A Bourse Diary

Thoughts on stocks, speculation and ... life

Friday, November 25, 2005

On Stop-Loss

Particularly beginners are always told to "protect" their trades by "persistently" setting a stop loss orders as if it were a nearly a "miracle weapon" to minimize losses and hence boost overall performance. The second "hint" that very often follows then, is portfolio risk protecting (or hedging) through put options.

I find that one should not protect the risk of stocks. At least not in this way. By the hedging the investor cuts finally his performance. The risk protection (or balance) is to be taken rather by diversification of the entire portfolio on the different investment classes (bonds, shares, real estate etc.). In the class of the shares itself, one should not "protect" - the risk of the investment is "paid" by (possible) higher yield here. The volatility, which can be very substantial, is part of the risk and part of the price. If you consider the risk of holding stocks too high, then buy less stocks and distribute your money more into the other investment classes. To protect the stocks portfolio is quasi to make from shares bonds. From fiscal point of view some hedging strategies can be of course derived (at least in Europe), but this is not the theme. If you come to invest on the stock market, you do have to be able to live with the volatility of stocks, otherwise it's just the wrong place for you...

Risk balancing and protecting strategies conduct for instance banks or funds, but this is not investment in the actual sense, still less speculation. It's other people's money that is hedged e.g. in the structured products (warranty, bonus certificates etc.). The banks in most cases do not speculate, the banks earn at the fees etc. and not at the market, therefore they hedge the market movements.

Monday, November 21, 2005

A Mechanical Bull Market?

It is a common theory and view (also, so far I correctly remember, shared by Nobel Prize laureates) that the capital markets are "perfect", "efficient", so that they form a "perfect" price on basis of all information available in each single moment in time. One says, the market "discounts" all existing information efficiently, therefore it is actually not possible to outperform the average...

I believe, the truth is just the opposite: the markets are always wrong, the current price is never, where it should be - either is it too low or too high... This is by the way one of the views of George Sorros, on which he develops his investment philosophy.

About, say, 90% of the public do not know at all, where the price is to stand, can not discount information at all, and mostly do not even know what "discounting" means. In that point I like the technical analysts: they admit openly that they do not "discount" at all, do not bother about evaluation, "fair" prices etc.. They observe a chart and that's it. I regard this as nonsense, but at least they are honest...

In this sense: I believe that there is a certain mechanism, which presses the prices upward at the stock exchange. 90% of the public bets on long, on rising stocks. Of them about 90% do not know at all whether the current price is fair or not. Since however no one sells so gladly with losses, most hold their positions into the profit zone (at least). From this massive buying and holding in attitude a mechanical pressure develops upward.

Here it must be underlined very clearly that the upward tendency at the stock exchange is also on a long-term basis fundamentally supported and favors the long speculation.

Not knowing, where the correct price lies, the public buys and waits for higher quotations until something brings this "house of cards" to a fall. This happens rather at the extreme lows or tops of the market. Otherwise, if the situation is not extreme, the stock market wings itself up - one would like to say nearly mechanically. I believe, that bull market mechanism becomes slowly set in motion now.

The Bourse is not Casino

The stock exchange is not Casino, although it is frequently compared with it. Yes, of course - there are aspects of gambling, coincidences, not foreseeable reactions and accordingly very personal luck or misfortune, but at the stock exchange there are also very serious non-gambling elements, which make the comparison with the Roulette table completely inaccurate and misleading.

But, if we remain nevertheless with the Casino symbol, I would say, at the stock exchange one has the choice between the one or the other side of the table - to sit down on the side of the players or on those of the bank.

The bank in the Casino wins - as well known - always in the long run. It's simply statistic probabilities. Only enough capital is necessary to "bridge" the possible streaks of losses. The longer the play however lasts, the bank will come to its profit.

This is the long-term investor at the stock exchange. The shares (and here is the general level of the stock markets meant, represented approximately by the large indices) rise on a long-term basis. Behind it stands the progress of mankind. Apart from the pure inflationary development it is also the real growth of the economy. One needs only enough capital, in order to outlast the bear market streaks and not be forced to sell low.

Oddly, the most investors go to the gamblers' side of the table. There certainly is the chance to win much and quickly (in contrast to the bank, which is winning not enormously but constantly and "safely"). But in the long run the gamblers loose. The roulette ball just twirls the money from the one hands into others and in the end into the hands of the bank.

But enough with this casino symbolic...

Saturday, November 19, 2005

Trend = Liquidity + Psychology

You know Andre Kostolany? His isn't that famous in the USA. Though, Kostolany was a great investor and - more importantly - has very strikingly described what I consider the central mechanism of the development on the stock exchanges. Symbolically it could be written down like this:

Trend (T) = Liquidity (L) + Psychology (P)

The main direction of the stock prices is determined by the monetary conditions (L) and the psychological attitude (P) of the investors (I call them "the public", because not only the directly involved and active stock-holders or investors are meant). A bull market emerges when both factors turn "positive", and there is a bear market if both factors are "negative". If factors are mixed (one positive, one negative) there is a flat or undetermined trend, possibly with a slight bias in the direction of the stronger one.

The market will go up if the public has a positive attitude towards stocks AND has enough (liquid) money to buy and vice versa. The "AND" is crucial: that's why e.g. on the top of a bull market, when sentiment is strongly positive, prices can stagnate regardless of the good news from the companies and the economy. The pace of the real growth and the investment activity, on the one side, absorbs much of the liquidity in the financial system. On the other, such development goes normally with higher inflationary pressure and hence increasing interest rates (on the money market - dominantly due to Central Bank (Fed) rate hikes - and on the capital market (longer durations) due to aversion to fixed income securities). The liquidity conditions turn "negative".

And vice versa: in the bottom of a bear market, when mainly bad news are coming from the economy, the business activity is low and there are no inflation concerns, the Central Bank can ease the monetary supply, the interest rates fall and the market is provided enough liquidity. It is ready for an upturn. When - suddenly - the sentiment of the public also changes, both factors turn positive, the stock market can explode upside. We saw something like this in 2003 - the long bear market and permanently bad news (from Enron and 9/11 to the Iraq tensions) have depressed sentiment (and prices) extremely although the monetary conditions (liquidity) were very stimulating. It was just a spark necessary and the market went up impressively although ca. 6-12 months afterwards the news from the economy still was negative.

From both, unfortunately, only the monetary conditions can be reliably observed. The attitude can change very suddenly, it is very instable and not foreseeable. There are only some indications for the sentiment of the public. Therefore the most crucial parameter for the stock market remains the liquidity situation.

Where do we stand now? The liquidity is narrowing as described in Where is the Threshold? posting, but still not a concern. Everyone seems to fear a cooling down of the economic activity, though this will free up liquidity from the real business and investments and also keep interest rates down. This will prepare the market for a strong up-move. I would expect, that if the economy growth pace decreases a bit, the stocks - astonishingly - will jump up!

Thursday, November 17, 2005

Fundamental Analysis

May be the previous postings will be better understood in the context of my general view on speculation and stocks. Please be patient. I will post step by step on fundamental analysis of the market - the only one to provide sustainable success, in my view of course... Life will teach us...

My approach is strictly top-down. First one should think about the overall conditions of the market and to decide on the overall trend and perspective. Later then you should consider which sector, stock etc. to purchase or to sell. In a bull market almost all stocks - good and bad - move up, and in a bear market all shift down. The good perform of course better, but you see: the main direction of the market is the more crucial point. And the main direction is to be analyzed at first. How I approach this...well, as mentioned, step by step...

See you...

Wednesday, November 16, 2005

Where is the Threshold?

Rising interests - both at the money market (Fed) of long bonds - is not good for the stock exchanges. Period. And here forget at first about valuations (no matter how you measure them) - they are not that important. We are confronted and (it is not over by now) with rising interest. If the money supply "narrows", the shares suffer. One should expect some difficulties on the stock exchanges for the coming time.

Now, the situation, as previously said, is somewhat more relaxed due to low interest rates. That why the US markets keep stable. Nevertheless, the increasing yields "endanger" the stocks. Don't get me wrong - no crash, no bear market. Possibly even easily improving Wall Street, but "with emergency brake on".

The danger of inflation is to a large extent well-known and well-considered. The prices reacted accordingly in October (downward). Nevertheless a decrease in liquidity can be hardly "discounted" - when it comes, it inevitably affects the market. However we speak of a tightening of liquidity from a high level. Therefore the monetary situation is not yet causing concern.

Secondly, the danger of inflation mainly comes from the energy prices (and in second place by the strong real estate market). Each easing here could let the Fed to pause with the interest rates increases. In my eyes this would move the fairly attractive valuation of the stocks relative to fixed income immediately into the focus of the investors.

If the inflation , i.e. the energy prices, should persistently stay high, the Fed will the go on for so long until the economy clearly cools down (if necessarily, naturally, until recession).

The question is, where is the threshold at that the commodity prices (energy) plus property market the USA eases (stops): an easy or strong cooling or only with recession?

Since I assume that by the increasing interests the American economy will just a little bit "weaken", i.e. show somewhat lower pace of growth, the real estate market will stop ("but not burst") and the energy prices will more promptly react (downward), the stocks are a Buy (or a Hold respectively). I expect possible corrections but not too sharp.

Inflation Fears (3)

Compared with 1993-1994 the interest rates, particularly the long duration bonds, are too low now. On the one hand, it shows that the market does not really believe the inflation story in mid to long term. On the other hand, it is obviously too much money out there, that looks for the safety of a fixed interest. America may not save particularly much (although, I would place this under question marks despite a statistical savings rate of 0%), but in the global world there are many which save almost extremely (Germans, Japanese, Asian altogether, etc.).
Low interests actually offer ideal conditions for the financing of investments, thus, for growth. We see good growth rates in some parts of the world, but the investment activity is not quite pronounced. The companies can manage the demand with the existing capacities, especially given the constantly increasing productivity . Thus, they need not much money from the capital market (for instance from the corporate bond market).
In principle that situation should positively affect the stock markets. Nevertheless the large indices did not reflect this by now. To me, we seem to accumulate great potential for a bullish upturn.

The problem, however, is that with arising inflation the abnormally low interests of long duration bonds should rise. That complicates the forecast for the next months: if the money should move toward shares, we will see of course higher stock prices.

However one should also expect that the positions in bonds move only to shorter durations (the skeptical bond investors might not become enthusiastic on stocks over night). With rising long-term interest rates, however, the economic dynamics will weaken somewhat (as I assume - only somewhat) and will automatically worsen the relative valuation of the stocks versus loans.
But will this influence the stock prices?...

Inflation Fears (2)

In earlier times a large part of the inflation was based on structural "problems" - both economical and political nature. Accordingly, in order to deal with the inflation pressure, the Fed reacted (as normal and as today too) with interest rate hikes.
However, in earlier periods the inflation was only to be stopped by driving the interest rates so high till the economy fell into recession, or at least was strongly cooled down. The reason for this were some structural problems: the much stronger position of the trade unions (and the associated inflationary spiral), the higher state ratio to GDP and the lower intensity of competition, missing production capacities in the developing countries, and also very important - the Cold War with all transfer payments into the geopolitically important regions (official and unofficially, also in form of credits, from which everyone knew they are never going to be paid back). This was then neseccary to simply secure strategic interests (which was quite good and correct considering the danger, which went out from the communist block). The list could be expanded...

Therefore stopping of the inflation was possible only by very high interest rates and finally through strong deceleration of the economy, even recession.

Since Reagans's presidency however much happened in America and in the world weaken or solve many of the structural problems. Much was made for liberalisation of the American economy, for more dynamic and less restrictions on the flow capital and investment. Since beginning of the 90's the capital received even more real possibilities for investments world-wide. Many countries provided (and some of them quite successfully) better investment conditions and political security. Accordingly the production capacities and resource of these countries grew (perhaps Asia and China are the most prominent examples, in addition, many Eastern European countries, some South American ones etc.).

Between 1993 and 1994 we had a similar situation like now. The incrasing inflation rate let the yields on the capital market and the Fed rate go up. The stock markets went down fearing coming recession (which was to be expected by experience). But this time it was not necessary for the economy to fall into recession to coll down the inflation. The growth pace dipped a little which immediatly eased the inflation pressueres due to the changed structural conditions (in the USA and world-wide). What followed was one of the greatest bull markets of the history.

Today we witness very similar situation. The main difference are the very low yields on the bond markets. This could be a couse of some concern...

...to be continued...

Inflation Fears

In the last weeks topic No. 1 and fear factor No. 1 was the inflation. This was also the main reason for the worse sentiment and coused downward pressure on the stocks in October.

The inflation - and we speak now particularly of the USA, although much can be assigned to the Western European markets as well - the inflation, thus, remained rather moderate to before few months (up to the summer). The American, but also the global economy were exposed to several "inflation tests": rising commodity prices, falling dollar, decent growth rates, until recently extremely low interest rates (money market and capital market), which were actually at first intended to protect "us" against deflation. Besides, a solid development on the stock market (2003 - very strong, since 2004 in America not big profits, but nevertheless: profits) plus rising real estate prices in the USA and in some other parts of the world. One could still extend the list by some. Important is however that the American economy withstood this tests, so that we could not register much of inflation in the recent past. The forces of technologies, productivity, more intensive international competition and the better allocation of capital and work(force) in the course of the globalization (catchword: China) are obviously a very strong counterweight to the inflation forces mentioned above. Even at present the core CPI is on a quite acceptable and conformal level.

The inflation concerns came from the high energy prices, which finally affected the overall inflation rate and also the PPI (Producer Price Index). Obviously energy prices on such price levels cannot be absorbed by productivity increases (or the like) by the economy without inflation. Nevertheless I want to state that the American (in addition, the global economy) has no structural inflation problems.

This was however not always like that... (to be continued)

Saturday, November 12, 2005

A Bourse Diary

The english version of my bourse diary (Börsennotizbuch) will be soon available here.

Disclaimer: All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and are in no way intended to serve as personal investing advice and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Readers should not make any investment decision without first conducting their own thorough due diligence. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise. While the information provided is obtained from sources believed to be reliable, its accuracy or completeness cannot be guaranteed.