3/24/14 – Is the Stock Market a Herd of Cows?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 24, 2014 8:40:57 AM

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I realize the headline sounds like Chance the Gardener from Being There, but let’s use this image as a way to look at whether you can, in fact, time the stock market.

Value investors, notably Warren Buffett, consider it possible to value companies—that is, to determine how much a company should be worth on a fair basis. Their strategy is to buy shares of those companies when the price is less than what they consider fair value and then wait for the price to come back up. In other words, they’re timing individual stocks. I’m not prepared to argue against Mr. Buffett’s ability to do what he says, and enough other investors have done the same thing to suggest it’s not just him.

Similarly, growth investors expect to be able to buy future growth cheaply and benefit from current mispricing. Again, there are enough examples of success to show that this can work.

At a different level, a farmer buying a cow is doing exactly the same thing. He’s looking at the future costs and benefits of that cow, and deciding whether it’s worth the price. Companies are sometimes referred to as “cash cows,” which makes the comparison explicit. If a farmer can buy a cow successfully, so too can an investor buy a share of stock at a good price.

The question then becomes, can a farmer successfully buy a herd of cows? Or does the fact that he’s buying more than one make it impossible to decide whether it’s a good purchase? On the face of it, this is a silly question. Why should it be harder to decide how much to pay for a herd of cows, as opposed to one cow?

With respect to the stock market, this is exactly the argument you often hear. If a company is like a cow, then the stock market is just a group of companies, or a herd of cows. The idea that it’s impossible to determine whether the stock market is cheap or expensive, and to trade on that determination, essentially devolves to the assertion that you can’t profitably buy and sell a herd of cows.

I certainly don’t know enough about farming to say if that’s true or not, but I strongly suspect it isn’t. In either case, though, it highlights an inconsistency that investors have to grapple with.

If the market is efficient, then it should be efficient at the company level as well—which is to say that active management shouldn’t work. If that’s the case, then buy-and-hold is the only strategy that makes sense, If, however, the market is not efficient, if company mispricings exist, then active management can work—to the relief of all the mutual fund and hedge fund managers out there. But it should also be possible to actively manage the market as a whole, as well as at the company level.

Barring some reason that a herd of cows is fundamentally different to buy than a single cow, mixing the two positions is not logically consistent. The argument that the market as a whole is different has some merit: portfolios do act differently than individual companies, just as herds of cows do from individual cows. The question is whether the portfolio effects overwhelm the basic nature of the individual unit.

Given the large changes in pricing, at the market level, that we’ve repeatedly witnessed, as well as the success of various simple quantitative market signals, which I’ve discussed before, the weight of the evidence suggests it is indeed possible to time the market, just as it’s possible to buy a herd of cows. That doesn’t guarantee success, of course, but the fact that it does seem to be possible runs counter to what most investors out there believe.

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Tune in to CNBC's Power Lunch on Wednesday, February 26, between 1:45 and 3:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Check local listings for availability. 

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

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