This blog post originally appeared on RealMoney Silver on Jan. 28 at 8:10 a.m. EST.
"These traders, not economists or securities analysts, can turn the world upside down, make governments tremble, give central bankers colitis and ruin the lives of ordinary men and women saving for their children's college education or their own retirement. In America today, it is the traders, not the politicians or the generals or the corporate bosses, who have the power." -- Ben Stein, New York Times "Can Their Wish Be the Market's Command?"My Sunday morning routine is usually cast in stone. I typically wake up at around 5 a.m. EST and spend an hour or so writing my opening missive for Monday. Then, I read the obituaries -- I am, after all, still a short- seller! -- and then the Sports, Week in Review and Business sections in the New York Times. Thereafter, I work on solving Sunday's New York Times crossword puzzle. (I am proud to say that I have completed the last five in a row.) Next, I watch NBC's "Meet The Press," ESPN's "Sports Reporters" and ABC's "This Week With George Stephanopoulos." Finally, my regular day starts, and these days, it is filled with thoughts about the stock market, cogitating over the week that was and what to do next and why, in addition to calls or emails between other hedge hoggers. Yesterday morning, I was prepared to write a column preliminarily entitled "The Case for a Bull Market: What Could Go Right and How." I was going to emphasize the latent buying power of sovereign wealth funds and make the case that the equity market might be discounting a far deeper recession than might occur. I had planned to underscore that interest rates remain subdued, that the curative process of restoring capital bases at leading financial institutions continues apace and that a negative sentiment bubble seems to be emerging coincident with lower share prices. I was even going to highlight that there might be some light at the end to the tunnel of housing as fiscal and monetary stimulation is moving into overdrive. That is, until I read Stein's column -- "Can Their Wish Be the Market's Command?" -- in Sunday's New York Times business section. No one has the concession on the truth, especially as it relates to investing. But rigorous analysis, logic of argument, power of dissection, weighing sentiment and modeling remain good ways to try to find that truth. I have chronicled Stein's general lack of realism in his series of New York Times articles, in communicating and recognizing growing economic problems and in improperly isolating and laying blame on the stock market's poor showing to his list of imaginary ne'er-do-wells.
- Six months ago, Mr. Stein blamed the market's weakness on the media's hysteria.
- Seven weeks ago, he blamed the market's weakness on Goldman Sachs (GS) and its economist, Dr. Jan Hatzius. (Note: Not even the Dr. Evils at Goldman Sachs benefited in the aggregate from the subprime meltdown (as suggested by Stein). Sure, Goldman shorted mortgage debt, but, in the main, the broker/dealer is long the economy/markets. Proof positive is Goldman's weak performing common stock, the source of how most Goldman principals make their incomes.)
- Yesterday, Stein blamed the market's weakness on traders.
"In the short run, the market is a voting machine. In the long run, it's a weighing machine." -- Benjamin GrahamStein and I both agree that statistics show, in the long run, stocks rise and economies prosper -- though that was not the subject of yesterday's column. And, yes, daily market volatility of 2% to 3% is occurring because of trigger-happy hedge fund traders' buying and selling. But it is a broad list of economic uncertainties (and daily headline risks) that generate indecision and lack of confidence in their trading actions that seem to be producing this volatility.
- 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.
"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 SteinStein'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.