Kass: Ben Stein Blames You

Traders influence volatility, but they cannot control stock prices over any reasonable time frame. Investors do.

Wild intraday price moves are unsettling to most investors, but the history of stocks shows that yearly market moves more often than not do produce meaningful price changes. Though sometimes impacted by an exogenous event, outsized changes are dependent upon the degree of confidence or certainty in economic outcomes. When uncertainties exist, stock prices and economies can stall for years (and sometimes even for a decade or more) and vice versa.

The view of a favorable long run is all well and good, but in the highly competitive world of hedge funds/personal money management, properly identifying and navigating monthly and yearly trends/moves (as well as finding superior individual stocks) can result in superior and differentiated investment performance.

Just ask investors who have prospered and outperformed and money managers who have demonstrated a consistent ability to time buying/selling and identify value in markets, sectors and stocks -- namely, Ken Heebner, Stanley Druckenmiller, Leon Cooperman, George Soros and Steve Cohen.

Back to Ben's vision of our economy and the markets.

Over the last two months, many previously bullish economic/market commentators have incorporated the reality of the economic, credit market and stock market situation by scaling back their optimism. Brokerage firm economists and strategists at Morgan Stanley (MS Quote - Cramer on MS - Stock Picks), Goldman Sachs, Merrill Lynch (MER Quote - Cramer on MER - Stock Picks) et al. have adjusted their extrapolations of prosperity toward more realistic goals and assumptions.

While Stein has questioned the motivation of some of this (especially at Goldman Sachs), we all know that massive capital and people commitments are made to insure accuracy of those predictions. And, if wrong, again, as my Grandma Koufax used to say, "Dougie, they'll have less bread to be buttered."

Even Dr. Arthur Laffer did an about-face on CNBC's "Kudlow & Company" and has turned cautious, and several other of Sir Larry Kudlow's Band of Merry Men have grown less cheery.

At Wharton, I learned that the basis for determining market valuation lies at the foot of security analysis and modeling -- as delivered by Benjamin Graham and David Dodd in Security Analysis -- not on the part of the whims of traders.

As Ben Graham wrote, in the fullness of time, stocks move toward the weight of value. Investors use many rigorous and disciplined methodologies in valuing stocks and in determining fair market value:

1. Many strategists and investors use top-down, discounted cash flow and dividend models to determine the fair market level of equities. These models are not static; they change as the underlying model assumptions change. The most theoretically sound stock valuation method is called income valuation or the discounted cash flow method, involving discounting the profits (dividends, earnings or cash flows) the stock will bring to the stockholder in the foreseeable future and a final value on disposition. The discount rate normally has to include a risk premium, which is commonly based on the capital asset pricing model.

2. The Gordon model is the best-known of a class of discounted dividend models. It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever.

3. The P/E method is perhaps the most commonly used valuation method in the stock brokerage industry. By using comparison firms, a target price-to-earnings (or P/E) ratio is selected for the company, and then the future earnings of the company are estimated. The valuation's fair price is simply estimated earnings times the target P/E.

4. Some feel that if the stock is listed in a well-organized stock market, with a large volume of transactions, the listed price will be close to the estimated fair value. This is called the efficient market hypothesis. On the other hand, studies made in the field of behavioral finance tend to show that deviations from the fair price are rather common, and sometimes quite large.

5. In addition to fundamental economic criteria, market criteria also have to be taken into account for a market-based valuation. Valuing a stock is not only to estimate its fair value but also to determine its potential price range, taking into account market behavior aspects. One of the behavioral valuation tools is the stock image, a coefficient that bridges the theoretical fair value and the market price.

Today, the aforementioned underlying dependent variables that support some of the model assumptions above are either being downgraded or are uncertain in their outcomes, and this is pressuring stocks.

"Because I usually write about finance, I have come to believe in the theory of what I would call 'financial realism,' or what might more accurately be called 'trader realism.' Under this theory, on which I have an imaginary patent, traders can see masses of data any minute of any day. They can find data to support hitting the 'buy' button or the 'sell' button. They don't act on the basis of what seems to them the real economic situation, but on what's in it for them."

-- Ben Stein

Stein's major assertion is that what his brother-in-law Melvin (a Harvard Law School graduate) taught him about legal realism applies to the stock market and to the traders running the stock market. Mr. Stein cites the following:

"What really happened (in the legal system) at the appellate level and probably at the trial level, too, was that judges made up their minds based on their predilections, their biases, which lawyer was their friend, what they had for breakfast that day."

He gives little rigorous documentation to his assertion. It is simply his feel that the traders set prices, as suggested in the following quote from his article, based on the magnitude of the stock market damage inflicted relative to his view of the economic damage that has occurred.

It is simply more B.S. from B.S.

"Note that the losses in United States markets alone are on the order of about $2.5 trillion in recent weeks. How can a loss of roughly $100 billion on subprime -- with some recoveries sure to come as property is seized and sold -- translate into a stock-market loss 25 times that size? The answer is trader realism.

"The losses in the stock market since the highs of October 2007 are about 14%. This predicts -- very roughly -- a fall in corporate profits of roughly 14%. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak."

And earlier in the article, he provides a synopsis of his almighty trader theory:

"More than that, they trade to support the way they want the market to go. If they are huge traders like some of the major hedge funds, they can sell massively and move the market downward, then suck in other traders who go short, and create a vacuum of fear that sucks down whatever they are selling.

"Note what is happening here: They are not figuring out which way the market will go. They are making the market go the direction they want."

The above demonstrates such a degree of naïveté that I am really shocked that The New York Times published the article.

For example, when a company misses its earnings guidance by a penny or two, the same disproportionate impact occurs on its share price. The equity capitalization loss is vastly in excess of the miss to profits. That is because, generally speaking, the miss to expectation can sometimes be seen as a warning of larger misses to come.