7 posts tagged “buying”

The reason for some institution's refusal to sell their positions that have appreciated dramatically (and that are most vulnerable to decline) can be deeper than the impression desired by publishing the positions. Management's compensation is usually a set percentage of the market value of the assets managed. If a profitable position is sold, the gain may be subject to taxation and paid out to clientele as a capital gains distribution. This effectively reduces the amount of money being managed and the associated fees.

The problems associated with selling positions that have profited most can be particularly acute in small mutual growth funds that have followed the practice of "taking losses and letting profits ride" for an extended period. The result is that their portfolio consists of only a few issues. By having locked themselves into holding a few profitable stocks, the fund's value becomes a function of the value of the rigid holdings and has nothing to do with the overall ability of management.

Keep in mind that money managers are human beings with basic needs such as food and shelter, which require employment. Also recognize that, especially in the larger institutions, clientele are not aware of the identity of the individual analyst making the investment decisions. This anonymity is often strictly enforced and a prerequisite for employment.

In this environment, the individual analyst (whether a genius or an idiot) is under pressure to conform to the crowd. To be too good or too bad relative to one's peers involves risks of criticism or resentment with the associated occupational hazards. This effect is obvious to anyone familiar with the financial media. When an analyst (usually independent) becomes popular because of accurate forecasting and then stumbles, the mistake (even though the overall return over time has been far superior) is pounced on. On the other hand, a spokesperson for a large institutional analytical service that has consistently been wrong, but that is one of the crowd, attracts media attention when making forecasts without criticism of past mistakes.

Understanding the structural aspects of institutional investing practices and employment pressures, you would logically conclude that the average institution would underperform the market, with the underperformance magnified by the fees involved. Yup.

External

Aside from the difficulties associated with internal structure and characteristics, institutions have the added problem of dealing with their clientele. Discretionary clientele who do not properly understand the stock market, although they have entrusted their investment decisions to someone else, often have a tendency to self-destruct. This is particularly evident in mutual funds, whose investors are continually adding or withdrawing (redemptions) money. People tend to add money when the market is highand the mood optimistic. Redemptions tend to dominate when the marketis low and the mood pessimistic.

The institutions are forced to invest the money—that is what they arebeing paid to do. Therefore, with more money coming in when the market is high, the institutions so affected are forced to buy at relatively high levels. Conversely, when redemptions dominate and the market is low, the institutions are forced to sell at depressed prices to fulfill the investor'sdemand for cash.

From the professional standpoint, the process is marvelous. We knowwe have buyers at high prices and sellers at low prices because of the demands of discretionary clientele creating a supply/demand imbalance. When they are doing their forced buying, it creates underlying buying demand and we can raise our prices. When they are forced to sell, we know there is "overhanging supply," and we can lower our purchase prices.

This buy-high/sell-low behavior (required to fulfill clientele's wishes) is not limited to mutual funds. It can affect any funds that can redeem or add capital according to their client's emotions: bank trust departments, pension funds, and the like. An important exception is closed-end mutual funds where the capital base is fixed and the investor must buy/sell shares in the open market rather than affecting the funds' specific holdings.

The market is a business. The purpose of the business is to acquire the monies of others through the process of buying low and selling high. Because of the anonymous nature of trading structure, it is very difficultto specifically identify the individual to whom you are selling or from whom you are buying. Consequently, physical coercion to create losingbehavior among fellow market participants cannot be applied. People do not enter the market to lose. However, they must be placed in a situation in which they will willingly part with their money. The only way to elicit losing behavior is psychological pressure. The most effective tool for applying the pressure is a change in market price. Faced with "paper" losses, those vulnerable to the emotion associated with "apparent" losses will capitulate, accepting the loss in the form of cash to relieve thepsychological strain.

The discretionary manager is subjected to the same emotional pressuresas all other market participants. It is not uncommon for discretionary managers to buckle under the pressure and sell low in direct conflict with historical or statistical precedent to alleviate pressures both self- and clientele-imposed. Conversely, when prices are too high, the emotionallure of greed can stimulate buying when prices are most vulnerable to severe decline. Those who conduct themselves professionally are acutelyaware of the psychological effects of price on institutional managers and take advantage. Such advantage is possible only by strict adherence to a methodology that prevents being lured into the irrational (emotional) behavior of the crowd. This is easily accomplished by having predetermi_ned buy/sell points dependent upon market condition, not price in itself.

The forced behavior of institutions provides one of the most important profit centers for the true professional.

The primary criterion, be it P/E or price, will not always give a buy/sell indication. In fact, most of the time (and sometimes for very long periods) the primary criterion will not meet the parameters to form the preliminary basis for a change in basic portfolio modeling. The primary criterion (depending on which method—projected earnings, lagging P/Es, or price—is chosen) is by far the most time consuming aspect of our timing technique.

The ancillary criteria are designed to confirm or reject the primary indication. The ancillary criteria (aside from a few rare exceptions) will always be issuing a buy or sell bias. Without an indication from the primary criterion, there is no need to be concerned with the ancillary facets in basic portfolio modeling because there can be no change.

There are twelve ancillary criteria, which might at first seem too burdensome to calculate. However, most (if not all) can be determined by a casual glance at major financial publications (Barron's or The Wall Street Journal). A weekly review of the ancillary criteria can probably be attained within 10 minutes after the sources are identified.

For the ancillary criteria to confirm the primary criterion, a minimum of six ancillary criteria must be in place.

Institutional Cash Reserves

If all markets involve predator/prey relationships, to acquire the cash of others requires that the others actually have cash from which they can be parted. Because of the specific stocks we utilize, as well as the growing dominance of institutions in day-to-day trading patterns, those institutions against whom we compete are important sources of profit.

The term institutional cash reserves refers to the ratio of institutional holding of cash (or cash equivalents) to common stock. The higher the institutional cash reserves, the more money they have available for the purchase of stock. The lower the cash reserves, the lower the institution's ability to buy stock irrespective of sentiment. To emphasize the importance of this institutional cash:noncash ratio, it was all you needed to understand to avoid the crash of 1987. At the time, the institutions were so lured into the stock market and their cash reserves became so depleted, they could not support stock prices. It was an inevitable splat time because of the depletion of possible buying demand.

Institutional cash reserves are tabulated regularly by a variety of surveys that scan mutual funds and/or pensions (Lipper, Herzfeld, a wide variety of brokerage firms, and the like) and the results regularly published in major financial publications.

For our purposes, all we need to know is the change in the cash:noncash ratio relative to where it was four weeks ago (or the next nearest reporting period depending on the source utilized).

BUY: The cash amount has increased. We have isolated potential buying demand that can be lured into the market to push prices higher.

SELL: The cash amount has decreased. The institutions are depleting their buying power, making themselves increasingly weak (perhaps helpless) in providing price support and thereby allowing selling supply to more easily dominate and depress prices.

Public Cash Reserves

Because of the rapid growth of institution's dominating trading activity, it has become popular to dismiss the public as an important market factor. However, as we have discussed in detail in previous chapters, the public is a very important factor, not only because of the predictable behavioral patterns of individuals, but because of the effects these patterns have on the institutions in which the public has entrusted funds.

We monitor this group's cash status by the weekly reporting of the total assets of money market funds. Money market fund assets include monies from groups other than the public, but for our purposes the changes in money market fund assets is all that is necessary for this criterion.

The weekly money market fund asset figures are reported in all major financial publications. Our comparison period is four weeks.

BUY: The amount (gross, no ratio needed) has increased. This isolates potential buyers (buying demand) and the associated potential for higher stock prices.

SELL: The amount has decreased. The amount of potential buying demand is lessening, and selling supply can more easily become dominant to depress stock prices.

The two previous factors were designed to isolate specific participants and their ability to effectuate future behavior because of their cash/noncash position. The amount of money in the overall economy is also important and is influenced by the actions of the Federal Reserve.

The figures relating to available money supply are provided weekly by the Federal Reserve and reported by all major financial publications. The money supply calculations include various categories (M-1, M-2, and M-3 being the most popular in gross form). Because of the various components of the money supply categories and changes in the economy, there is an ongoing debate within the financial community as to which measurement (with a myriad of adjustments) is the most accurate. For the purposes of our basic market timing, time and brain cells need not be wasted in agonizing as to which "M" (money supply measure) is chosen. One need only be concerned with sticking with the M originally chosen. We use M-1, which is basically the amount of cash in circulation.

As a criterion in our basic timing method, we compare the gross (not ratio) amount of M-1 to its level four weeks before.

BUY: The amount is increasing. More money is coming into the system, a portion of which can be lured into the stock market in the form of buying demand. In addition, the increased amount of available money helps the overall economy to expand.

SELL: The amount is decreasing. The withdrawal of money from the overall economy creates cash needs, on which investors draw against their stock holdings (because of the liquidity) before selling most other assets. This selling supply can function to depress prices. And the lessened money supply is often a good indication of a coming constriction in the broadly based economy.

Gold Price

The stock market, as with any other market, is constantly in competition with other investments. Gold, because of its history and physical nature relative to paper money, is a good indicator of relative popularity. Real estate, collectibles, and other "hard" commodities could probably be substituted for our gold criterion; but we have selected gold for its liquidity (with the metal being actively traded in markets throughout the world).

Again using a four-week comparison, we simply look at the net change in price for our indication. We use spot prices, but futures can be substituted as long as the same contract month is being compared.

BUY: Gold is up in price. This can be a good indication that stocks have become unpopular and undervalued. When the gold price declines and the metal disappoints investors, their buying demand can more easily shift to the stock market.

SELL: Gold is down in price. This can indicate stocks have become overvalued and can precede a reversal in investor sentiment, creating increased selling supply in the stock market.

Bonds

There is an inverse relationship between bond prices and interest rates. Higher bond prices mean lower interest rates, and lower bond prices equal higher interest rates.

There is also generally a very strong, direct correlation between stock and bond prices. Higher bond prices are usually accompanied by higher stock prices, lower bond prices by lower stock prices. The bond/stock price relationship is logical. Higher interest rates (lower bond prices) increase corporate costs borrowing and as such function to reduce earnings. Higher interest rates, because of the increased cost of capital, tend to slow the overall economy which can adversely affect corporate sales and consequently have a negative effect on corporate profitability. Within market structure, higher rates increase the cost of margin buying, which reduces buying demand.

Periods during which stock and bond prices diverge usually involve high levels of investor emotionalism. If sentiment is extremely pessimistic, high-quality bonds become viewed as safe havens and buying demand increases, adding price support for bonds while stocks falter. Conversely, during periods of extreme euphoria, bonds can become viewed as providing returns too low relative to stocks, creating selling supply in the bond market; this lowers bond prices while stock prices are advancing.

Our concern with the bond market in our timing model is the most common, direct price relationship. Using a four-week comparison period, our indication for this criterion is the next change in bond price down or up—we are not concerned with the magnitude of the differential. We use long-term U.S. Treasury bonds.

BUY: Bond prices are down. Interest rates have moved higher, probably depressing stock prices and making a price reversal more likely.

SELL: Bond prices are up. Interest rates have moved lower, possibly having an unsustainable elevating effect on stock prices and increasing the chance for a reversal.

It is always helpful to know the mindset of the competition: the crazierthey become, the easier the task of separating them from their money.

In the old days, the best measurements of the speculative public sector's behavior were odd lot ratios and cumbersome calculations associated with price/volume shifts in low-priced stocks. Thanks to the advent and popularity of listed option markets, we can now use put:call ratios as an easily observed substitute, taking only the time to flip to the proper page of Barron's to get an insight into this sector's current behavior. The purchase of call options is an indication that the buyer anticipates higher prices. Conversely, the purchase of put options indicates that the buyer forecasts lower prices.

Because of a lack of knowledge, the reluctance to sell short, or whatever, the volume of call buying generally exceeds the volume of put buying. Therefore, the two opposing elements cannot be considered equal in their volume: Calls are more popular. Consequently, it is the change in the ratio of put:call volume that is important to us as a measure of nonprofessional sentiment. Whether you use the volume of listed options associated with specific stocks, or those associated with market indices, or a combination, you should get the same results as long as the measurement is consistent. We use the total volume associated with individual common stocks plus the listed options on market indices (averages).

A somewhat more refined analysis involves the changes in option premiums, that is, the amount that the option's market price is above its intrinsic value.

Whether volume, premium or a combination is used is of little concern because the results are almost invariably parallel.

In determining this ancillary criterion we use a very simple comparison of the current ratio (and/or premium) with that of four weeks ago.

BUY: Put volume (and/or premium) has increased disproportionately to calls. This can be indicative of excessive pessimism, reducing overhead supply and allowing prices to advance more easily.

SELL^. Call volume (and/or premium) has increased disproportionatel_yto puts. This can indicate excessive optimism, making the market more vulnerable to decline.

Advisory Sentiment

We consider put:call relationships as measures of the sentiment of the public speculative sector. To gain a measure of the feelings within the analytical community and the effect on the institutional sector, a variety of services survey analysts and report their findings. These services vary in their clarity, most dividing analytical sentiment into three categories: bulls, bears, and neutral (or "correctionist").

Many an analyst's outlook is ambiguous: "If the market fails to advance or decline, it will stay even, and so on, and so on . . ." This is of no use in practicality, but it does help in job retention because the analyst cannot be wrong.) Most surveys also incorporate a great deal of subjectivity in their results. In addition, the surveys can be biased by a lack of adequate sample size, an overweighting (lack of randomness) of investment techniques utilized by the analysts selected for the survey, and a lack of method for compensating for changes in the analyst's forecasts between surveys.

Despite these shortcomings, the surveys (especially during extreme conditions) can be useful. If overly optimistic they have likely followed their emotions and have bought, possibly exhausting their buying demand and allowing prices to descend more easily. Conversely, when pessimism prevails, the analysts have likely sold, thereby reducing overhead supply which can allow prices to more easily advance.

The selection of the survey to be utilized is not important because, when dealing with adequate sample size, their results are generally parallel. Several are followed by Barron's weekly, you need to do to see the survey's results is flip to the appropriate page. The survey selected should be consistent, that is, use the same survey for each weekly comparison.

As previously mentioned, these surveys divided the analyst's sentiment between the percentage of bulls, bears, and "other." We only look at thepercentage of bulls, comparing the current reading to that of four weeks ago.

BUY: The percentage of bulls has decreased. This can be an indication of pessimism and a reduction in overhead supply, making an advancemore likely.

SELL: The percentage of bulls has increased. This can indicate that increasing optimism is depleting buying power and making the market more vulnerable to decline.

The Importance of Diversity

Two types of diversity are important in portfolio modeling: issue and time.

At the time of this writing, over the 16 years that the Time Overlay models have been published, 1065 specific stock positions have been concluded of which 1016 have been profitable. Although we consider this 95-percent accuracy rate to be acceptable (as we shall see later, it can be improved), some losses have occurred. Even though the probability is very low that an individual stock position will fail to be profitable, the possibility does exist that, if a portfolio consists of only a few stocks, they could turn out to be the losers and the method would result in loss.

Because of this, albeit very low, chance of loss, it is reasonable to reduce this loss possibility to a minimum by having several different issues in the portfolio. In actual market endeavors, over many years of employing the Time Overlay technique, we have never seen an account actually lose money that strictly adhered to the method. However, because the possibility exists, it is only prudent to consider issue diversity.

Of greater importance is time diversity. As you can see in Appendix A, listing the published buy/sell points, several buy indications are generally followed by several sell indications, and so on—an ongoing cyclical process. This inclusion of more than one buy or sell in sequence is by design. We are not primarily concerned with picking exact tops and bottoms in the popularized averages, with our emphasis being on the specific stocks we follow. Our concern with movements in the popularized averages is that these movements will enhance our profit extraction through the buying and selling of specific stocks.

As previous mentioned, there is a constant change in the relative attractiveness of the issues on our Master List. There is no reason for us to buy or sell everything at once. We want to enter the market gradually, expanding our exposure (investment level) over a series of buy indications, providing us time diversity as well as a better chance for issue diversity. When selling, our desire is the same, to gradually reduce our exposure. In other words, since the stocks we are involved with will not all hit their low or high points at the same time, it would be stupid for us to buy or sell everything at the same time.

When buying stock that qualifies for inclusion on our Master List, the lower the price is, the better. Since accumulation (buying) is designed to occur over a series of buy signals, it is possible that a stock can be bought repeatedly as its price descends, and this has occurred. The diversity in this case is by time: same issue, different prices.

In most cycles, the time duration between buy indications automatically provides issue diversity because different stocks will be relatively low- priced during different buying periods. During those buying periods in which stocks tended to duplicate—that is, the same stock was purchased during each buy indication—it might seem reasonable to conclude that the duplication increased risk. The actual results to date contradict this assumption, with the time and issue diversities of equal importance. The same stock purchased at increasingly lower prices reduced risk to the same degree as selecting several different issues.

The results of this technique, to date, also firmly indicate that the amount of diversity necessary to approach median return need not be very great. Only five to six individual positions, diversified by either issue or time, have been shown to almost invariably provide returns ± 5% of the median. This allows the technique to be employed by relatively small accounts.

Because of the careful selection technique of individual stocks, the results to date have repeatedly shown that time diversity is more important than issue diversity. It is more prudent to apply monies to a few stocks at different times than to many stocks at any one time. In fact, overdiversification as to the number of stocks can often be a severe disadvantage in optimizing return.

The important point is recognizing that both time and issue diversity are built into our investment technique. The time diversity aspect is automatic because of spacing the buy/sell points. The issue aspect is also (usually) automatic because the different stock issues appearing to have the best profit potential will generally vary between different buy indications.

The proponents of LBOs, usually the managements involved and those who are paid fat fees to construct the deals, point out that shareholders benefit by getting to sell their stock at a substantial premium relative to what the stock would be worth if there was not an LBO offer. They also point to somewhat hazy theoretical benefits including (but not limited to) concepts that the nonpublic corporation will be more competitive and thereby benefit the economy as a whole. In addition, they contend that those who provide the financing (usually through junk bonds) are pro. vided higher interest rates than they could otherwise obtain.

Critics of LBOs contend the only true value is to those who construct the deals and the management that takes over the corporation, in that they are provided very large profits with relatively low risk. They maintain that the added debt burden to the corporation detracts from its financial stability, using the high default rate of junk bonds as proof. Their criticism also includes a couple of accusations: For one, the junk bondholders are not properly appraised of the risk involved. Also, when banks are involved in the financing, the taxpayers (because the bank's deposits are insured by the federal government) are subsidizing a process that does nothing except make a select few enormously rich and destabilize the overall economy, as the U.S. savings and loan debacle clearly attests.

Irrespective of the arguments, one aspect is clear. The managements who are buying the stock from stockholders (the owners) are, in effect, competitors thinking they are buying the stock cheap (at least relative to their risk). Otherwise, why would they want the stock all to themselves? Our main point is to demonstrate that the objectives of management and shareholders (for whom management presumably works) can often bedivergent and directly competitive.

Corporate Raiders

Corporate acquisitions can take one of two forms: friendly or hostile. In riendly arrangements, the buyer and the corporation to be acquired agree

on the terms involved and all proceeds (usually) rather smoothly. In hostile situations, the management of the corporation resists the buyer's actions. The buyer in such instances is usually termed a raider.

For a variety of reasons, including the possibility of loss of employment, managements do not like raiders. They want the raider to go away. To entice the raider to leave, they may offer incentives, such as buying the raider's stock in the corporation at a price significantly above the free market price, providing the raider high paying preferred stock/bonds, or any other enticement that leaves the raider with a profit sufficient enough for him to promise not to return. These payments are called Greenmail. In a greenmail arrangement corporate management has paid off the threatening party without the permission of shareholders (or owners). The _shareholders have not even been given the choice as to whether they want to take the raider's presumed offer.

Thus, once again, corporate management and shareholder objectives can diverge and, in effect, place management and shareholders in direct _competition.

Some raiders have perfected their activities to an art, getting paid off _repeatedly without ever really making a serious attempt to takeover the "threatened" corporations. Other raiders have been known to buy stock in a corporation, then announce (or imply) that they might takeover the corporation at a price higher than the current market price. Speculators might rush in and push the stock higher. The raider then "changes his mind" and sells his stock into the buying demand (higher prices) created by the speculation. Such activities turn ethical stomachs. They are mentioned to reinforce the true nature of the market, which includes avoiding the assumption that corporations are automatically investors' friends.

Taking a Corporation Public

In taking a corporation public, instead of management buying stock from the public, it is selling its stock to the public. The sale may take the form of new stock issues, selling stock held previously taken private by means of LBOs, or simply large blocks of stock held by management in corporations already trading publically. Whatever the form, the implication is clear that management is selling because the price of the stock is too high. Again, the managements of corporations so involved have placed themselves in direct competition with other investors.

Avoiding competitive abuses from corporations entirely is not possible. Slimy types have been known to work their way to the top of some of the finest corporations. Once identified as the unethical types that these individuals almost always are, they can be avoided by staying away from the corporations with which they are involved. To reduce the possibility of being victimized by unscrupulous corporate managements, we confine investment interest to the issues that meet the selection criteria where shareholders concern plays an important role.

Many investors are unaware that the brokerage firm, upon which they rely for advice and/or the placement of orders, is often a direct market participant and as such is potentially a direct competitor. Brokerage firm_s, on a corporate level as well as through individual officers and employees, are often actively involved in the market on their own behalf.

The reasoning of those who ponder the merits (or lack of them) of broker participation generally gravitates toward one of two categories:

• It is good. After all, if the broker is so convinced of the merits of a particular stock that he or she purchased it, it seems only ethical to share this reasoning with the clientele. And, if a broker suggests a stock, it is an indication of demonstrated good faith that the broker has placed monies alongside those of his or her clientele. If the broker is wrong, all will suffer. Such personal participation may influence the broker to be more astute and work harder in stock selection to ensure success.
• It is bad. If a broker has a position in a stock and then recommends the stock to customers, the broker faces a potential conflict of interest. The broker's clientele could be used to support the price of the stock the broker owns. That is, the clientele, through their buying, will help increase the price of the stock and may even end up conveniently buying the stock owned by the broker at an elevated price.

There are many scholarly (and not so scholarly) discourses as to which line of reasoning is more accurate. The usual compromise is to advise clients (generally in the form of very small print on the bottom of a research report) if the broker has a position in the stock, so that clientscan make up their own minds about the potential advantages or disadvantages.

Such research reports are designed to aid both individual and institutional clientele in becoming informed as to the investment merits of a particular stock. They are sales tools. Naturally, if the brokerage firm owns the stock, the research report is generally favorable.

From our perspective, it makes no difference whether the involvement of brokerage firms as direct market participants is good or bad. We are only concerned that it exists. It is a factor in the market environment thatcan influence supply/demand, and as such it can provide opportunity for profit.

If large brokerage firms concentrate their own buying and/or the efforts of their sales force on a particular stock or stock group, you know you have buyers regardless of the ethical motivation behind the buying. With the influx of buyers, you can be reasonably assured the demand will be greater than the supply, and consequently you can expect the price ofthe stock to be pushed higher, thereby allowing a more propitious selling opportunity.

The major effect of brokerage activities is on buying, not selling, for various reasons. The negative is not as easy to sell as the positive. It is much easier to call clients and state something should be bought because of _optimistic prospects, than it is to tell them that a stock they own is not worth owning and should be sold. From the standpoint of the broker, if the client has bought something previously and it is up, them keeping the profitable position (albeit a paper position) reinforces the broker's ability. Conversely, if the broker has placed the client in a position that is losing, it can fit the "long-term" category with no acute realization of loss as long as the position is held. Also, selling might not be emphasized by a brokerage firm because the stock might be that of a corporate client of the brokerage firm. The brokerage firm might either be receiving fees to handle a corporation's offering of new securities or have the corporation as a client through its pension fund and/or managing personnel. In such instances, suggesting selling the corporate client's stock would be an obvious business blunder.