The Stock Market for Dummies


(E) While the stock market is unpredictable, its patterns are very repetitive. Those patterns are the same whether the stock market behaves and investors are making money or the stock market misbehaves and investors are losing money. Those patterns are as well the same over any time frames: intra-day, day, month or year. In 2008, the best portfolio performances were in the – 30% range while the worst performance was in the – 60% range. Understanding the behavior of the market is not sufficient to master its moves but certainly is beneficial to manage the risks of investing. So following is a reminder for the wise about the repetitive patterns of the stock market.

If the Stock Market were Predictable, No One Could Make or Lose Money

Every day at the closure of the NYSE on CNBC, after talking to many traders on the floor, Bob Pisani does a wonderful summary of what has moved the market up or down. But at the opening of the NYSE, traders could never tell to Bob, what will move the market up or down, when it will move it and how much will be the move up or down. The unpredictability of the stock market is due to the relationship between the “causes” and the “effects” of price variations that can only, somewhat and sometimes be understood after the fact. The same cause can one day makes the traders bullish but the following day bearish. It is because the market is unpredictable that someone can make or lose money.

The Stock Market Exists Because Prices are Changing Between Places and Over Time

The value of equities is based on uncertain future cash flows, bonds on interest rates, commodities on supply and demand and currencies on the economic health of the country.

The same asset is never traded at the same price between New York and Paris or between Hong-Kong and London. And at the same exchange, the price of an asset always changes over time. If the value of any asset will be always the same at any time and anywhere, why someone would be ready to trade it?

Timing is Everything to Gain or to Lose on the Stock Market

The challenge for any investor who wants to profit from the stock market is timing: being long on an asset rising or surfing a bubble for a class of assets early on in its formation and being short on an asset falling or stop surfing a bubble just before its crash. Very often, stocks with low P/E are more likely to rise and stocks with high P/E are more likely to fall. But in all cases, right timing and the portfolio is profitable. Wrong timing and the portfolio is losing money.

Expect Gray Swans in the Stock Market at any Time

Most of the time, prices are changing by a few percentages up or down of the time. In that case, market returns seem to converge to a mean, the magic 7% yearly return. But that can change at any time during a day, a few weeks or a few months. Stocks can have large price variations. Up and down. Asset prices are “discontinue”. In October 1987 during Black Monday, or in 2008 during the collapse of the US Financial System: prices jumped to the abyss. While in 2000 during the exuberance of the Internet bubble: prices jumped to the sky. Black Monday, the Internet bubble and the collapse of the US financial system are “Gray Swans”. Named by Nassim Taleb, Gray Swans are outliers that are outside “normal” expectations and have a dramatic impact on the markets.

The Three States of The Market Volatility

Stock prices bounce a lot and move in irregular trends. Volatility can take three states, mild, wild and slow:

  • Mild volatility occurs when stock prices have moderate moves and commonly observed over any time series. In that case, market returns converge toward a mean.
  • Wild volatility when stock prices have large jumps and only observed during market irrational exuberances or market crashes. In that case, market returns can be extremely low or high.
  • Slow volatility when prices are not changing much and observed when there is no market news to move the market or in August when traders are on vacations.

You Cannot Predict Price Moves but You Can Predict their Volatility

The volatility of the stock market is predictable. Price moves have a long-term dependency. A given event can affect other events in the future or other events elsewhere. In particular, shocks from Gray Swans to the stock market can have high degrees of persistence over large periods of time. Volatility clusters like the aftershocks of an earthquake after a Gray Swan. That was very much the case during the collapse of the US Financial System when in October 2008 the DJI traded in a 1,000 range pushing the S&P 500 Volatility Index (VIX) to 75 while its normal range is between 12 and 25. When prices are substantially higher or lower, further large price moves will follow. And, volatility clusters more after a stock market fall than after a stock market rise.

The Damage of a Gray Swan to the Return of a Portfolio

Gray Swans have a significant impact on a portfolio. Returns on an asset class are highly dependent on the cumulative effects of positive and negative Gray Swans. Unfortunately, the cumulative impacts of the negative Gray Swans are more damaging on a portfolio than the cumulative impacts of the positive Gray Swans. So do not expect the losses created by the negative Gray Swans to be totally compensated by the profits created by the positive Gray Swans.

Recent research by Professor Javier Estrada from the IESE Business School in Barcelona illustrates very well that point:

“ From 1990 to 2006, on average across 15 stock markets (Canada, France, Hong Kong, Japan, Singapore, Spain, UK, US…) missing the best 10, 20, and 100 days resulted in a reduction of 43.3%, 62.3%, and 95.2% in terminal wealth relative to a passive investment. Avoiding the worst 10, 20, and 100 days, in turn, resulted in an increase in terminal wealth of 87.9%, 204.4%, and 6,268.5%, again relative to passive investment.”

Is Warren Buffet the Smartest of the Luckiest Investor of All time?

I do not know. What I know is that Mr. Buffet is a very likable and ethical investor. He is extremely smart. He has been very selective in investing at a low cost in growing businesses with good management teams and competitive advantages. He has also been lucky to have invested at the beginning of the long-term economic expansion of the 20th century that has driven the Dow Jones so high in particular since the 80s. But will the stock market go higher in the 21 century and could the returns achieved by Mr. Buffet be repeated by another Warren Buffet? 

Note: The painting above is from a talented Hong-Kong artist.

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