Kenneth L. Fisher on How to Time the Market
"There is no end to the lengths people go to try to find the magic key to the stock market."
"At best, one can hope to be right about the stock market perhaps half the time. At worst, one is apt to be wrong most of the time. Stock market seers run hot for a couple of years. Then most embarrass themselves."
But there's more. Even if you COULD predict the market's major moves, Fisher says it wouldn't be worth it. He studied how an investor would have fared had he correctly called every 100-point move of the Dow Jones Industrial Average for the 5-year period ending Dec 31, 1982.
Such an investor (which of course, probably doesn't exist) would have earned a compound rate of return of 51.5%. That sounds great, but according to Fisher, it's no better than the return you could generate by buying a super stock.
And in the perfect-market-timing scenario, you also would be jumping in or out of the market 11 times during that span, resulting in significant trading costs. Plus, since the vast majority of those 100-point swings occurred in less than a year, you'd be taxed at higher short-term gains rates. Super Stocks make their gains over a three- to five-year period, generating long-term gains that are subject to lower tax rates.
Fisher does, however, offer a solution for how to time the market. His two rules:
1. When a company is selling at a (sufficiently) low PSR (Price-Sales Ratio) - BUY it.
2. If you can't find companies selling at (sufficiently) low PSRs, DON'T buy stocks.
Of course, this isn't exactly market timing in the way most people think of it, because it looks at specific stocks rather than the entire market. But whether you call it market timing or not, it's certainly a lot better plan than those used by most investors who try to time the broader market's movements.
Source: Kenneth L. Fisher, Super Stocks, reissued edition (NY: McGraw-Hill, 2008)
Thursday 28 May 2009
Peter Lynch's Pearl of Wisdom
Another One of Peter Lynch's Many Pearls of Wall Street Wisdom
Lynch once said in an interview that putting money into stocks and counting on having nice profits in a year or two is "just like betting on red or black at the casino...... What the market's going to do in one or two years, you don't know."
This is a crucial general approach shared by Lynch and many of the other gurus of investing. It's simple in theory, but in practice it is one of the hardest things for an investor. Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. Over the long term, however, good stocks rise like no other investment vehicle. Lynch's philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains, jump in and out an there's a good chance that you'll miss out on a chunk of them.
That, of course, means resisting the temptation to bail when the market takes some short-term hits and good stocks fall in value - no easy task. But as Lynch once said, "The real key to making money in stocks is not to get scared out of them."
Lynch once said in an interview that putting money into stocks and counting on having nice profits in a year or two is "just like betting on red or black at the casino...... What the market's going to do in one or two years, you don't know."
This is a crucial general approach shared by Lynch and many of the other gurus of investing. It's simple in theory, but in practice it is one of the hardest things for an investor. Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. Over the long term, however, good stocks rise like no other investment vehicle. Lynch's philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains, jump in and out an there's a good chance that you'll miss out on a chunk of them.
That, of course, means resisting the temptation to bail when the market takes some short-term hits and good stocks fall in value - no easy task. But as Lynch once said, "The real key to making money in stocks is not to get scared out of them."
How to employ buy and hold in our overall investing philosophy?
How to employ buy and hold in our overall investing philosophy?
The more you trade, the less well you do. Have a strategy and then let that strategy work.
Warren Buffett often hold stocks for years and years. But not all buy and hold strategists need to follow him.
You can choose to hold a stock for a year and then rebalances your portfolio. By doing so, you are making sure you are not holding stocks that no longer meets your criteria. While you may choose to rebalance annually, you may also rebalance your portfolio more frequently.
You are free to pick a rebalancing period - be it monthly, quarterly, semiannually, or annually. Sticking to this discipline is more important than the decision about which specific period to use.
Keep it Simple and Safe (K.I.S.S): The novice investors might expect someone emerging from a study of the different strategies and the stock market results to come out with some highly complex, esoteric formulas for how to produce the best returns. Instead, it was just the opposite.
The more you trade, the less well you do. Have a strategy and then let that strategy work.
Warren Buffett often hold stocks for years and years. But not all buy and hold strategists need to follow him.
You can choose to hold a stock for a year and then rebalances your portfolio. By doing so, you are making sure you are not holding stocks that no longer meets your criteria. While you may choose to rebalance annually, you may also rebalance your portfolio more frequently.
You are free to pick a rebalancing period - be it monthly, quarterly, semiannually, or annually. Sticking to this discipline is more important than the decision about which specific period to use.
Keep it Simple and Safe (K.I.S.S): The novice investors might expect someone emerging from a study of the different strategies and the stock market results to come out with some highly complex, esoteric formulas for how to produce the best returns. Instead, it was just the opposite.
Redefining Risk
Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price. Volatility is not risk. Avoid investment advice based on volatility.
Redefining Risk
Risk was the chance that you might not meet your long-term investment goals. And the greatest enemy of reaching those goals: inflation. Nothing is safe from inflation. It's major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.
Investors usually use Treasury bills as their benchmark for risk. These are considered risk-free because their nominal value can't go down. However, T-bills and bonds are in fact highly risky because of their susceptibility to inflation.
For example, if you buy a 10 year-T-bill that pays 3 percent in interest per year, and inflation is creeping up at, say, 2 percent per year, the real value of your investment at maturity will end up being significantly less than 3 percent greater than the price you paid for it. In the case of low-interest-paying T-bills, higher inflation could even mean that your investment loses value, in terms of real purchasing power, over its lifetime.
Realistic definition of Risk
A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes:
1. The probability your investment will preserve your capital over your investment time horizon.
2. The probability your investments will outperform alternative investments during the period.
Why Volatility is not Risk?
Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price.
There is no correlation between this volatility-related-risk and return.
So if volatility is not risk, what is?
The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15 or even 30 years away - is a completely inappropriate definition. (David Dreman)
In the short-term, stocks fluctuate unpredictably, so if you're saving to buy a house or a car within the next two years or so, bonds and T-bills are a good choice. But over the long term, stocks far more often than not outperform alternative investments like bonds or T-bills.
In fact, Dreman's research shows that inflation-adjusted returns for stocks - which, unlike bonds or T-bills have the ability to produce increasing earnings streams - have consistently outpaced those of bonds and T-bills since the start of the 1800s. The gap has widened since the mid-1920s, when inflation began to have a more significant impact.
What's more, from 1946 to 1996, according to Dreman, compound returns after inflation for stocks were better than those of bonds 84% of the time if your holding period was 5 years.
Take Home Lesson
Using Dreman's definition of risk, stocks are actually the safest investment out there over the long term.
Investors who put some or most of their money into bonds and other investments on the assumption they are lowering their risk are, in fact, deluding themselves.
"Indeed, it goes against the principle we were taught from childhood - that the safest way to save was putting our money in the bank."
Redefining Risk
Risk was the chance that you might not meet your long-term investment goals. And the greatest enemy of reaching those goals: inflation. Nothing is safe from inflation. It's major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.
Investors usually use Treasury bills as their benchmark for risk. These are considered risk-free because their nominal value can't go down. However, T-bills and bonds are in fact highly risky because of their susceptibility to inflation.
For example, if you buy a 10 year-T-bill that pays 3 percent in interest per year, and inflation is creeping up at, say, 2 percent per year, the real value of your investment at maturity will end up being significantly less than 3 percent greater than the price you paid for it. In the case of low-interest-paying T-bills, higher inflation could even mean that your investment loses value, in terms of real purchasing power, over its lifetime.
Realistic definition of Risk
A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes:
1. The probability your investment will preserve your capital over your investment time horizon.
2. The probability your investments will outperform alternative investments during the period.
Why Volatility is not Risk?
Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price.
There is no correlation between this volatility-related-risk and return.
- Higher volatility does not give better results, nor lower volatility worse.
- Studies have shown that there is not necessarily any stable long-term relationship between volatility-related-risk and return, and often there is no relationship between the return achieved and the volatility-related-risk taken.
So if volatility is not risk, what is?
The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15 or even 30 years away - is a completely inappropriate definition. (David Dreman)
In the short-term, stocks fluctuate unpredictably, so if you're saving to buy a house or a car within the next two years or so, bonds and T-bills are a good choice. But over the long term, stocks far more often than not outperform alternative investments like bonds or T-bills.
In fact, Dreman's research shows that inflation-adjusted returns for stocks - which, unlike bonds or T-bills have the ability to produce increasing earnings streams - have consistently outpaced those of bonds and T-bills since the start of the 1800s. The gap has widened since the mid-1920s, when inflation began to have a more significant impact.
What's more, from 1946 to 1996, according to Dreman, compound returns after inflation for stocks were better than those of bonds 84% of the time if your holding period was 5 years.
- Stocks also outperformed T-bills in 82% of those 5-year periods.
- Using 10-year periods, stocks beat bonds 94% of the time and T-bills 86% of the time.
- When you look at 20-year holding periods, stocks beat both bonds and T-bills 100 percent of the time.
Take Home Lesson
Using Dreman's definition of risk, stocks are actually the safest investment out there over the long term.
Investors who put some or most of their money into bonds and other investments on the assumption they are lowering their risk are, in fact, deluding themselves.
"Indeed, it goes against the principle we were taught from childhood - that the safest way to save was putting our money in the bank."
Observing Long-Term Investing
Observing Long-Term Investing
Study the 2 lists of the top 30 shareholders of a particular company below.
Excluding the institutions, there are 10 individual investors who invested in this company from the year 2002 to 2008. These are certainly long-term investors.
The share price of this compay ranged 3.85 to 8.35 in 2002.
In 2008, the price ranged from 10.50 to 13.00.
It is presently priced at 10.70.
The dividend per share for the recent 6 years were 5.8c (2002), 12.8c (2003), 56c (2004), 63.2c (2005), 63.5c (2006), 63.5c (2007), giving a total of 264.8c. The DY the last 5 years ranged from 10.1% to 6.7% varying with the share price.
What lessons can we derive from the investing behaviours of these long-term "buy and hold" investors? Perhaps, you may spot my name within this list. hahaha!!
http://announcements.bursamalaysia.com/EDMS/subweb.nsf/7f04516f8098680348256c6f0017a6bf/6a8c0c56bb45fd2c48256d02000ff5d0/$FILE/DLady-AnnualReport%202002%20(950KB).pdf
Dutch Lady Annual Report 2002
30 Largest Shareholders Page 45
1. Frint Beheer IV BV* 32,074,800 50.12
2. Amanah Raya Nominees (Tempatan) Sdn Bhd* 16,008,000 25.01 %
- Skim Amanah Saham Bumiputera
3. RHB Nominees (Asing) Sdn Bhd 540,000 0.84 %
- Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A.
4. Yong Siew Lee 270,000 0.42 %
5. Kumpulan Wang Simpanan Guru-Guru 220,000 0.34%
6. Yeo Khee Bee 215,000 0.34 %
7. Employees Provident Fund Board 201,000 0.31%
8. Menteri Kewangan Malaysia Section 29 (SICDA) 189,800 0.30 %
9. Ng Lam Shen 160,000 0.25 %
10. Quek Guat Kwee 160,000 0.25 %
11. Amanah Raya Nominees (Tempatan) Sdn Bhd 157,000 0.25 %
-Dana Johor
12. Universiti Malaya 144,000 0.23 %
13. Amanah Raya Nominees (Tempatan) Sdn Bhd 128,000 0.20 %
-Amanah Saham Johor
14. Lee Sim Kuen 120,000 0.19 %
15. Tong Yoke Kim Sdn Bhd 120,000 0.19 %
16. Foo Mee Lee 117,404 0.18 %
17. Wong So-Ch’I 111,000 0.17 %
18. Soon Ah Khun @ Soon Lian Huat 110,000 0.17 %
19. Wong So Haur 109,000 0.17 %
20. Lim Teh Realty Sdn Bhd 90,000 0.14 %
21. Foo Loke Weng 80,804 0.13 %
22. HSBC Nominees (Asing) Sdn Bhd 80,000 0.13 %
- Pictet and Cie for Ace Fund Sicav (Emerging Market)
23. Mayban Nominess (Tempatan) Sdn Bhd 75,000 0.12 %
- for Goh Sin Bong
24. Lim Pin Kong 75,000 0.12 %
25. Neoh Soon Leong 72,000 0.11 %
26. See Cheng Siang 72,000 0.11 %
27. Leong Lai Meng 60,000 0.09 %
28. Looi Chin Seng 60,000 0.09 %
29. HSBC Nominees (Tempatan) Sdn Bhd 60,000 0.09 %
- for Goh Hiong Eng
30. Sak Mok @ Sak Swee Len 58,000 0.09%
http://announcements.bursamalaysia.com/EDMS/subweb.nsf/7f04516f8098680348256c6f0017a6bf/5f300a009db8aabf482575a70014e6ae/$FILE/DLADY-AnnualReport2008%20(1MB).pdf
Dutch Lady Annual Report 2008
30 Largest Shareholders Page 49
1. Frint Beheer IV BV* 32,074,800 50.12%
2. Amanah Raya Nominees (Tempatan) Sdn Bhd 12,500,000 19.53%
- Skim Amanah Saham Bumiputera
3. Kumpulan Wang Persaraan (Diperbadankan) 2,109,200 3.3%
4. Permodalan Nasional Berhad 1,843,500 2.88%
5. Public Nominees (Tempatan) Sdn Bhd 837,300 1.31%
- Pledged Securities Account for Aun Huat & Brothers
Sdn Bhd (E-IMO/BCM)
6. Aun Huat & Brothers Sdn Bhd 587,100 0.92%
7. Cartaban Nominees (Asing) Sdn Bhd 540,000 0.84%
- Exempt An For Bank Sarasin-Rabo (Asia) Limited (AC Client Frgn)
8. Yong Siew Lee 430,000 0.67%
9. Yeo Khee Bee 391,300 0.61%
10. Quek Guat Kwee 162,000 0.25%
11. Kumpulan Wang Simpanan Guru-Guru 156,300 0.24%
12. SBB Nominees (Tempatan) Sdn Bhd 144,000 0.23%
- Universiti Malaya (CAFM)
13. Citigroup Nominees (Asing) Sdn Bhd 125,700 0.20%
- CBNY For DFA Emerging Markets Small Cap Series
14. Lee Sim Kuen 120,000 0.19%
15. Wong So-Ch’i 111,000 0.17%
16. Tong Yoke Kim Sdn Bhd 110,000 0.17%
17. Wong So Haur 109,000 0.17%
18. Chow Kok Meng 99,900 0.16%
19. Lim Teh Realty Sdn Berhad 90,000 0.14%
20. Foo Yoke Keong Adrian 80,000 0.13%
21. Cartaban Nominees (Tempatan) Sdn Bhd 80,000 0.13%
- Exempt An For Kam Nominees (Tempatan) Sdn Bhd
22. Tan Pak Nang 74,000 0.12%
23. Mayban Nominees (Tempatan) Sdn Bhd 74,000 0.12%
- Affin Fund Management Berhad For CIMB Aviva Assurance
Berhad (270185)
24. Ng Lam Shen 71,300 0.11%
25. Tan Kim Onm 66,000 0.10%
26. Labuan Reinsurance (L) Ltd 62,700 0.10%
27. HSBC Nominees (Tempatan) Sdn Bhd 60,000 0.09%
- Pledged Securities Account for Goh Hiong Eng
28. Sak Moy @ Sak Swee Len 58,000 0.09%
29. Theo Chin Lian 56,000 0.09%
30. Chua Sim Hong 55,900 0.09%
Total: 53,280,000 83.27%
Study the 2 lists of the top 30 shareholders of a particular company below.
Excluding the institutions, there are 10 individual investors who invested in this company from the year 2002 to 2008. These are certainly long-term investors.
The share price of this compay ranged 3.85 to 8.35 in 2002.
In 2008, the price ranged from 10.50 to 13.00.
It is presently priced at 10.70.
The dividend per share for the recent 6 years were 5.8c (2002), 12.8c (2003), 56c (2004), 63.2c (2005), 63.5c (2006), 63.5c (2007), giving a total of 264.8c. The DY the last 5 years ranged from 10.1% to 6.7% varying with the share price.
What lessons can we derive from the investing behaviours of these long-term "buy and hold" investors? Perhaps, you may spot my name within this list. hahaha!!
http://announcements.bursamalaysia.com/EDMS/subweb.nsf/7f04516f8098680348256c6f0017a6bf/6a8c0c56bb45fd2c48256d02000ff5d0/$FILE/DLady-AnnualReport%202002%20(950KB).pdf
Dutch Lady Annual Report 2002
30 Largest Shareholders Page 45
1. Frint Beheer IV BV* 32,074,800 50.12
2. Amanah Raya Nominees (Tempatan) Sdn Bhd* 16,008,000 25.01 %
- Skim Amanah Saham Bumiputera
3. RHB Nominees (Asing) Sdn Bhd 540,000 0.84 %
- Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A.
4. Yong Siew Lee 270,000 0.42 %
5. Kumpulan Wang Simpanan Guru-Guru 220,000 0.34%
6. Yeo Khee Bee 215,000 0.34 %
7. Employees Provident Fund Board 201,000 0.31%
8. Menteri Kewangan Malaysia Section 29 (SICDA) 189,800 0.30 %
9. Ng Lam Shen 160,000 0.25 %
10. Quek Guat Kwee 160,000 0.25 %
11. Amanah Raya Nominees (Tempatan) Sdn Bhd 157,000 0.25 %
-Dana Johor
12. Universiti Malaya 144,000 0.23 %
13. Amanah Raya Nominees (Tempatan) Sdn Bhd 128,000 0.20 %
-Amanah Saham Johor
14. Lee Sim Kuen 120,000 0.19 %
15. Tong Yoke Kim Sdn Bhd 120,000 0.19 %
16. Foo Mee Lee 117,404 0.18 %
17. Wong So-Ch’I 111,000 0.17 %
18. Soon Ah Khun @ Soon Lian Huat 110,000 0.17 %
19. Wong So Haur 109,000 0.17 %
20. Lim Teh Realty Sdn Bhd 90,000 0.14 %
21. Foo Loke Weng 80,804 0.13 %
22. HSBC Nominees (Asing) Sdn Bhd 80,000 0.13 %
- Pictet and Cie for Ace Fund Sicav (Emerging Market)
23. Mayban Nominess (Tempatan) Sdn Bhd 75,000 0.12 %
- for Goh Sin Bong
24. Lim Pin Kong 75,000 0.12 %
25. Neoh Soon Leong 72,000 0.11 %
26. See Cheng Siang 72,000 0.11 %
27. Leong Lai Meng 60,000 0.09 %
28. Looi Chin Seng 60,000 0.09 %
29. HSBC Nominees (Tempatan) Sdn Bhd 60,000 0.09 %
- for Goh Hiong Eng
30. Sak Mok @ Sak Swee Len 58,000 0.09%
http://announcements.bursamalaysia.com/EDMS/subweb.nsf/7f04516f8098680348256c6f0017a6bf/5f300a009db8aabf482575a70014e6ae/$FILE/DLADY-AnnualReport2008%20(1MB).pdf
Dutch Lady Annual Report 2008
30 Largest Shareholders Page 49
1. Frint Beheer IV BV* 32,074,800 50.12%
2. Amanah Raya Nominees (Tempatan) Sdn Bhd 12,500,000 19.53%
- Skim Amanah Saham Bumiputera
3. Kumpulan Wang Persaraan (Diperbadankan) 2,109,200 3.3%
4. Permodalan Nasional Berhad 1,843,500 2.88%
5. Public Nominees (Tempatan) Sdn Bhd 837,300 1.31%
- Pledged Securities Account for Aun Huat & Brothers
Sdn Bhd (E-IMO/BCM)
6. Aun Huat & Brothers Sdn Bhd 587,100 0.92%
7. Cartaban Nominees (Asing) Sdn Bhd 540,000 0.84%
- Exempt An For Bank Sarasin-Rabo (Asia) Limited (AC Client Frgn)
8. Yong Siew Lee 430,000 0.67%
9. Yeo Khee Bee 391,300 0.61%
10. Quek Guat Kwee 162,000 0.25%
11. Kumpulan Wang Simpanan Guru-Guru 156,300 0.24%
12. SBB Nominees (Tempatan) Sdn Bhd 144,000 0.23%
- Universiti Malaya (CAFM)
13. Citigroup Nominees (Asing) Sdn Bhd 125,700 0.20%
- CBNY For DFA Emerging Markets Small Cap Series
14. Lee Sim Kuen 120,000 0.19%
15. Wong So-Ch’i 111,000 0.17%
16. Tong Yoke Kim Sdn Bhd 110,000 0.17%
17. Wong So Haur 109,000 0.17%
18. Chow Kok Meng 99,900 0.16%
19. Lim Teh Realty Sdn Berhad 90,000 0.14%
20. Foo Yoke Keong Adrian 80,000 0.13%
21. Cartaban Nominees (Tempatan) Sdn Bhd 80,000 0.13%
- Exempt An For Kam Nominees (Tempatan) Sdn Bhd
22. Tan Pak Nang 74,000 0.12%
23. Mayban Nominees (Tempatan) Sdn Bhd 74,000 0.12%
- Affin Fund Management Berhad For CIMB Aviva Assurance
Berhad (270185)
24. Ng Lam Shen 71,300 0.11%
25. Tan Kim Onm 66,000 0.10%
26. Labuan Reinsurance (L) Ltd 62,700 0.10%
27. HSBC Nominees (Tempatan) Sdn Bhd 60,000 0.09%
- Pledged Securities Account for Goh Hiong Eng
28. Sak Moy @ Sak Swee Len 58,000 0.09%
29. Theo Chin Lian 56,000 0.09%
30. Chua Sim Hong 55,900 0.09%
Total: 53,280,000 83.27%
Wednesday 27 May 2009
Total Returns vs Total Wealth vs Total Real Returns
Total Returns
Total returns means that all returns, such as interest and dividends and capital gains, are automatically reinvested in the asset and allowed to accumulate over time.
A graph depicting the total return indexes for stocks, long- and short-term bonds, gold, and commodities from 1802 through 2001, showed that the total return on equities dominates all other assets. Even the cataclysmic stock crash of 1929, which caused a generation of investors to shun stocks, appears as a mere blip in the stock return index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns.
Total Returns vs Total Wealth
However, the total wealth in the stock market, or in the economy, does not accumulate as fast as the total return index. This is so because investors consume most of their dividends and capital gains, enjoying the fruits of their past saving.
It is rare for anyone to accumulate wealth for long periods of time without consuming part of his or her return.
Total returns means that all returns, such as interest and dividends and capital gains, are automatically reinvested in the asset and allowed to accumulate over time.
A graph depicting the total return indexes for stocks, long- and short-term bonds, gold, and commodities from 1802 through 2001, showed that the total return on equities dominates all other assets. Even the cataclysmic stock crash of 1929, which caused a generation of investors to shun stocks, appears as a mere blip in the stock return index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns.
Total Returns vs Total Wealth
However, the total wealth in the stock market, or in the economy, does not accumulate as fast as the total return index. This is so because investors consume most of their dividends and capital gains, enjoying the fruits of their past saving.
It is rare for anyone to accumulate wealth for long periods of time without consuming part of his or her return.
- The longest period of time investors typically plan to hold assets without touching principal and income is when they are accumulating wealth in pension plans for their retirement or in insurance policies that are passed on to their heirs.
- Even those who bequeath fortunes untouched during their lifetimes must realize that these accumulations often are dissipate in the next generation.
The stock market has the power to turn a single dollar into millions by the forbearance of generations - but few will have the patience or desire to let this happen.
Total Returns vs Total Real Returns
The focus of every long-term investor should be growth of purchasing power - monetary wealth adjusted for the effect of inflation. The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods.
The wiggles on the stock return line represent the bull and bear markets that equities have suffered throughout history. The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to invetors when they occur, are insignificant when compared with the upward movement of equity values over time.
In contrast to the remarkable stability of stock returns, real returns on fixed-income assets have declined markedly over time. From 1802 to 1926, the annual real returns on bonds and bills, although less than those on equities, were significantly positive. However, since 1926, and especially since World War II, fixed-income assets have returned little after inflation.
Volatility is the friend of the Value Investor (2)
Volatility is the friend of the Value Investor (2)
September 3, 1929:
DJIA hit a historical high of 381.17
Seven weeks later, stocks crashed. The next 34 months saw the most devastating decline in share values in U.S. history.
July 8, 1932:
The carnage was finally over. DJIA stood at 41.22.
The marke value of the world's greatest corporations had declined an incredible 89%.
Millions of investors' life savings were wiped out.
Thousands of investors who borrowed money to buy stocks were forced into bankruptcy.
America was mired in the deepest economic depression in its history.
LESSONS FOR THE LONG-TERM VALUE INVESTOR
In summer of 1929, a journalist interviewed John J. Raskob, a senior financial executive at General Motors, about how the typical individual can build wealth by investing in stocks. Raskob claimed that America was on the verge of a tremendous industrial expansion. He maintained that by putting $15 a month into good common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years. Such a return - 24% per year - was unprecedented, but the prospect of effortlessly amassing a great fortune seemed plausible in the atmosphere of the 1920s bull market. Stocks excited investors, and millions of people put their savings into the market seeking a quick profit.
On September 3, 1929, a few days after Raskob's ideas appeared, the Dow Jones Industrial Average hit a historic high of 381.17. Seven weeks later, stocks crashed. Raskob's advice was ridiculed and denounced for years to come. It was said to represent the insanity of those who believed that the market could rise forever and the foolishness of those who ignored the tremendous risks inherent in stocks.
Conventional wisdom holds that Raskob's foolhardy advice epitomizes the mania that periodically overruns Wall Street. However, is this verdict fair? The answer is a decidedly no.
If you were to calculate the value of the portfolio of an investor who followed Raskob's advice, patiently putting $15 a month into stocks, you would find that:
Although not as high as Raskob had projected, $60,000 still represents a fantastic 13% return on invested capital, far exceeding the returns earned by conservative investors who switched their money to Treasury bonds or bills at the market peak. Those who never bought stock, citing the great crash as the vindication of their caution, eventually found themselves far behind investors who had patiently accumulated equity.
An important theme in the history of Wall Street is not the prevalence of foolish optimism at market peaks; rather, it is that over the last century, accumulations in stocks have always outperformed other financial assets for the patient investor. Even such calamitous events as the great stock crash of 1929 did not negate the superiority of stocks as long-term investments.
September 3, 1929:
DJIA hit a historical high of 381.17
Seven weeks later, stocks crashed. The next 34 months saw the most devastating decline in share values in U.S. history.
July 8, 1932:
The carnage was finally over. DJIA stood at 41.22.
The marke value of the world's greatest corporations had declined an incredible 89%.
Millions of investors' life savings were wiped out.
Thousands of investors who borrowed money to buy stocks were forced into bankruptcy.
America was mired in the deepest economic depression in its history.
LESSONS FOR THE LONG-TERM VALUE INVESTOR
In summer of 1929, a journalist interviewed John J. Raskob, a senior financial executive at General Motors, about how the typical individual can build wealth by investing in stocks. Raskob claimed that America was on the verge of a tremendous industrial expansion. He maintained that by putting $15 a month into good common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years. Such a return - 24% per year - was unprecedented, but the prospect of effortlessly amassing a great fortune seemed plausible in the atmosphere of the 1920s bull market. Stocks excited investors, and millions of people put their savings into the market seeking a quick profit.
On September 3, 1929, a few days after Raskob's ideas appeared, the Dow Jones Industrial Average hit a historic high of 381.17. Seven weeks later, stocks crashed. Raskob's advice was ridiculed and denounced for years to come. It was said to represent the insanity of those who believed that the market could rise forever and the foolishness of those who ignored the tremendous risks inherent in stocks.
Conventional wisdom holds that Raskob's foolhardy advice epitomizes the mania that periodically overruns Wall Street. However, is this verdict fair? The answer is a decidedly no.
If you were to calculate the value of the portfolio of an investor who followed Raskob's advice, patiently putting $15 a month into stocks, you would find that:
- his or her accumulation would exceed that of someone who placed the same money in Treasury bills after less than 4 years!
- after 20 years, his or her stock portfolio would have accumulated to almost $9,000, and
- after 30 years, over $60,000.
Although not as high as Raskob had projected, $60,000 still represents a fantastic 13% return on invested capital, far exceeding the returns earned by conservative investors who switched their money to Treasury bonds or bills at the market peak. Those who never bought stock, citing the great crash as the vindication of their caution, eventually found themselves far behind investors who had patiently accumulated equity.
An important theme in the history of Wall Street is not the prevalence of foolish optimism at market peaks; rather, it is that over the last century, accumulations in stocks have always outperformed other financial assets for the patient investor. Even such calamitous events as the great stock crash of 1929 did not negate the superiority of stocks as long-term investments.
Volatility is the friend of the Value Investor
Volatility is the friend of the Value Investor
May 1994
Dow Jones Industrial Average 3,700
Interest rates rising rapidly. Worst year in the history of the bond market.
Stocks already up 60% from their October 1990 low. Few forecasters predicted further gains for equities.
Just 7 months later, stocks would embark on the greatest bull market run in history.
March 1998
Dow was at 8,800
The world stock market had been rolled the previous October by collapse of the Asian markets.
This precipitated a record 550-point drop in the Dow and closure of the New York Stock Exchange.
Few months later, the markets were shaken by collapse of the huge hedge fund Long-Term Capital Management.
From July to early Septermber 1998, Dow fell 20%.
The trillions of dollars of contracts held by this fund on the verge of bankruptcy threatened the functioning of financial markets, causing an unprecedented intervention by the Federal Reserve to restore liquidity.
Three quick rate cuts by the Fed restored investor confidence.
With the uncertainty surrounding Y2K less than 2 years away, few envisioned that October 1998 would begin one of the most spectacular bull markets in history.
March 2000
The technology-laden Nasdaq more than tripled, crossing 5000.
Prices of the world's largest equities surpassed 100 times earnings for the first time in the history of the markets.
Investors optimism was rife.
The Internet launched a gold rush that made instant millionaires of many workers in start-up companies who were paid with stock options.
John Doerr, a venture capitalist, called the run-up of Internet stocks the largest legal act of wealth creation in world history.
And many who missed the first round were lured into a bull market that appeared to ensure profits to all who participated.
This domestic exuberance was matched by a feeling that liberal democracies built on free markets had triumphed as a model for international development.
The entire world seemed to stand at the threshold of unprecedented economic growth, where U.S. based corporations would lead the way.
The communications revolution confirmed that the world was getting smaller and that national boundaries were shrinking.
Communism had been replaced by democracies in eastern Europe, apartheid was peacefully eliminated in South Africa, and even the Israelis and Palestinians were close to a historic peace accord.
Post March 2000
Then it all came crashing down.
The Nasdaq, which had peaked in March 2000 at over 5,000, fell by more than 70% in the next 18 months.
Internet stocks declined even further, and international terrorists launched a successful full-scale attack on the United States.
From March 2000 - September 2001, stock values, as measured by the broad Wilshire 5000 Index, fell 40% and wiped about $5 trillion from market values.
LESSONS AND CHALLENGES FOR THE LONG-TERM VALUE INVESTOR
- The public, once universally regarded as fickle and quick to abandon stocks in difficult times, stuck with equities.
- There was remarkably little panic selling by investors, and surveys showed that few lost their faith that stocks were still the best long-term investment.
- Long-term real returns on equities have averaged about 7% per year over all long-term periods.
- Even counting the bear market of 2000 - 2001, real returns averaged 11.3% per year in the 8 years since 1994.
- From the beginning of grand bull market in August 1982 through March 2000, real returns averaged 15.6% per year.
- These stock returns were significantly above the long-term average.
- Be cautious of bull market that drove investor expectations too high.
- During the bear market, many investors should not have un-realistic expectations of what the stock market can deliver.
- The lure of short-run gains, the attraction of various paradigm, and the relentless pressure to keep pace with hot sectors and hot stocks caused many investors to abandon their long-term principles.
- Real returns of 7% per year, even though doubling wealth every 10 years, is too slow for many who tasted the spectacular gains made in the bull market.
- Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. (John Maynard Keynes 1937)
- Although future stock returns may be diminished from the past, there is overwhelming reason to believe that stocks will remain the best investment for all those seeking steady, long term gains. (Jeremy J. Siegel, Stocks for the Long Run)
Tuesday 26 May 2009
PE Ratio and Future Stock Returns
PE Ratio and Future Stock Returns
Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.
Current yield of a bond
= interest received / the price paid
This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.
Earnings yield of a stock
= EPS / Price
= 1 / (PE)
Bonds vs Stocks
Stocks
Predicting Future Short-term Stock Returns using PE ratio
There are limitations to using the PE ratio to predict future short-term stock returns.
For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
And in the short run, there are many other sources of market movement, such as:
Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.
Current yield of a bond
= interest received / the price paid
This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.
Earnings yield of a stock
= EPS / Price
= 1 / (PE)
Bonds vs Stocks
Stocks
- Since the underlying assets of a firm or stock are real, the earnings yield is a REAL, or inflation-adjusted, return.
- Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.
- In contrast, the NOMINAL return earned from fixed-income assets, where all the coupons and the final payment are fixed in money terms and do not rise with inflation.
The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns.
- The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%.
- This earnings yield exactly matches the 6.8% real return on equities from 1871.
Predicting Future Short-term Stock Returns using PE ratio
There are limitations to using the PE ratio to predict future short-term stock returns.
For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
And in the short run, there are many other sources of market movement, such as:
- changes in interest rates or
- the risk premium demanded by stockholders.
Valuing the Market - Market PE Ratio
Valuing the Market - Market PE Ratio
The Price-to-Earnings Ratio
The most basic and fundamental yardstick for valuing stocks is the PE ratio. It is simply the ratio of the price of a share of stock to the annual EPS and measures how much an investor is willing to pay for a dollar's worth of current earnings.
The single most important variable determining the PE ratio of an individual stock is the expectation of future earnings growth.
If investors believe that earnings growth is going to accelerate, they will pay a higher price relative to current earnings than if they expect earnings to stagnate or decline.
However, earnings growth is not the only variable influencing the PE ratio. PE ratio are also influenced by other factors such as:
Market PE Ratio
The PE of the entire Market =
Total market value of all stocks / aggregate earnings of all stocks
The historical average value of Market PE since 1870 is 14.5.
High Market PE due to drop in Earnings
Peaks in the Market PE ratio are not always bad omens for investors.
If a sharp drop in earnings cause the PE ratio to spike upward, such as occurred in the 1894, 1921, 1938, and 1990 - 1991 recessions, real returns following these spikes have averaged a robust 9.7% annually over the subsequent 5 years.
These returns are high because sharp declines in earnings always have been temporary, caused by recession or other special circumstances, and earnings as well as stock prices have rebounded subsequently.
Nevertheless, the PE ratio associated with the 2000-2001 recession is so high that investors should not expect above average returns to prevail.
High Market PE due to High Stock Prices
When surges in stock prices cause Market PE ratios to rise, as occurred in September 1929, July 1933, June 1946, November 1961, and August 1987, 5-year future real returns have averaged only 1.1%.
Surging stock prices often reflect undue optimism about future earnings growth. When faster earnings growth is not realized, stock prices fall, and returns suffer.
Certainly the Market PE spike that occurred in late 1999 and early 2000 accurately foretold poor future returns.
The Price-to-Earnings Ratio
The most basic and fundamental yardstick for valuing stocks is the PE ratio. It is simply the ratio of the price of a share of stock to the annual EPS and measures how much an investor is willing to pay for a dollar's worth of current earnings.
The single most important variable determining the PE ratio of an individual stock is the expectation of future earnings growth.
If investors believe that earnings growth is going to accelerate, they will pay a higher price relative to current earnings than if they expect earnings to stagnate or decline.
However, earnings growth is not the only variable influencing the PE ratio. PE ratio are also influenced by other factors such as:
- interest rates,
- risk attitudes of investors,
- taxes, and
- liquidity among others.
Market PE Ratio
The PE of the entire Market =
Total market value of all stocks / aggregate earnings of all stocks
The historical average value of Market PE since 1870 is 14.5.
High Market PE due to drop in Earnings
Peaks in the Market PE ratio are not always bad omens for investors.
If a sharp drop in earnings cause the PE ratio to spike upward, such as occurred in the 1894, 1921, 1938, and 1990 - 1991 recessions, real returns following these spikes have averaged a robust 9.7% annually over the subsequent 5 years.
These returns are high because sharp declines in earnings always have been temporary, caused by recession or other special circumstances, and earnings as well as stock prices have rebounded subsequently.
Nevertheless, the PE ratio associated with the 2000-2001 recession is so high that investors should not expect above average returns to prevail.
High Market PE due to High Stock Prices
When surges in stock prices cause Market PE ratios to rise, as occurred in September 1929, July 1933, June 1946, November 1961, and August 1987, 5-year future real returns have averaged only 1.1%.
Surging stock prices often reflect undue optimism about future earnings growth. When faster earnings growth is not realized, stock prices fall, and returns suffer.
Certainly the Market PE spike that occurred in late 1999 and early 2000 accurately foretold poor future returns.
Long-Term Earnings Growth and Economic Growth (2)
Long-Term Earnings Growth and Economic Growth (2)
Long-Term Growth of GDP, Earnings and Dividends, 1871 -2001
Real GDP Growth 3.91%
Real Per-Share Earnings Growth 1.25%
Real Per-Share Dividend Growth 1.09%
Dividend Yield (median) 4.54%
Payout Ratio (median) 58.75%
The above shows the summary statistics for dividends per share, earnings per share (EPS), and stock returns from 1871 through September 2001. The data show that real per-share earnings growth over the entire 130 years has been a paltry 1.25%, considerably below the nearly 4% growth rate of real GDP. Because of the funding requirement, EPS growth does not match aggregate economic growth over the long run.
Long-Term Growth of GDP, Earnings and Dividends, 1871-1945
Real GDP Growth 4.51%
Real Per-Share Earnings Growth 0.66%
Real Per-Share Dividend Growth 0.74%
Dividend Yield (median) 5.07%
Payout Ratio (median) 66.76%
Long-Term Growth of GDP, Earnings and Dividends, 1946-2001
Real GDP Growth 3.11%
Real Per-Share Earnings Growth 2.05%
Real Per-Share Dividend Growth 1.56%
Dividend Yield (median) 3.53%
Payout Ratio (median) 51.91%
The data before and after World War II also show that the acceleration of earnings growth since World War II is associated with the drop in the dividend yield. Greater retained earnings allow firms to buy back shares and reinvest for growth. John Williams' contention that dividends withheld today spur earnings growth in the future is strongly supported by the data.
Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)
Long-Term Growth of GDP, Earnings and Dividends, 1871 -2001
Real GDP Growth 3.91%
Real Per-Share Earnings Growth 1.25%
Real Per-Share Dividend Growth 1.09%
Dividend Yield (median) 4.54%
Payout Ratio (median) 58.75%
The above shows the summary statistics for dividends per share, earnings per share (EPS), and stock returns from 1871 through September 2001. The data show that real per-share earnings growth over the entire 130 years has been a paltry 1.25%, considerably below the nearly 4% growth rate of real GDP. Because of the funding requirement, EPS growth does not match aggregate economic growth over the long run.
Long-Term Growth of GDP, Earnings and Dividends, 1871-1945
Real GDP Growth 4.51%
Real Per-Share Earnings Growth 0.66%
Real Per-Share Dividend Growth 0.74%
Dividend Yield (median) 5.07%
Payout Ratio (median) 66.76%
Long-Term Growth of GDP, Earnings and Dividends, 1946-2001
Real GDP Growth 3.11%
Real Per-Share Earnings Growth 2.05%
Real Per-Share Dividend Growth 1.56%
Dividend Yield (median) 3.53%
Payout Ratio (median) 51.91%
The data before and after World War II also show that the acceleration of earnings growth since World War II is associated with the drop in the dividend yield. Greater retained earnings allow firms to buy back shares and reinvest for growth. John Williams' contention that dividends withheld today spur earnings growth in the future is strongly supported by the data.
Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (1)
How do you value stock?
Stock prices are the present value of future dividends.
What are the determinants of stock prices?
These are earnings and dividends on a PER-SHARE basis.
Is economic growth an important factor influencing future dividends and hence stock prices?
Not necessarily. Although economic growth may influence AGGREGATE earnings and dividends favourably, economic growth does not necessarily increase the growth of per-share earnings or dividends. It is earnings per share (EPS) that is important to Wall Street because per-share data, not aggregate earnings or dividends, are the basis of investor returns.
What is the reason economic growth does not necessarily increases EPS?
Economic growth requires increased capital expenditures and this capital does not come freely. Implementing and upgrading technology requires substantial firm investment. These expenditures mus tbe funded either by borrowing in the debt market (through banks or trade credit or by selling bonds) or by floating new shares. The added interest costs and the dilution of profits that this funding involves place a burden on the firm's bottom line.
Can earnings increase without increasing capital expenditures?
Yes, in the short run, this may occur, but the long-run historical evidence suggests that it will not. One of the signal characteristics of long-term historical data is that the level of the capital stock - the total value of all physical capital such as factories and equipment, as well as intellectual capital, that has accumulated over time - has grown in proportion to the level of aggregate output. In other words, a 10% increase in output requires a 10% increase in the capital stock.
Will investment in productivity-enhancing technology spur earnings growth to permanently higher levels?
"Cost-saving investments" frequently touted as a source of increasing profit margins, only temporarily affect bottom-line earnings. As long as these investments are available to other firms, competition will force management to reduce product prices by the amount of the cost savings, and extra profits will quickly be competed away. In fact, capital expenditures often are undertaken not necessarily to ENHANCE profits but rather to PRESERVE profits when other firms have adopted competitive cost-saving measures.
Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)
How do you value stock?
Stock prices are the present value of future dividends.
What are the determinants of stock prices?
These are earnings and dividends on a PER-SHARE basis.
Is economic growth an important factor influencing future dividends and hence stock prices?
Not necessarily. Although economic growth may influence AGGREGATE earnings and dividends favourably, economic growth does not necessarily increase the growth of per-share earnings or dividends. It is earnings per share (EPS) that is important to Wall Street because per-share data, not aggregate earnings or dividends, are the basis of investor returns.
What is the reason economic growth does not necessarily increases EPS?
Economic growth requires increased capital expenditures and this capital does not come freely. Implementing and upgrading technology requires substantial firm investment. These expenditures mus tbe funded either by borrowing in the debt market (through banks or trade credit or by selling bonds) or by floating new shares. The added interest costs and the dilution of profits that this funding involves place a burden on the firm's bottom line.
Can earnings increase without increasing capital expenditures?
Yes, in the short run, this may occur, but the long-run historical evidence suggests that it will not. One of the signal characteristics of long-term historical data is that the level of the capital stock - the total value of all physical capital such as factories and equipment, as well as intellectual capital, that has accumulated over time - has grown in proportion to the level of aggregate output. In other words, a 10% increase in output requires a 10% increase in the capital stock.
Will investment in productivity-enhancing technology spur earnings growth to permanently higher levels?
"Cost-saving investments" frequently touted as a source of increasing profit margins, only temporarily affect bottom-line earnings. As long as these investments are available to other firms, competition will force management to reduce product prices by the amount of the cost savings, and extra profits will quickly be competed away. In fact, capital expenditures often are undertaken not necessarily to ENHANCE profits but rather to PRESERVE profits when other firms have adopted competitive cost-saving measures.
Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)
Valuation of Cash Flows from Stocks
Valuation of Cash Flows from Stocks
Stocks have value only because of the potential cash flows that investors receive. These cash flows can come from any distribution (such as dividends or capital gains realized on sale) that stockholders expect to receive from their share of ownership of the firm, and it is by forecasting and valuing these expected future cash flows that one can judge the investment value of shares.
The value of any asset is determined by the discounted value of all expected future cash flows.
Future cash flows from assets are DISCOUNTED because cash received in the future is not worth as much as cash received in the present. The reasons for discounting are:
1. the innate TIME PREFERENCES of most individuals to enjoy their consumption today rather than wait for tomorrow,
2. PRODUCTIVITY, which allows funds invested today to yield a higher return tomorrow, and
3. INFLATION, which reduces the future purchasing power of cash received in the future.
4. UNCERTAINTY associated with the magnitude of future cash flows.
These factors 1, 2, and 3 also apply to both stocks and bonds and are the foundation of the theory of interest rates. Factor 4 applies primarily to the cash flows from equities.
The fundamental sources of stock valuation are the dividends and earnings of firms.
Stocks have value only because of the potential cash flows that investors receive. These cash flows can come from any distribution (such as dividends or capital gains realized on sale) that stockholders expect to receive from their share of ownership of the firm, and it is by forecasting and valuing these expected future cash flows that one can judge the investment value of shares.
The value of any asset is determined by the discounted value of all expected future cash flows.
Future cash flows from assets are DISCOUNTED because cash received in the future is not worth as much as cash received in the present. The reasons for discounting are:
1. the innate TIME PREFERENCES of most individuals to enjoy their consumption today rather than wait for tomorrow,
2. PRODUCTIVITY, which allows funds invested today to yield a higher return tomorrow, and
3. INFLATION, which reduces the future purchasing power of cash received in the future.
4. UNCERTAINTY associated with the magnitude of future cash flows.
These factors 1, 2, and 3 also apply to both stocks and bonds and are the foundation of the theory of interest rates. Factor 4 applies primarily to the cash flows from equities.
The fundamental sources of stock valuation are the dividends and earnings of firms.
Fed Model of Stock Market Valuation
Fed Model of Stock Market Valuation
Greenspan's testimony in his semiannual address to Congress in 1997 suggested that the central bank regarded the stock market as overvalued whenever this earnings yield fell below the bond rate and undervalued whenever the reverse occurred.
The basic idea behind this Fed model is that bonds are the chief alternative for stocks in investors' portfolio.
Greenspan's testimony in his semiannual address to Congress in 1997 suggested that the central bank regarded the stock market as overvalued whenever this earnings yield fell below the bond rate and undervalued whenever the reverse occurred.
The basic idea behind this Fed model is that bonds are the chief alternative for stocks in investors' portfolio.
- The return on a bond can be termed the interest yield.
- The return on stocks is termed the earnings yield.
- When the interest yield rises above the earnings yield, stock prices fall because investors shift their portfolio from stocks to bonds.
- On the other hand, when the interest yield falls below the stock yield, investors move into stocks, boosting their price.
Institutions have been using the relation between interest yields and stock yields to determine their asset allocations for many years.
What is unique about the Fed model is that it directly compares these two yields rather than just noting a correlation between them.
The Fed model appears to have worked fairly well since 1970. When interest rates fell, stocks rallied to bring the earnings yield down, and the opposite occurred when interest rates rose.
What is surprising is that this relation holds despite the fact that stocks and bonds are very different assets. The reason why the Fed model works is that the market rates these two advantages as approximately of equal value when inflation is an important factor.
There is no question that both bonds and stocks do badly when inflation increases.
- Bond prices fell in the late 1960s and 1970s because rising inflation forced interst rates up to offset the depreciating value of money.
- Inflation was accompanied by an increase in energy costs, poor productivity growth and poor monetary policy. Therefore, inflation depresses corporate profits and real stock returns.
- Finally, inflation increases uncertainty and raises the threat of central bank tightening of money policy to halt rising consumer prices. This is also negative for stocks.
Falling interest rates boosted both stock and bond prices as economic growth increased. The 1980s amd 1990s were good decades for both stocks and bonds as inflation declined from its record high levels.
However, both history and theory suggest that the Fed model breaks down when inflation is very low or when consumer prices are stagnant and deflation threatens. In such circumstances, bonds (especially risk-free government bonds) will do very well, but stocks returns will be ambiguous.
Given that interest rates and inflation have now shrunk to their lowest level in four decades, stock investors should be wary of using the Fed model.
- Stocks still will welcome any Fed reduction in interest rates, but declines in long-term government bond rates often signal strong deflationary or recessionary forces. It will be harder under these circumstances for firms to raise their output prices to cover costs. Deflation undermines firms' pricing power, and this cuts into profit margins.
- Moreover, because it is extremely difficult for firms to negotiate nominal wage cuts, deflation increases real wage costs and reduces profits. Thus nominal assets such as bonds will shine under deflation, whereas real assets often suffer.
Unless inflation heads upward again, it is unlikely that the tight correlation experienced over the past two decades between these two yields will continue.
- In a low-inflation world, pricing power and earnings potential will dominate stock valuations, whereas bonds will be valued for their ability to hedge deflationary risk.
- Rising and falling interest rates still will be very important determinants of stock prices in the very short run but long-run patterns are apt to diverge as investors recognize the fundamental differences in the assets.
Additional notes:
Present market PE of KLSE is around 15, giving an earnings yield of 6.7%.
The interest rate is about 3%.
Monday 25 May 2009
Does the value of stocks depend on dividends or earnings?
Does the value of stocks depend on dividends or earnings?
Management determines its dividend policy by evaluating many factors, including:
Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.
However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.
Dividend Payout Ratio
Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.
The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.
Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.
How to value Stocks?
Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.
Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)
John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:
"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."
Ref: Stock for the Long Run, by Jeremy Siegel
Management determines its dividend policy by evaluating many factors, including:
- the tax differences between dividend income and capital gains,
- the need to generate internal funds to retire debt or invest, and,
- the desire to keep dividends relatively constant in the face of fluctuating earnings.
Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.
However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.
Dividend Payout Ratio
Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.
The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.
Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.
How to value Stocks?
Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.
Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)
John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:
"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."
Ref: Stock for the Long Run, by Jeremy Siegel
Sources of Shareholder Value
Sources of Shareholder Value
For the equity holder, the source of future cash flows is the earnings of firms.
Earnings create value for shareholders by the :
If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.
If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.
Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.
Which creates more value?
Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.
Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.
Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.
Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.
-----
Fear of misusing retained earnings
If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.
Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.
Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.
In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.
Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.
Ref: Stocks for the Long Run, Jeremy Siegel
For the equity holder, the source of future cash flows is the earnings of firms.
Earnings create value for shareholders by the :
- Payment of cash dividends
- Repurchase of shares
- Retirement of debt
- Investment in securities, capital projects, or other firms.
If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.
If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.
Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.
Which creates more value?
Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.
Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.
Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.
Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.
-----
Fear of misusing retained earnings
If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.
Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.
Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.
In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.
Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.
Ref: Stocks for the Long Run, Jeremy Siegel
Nature of Growth and Value Stocks
Nature of Growth and Value Stocks
These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.
The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.
Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.
In fact, over time, many stocks go through value and growth designations as their market price fluctuates.
The literature often showed value stocks beating growth stocks. What does this mean?
As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value. It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.
There is no question that investors always should be concerned with valuation, no matter which stocks they buy.
These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.
The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.
Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.
In fact, over time, many stocks go through value and growth designations as their market price fluctuates.
The literature often showed value stocks beating growth stocks. What does this mean?
As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value. It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.
There is no question that investors always should be concerned with valuation, no matter which stocks they buy.
Stocks and the Business Cycle
Stocks and the Business Cycle
The stock market has been surging to new highs almost daily, driving down dividend yields and price-earnings ratios skyward. Is this bullishness justified? The careful investors want to know if the economy is really going to do well enough to support these high stock prices.
What do the economists forecast?
The lesson is that the markets and the economy are often out of sync. It is not surprising that many investors dismiss economic forecasts when planning their market strategy.
Quote: 'The stock market has predicted nine out of the last five recessions!' (Paul Samuelson)
Quote: 'I'd love to be able to predict markets and anticipate recessions, but since that's impossible, I'm as satisfied to search out profitable companies as Buffett is.' (Peter Lynch)
However, do not dismiss the business cycle too quickly when examining your portfolio. The stock market still responds quite powerfully to changes in economic activity. Although there are many 'false alarms' like 1987 when the market collapse was not followed by a recession, stocks almost always fall prior to a recession and rally rigorously at signs of an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy.
This is no easy task, however. To make money by predicting the business cycle, one must be able to identify peaks and troughts of economic activity BEFORE they actually occur, a skill very few, if any, economists possess. Yet business cycle forecasting is a popular stock market endeavour not because it is successful - most of the time it is not - but because the potential gains are so large.
The stock market has been surging to new highs almost daily, driving down dividend yields and price-earnings ratios skyward. Is this bullishness justified? The careful investors want to know if the economy is really going to do well enough to support these high stock prices.
What do the economists forecast?
- Will the real GDP increase over the next four quarters?
- Will the growth be at a healthy rate?
- Will there be a recession in the next year or few years?
- Even if a recession occurs, will it be brief or prolong?
- What will corporate profits (one of the major factors driving stock prices) be in the next year or 3 years?
The lesson is that the markets and the economy are often out of sync. It is not surprising that many investors dismiss economic forecasts when planning their market strategy.
Quote: 'The stock market has predicted nine out of the last five recessions!' (Paul Samuelson)
Quote: 'I'd love to be able to predict markets and anticipate recessions, but since that's impossible, I'm as satisfied to search out profitable companies as Buffett is.' (Peter Lynch)
However, do not dismiss the business cycle too quickly when examining your portfolio. The stock market still responds quite powerfully to changes in economic activity. Although there are many 'false alarms' like 1987 when the market collapse was not followed by a recession, stocks almost always fall prior to a recession and rally rigorously at signs of an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy.
This is no easy task, however. To make money by predicting the business cycle, one must be able to identify peaks and troughts of economic activity BEFORE they actually occur, a skill very few, if any, economists possess. Yet business cycle forecasting is a popular stock market endeavour not because it is successful - most of the time it is not - but because the potential gains are so large.
Risks and Investors' Holding Period
Risks and Investors' Holding Period
Total Real Returns
The focus of every long-term investor should be the growth of purchasing power - monetary wealth adjusted for the effect of inflation.
The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0% per year after inflation in all major subperiods.
The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.
Risk and Holding Period
For many investors, the most meaningful way to describe risk is by portraying a worst-case scenario.
Stocks unquestionably are riskier than bonds or bills in the short run.
It is very significant that stocks, in contrast to bonds or bills, have never offered investors a negative real holding period return yield over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power clearly has been a diversified portfolio of equities.
As the holding period increases, the probability that stocks will outperform fixed-income assets increases dramatically.
Total Real Returns
The focus of every long-term investor should be the growth of purchasing power - monetary wealth adjusted for the effect of inflation.
The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0% per year after inflation in all major subperiods.
The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.
Risk and Holding Period
For many investors, the most meaningful way to describe risk is by portraying a worst-case scenario.
Stocks unquestionably are riskier than bonds or bills in the short run.
- In every 5-year period since 1802, the worst performance in stocks, at -11% per year, has been only slightly worse than the worst performance in bonds or bills.
- For 10-year holding periods, the worst stock performance actually has been BETTER than that for bonds or bills.
- For 20-year holding periods, stocks have never fallen behind inflation, whereas bonds and bills once fell as much as 3% per year behind the rate of inflation.
- For 30-year periods, the worst annual stock performance remained comfortably ahead of inflation by 2.6% per year, which is just below the average 30-year return on fixed-income assets.
It is very significant that stocks, in contrast to bonds or bills, have never offered investors a negative real holding period return yield over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power clearly has been a diversified portfolio of equities.
As the holding period increases, the probability that stocks will outperform fixed-income assets increases dramatically.
- For 10-year horizons, stocks bea bonds and bills about 80% of the time.
- For 20-year horizons, it is over 90% of the time, and
- For 30-year horizons, it is virtually 100% of the time.
Although the dominance of stocks over bonds is really apparent in the long run, it is more important to note that over 1- and even 2-year periods, stocks outperform bonds or bills only about 3 out of 5 years. This means that in nearly 2 out of every 5 years a stockholder will fall behind the return on Treasury bills or bank certificates. The high probability in the short run of underperforming bonds and bank accounts is the primary reason why it is so hard for many investors to stay in stocks.
Investor Holding Periods
Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. Yet these long horizons are far more relevant than most investors recognize. One of the greatest mistakes that investors make is to underestimate their holding period. This is so because many investors think about the holding periods of A PARTICULAR stock, bond, or mutual fund. But the holding period that is relevant for portfolio allocation is the length of time the investors hold ANY stocks or bonds, no matter how many changes are made among the individual issues in their portfolio.
Average Investor Holding Period
Let us study the average length of time that investors hold financial assets based on gender and the age at which they BEGIN purchasing such assets. It is assumed:
- That individuals accumulate savings during their working years in order to build sufficient assets to fund their retirement, which normally occurs at age 65.
- After age 65, retirees live off the funds derived from both the returns and sale of their assets. It is also assumed that investors either plan to exhaust all their assets by the end of their expected life span or plan to retain one-half of their retirement assets at the end of their expected life span as a safety margin or for bequests.
Under either assumption:
- Individuals who begin accumulating assets in their 30s will hold financial assets for 40 years and more.
- Even investors who begin accumulating assets near retirement will have a holding period of up to 20 years or more. It should be noted that the life expectancy for males is now about 82 years; for females, more than 86 years; and for either spouse, about 90 years.
- Many retirees will be holding assets for 20 years or longer. In addition, if the investor works beyond age 65 , which is increasingly common, or plans to leave a large percentage of assets as a bequest, the average holding period is even longer than those indicated.
Conclusion
No one denies that in the short run stocks are riskier than fixed-income assets. In the long run, however, history has shown that this is not the case.
There is still much uncertainty about what a dollar will be worth two or three decades from now.
Historical evidence indicates that we can be more certain of the purchasing poer of a diversified portfolio of common stocks 30 years hence than we can of the final payment on a 30-year U.S. government bond.
Reap the benefits of market volatility
Reap the benefits of market volatility
When stocks are collapsing, worst-case scenarios loom large in investors' minds. On May 6, 1932, after stocks had plummeted 85% from their 1929 high, Dean Witter issued the following memo to its clients:
"There are only two premises which are tenable as to the future. Either we are going to have chaos or else recovery. The former theory is foolish. If chaos ensues, nothing will maintain value; neither bonds nor stocks nor bank deposits nor gold will remain valuable. Real estate will be a worthless asset because titles will be insecure. No policy can be based upon this impossible contingency. Policy must therfore be predicated upon the theory of recovery. The present is not the first depression; it may be the worst, but just as surely as conditions have righted themselves in the past and have gradually readjusted to normal, so this will again occur. The only uncertainty is WHEN it will occur.... I wish to say emphatically that in a few years present prices will appear as ridiculously low as 1929 values appear fantastically high."
Two months later the stock market hit its all time low and rallied strongly. In retrospect, these words reflected great wisdom and sound judgment about the temporary dislocations of stock prices. Yet, at the time they were uttered, investors were so disenchanted with stocks and so filled with doom and gloom that the message fell on deaf ears. Investors often overreact to short-term events and fail to take the long view of the market.
1987 Crash v.s. 1929 Crash
Despite the drama of the October 1987 market collapse, which often has been compared with 1929, there was amazingly little lasting effect on the world economy or even the financial markets. Because this stock market crash did not augur either a further collapse in stock prices or a decline in economic activity, it probably will never attain the notoriety of the crash of 1929. Yet its lesson is perhaps more important: Economic safeguards, such as prompt Federal Reserve action to provide liquidity to the economy and ensure the financial markets, can prevent an economic debacle of the kind that beset our economy during the Great Depression.
This does not mean that the markets are exempt from violent fluctuations. Since the future will always be uncertain, psychology and sentiment often dominate economic fundamentals. As Keynes perceptively stated 60 years ago in The General Theory, "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." Precarious estimates are subject to sudden change, and prices in free markets will always be volatile. But history has show that investors who are willing to step into the market when others are panicking to leave reap the benefits of market volatility.
When stocks are collapsing, worst-case scenarios loom large in investors' minds. On May 6, 1932, after stocks had plummeted 85% from their 1929 high, Dean Witter issued the following memo to its clients:
"There are only two premises which are tenable as to the future. Either we are going to have chaos or else recovery. The former theory is foolish. If chaos ensues, nothing will maintain value; neither bonds nor stocks nor bank deposits nor gold will remain valuable. Real estate will be a worthless asset because titles will be insecure. No policy can be based upon this impossible contingency. Policy must therfore be predicated upon the theory of recovery. The present is not the first depression; it may be the worst, but just as surely as conditions have righted themselves in the past and have gradually readjusted to normal, so this will again occur. The only uncertainty is WHEN it will occur.... I wish to say emphatically that in a few years present prices will appear as ridiculously low as 1929 values appear fantastically high."
Two months later the stock market hit its all time low and rallied strongly. In retrospect, these words reflected great wisdom and sound judgment about the temporary dislocations of stock prices. Yet, at the time they were uttered, investors were so disenchanted with stocks and so filled with doom and gloom that the message fell on deaf ears. Investors often overreact to short-term events and fail to take the long view of the market.
1987 Crash v.s. 1929 Crash
Despite the drama of the October 1987 market collapse, which often has been compared with 1929, there was amazingly little lasting effect on the world economy or even the financial markets. Because this stock market crash did not augur either a further collapse in stock prices or a decline in economic activity, it probably will never attain the notoriety of the crash of 1929. Yet its lesson is perhaps more important: Economic safeguards, such as prompt Federal Reserve action to provide liquidity to the economy and ensure the financial markets, can prevent an economic debacle of the kind that beset our economy during the Great Depression.
This does not mean that the markets are exempt from violent fluctuations. Since the future will always be uncertain, psychology and sentiment often dominate economic fundamentals. As Keynes perceptively stated 60 years ago in The General Theory, "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." Precarious estimates are subject to sudden change, and prices in free markets will always be volatile. But history has show that investors who are willing to step into the market when others are panicking to leave reap the benefits of market volatility.
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