices to start falling again. The possibility of rising interest rates amidst a severe recession is not the sort of market where money is easy to coin.
Thousands of variations on a theme and a million possible combinations of variables add complexity to these four major determinants of price action. No formula works all the time, which is why it feels so random. Even to the best investors, it’s an educated guess with a significant possibility of being wrong. One reason for diversification is that anyone who thinks he’s got all the answers just hasn’t been doing it long enough. In poker, they call it “money management.” Investors need to consider the possibility that they’ll be dead wrong, and even if that happens they need to be able to absorb their losses and still have enough to get back in the market.
If you know what you’re doing and can keep at it, the odds can be in your favor. Madoff reminds us, however, that nobody except liars get it right every time.
Hope this helps.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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