Stock Price Behavior Conundrum

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BenSolar
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Stock Price Behavior Conundrum

Post by BenSolar » Fri May 07, 2004 6:23 am

Since I've been a relatively close observer of the stock market one thing has vexed me. Reports like this one:

U.S. stocks open down after strikingly strong jobs report
NEW YORK, May 7 (Reuters) - U.S. stocks opened sharply lower on Friday, after a report showing strikingly strong jobs growth in April stoked fears of an earlier than expected interest rate hike by the Federal Reserve.


Here we have some seemingly very positive economic news: businesses are hiring more than expected and so surely must be doing more business than expected, higher profits, etc, ... . But, stocks go down, and it is reported that the drop is because of fears that interest rates will go up sooner as a result of growth.

Good news is bad news, bad news is good news. This has always puzzled me. How can it be so? It struck me this morning that maybe this reaction/interpretation is an outgrowth of a misguided belief in the correctness of the Fed Model. Interest rates go up, future earnings are discounted at a higher rate, so the value of the market goes down, per that model. But, the very thing that makes people fear higher interest rates is in fact a quickening of business growth, which itself means higher profits in the future.

Higher discount rate, higher profits: the two are offsetting, and the price shouldn't change. It appears the market is incorrectly linking real interest rates and nominal interest rates: increases in nominal interest rates on bonds are driving up the real interest rates available through stocks.

So, does this mean we have to wait for higher interest rates/inflation to drive stock prices back down to a higher return? Well, nominal interest rates are surely not the only factor affecting the stock markets real interest rate. And, predicting changes in nominal interest rates is a tough task (to say the least). But, it sure seems like some factors are lined up to push inflation: massive federal debt being a big factor in my eyes. I mean, geez, I have to admit I am basically in the dark here. But, just the simple facts that rates are sooo low, that business does seem to be picking up, and oil prices seem likely going to stay high/go higher given the unrest in the MidEast ... all these things make me think higher inflation and higher interest rates are in the pipeline.

So has widespread belief in the Fed Model (an incorrect application of the discounted dividends model of stock valuation) opened up an exploitable inefficiency in stock market pricing? If we 'know' that the intermediate future (say 1-10 years) will bring higher interest rates and lower stock valuations, then how do we exploit it? Will the increase in real interest rates available from stocks be paralleled by an increase in real interest rates available from TIPS (meaning their price will drop)? Are short term bonds/money market accounts a place where money can be stashed without loss of real capital? Do precious metals funds offer an asset class that might see growth in such an environment?

Well, I don't know the answers, but I have my strong hunches. And I have put my money behind them to some extent, with far more in short term/stable value type instruments than I would have if I didn't think a return toward mean in stock valuations was coming. Identifying the good is bad/bad is good conundrum and a possible explanation for it makes me feel a little more grounded in my strategy. So, does this make much sense? Any thoughts and comments are appreciated.

(editted for spelling)
Regards,
Last edited by BenSolar on Fri May 07, 2004 7:40 am, edited 1 time in total.
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by NeuroFool » Fri May 07, 2004 7:16 am

Hi Ben!

You have been reading my mind! I logged on today to make a very similar observation.

Jobs up! Economy up! Profits up! SELL SELL SELL!

What the heck? :?

It seems as if perhaps the only thing propping up stock prices has been abnormally low interest rates.

Anyway, I don't know what to make of all these short term movements. I love watching the markets like I watching college basketball: every move, every shot every basket every steal is great fun to watch, but what really matters is the score after 40 minutes. In the long run, even though Liberty is scoring some points, 99% of the time Duke will win. :D

As for the markets I am very glad that:

1) I have an asset allocation that I am comfortable with and makes sense to me

2) I am in the accumulation phase, saving a substantial percentage of my (meager) income

3) I believe in periodic reballancing, and can take advantage of this due to nearly all my investments being in tax-advantaged accounts.

4) Dollar Cost averaging is my friend!

Given these parameters, volatility in any one sector is good, no? buy low and sell high. And while everyone is scratching their heads trying to figure out what to do, and while every financial writer is wasting ink TELLING people what to do, I'm just sticking to the plan.

Over the past few years I have tweaked my portfolio a bit, mostly just to increase my international component from 30% equities to 40% equities, and I added a global bond fund to about 10% of bonds component (due mostly to limited choices in wife's SIMPLE plan). But at this point, I would feel comfortable with my asset allocation for the next 30 years, regardless of what any market might do, or whether the economy does great or whether it tanks.

Perhaps rising budget deficits and increased oil prices will make interest rates and/or inflation jump in the next few years. Maybe this will be the trigger to bring domestic Large Caps back to historical levels. Maybe not. But boy, do I sure sleep better at night now that I don't own any individual stocks, and that I have 6-10 asset classes represented in my portfolio. At least there is always ONE that tend to be UP. :)

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Post by BenSolar » Fri May 07, 2004 7:55 am

NeuroFool wrote:1) I have an asset allocation that I am comfortable with and makes sense to me

2) I am in the accumulation phase, saving a substantial percentage of my (meager) income

3) I believe in periodic reballancing, and can take advantage of this due to nearly all my investments being in tax-advantaged accounts.

4) Dollar Cost averaging is my friend!

Given these parameters, volatility in any one sector is good ... I'm just sticking to the plan.


Hi Neuro!

I wouldn't really recommend anything different. Such a plan will work, and will be lower risk than my approach. :great:

My own tweaking away from US large caps and toward short term bonds/stable value-fixed interest may or may not turn out for the good, I admit. :? If I had a better selection of investments in my 401k, I would likely be less cash heavy. But, given my options and what I think I know about the markets, I've decided to try to avoid some of the buying high that I feel DCAing into large cap US stocks at this time is doing, and have a reserve from which I can 'buy low' with some oompfh if/when valuations are better, and/or I have better investment options. Misguided as I may be. :)

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by wanderer » Fri May 07, 2004 5:58 pm

bensolar -

it is indeed a strange world.

only explanation I have is that high dividend payers like reits and bonds have to be adjusted down to make up for the rising interest rates. So if, say, to attract reit investors, reits have to offer 4% real, and inflation looks like it will run 6%, then prices have to go down so that noiminal will get up to 10% (ignoring price appreciation).

but you are right, better business environment means the dividend on the reits is much more secure... (except if they leverraged with variable rate debt...).

that's what I keep telling myself...

I do like the cash at the end of each period and I continue to DCA into inflation protected investments (O&G, materials, bgeix).

Oh, and a thank you to raddr for pushing me to get out of vwehx. :great: Still have about 1% there.
regards,

wanderer

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Post by BenSolar » Sat May 08, 2004 2:56 pm

only explanation I have is that high dividend payers like reits and bonds have to be adjusted down to make up for the rising interest rates. So if, say, to attract reit investors, reits have to offer 4% real, and inflation looks like it will run 6%, then prices have to go down so that noiminal will get up to 10% (ignoring price appreciation).

but you are right, better business environment means the dividend on the reits is much more secure... (except if they leverraged with variable rate debt...).


Hmm ... real estate is commonly regarded to be an inflation hedge. One pretty much expects rents to rise with inflation. So if your real estate is priced for a long term real return of 4% now, then if inflation jumps to 6% next year, then we expect rents and return to rise 6% next year. So why should we expect to pay less for real estate when at the end of the next year of higher inflation, rents and return will also be higher such that we still get 4% real return at the current price?

REITs insert a layer of management that has to be paid, so we can expect REITs to trail the return of directly owned real estate by some amount. But the return still tracks inflation, so that we know how much real return to expect when we buy it (as opposed to fixed rate bonds, for which we know how much nominal return we can expect, but real return is at the mercy of future inflation). Per raddr's research the dividend growth rate of REITs trails inflation by about 1%. So the real return expected from REITs ignoring changes in valuation is Dividend Yield - 1. Dividend yield of VGSIX is 5.5%, so the expected real return is 4.5%. It doesn't matter what inflation is going to be or is ... if we are thinking of the long run ... we can expect to get our 4.5% real return from REITs bought at current prices whether we expect inflation to be 20% or 2%. Thus a sell-off of REITs because of higher expected inflation is irrational.

Say the market thinks current inflation is 2% and over the course of a month comes to expect inflation next year of 4%. If the market drops the price of REITs over the course of that month such that the dividend yield rises by 2% to reflect the 2% higher expected inflation, then the market has changed how much real return they demand from REITs. Using the dividend yield from above if the price drops such that dividend yield goes from 5.5 to 7.5, then the real return expected changes from 4.5% to 6.5%

Or at least thats the way I understand it. :)
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by wanderer » Sun May 09, 2004 3:31 am

I admit to being somewhat puzzled by REIT returns. In light of their 'clear' (90%+ agreed they were) overvaluation (say 20%) relative to NAV, their bond like rents (they move upward but slowly), the recent sell-off makes some sense. And some market irrationality coming to its senses.

(Still kick myself for making such a boneheaded play of not DCAing slowly. But I DCA in on gold and materials and O&G, etc.)

Again, coulda been worse, raddr gets a high five for urging me to reduce VWEHX exposure. Now I have a ton of cash.
regards,

wanderer

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Post by BenSolar » Sun May 09, 2004 4:32 am

wanderer wrote:I admit to being somewhat puzzled by REIT returns. In light of their 'clear' (90%+ agreed they were) overvaluation (say 20%) relative to NAV, their bond like rents (they move upward but slowly), the recent sell-off makes some sense. And some market irrationality coming to its senses.


They sure did have a big run. :shock: But when I look for other options in liquid securities, I don't see many that I can realistically expect to give me 4.5% real return. Microcap value? Might expect higher from there. Emerging market? Maybe, I don't really have any informed opinion on them, but they have also been on a tear.

(Still kick myself for making such a boneheaded play of not DCAing slowly. But I DCA in on gold and materials and O&G, etc.)


I suspect you will end up just fine on your REIT purchase within a few years. You bought some high yield funds, eh? Easy in retrospect to say DCA, but pretty easy at the time to buy that yield :) .

Again, coulda been worse, raddr gets a high five for urging me to reduce VWEHX exposure. Now I have a ton of cash.


Nice. I reduced my US large cap some more in light of the screaming returns last year and bubblicious valuations now. Quite happy with my 401k's stable value fund at 4%. :)

I think I can still beat 15% on a well selected rental here. Not counting management time. Rent growth is outpacing the CPI here, even if it trails housing price increases.

Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by wanderer » Sun May 09, 2004 2:38 pm

I like John Mauldin's quote that the benchmark in this environment is is a mmkt fund.

My colleagues, barely chastened victims of the late 90s gogo nonsense think I'm nuts for saying that. They rode the NT express from $1 a share (if you believe all their purchase point claims - I don't) to $8.60. It's back to $4.
regards,

wanderer

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Post by BenSolar » Mon May 10, 2004 5:38 am

wanderer wrote:I like John Mauldin's quote that the benchmark in this environment is is a mmkt fund.

My colleagues, barely chastened victims of the late 90s gogo nonsense think I'm nuts for saying that. They rode the NT express from $1 a share (if you believe all their purchase point claims - I don't) to $8.60. It's back to $4.

Be nice if you could consistently get in and out at the right times. :?

The benchmark is a money market fund. ... Makes sense if we believe that the markets will mean revert. Seems incredibly unlikely that average valuations will never be seen again. But if one can assemble a range of asset classes that have decent long term prospects, then I like my chances of coming out ahead over any middling to long term. I do like my bit of extra cash buffer at the moment. Maybe it's ill-advised, but I like it. :)
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by Mike » Mon May 10, 2004 2:33 pm

Good news is bad news, bad news is good news.


Part of what is going on is that news announcers rarely know all of the factors that make the market move up or down on any given day. They are just guessing as to which factors are important. Another influence is that many traders tend to make bets on what they think is going to happen, and thereby bid prices up in advance of anticipated good news. When the good news actually hits, they sell to take their profits because they figure that they have gotten all of the milage out of the news that they are going to.

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Post by BenSolar » Mon May 10, 2004 4:28 pm

Mike wrote:
Good news is bad news, bad news is good news.


Part of what is going on is that news announcers rarely know all of the factors that make the market move up or down on any given day. They are just guessing as to which factors are important. Another influence is that many traders tend to make bets on what they think is going to happen, and thereby bid prices up in advance of anticipated good news. When the good news actually hits, they sell to take their profits because they figure that they have gotten all of the milage out of the news that they are going to.


Yep, both of those are true. There are a lot of investors who think of stock yield/interest rates like I described, though. I think it's a real phenomenon, this mixing up of nominal and real returns. I've definitely seen it argued more than once at TMF.
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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Post by Mike » Tue May 11, 2004 12:30 am

There are a lot of investors who think of stock yield/interest rates like I described, though.


I agree, a lot of investors analyze thngs just as you have stated. It is the interaction of many people who make decisions based upon different sets of data that make the market reasonably efficient in the long run. That is the genius of crowds. Many more factors can be considered by a large group of people than can be considered by just a few. Of course, in the short run, crowds can be swayed by a common mania that distorts collective decision making for a while. That is the nature of crowd psychology, both genius and madness can manifest themselves at different times.

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Post by wanderer » Tue May 11, 2004 2:51 am

I still believe the demand for dependable income-paying assets, like real estate and REITs, will increase as the boomers flee the regular salaries of the workplace and as their US-based employers desert them.

It'll be a bit of a climb - I'm down almost 20% on these REITs. I do enjoy money sloshing thru the mmkt fd, tho. Just wish the NAV was bigger...
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wanderer

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Post by BenSolar » Tue May 11, 2004 4:29 am

wanderer wrote:I still believe the demand for dependable income-paying assets, like real estate and REITs, will increase as the boomers flee the regular salaries of the workplace and as their US-based employers desert them.


I agree. I think the recent peak in valuations won't be the highest one for this asset class over the next 10-15 years. Valuation peaked higher in 98. It does seem demand for income producing, inflation protected assets seems likely to stay high and go higher as the boomers move toward retirement.

If inflation continues to pick up and the economy keeps rolling, then REITs will be positioned for a good run in a year or two as rents and yield rise.

Editted to add: I don't really have any idea where REIT valuations are going. :)
Regards,
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus

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