Walk Down Wall Street Stock Valuation From

Walk Down Wall Street

Stock Valuation from the Sixties through the Nineties

Malkiel notes that there were a number of speculative trends from the 1960s to 1990s, and that they all mended up in the same way. Every few years, the stock market has another bubble or speculative mania which soon crashes and levels off, such as overvalued food stocks in the 1980s or the Nifty Fifty blue chips in the 1970s, but in both cases the speculative phase ended and stocks returned to their normal values. By the 1990s, institutions accounted for more than 90% of the trading volume on the NYSE, and yet professional investors participated in several distinct speculative movements from the 1960s through the 1990s. In each case, professional institutions bid actively for stocks not because they felt such stocks were undervalued under the firm foundation principles, but because they anticipated that some greater fools would take the shares off their hands at even more inflated prices (Yan, p. 5).

The Soaring Sixties

1. The New "New Era": The growth-stock/New-issue craze:

a. Growth was the magic work in those days, taking on an almost mystical significance. More new issues were offered in the 1959-62 period than at any previous time in history. It was called the "tronics boom," because the stock offering often included some garbled version of the word "electronics" in their title, even if the companies had nothing to do with the electronics industry.

b. Jack Dreyfus commented on the mania as follows: a shoelace making firm changed the name from Shoelaces, Inc. To Electronics and Silicon Furth-Burners. In today's market, the words "electronics" and "silicon" are worth 15 times earnings. However, the real play comes from the word "furth-burners," which no one understands.

c. The SEC uncovered many evidence of fraudulence and market manipulation in this period. Many underwriters allocated large portions of hot issues to insiders of the firms such as partners, relatives, officers, and other securities dealers to whom a favor was owed. The tronics boom came back to earth in 1962.

2. Synergy Generates Energy: The Conglomerate Boom.

a. Part of the genius of the financial market is that if a product is demanded, it is produced. The product that all investors desired was expected growth in earnings per share. By the mid-1960s, creative entrepreneurs had discovered that growth meant synergism, which is the quality of having 2 plus 2 equal 5.

b. In fact, the major impetus for the conglomerate wave of the 1960s was the acquisition process itself could be made to produce growth in earnings per share. The trick is the ability of the acquiring firm to swap its high-multiple stock for the stock of another firm with a lower multiple. The targeting firm can only "sell" its earnings at multiple of 10, say. But when these earnings are packaged with the acquiring firm, the total earnings could be sold at a multiple of 20.

c. As a result of such manipulations, corporations are now required to report their earnings on a "fully diluted" basis, to account for the new common shares that must be set aside for potential conversions. The music slowed drastically for the conglomerates on January 19, 1968. On that day, the granddaddy of the conglomerates, Litton Industries, announced that earnings for the second quarter of that year would be substantially less than had been forecast. In the selling wave that followed, conglomerate stocks declined by roughly 40% before a feeble recovery set in.

d. The aftermath of this speculative phase revealed two factors. First, conglomerates were mortal and were not always able to control their far-flung empires. Second, the government and the accounting profession expressed real concern about the pace of mergers and about possible abuses. Few mutual or pension funds were without large holdings of conglomerate stocks. They were hurt badly.

During the 1980s and 1990s de-conglomeration came into fashion. Many of the old conglomerates began to shed their unrelated, poor-performing acquisitions to boost their earnings.

3. Performance comes to the market: the bubble in Concept stocks

a. With conglomerates shattering about them, the managers of investment funds found another magic word: performance in the late 1960s. The commandments for fund managers were simple: Concentrate your holdings in a relatively few stocks and don't hesitate to switch the portfolio around if a more desirable investment appears. And because near-term performance was important it would be best to buy stocks with an exciting concept and a compelling and believable story (Yan, p. 6).

b. Cortess Randall was the founder of National Student Marketing (NSM). His concept was a youth company for the youth market. Blocks of NSM were bought by 21 institutional investors. Its highest price was 35.25. However, in 1970, its lowest price was 7/8.

II. The Sour Seventies

1. In the 1970s, Wall Street's pros vowed to return to "sound principles." Concepts were out and investing in blue-chip companies was in. They were called the "Nifty Fifty," also "one decision" stocks. You made a decision to buy them, once, and your portfolio-management problems were over.

2. Hard as it is to believe, the institutions had started to speculate in blue chips. In 1972, P/E for Sony is 92, for Polaroid is 90, for McDonald's is 83. Institutional managers blithely ignored the fact that no sizable company could ever grow fast enough to justify an earnings multiples of 80 or 90.

3. The end was inevitable. The Nifty Fifty were taken out and shot one by one.

III. The Roaring Eighties

1. The Triumphant Return of New issues: the high-technology, new-issue boom of the first half of 1983 was an almost perfect replica of the 1960s episodes, with the names altered to include the new fields of biotechnology and microelectronics. The total value of new issuers in 1983 was greater than the cumulative total of new issues for the entire preceding decade.

2. Concepts Conquer Again: the Biotechnology Bubble: valuation levels of biotechnology stocks reached an absurd level. In 1980s, some biotech stocks sold at 50 times sales.

3. From the mid-1980s to the late 1980s, most biotechnology stocks lost three-quarters of their market value.

IV. The Nervy Nineties

1. One of the largest booms and busts of the late twentieth century involved the Japanese real estate and stock markets. From 1955 to 1990, the value of Japanese real estate increased more than 75 times. By 1990, Japan's property was appraised to be worth 5 times as much as all American property.

2. Stock prices increased 100-fold from 1955 to 1990. At their peak in Dec 1989, Japanese stocks had a total market value of about $4 trillion, almost 1.5 times the value of all U.S. equities and close to 45% of the world's equity market capitalization.

Stocks sold at more than 60 times earnings, almost 5 times book value, and more than 200 times dividends (Yan, p. 7).

3. The financial laws of gravity know no geographic boundaries. The Nikkei index reached a high of almost 40,000 on the last trading day of the decade of the 1980s. By mid-August 192, the index had declined to 14,309, a drop of about 63%. In contrast, the DJIA fell 95% from Dec 1929 to its low in the summer of 1932.

Chapter 4: The Biggest Bubble of All: Surfing on the Internet

One of the greatest speculative bubbles, at least before the 2008-09 crash, was the Dot.com and New Economy bubble of the 1990s, which crashed in the early 2000s. It was no different from the railroad manias of the 19th Century, the South Sea Bubble of 1720, and the IPO, electronics and conglomerate mania of the 1960s. All of these had their heyday, and those who bought early and sold before the crash made money, but there was a reason that Wall Street kept the speculative high-tech stocks in a separate market, since many of these Internet companies would be here today and gone tomorrow, with only a few survivors. Despite the constant speculative mania, Malkiel still believes in the efficient markets theory and that they will always weed out frauds, scams, corruption and inefficiency.

Chapter 4. The Biggest Bubble of All: Surfing on the Internet

1. The NASDAQ Index, an index essentially representing high-tech New Economy companies, more than triples from late 1998 to March 2000. The P/E ratios of the stocks in the index that had earnings soared to over 100.

2. Amazon sold at prices that made its total market cap larger than the total market values of all the publicly owned booksellers such as Barnes & Noble. Priceline sold at a total market cap that exceeded the cap of the major carriers United, Delta, and American Airlines combined.

3. Cooper, Dimitrov and Rau found that 63 companies that changed their names to include some Web orientation enjoyed a 125% greater increase in price during 10 day Cooper, Dimitrov and Rau found that 63 companies that changed their names to include some Web orientation enjoyed a 125% greater increase in price during 10 day period than that of their peers. In the post-bubble period, they found that stock prices benefited when dot-com was deleted from the firm's name.

4. The relationship between profits and share price had been severed.

5. Security analysts $peak up:

a. Mary Meeker was dubbed by Barron's the "Queen of the Net." Henry Blodgett was known as "King Henry." Henry flatly stated that traditional valuation metrics were not relevant in "the big-bang stage of an industry." Meeker suggested that "this is a time to be rationally reckless."

b. Traditionally, ten stocks are rated "buys" for each on that is rated "sell, but during the bubble, the ratio of buys to sells reached close to 100 to 1.

6. The writers of the media: the bubble was aided and abetted by the media -- which turned us into a nation of traders. Journalism is subject to the laws of supply and demand. Since investors wanted more information about Internet investing opportunities, the supply of magazines increased to fill the need.

7. The result was that turnover reached an all-time high. The average holding period for a typical stock was not measured in years but rather in days and hours. Redemption ratios of mutual funds soared and the volatility of individual stock prices exploded.

8. History tells us that eventually all excessively exuberant markets succumb to the laws of gravity. In the early days of automobile, we had close to 100 automobile companies, and most of them became road kill. The key to investing is not how much industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.

9. The lesson here is not that markets occasionally can be irrational and, therefore, that we should abandon the firm foundation theory. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality -- albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors, but eventually, true value is recognized by the market, and this is the main lesson (Yan, p. 8).

Chapter 6: Technical Analysis and the Random-Walk Theory

Malkiel believes that technical analysis of the markets is completely bogus and will not work at all. He finds that almost all of its supposed correlations are false, and even attempts to prove it by showing a ridiculous link between the stock market and the hemlines of women's dresses. This chapter is basically a complete decimation of technical analysis; there's no other way to really put it. Those who are constantly trying to find correlations on charts are too abstract and removed from day-to-day reality, and this makes the effect of false correlations even worse.

Technical and Fundamental Analysis

The efficient market theory (from academics) has three versions -- the "weak," the "semi-strong," and the "strong." All three forms espouse the general idea that except for long-run trends, future stock prices are difficult, if not impossible, to predict. The weak form attacks the underpinnings of technical analysis, and the semi-strong and strong forms argue against many of the beliefs held by those using fundamental analysis.

I. Technical vs. Fundamental analysis:

1. Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks.

2. Technical analysis is essentially the making and interpreting of stock charts. Thus its practitioners are called chartists. Most chartists believe that the market is only 10% logical and 90% psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave. Charts tell only what the other players have been doing in the past. The chartist's hope, however, is that a careful study of what the other players are doing will shed light on what the crowd is likely to do in the future (Yan, p. 10).

3. Fundamental analysts believe the market is 90% logical and only 10% psychological. Fundamentalists believe that eventually the market will reflect accurately the security's real worth. Perhaps 90% of the Wall Street security analysts consider themselves fundamentalists.

II. What Can Charts Tell You?

1. The first principle of technical analysis is that all info about earnings, dividends and the future performance of a company is automatically reflected in the company's past market prices.

2. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest. As John Magee wrote in the bible of charting, Technical Analysis of Stock Trends, "Prices move in trends and trends tend to continue until something happens to change the supply-demand balance."

III. The Rationale for the Charting Method

To me, the following explanations of technical analysis appear to be the most plausible.

1. Trends might tend to perpetuate themselves for either of two reasons. First, it has been argued that the crowd instinct of mass psychology makes it so. When investors see the prices of a speculative favorite going higher and higher, they want to jump on the bandwagon and join the rise.

2. Second, there may be unequal access to fundamental info about the firm.

When some favorable piece of news occurs, it is alleged that the insiders are the first to know and they act, buying the stock and causing its price to rise.

The insiders then tell their friends, who act next. Then the professionals find out the news and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs get the info and buy. This process is supposed to result in a rather gradual increase/decrease in the price of the stock when the news is good/bad.

3. Chartists are convinced that even if they do not have access to this inside info, observation of price movements alone enables them to pick up the scent of the 'smart money' and permits them to get in long before the general public.

IV. Why Might Charting Fail to Work?

1. First, the chartist buys in only after price trends have been established, and sells only after they have been broken. Because sharp reversals in the market may occur quite suddenly, the chartist often misses the boat. By the time an uptrend is signaled, it may already have taken place.

2. Second, such techniques should ultimately be self-defeating. As more and more people use it, the value of any technique depreciates.

V. The Techniques of Fundamental Analysis

1. The technician is interested only in the record of the stock's price, whereas, the fundamentalist's primary concern is with what a stock is really worth. His most important job is to estimate the firm's future stream of earnings and dividends. To do this, he must estimate the firm's sales level, operating costs, corporate tax rates, depreciation policies and the sources and costs of its capital requirements (Yan, p. 11).

2. Because the general prospects of a company are strongly influenced by the economic position of its industry, the obvious starting point for the security analyst is a study of industry prospects. Indeed, in almost all professional investment firms, security analysts specialized in particular industry groups.

VI. Why Might Fundamental Analysis Fail to Work?

1. There are three potential flaws in this type of analysis. First, the information and analysis may be incorrect.

2. Second, the security analyst's estimate of "value may be faulty."

3. Third, the market may not correct its "mistake" and the stock price might not converge to its value estimate.

4. To make matters even worse, the security analyst may be unable to translate correct facts into accurate estimates of earnings for several years into the future. Even if the security analyst's estimates of growth are correct. This information may already be reflected accurately by the market, and any difference between a security's price and value may result simply from an incorrect estimate of value.

5. The final problem is that even with correct info and value estimates, the stock you buy might still go down. Not only can the average multiple change rapidly for stocks in general but the market can also dramatically change the premium assigned to growth. One should not take the success of fundamental analysis for granted.

VII. Using Fundamental and Technical Analysis Together.

Many analysts use a combination of techniques to judge whether individual stocks are attractive for purchase.

1. Rule 1: buy only companies that are expected to have above average earnings growth for five or more years. An extraordinary long-run earnings growth rate is the single most important element contributing to the success of most stock investment. The purchaser of a stock whose earnings begin to grow rapidly has a chance at a potential double benefit -- both the earnings and the multiple may increase.

2. Rule 2: never pay more for a stock than its firm foundation of value.

Generally, the earnings multiple for the market as a whole is a helpful benchmark. What is proposed is a strategy of buying unrecognized growth stocks whose earnings multiples are not at any substantial premium over the market. In sum, look for growth situations with low price-earnings multiples. If the growth takes place, there's often a double bonus -- both the earnings and the multiple rise, producing large gains.

Beware of very high multiple stocks in which future growth is already discounted. If growth doesn't materialize, losses are doubly heavy -- both earnings and the multiples drop (Yan, p. 12).

3. Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air. The above rules seem sensible; the point is whether they really work? -- Not really (However, the author uses these rules as advice for those investors who want to pick stocks by themselves, though he strongly recommend investors

Chapter 11: Potshots at the Efficient-Market Theory and Why They Miss

Malkiel restates his central thesis in this chapter, that the markets are efficient and tend to eliminate speculative bubbles, and that stock prices always correct back to the mean. He attempts to disprove most opponents of the efficient markets theory, although he struggled to deconstruct Benjamin Graham's argument about how value stocks will always have high values. Malkiel points out that over a long period, both growth and value stocks do match up with the overall market, but value stocks do not have the monstrous dips that growth stocks have. Robert Shiller concluded from a longer history of stock market fluctuations that stock prices show far "too much variability" to be explained by an efficient-market theory of pricing, and that one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market.

The author reviewed all the recent research proclaiming the demise of the efficient-market theory and purporting to show that market prices are, in fact, predictable.

His conclusion is that such obituaries are greatly exaggerated and that the extent to which the stock market is usefully predictable has been vastly overstated. He shows that following the tenets of the efficient-market theory -- that is, buying and holding a broad-based market index fund -- is still the only game in town. Although market may not always be rational in the short run, it always is over the long haul.

I. What do we mean by saying markets are efficient?

1. Markets can be efficient even if they sometimes make egregious errors in valuation. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends.

2. Economists view markets as amazingly successful devices for reflecting new info rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don't allow investors to earn above average returns without accepting above-average risks.

3. No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market (Yan, p. 18). And while there are undoubtedly profitable trading opportunities that occasionally appear, there are quickly wiped out once they become known. No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs.

II. Potshots that completely miss the target

1. Dogs of the Dow: out-of-favor stocks eventually tend to reverse direction. The strategy entailed buying each year the ten stocks in the DJ that had the highest dividend yields. The idea was that these ten stocks were the most out of favor, so they typically had low price-earnings multiples and low price-to-book-value ratios as well. This strategy consistently underperformed the overall market during the last half of the 1990s. "The strategy became too popular" and ultimately self-destructed.

2. January Effect: stock-market returns have tended to be especially high during the first two weeks of January. The effect appears to be particularly strong for smaller firms. One possible explanation for it is that tax effects are at work. Some investors may sell securities at the end of the calendar year to establish short-term capital losses for income tax purposes. Although this effect could be applicable for all stocks, it would be larger for small firms because stocks of small companies are more volatile and less likely to be in the portfolios of tax exempt institutional investors and pension funds. However, the transaction costs of trading in the stocks of small companies are substantially higher than for larger companies (because of the higher bid-asked spreads) and there appears to be no way a commission-paying ordinary investor could exploit this anomaly.

3. Hot news response: some academics believe that stock prices underreact to news events and, therefore, purchasing (selling) stocks where good (bad) news comes out will produce abnormal returns. Fama found that apparent under-reaction to info is about as common as overreaction, and post-event continuation of abnormal returns is as frequent as post-event reversal.

4. It is obvious that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct. Indeed, the January effect became undependable after it received considerable publicity.

III. Potshots that get close but still miss the target

1. Short-term momentum: Lo and Mackinlay found that for two decades broad portfolio stock returns for weekly and monthly holding periods showed positive serial correlation. Moreover, Lo and others have suggested that some of the stock-price pattern used by so-called technical analysis may actually have some modest predictive power. Behavioral economists find such short-run momentum to be consistent with psychological feedback mechanisms. Individuals see a stock price rising and are drawn into the market in a kind of "bandwagon effect." However, two factors prevent us from believing markets are inefficient (Zan, p. 19):

a. It is important to distinguish statistical significance from economic significance. The statistical dependencies giving rise to momentum, in fact, are extremely small and are not likely to permit investors to realize excess returns.

b. We should ask whether such patterns of serial correlation are consistent over time.

2. The dividend jackpot approach: Depending on the forecast horizon involved, as much as 40% of the variability in future market returns can be predicted on the basis of the initial dividend yield of the market as a whole. Investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high. These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high (low) when interest rates are high (low). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the dividend behavior of U.S. corporations may have changed over time. Companies in 21st century may be more likely to institute a share repurchase program rather than increase their dividends. Thus dividend yield may not be as meaningful as in the past. Finally, this phenomenon does not work consistently with individual stocks. Investors who simply purchase a portfolio of individual stocks with the highest dividend yields in the market will not earn a particularly high rate of return.

3. The Initial P/E predictor: Campbell and Shiller report that over 40% of the variability in long-horizon returns can be predicted on the basis of the initial market P/E.

4. Long-run return reversals: buying stocks that performed poorly during the past three years or so is likely to give you above-average returns over the next three years. However, return reversals over different time periods are often rooted in solid economic facts rather than psychological swings. The volatility of interest rates constitutes a prime economic influence on share prices. Because bonds -- the front-line reflectors of interest-rate direction -- compete with stocks for the investor's dollars, one should logically expect systematic relationships between interest rates and stock prices. When interest rates go up, share prices should fall, other things being the same, so as to provide larger expected stock returns in the future. Only if this happens will stocks be competitive with higher yielding bonds. Similarly, when interest rates fall, stocks should tend to rise, because they can promise a lower total return and still be competitive with lower yielding bonds.

5. The small firm effect: since 1926, small firms have produced returns over 1.5% points larger than the returns from large stocks. But, small stocks may be riskier than larger stocks and deserve to give investors a higher rate of return. Thus, even if this effect was to persist in the future, it's not at all clear that such a finding would violate market efficiency. Moreover, this effect may due to "survivorship bias." And in most world markets it was the larger cap stocks that produced larger rates of return.

IV. Why even close shots miss

1. Regarding to internet bubble, when we know ex-post that major errors were made, there were certainly no clear ex-ante arbitrage opportunities available to rational investors. Even when clear mispricing arbitrage opportunities seem to have existed, there was no way to exploit them (Zan, p. 20).

2. The most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. But the fact is that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. During the past 30 years, about two-thirds of the funds proved inferior to the market as a whole. The same result also holds for professional pension fund managers. There are some funds which beat index, but the problem for investors is that at the beginning of any period they can't be sure which funds will be successful and survive.

V. A Summing Up

1. Market valuation rest on both logical and psychological factors.

2. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into market prices. Prices adjust so well to reflect all-important info that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts.