the fed taper and markets

The Fed has continued its policy to pull down its stimulus program, quantitative easing. And the markets across the globe react: here's one example.

The long-term-bonds-buying program, predominantly, was meant to bring down the long term interest rates. The short term rates are already lower, and the intention is to keep them lower. The result has been lower interest rates across different treasury maturities.

The goal was to see the growth in the economy. Whether that has been achieved depends upon how we see it. The indicators could be output, consumption, unemployment rate, markets or other elements. 

The GDP growth has been pretty decent:

The stock markets have gained:

The Fed therefore considers reducing the stimulus gradually, and the policy is showing up on those lines already.

Because of this the capital is supposedly flowing out of the global markets, and coming back to the US, and consequently, those markets are down.

I am not sure if it is justified for the global markets to go down. If the fundamentals of the economy of a country have changed, it is a reason for the revision of valuations. On the other hand, if the earning power, cash flows generating ability, the growth rate and risks therein have not changed significantly, the valuation should not change.

The fact that market prices have changed gives a reason for the investors to have a look at both markets in general and selective stocks in particular.

Let's check out if anything interests us.

the expectations game

The timing game is certainly not a good game to play. There are many other games out there for the enthusiasts to play. One is the expectations game. In fact, this is the game that sets prices for stocks specifically, and for the markets in general.

The expectations game 
It all starts with some expectations about specific elements of a company which is about to announce certain key information for the markets. For instance, let's take quarterly earnings report. The market would have set certain expectations regarding the company's revenue, margins, operating profit and net earnings in advance of the company's announcement. These expectations are usually based on analyst views and research, news from media and rumors about the company's performance. Of course, there is certain element of insider information out there though it is considered illegal. 

The short term absurdity

A combination of these factors set the stock prices of the company in advance. After the announcement, the stock prices react only to the expectations compared with the actual performance, rather than to the actual performance directly. It might sound a bit strange, but, it is a fact.

For instance, if the expected revenue growth was 5% and actual growth was 7% the stock price is likely to go up. On the other hand, if the expected operating margin was 10% and actual was 8% the stock price is likely to go down.

The market would not react to the actual performance compared with the past performance. Let's consider this: If the operating margin in the previous quarter or year was 6%, the current margin of 8% is considered to be a better performance. However, because the market has already considered this fact in advance, there would be no reaction to this after the announcement. Oddly, the focus would be only on the expectations and actual. That is why, instead of stock price going up, it would go down.

The managers who are aware of this phenomenon are ready to participate in the game too. The game gets more interesting: They are more likely to play down the expectations by giving lower guidance for the future, and beating the expectations by better-than-expected performance.

The expectations game is played not only on the earnings performance;  we can see it on dividends, debt, equity, acquisitions, divestitures, restructuring, and many other elements affecting the financial performance.

Such is the behavior of the markets.

The recent announcement from Apple was quite good based on the actual performance; yet the stock fell 8%.

Reliance stock fell on lower than expected operating profits, though net earnings were above expectations. As of now the company is in the high capex phase, and has plans to increase investments in its energy, retail and telecom businesses. The market is slowly factoring these elements in its expectations, although, the stock price currently does not reflect the expectations game fully.  In time, but well before the actual performance, these expectations would have built in the stock prices.

A better game to play
What is crucial though is to realize that these games look good in the short term where the excitement is imminent. However, in the long term the stock prices reflect the fundamental aspects of the operating business of the company. Ultimately, the earning power (i.e. the ability to generate cash flows) of the business impacts its true worth, the intrinsic value. That is why it is better to concentrate on the long term performance of the business rather than the short term. It is also an easier game to play. We should be under control regarding when to buy, when to sell, and more importantly when to keep quiet. Too much of nonsense takes place when there is too much of an activity in the markets. 

Those who have the virtue of patience and are adept at the liquidity game, i.e. are able to withstand short term crashes in the stock prices by not selling due to panic, should come out as winners.

It's going to be fine in the long run for someone who has done the homework right and behaved right.

timing the game

The year behind

A good year has ended for the markets, that is, for the Dow (up 26%) and S&P-500 (up 31%).

And not so good for the Sensex and Nifty:

The hindsight game

It would have been better if we had invested in the US markets at the start of 2013. It was that easy; Was it? 

Hindsight plays a dominant role when it comes to giving advice; that is one more reason not to fall prey to investment advisers. They are as weak or as strong as we all are. If they had special abilities, they would be rich and too knave to offer help anyway. 

The timing game

It will be interesting to see if one can ever time the markets, that is, pick the right time to buy or sell investments. The game is too complicated to do that simply because there is too much of emotions of both individuals and firms involved out there to make a perfect timing.

I set out below some indicators to find out if we can make better investment decisions. At the beginning of Jan-1994, the Nifty was 1083.74; it ended at 6304 on 31 Dec 2013. Over 20-year period it returned 6.76% p.a. You can call it after-tax return since long-term capital gains on stocks are tax exempt in India. Still, not that great considering government bonds, AAA bonds and inflation.

It would be different if Nifty was bought and sold at different time intervals.

The annual game

The year-on-year change highlights changes in market values from one year to another:

The return for the year 2008, for instance, was negative (52)% compared to 76% for 2009. Over 6-year period from 31 Dec 2007 to 31 Dec 2013, Nifty has not moved much. The haphazard annual movement is not surprising given short-term reactions to events. We can then conclude that timing the right year for buy or sell decisions is difficult if one year is the investment horizon. A monkey can yield results not significantly different from any individual on average.

The 3-year game

The 3-year change highlights changes in market values over the 3-year investment period:

The return for 2007 (i.e. buy on 31 Dec 2004 and sell on 31 Dec 2007), for instance, was 43%. However, for 2013 it was close to 1%. It is evident that there are some good years and some bad years. Yet, not good enough for investment decisions.

The 5-year game

The 5-year change highlights changes in market values over the 5-year investment period:

The return for 2007 (i.e. buy on 31 Dec 2002 and sell on 31 Dec 2007), for instance, was 41%. For 2009 it was 20% and for 2012 it was almost negative; and for 2013 it was 16%. Although, not fully conclusive, I view this game as the better one. 

The 10-year game

The 10-year change highlights changes in market values over the 10-year investment period:

The return for 2007 (i.e. buy on 31 Dec 1997 and sell on 31 Dec 2007), for instance, was 19%. We can see that the returns are quite steady each year. For 2013 it was close to 13%. 

The hindsight again
We know that these are based on past years data, and with the power of hindsight we can argue that the 10-year game is the best game to play. The longer the duration, the lower the risk, and hence it is safer to play the game. This is true at least for those investors who are not skilled to invest based on business analysis. Index-buying is their best ally.

For those who are skilled or interested in learning I would argue that selective stock picking over 3-to-5-year period should yield decent results. This is because for the markets to be efficient (i.e. for the price to catch up with value) it takes time. If the business is of high quality, longer timeline should yield much superior returns. I am ever ready to play this game.

The long-term game 

Just if you are interested here are the returns for each year on a to-date basis, that is, buy in Jan-1994 and sell each year.

The return for 2007 (i.e. buy in Jan-1994 and sell on 31 Dec 2007), for instance, was 13%. For 2013 it was 9%. Buy-and-hold is always a good strategy; the caveat is, you have to either buy the market itself (i.e. the broader index) or a good business. 

If you ever bought a bad business and held on, the results will be disastrous, and hardly surprising. A bad business is the one which not only dissipates capital, but also needs more capital periodically just to continue as a going concern; in short, the more you pour in, the more it leaks out. Stay away from it.

The story so far on the markets

Market inefficiencies

How attractive is the market
What moves market
Implied market rates
Falling prey to markets
The dancing Dow
The 1000-6000 market
The drunken steps
Future to the back
Nifty and the players
Need for a broader index
Reflections of the market
Markets on to something

Concluding thoughts

It is futile to time the markets; it wastes energy, and takes a toll on health; it defies any reasoning. It is far better to think and act like a rational business owner; or at least we can try.