Market Watch - March 2005
How Wall Street Firms Handle
Research
Research on publicly listed companies, like Microsoft, is generated
by the research department of a Wall Street firm, say Merrill Lynch.
Once that research is initiated, several influential and well-connected
Wall Street personal will have knowledge of the research. After
going through the appropriate committee approval, appointment of
the research team, and distribution of the research findings to
the firm’s brokers, three primary “sets” of people
then know what will be published about the company under research,
creating the potential for use of illegal inside information. The
firm’s top executives, other Wall Street firms’ research
departments, and an array of brokers, who by now have already contacted
the firm’s largest institutional clients, all have this information
before the public at large have learned anything. It is frequently
observed that during this process, before the public gets the research
information, there is a price movement in the stock that would be
considered significant. You might remember reading about “a
stock jumping 3 1/2 points after Smith Barney (for example) issued
an optimistic earnings report”.
The market varies in the extremes of its price over a calendar year
an average of 21%. 3 1/2 points on a $25 stock is about 14%. So
by the time the research information gets to us, the public, it
is likely that a nice percentage of appreciation has already occurred.
(The positive points that the analyst wants to make are then what
professionals call “discounted into the price”).
If you are a long-term investor, buy the stock and forget it. However,
if you are trading within this 21% average range of the stock market
annually, much of your profit may already be gone. Hence the necessity
of doing your own research.
What Aids Are There To Help Us In Our Decision
Making Process?
We could break publicly available research material into
two different categories: (1) those services that are available
from, and/or influenced by, stock brokerage firms, and (2) those
services that are completely independent of the influence of brokerage
firms and financial institutions who benefit from the purchase or
sale of stocks and bonds. Mainstream publications like the Wall
Street Journal, Fortune Magazine, Business Week, and so forth, including
CNBC, and programs like that, are all financed by, and beholden
to, brokers, or other advertisers whose advice is mostly designed
to make money for those institutions. While most of them are honest,
they all have paid huge fines the last few years, pointing out that
even honest institutions allow self interest to interfere with sound
investment judgment and advice.
On the other hand, there is a cadre of publications available for
interested investors. Dow Theory Letters (www.dowtheroryletters.com)
provides a daily market summery and a newsletter every 3 weeks that
is an excellent analyses of market conditions. Dow Theory Letters
is the oldest, most independent review of the market available today.
Value oriented investors can use a publication called IQ Trends
(www.iqtrends.com).
IQ Trends is also an independent, old publication started by Geraldine
Weiss whose theory is DIVIDENDS DON’T LIE. Mrs. Weiss follows
350 of the best-capitalized, most secure stocks in the US. She has
broken stocks into undervalued stocks (buying area), rising stocks
(still a value but getting to be less so), overvalued stocks (do
not buy), and declining trends (to keep track of stocks that may
soon be at historical “value prices”). This service
is available twice a month, either online or through the mail. If
ordering IQ Trends, be sure to get the complimentary book published
by Mrs. Weiss that points out why dividends are so important in
calculating total returns entitled The Dividend Prescription.
While the above two publications will provide entree into other
things to read, there are additional bedrock publications which
are independent and can help us in understanding the macroeconomics
of investments in today’s rapidly changing economic climate.
The American Institute for Economic Research (www.aier.org)
publishes an “Economic Education Bulletin” every month.
It’s excellent and only $25 a year. Adrian Van Eck has several
monthly publications, but only one is a monthly economic publication,
Money-Forecast Letter (1-800-542-5018). One classic book stands
out written by deceased Columbia Professor Benjamin Graham called
The Intelligent Investor. The authors’ website, www.gwrauch.com,
has posted several articles that can answer investment questions
common to all of us. Finally, Value Line has a service (www.valueline.com)
called Value Line Investment Survey 3.0 that is free for 30 days
and follows all of the major listed U.S. companies. And you can
use the service to sort stocks any way you’d like. (For example,
I separate stocks by rating (ONLY “A” rated or better)
then by yield (ONLY 3% or better, etc.).
Over a period of time, the average dividend yield on the Dow Jones
30 Industrials is 4.3% which means that $4.30 is paid out for every
$100 invested. The average price earnings ratio from 1920 to the
present is 14.4 times earnings. If we discipline ourselves to buy
only A rated stocks that are at or below 14.4 times earnings and
that provide a minimum yield of 4.3%, the odds of making money in
this market increase dramatically. Especially if we purchase these
stocks when the market sells off (like from 10,700 last year to
9,000, and like it might also sell off this year).
Current State of the Economy
Because of the lowering of interest rates, the government’s
deficit spending, the Federal Reserve’s manufacturing of money,
and because foreigners are willing to take US bonds in exchange
for our trade deficit, the economy, so far, has enjoyed a soft landing.
The economics of the current situation of the United States are
troublesome, and over the long run we may pay dearly for today’s
economic dysfunctions. There is no doubt, however, that cash flow
has increased. An increase in cash flow can be associated with increased
earnings (or profitability) and inflation. In our case, it is both.
Should we be able to muddle through this for the next several years
without large further increases in the government deficit, the trade
deficit, and additional consumer borrowing, we may just luck out
due to the shear power, and size, of this economy.
In the process of accumulating trade deficits, so much new debt,
and government spending deficits, the dollar has become less desirable
because of the additional debt obligations accrued to the dollar.
While the magnitude of these economic dislocations is troubling,
and while other countries are threatening to diversify their foreign
exchange holdings out of dollars and into currencies like the Euro
and the Yen, it’s important to remember that the rest of the
free world is heavily dependant upon the US economy and our spending
habits. We still represent only 4 1/2 % of the world’s population,
and we account for more than 30% of the world’s $33 trillion
annual GDP. Never in history has one country created prosperity,
for the rest of the world, of such a magnitude, in such a short
period of time.
Conclusion
While cash flow has increased, which is positive, the intelligent
investor should not expect the market to perform at levels much
higher than existing today. This market is already over priced,
and it’s a miracle the market remains at these levels. The
government’s whole program so far has worked: “keep
the market from “crashing”, and allow earnings over
a period of several years to catch up with the current level of
the market”.
Currently
the Dow Jones Industrial Average, and the yield on those stocks,
is at a price that is historically high. Because the price earnings
ratio is 30% above the mean 14.4 times average historical price
earnings ratio, and because the cash yield on stocks is historically
low, one must accept that mathematically the market is not a buy.
There is high risk of an investor losing principal if the market
returns to historical averages quickly. On the other hand, there
are usually selective opportunities. Waiting for the market to reverse
itself, in its annual downward trend, might provide interesting,
and profitable, buying opportunities later on this year.
Caveat Emptor!
George Rauch
March 1, 2005
