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The Art of Investing: Stocks

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community.  This post delves into some of the issues as they relate to equities.  What follows are some very insightful comments from Cliff Jarvis.

The Science Argument: Valuation. There is a camp of investment managers who believe that the value of a stock is simply the present value of future earnings. After all, it is no more than partial ownership of a business. Viewed as an investment, the long-term stream of future cash flow must justify the initial cost of the investment. Therefore, stocks have a fair value based on past, current, and estimated future earnings. Historically, there has been a fair value for the major stock indexes which is in the area of 15x’s earnings. Higher than 15x’s earning, the stock market is expensive; lower than that, the market is cheap. Currently, the major indexes are over 20x’s earnings.

The law of fair valuation states that, while actual prices will fluctuate, fair value will inevitably win over the long-term. But in the short term which can last many years, perhaps even a decade, this law is at best obscure. This brings into play the second, and often the more important rule.

The Art Argument: The Trend is your friend.  As mentioned, in the short term, value may not be the best indicator. Instead, we in believe momentum and mass psychology rules. It is currently ruling up. Once a direction is established, either up or down, it takes on a life of its own. Numerous factors have combined to yield 10 years of low volatility. Stock market sell-offs have been minor despite subpar economic growth and high valuations. Many argue that an important factor is that central banks around the world have been openly buying assets (bonds & stocks) to boost prices and to induce economic growth. This intervention induces another factor of stock buy-backs on the part of our major corporations to boost earnings per share; this has created enormous upside momentum. Furthermore, it is common knowledge that the Federal Reserve will support asset prices when necessary (the Bernanke Put).

As a result of these influencing factors risk awareness has been dulled and, in the short term may be rightfully so. The stocks markets continue to smoothly chart higher and higher. But is the concept of fair value still lurking out there?   When, if ever, will it return?  But in the meantime, there may be a great deal of money to be made. And, after all, many, many good things are happening that could rightfully drive the markets by increasing earnings and thus fair value.

Further complicating proper investment decisions is ever-changing government policy. For example, our government is now in a heated debate over tax policy. If they lower corporate tax rates, what will that do to boost earnings? If the abundance of cash reserves held overseas by corporations are induced to come home, what will that do to stock buy-back programs and economic expansion? Politics influences economics and politics cannot be reduced to computer models.

So can investment planning be reduced to math inside of a computer model? We would argue that a human element is needed. It has become increasingly obvious to us that some things are simply incomprehensible and that investment planning is just as much art, as it is science. This is especially true in today’s world where headlines are manipulated and central banks of governments are overriding free market forces.