THE WISDOM OF CROWDS AND STOCK MARKET PRICES

by Brian Durno, CFA – December 26, 2011

The stock market is a forward looking pricing mechanism.

In the short term, a stock price reflects the balance between supply by sellers and demand by buyers. In a typical trading day, thousands of market participants interact and agree on a price. Every millisecond, there is price discovery. A buyer and seller agree on a price that represents the entire stream of cash flow to be produced by a company for over its expected lifespan.

Imagine, on your graduation day from university, there are thousands of people setting a price on what they anticipate your net worth will be over the course of your entire lifetime. Informed fundamental investors are fully up to date on all publicly available news on the company and the historical record of financial results. There may be general agreement on the historical facts, so why then is there such dramatic volatility in the short term movements of stock price?

Short term supply and demand for a stock can be influenced by many variables other than facts. In many cases, a fixation on the most recent experience is extrapolated long into the future and this point of view is not objectively questioned. In this way, the emotional state of the participants plays an important role in influencing short term decisions.

It is during times of heightened emotion that you will find the most mistakes being made in an auction market pricing mechanism like the stock market. Emotion, in this case, works both ways, negative and positive. Fear and panic produce as many mistakes as greed and excitement. For an example of this phenomenon, we will review some critical points during the last eleven years or so of the Canadian stock market, represented by the S&P/TSX Composite Index.

TSX Index

It is the summer of the year 2000. The TSX index reaches 11,402, the peak of the technology lead bull market. The bubble bursts and by the fall of 2001 the TSX index fell to 6,301 a decline of 44.7%. Fast forward a few months to the spring of 2002 and it looks like the worst is behind us, the TSX closes at a level of 7,992, an increase of 26.8% in a very short time period.

However, by the fall of 2002 the TSX hits new lows and closes at 5,678, a 29% decline from what seemed like the bottom in the spring of 2002. From this low, had you been advised that something very dramatic was about to happen and that you should certainly not sell your stocks and perhaps you should think of adding money to the markets, you may have had good reason to think this advice was crazy. You would have found no shortage of analysts, economists and even some very successful portfolio managers that had produced great returns for their clients short selling stocks for the past three years, advising you of the opposite point of view. It would have felt comfortable to agree with this latter group, take their advice and avoid stocks.

Unfortunately, that would have been bad advice. From the fall of 2002 to the spring of 2006, the TSX climbed a staggering 120%, closing at 12,495. This bull market occurred without a single 10% market correction, pretty much straight up for over four years.  Many short sellers were out of business and the economists had “revised” their forecasts.

If you received advice in the spring of 2006 to avoid stocks because there appeared to be trouble brewing in the markets, it would have also seemed a little “out of touch” considering the recent bull run the market just experienced. Assuming you took the advice and sold your stocks, you would have felt validated as the first market correction in over 4 years occurred in the summer of 2006, with the index closing at 10,861, a decline of just over 13%.

Happy with the advice, you continue to listen and avoid stocks. By the summer of 2008, the index has ignored your expert advisor and has gained 39.5% to close at 15,155 while you remained in cash. The key question is what to do at this point?  You’ve been wrong for over 2 years and everyone seems to making money in the stock market.

We all know what happens after the summer of 2008, the TSX declines 50.6% 7,479.96 by the spring of 2009, during the financial crisis. The TSX subsequently recovered over the next 2 years, reaching 14,329 in March of 2011 before suffering another correction bringing us to 11,695 as of December 2011.

Considering the widespread coverage of financial media, there are literally thousands of opinions on the markets provided every day. You don’t need a mathematics degree to realize that with a large enough sample size of opinions, there will always be someone who calls a market top or a market bottom correctly in advance of the event occurring.

However, we have yet to find one person that has consistently been able to accurately predict market tops and or bottoms (in advance). Warren Buffett published his now famous op-ed in the New York Times on October 17, 2008 titled, “Buy American, I am”, where he argued that now was the time to be buying stocks. The S&P 500 closed the night before at 946.43, 40% below its peak in 2006.

The interesting point to note is that  Warren Buffett’s advice was wrong before it was right. In March of 2009, the S&P 500 slumped to 666.79 almost 30% below the level that Buffett advised buying stocks. Today the S&P 500 level is about 1,234. The key point to this discussion is that the best time to invest is typically when things look the worst.

At these times the majority of market commentary will be focused on one side of an argument. When we enter periods that are full of confusion and the majority of market  commentary is negative, these are generally the conditions that present opportunities in the stock market. At The Investment Partners Fund, the Portfolio Managers have 100% of their investable net worth invested in the Fund alongside unitholders.

Unitholders can be sure that 100% of our energy is committed to finding these opportunities and providing strong long term risk adjusted performance.

We have our money where our mouth is.

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