7 posts tagged “money”
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 predetermined 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.
Although the emphasis is to assist individuals in developing and implementing their own investment strategies, we do not mean to imply that all money managers should be avoided. There are many competent managers.
Yet the selection of a manager cannot be taken lightly. The fate of the monies entrusted is most likely sealed at the time the manager is selected. It is no time to blindly follow friendships, media hype, or personal emotion. Almost all of the difficulties associated with the selection process can be eliminated by following three simple guidelines.
1. Familiarity with the Investment Technique
Money is a tangible: Either you have it or you don't. Generating money from money is a very specific process: Specific investments, must be chosen and the investments managed under specific techniques. Irrespective of how money is applied (even hidden in a mattress), there is an element of risk. To place the element of risk in a context suitable to individual resources, needs, and goals, it is mandatory that investors understand the specific investment techniques determining how monies are invested.
Obviously, avoid managers who stipulate techniques that have not produced suitable results when back-tested over a long period or who stipulate that their methods are proprietary (secret to all but themselves). Despite the glaring dangers, people seem to be attracted to proprietary "systems," the bait probably associated with greed. The fact is that the markets have been around for a long time. There is little that is not known and has not been adequately tested. In other words, would you entrust your life to a brain surgeon whose operational procedure was his own little secret? Suffice it to say that, within the financial community, there is ongoing communication among the ethical elements to provide clientele with superior products.
In effect, the investment method being utilized by the manager should be the same method you would personally use had you not decided to entrust the day-to-day investment routine to the expertise of others.
2. Familiarity with the Individual Analyst
Little known to the investing public, there has been a prolonged and ongoing battle within the financial community over full disclosure to clientele as to the specific identity of individual analysts managing the clientele's money in larger institutions.
Institutional management generally favors anonymity, stating that specific investment decisions (unless very bad and some underling is selected for blame) are a "team effort," and no one individual should be singled out as being better or worse than the team.
Many analysts counter that the "team" argument is a joke. It allows the institution to maintain fat salaries for dead wood ("good old boys") while inhibiting the advancement of truly superior individual analysts—sort of a slave labor relationship. These analysts further contend that the institution's desire for anonymity is to keep monies under institutional management. If the better analyst, known to clientele, were to leave the institution, the clientele would also leave to keep their funds with the superior analyst.
To us the bottom line is simple. You should know the specific analyst who is involved with your money and have some means of individual communication. It is your money and you have a right to know both the investment methods being used and the individual making the investment decisions.
In the world of investment techniques, the originators of the methods often manage money using those techniques. In effect, the investor often has access to the source. If the source is not in the money management business, he or she will probably be willing to direct the investor to a manager who has demonstrated a familiarity with the originator's work. If the originator is dead or out of business someone else will likely emerge as the best known analyst following the technique who can personally provide (or personally recommend another for) appropriate discretionary management. If you want the best, nothing can be lost by seeking it.
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.
Corporations Role on Stock Market
Most of the investing public fail to view corporations as direct market participants. They usually assume that the relationship of a corporation to the trading of its stock is an arm's length situation. The corporation, they reason, is consumed by business activities, and the stock exchange is independently judging the relative merits of the corporation's activities.
Yet corporations and the stock market are intertwined on both a theoretical and practical basis. It is widely presumed, and generally true, that the goals of the corporation's management and the stockholders are identical: to maximize the corporation's profitability and consequently to optimize the value of ownership (that is, the common stock). Corporationsare established because of money and the stock market is established because of money.
However, in some instances the objectives of management and stockholders conflict. In these cases, the corporation is both a direct market participant and a direct competitor.
The Dangers of New Issues
Such a conflict is clear, for example, when corporations offer new issues of stock during seller's markets.
The sale of common stock allows access to money without any guarantee it will be returned, and without having to make interest payments. In effect, it is a source of cheap capital. Many corporations, keenly aware of stock market activity, have a genuine desire that their stock command a high market price. The more people are willing to pay for the stock, the higher the (paper) valuation of the entire corporation and the more money available through the sale of new stock.
Thus, when the market is high and a euphoric atmosphere prevails, corporations (both new and established) will come to market to sell new issues of stock. In effect, they are taking advantage of the elevated stock pricing to generate more money through the sale of new stock than would be available if stock prices were lower. In other words, they are selling high—to the corporation's owners!
This type of corporate activity is usually a clear warning signal of impending decline. The corporations, by rushing to sell themselves through new stock issues, are effectively advertising that stock prices are too high. Yet few investors heed the warning. On a more elementary basis, the new corporate stock offerings are increasing the supply of stock and dissipating buying demand over a larger number of shares. Both factors add to a curtailment of price advance and a consequent lessening of buying demand, with the eventual result of supply outweighing demand, causingprices to decline.
Stock Splits
Corporations might also take advantage of high prices with stock splits. The effect of a stock split is simply to expand the number of outstanding shares. Although attractive to naive investors, the effect of a stock split is usually meaningless to the real value of the stock.
For example, let's say a corporation has 1000 shares outstanding and earns $4000. The earnings per share would be: $4 per share.
Now let's say there is a 2-for-1 stock split. The company exchanges two new shares for each old share. The per share earnings change to: $2 per share.
The end result is that the investor has twice as much of what is worth half as much. In other words, if the stock was worth $50 per share before the2-for-1 split, it would be worth $25 per share after the split with twice as much outstanding stock.
This group consists of pension funds, mutual funds, mutual insurance companies, bank trust departments, brokerage firms that accept discretionary accounts, and any other entity that invests monies on behalf of those who have entrusted their funds. The institution may use pooled monies (mixing together the monies of many different individuals) or invest for others on an individual basis.
There is a significant difference between institutional money management and most other professions. Doctors can (sometimes) bury mistakes. Attorneys can befuddle their clients about why their case was lost. Administrators can attribute mistakes to staff. Politicians can cast blame on predecessors. But institutional money managers have nowhere to hide: Either they have made money or they have not.
To check institutional results, all you need to do is see how the money under management performed relative to some predetermined standard, the most popular standard being major market averages. Many investors might be surprised that most institutions are unable to outperform the market and/or profit consistently.
This is not to imply that institutional managers are ignorant, for many of them are quite competent. The difficulties, even for the most astute manager, can be inherent in the structure of the institutions themselvesand the market.
The primary advantage of institutions is their financial power. Because of the large amounts of money at their disposal, their investment actionscan significantly affect the supply/demand balance and consequently price changes.
The Problems of Institutional Investing
This financial power can also function as a disadvantage because of a lack of maneuverability and liquidity. Dealing with large dollar volumes, institutions often find themselves with very large stock positions. When the time comes to sell, there might not be enough buyers to purchase the large amount of stock unless the price is lowered significantly. In such instances, institutions can be forced to accept lower prices when they sell. Conversely, when they buy, they can be forced to pay higher prices because of the large amounts of stock involved. Of all investor groups, institutions are the mostpredictable, and as such they are frequently preyed upon by true professionals.
In isolating the institutional characteristics that afford profit opportunity, it is possible to categorize institutions as to type (pension funds, mutual funds, etc.), ethical standards (high, low, none), investment strategies (fundamental, technical, etc.), method of funding (constant or variable), and taxation (immediate or deferred).
The institutional manager is, by definition, in the business of investing the monies of others and consequently is influenced by both the attitudes and actions of clientele. The source of the capital can have a significant influence on performance. The greater the stability of the funds that are being added/withdrawn, the easier the task of management.
1. Unit of account. Money provides one unit in which the values of various goods and services can be expressed and related to each other. It eliminates the obvious problems a barter system presents, such as how many watermelons would equal the value of one chair. By giving everything a price in money, we can easily relate one good or service to another.
2. Medium of exchange. Money facilitates the exchange of goods and services and expedites trade, making an economy more efficient and permitting a higher standard of living.
3. Store of value. Money that is not immediately spent can be saved and spent later, ideally at the same value. This encourages saving, hence capital creation, hence production.
4. Unit of deferred payment. Money not immediately needed can be lent to others, gaining interest and financing projects that provide a return to society.
All these functions and their benefits assume that money is sound, that is, that its purchasing power remains constant.
