PDF Version: P123 Strategy Design Introduction – We Can Get a Handle on Stock Prices
Stock pricing is not random. It is not arbitrary. It is not mired in conspiracy and manipulation (and if the SEC finds instances to the contrary, life would likely get very ugly for the perpetrators). Actually, stock pricing is one of the most rational phenomena in the human condition. That doesn’t mean it’s easy to master, so no, don’t run out and bet everything you have on your favorite stock. But there’s a difference between randomness, etc. and rational-but-difficult. The former is prescription for hopelessness. With the latter, however, there are things we can do to master the process and boost the probabilities in our favor as best we can, which for thoughtful investors, has been and can be well worthwhile.
An Auction – Chapter 1
The large bright chandelier illuminated room is packed with eager investors. Some are elderly retirees looking to secure their golden years. Some are twenty-somethings looking strike it rich. There are many mainstream careerists here, some in the finance profession but many who work in other fields.
The din gradually grows and heads start turning toward stage right at the front of the room. Tuxedo-clad John M. (the M stands for Market) appears from the wings and strides purposefully to the podium located at the center of the stage. The din grows louder until he raises his right hand and motions for silence.
The audience quiets.
Mr. Market reaches into his right rear pocket and takes out his wallet. He takes something from it and puts the wallet back in his pocket. He unfurls the paper he now holds and raises it high for all to see.
“I have in my hand a $20 bill,” he says. “Good authentic U.S. currency. Current issue, drawn directly from the day-to-day stream of commerce this morning, more specifically, the ATM down the hall to the left from the front entrance to this room. This is the first item up for bid.”
The audience stirs anxiously each participant grasping his or her paddle ready to spring it higher to capture Mr. Market’s attention.
“I’ll’ open the bidding at $25, $25, $25. Who’ll bid $25?”
Groans. No paddles rise. There are no bidders.
John Market grumbles subtly.
“$24,” he says. “Who’ll offer $24.
Again, no bidders.
After trying $23, $22, $21 and even $20.10 and still attracting no bids, Mr. Market switches tactics.
$15!” He says. “Who’ll bid $15 for this $20 bill.”
Pandemonium erupts. Everyone rises at once shouting “Me, me, me, me dammit, can’t you see me!” while frantically waving his or her paddle.
Mr. Market is flummoxed. Nobody is backing down. He’s got to get this narrowed down lest he face a riot.
$17,” he says. He assumes that will winnow some of them out. He took Economics in college. He knows full well that as prices rise, demand drops. In fact, that’s the whole point of Mr. Market’s auctions. If one item is being offered, as is usually the case, bidding must be allowed to rise high enough to narrow demand to one buyer; a match of supply and demand.
But the new price of $17 accomplishes nothing. Everybody is still jumping up and down, screaming and waving their paddles. John Market tries again at $18. That accomplishes nothing. Even when the bidding is re-set to $19.90, everybody is still bidding.
Finally, Mr. Market breathes heavily and says “$20.” Who will offer me $20.00 for this $20 bill?”
Who could have imagined how quickly a room full of loud frantic bidders would go silent and take their seats?
Mr. Market shrugs his shoulders, puts the $20 bill back in his wallet, announces cancellation of the auction for the first item, and a 15-minute break for coffee and regrouping.
What Happened?
We saw a market in which 100% of participants valued a financial asset with complete confidence and perfect precision.
When the item was overpriced by Mr. Market, nobody would buy. When he underpriced the item, everybody wanted it.
Everybody used the same valuation criteria. What value would accrue to me if I were to own the asset. All concluded that the asset, the $20 bill asset, was worth $20. If priced below that, there would be a guaranteed positive return. There was no reason to refrain from bidding. Even at $19.90, as trivial as the return would be, there would be no time lag and no risk of not realizing the gain. So clearly, one should bid. At $20.10, the return would be negative, albeit trivially so. Then why bother? Why voluntarily accept a negative return that has no hope of it transitioning to a gain later on? Even if you assume the value will decline due to expected deflation, your return on the investment would still be no different from the return on the $20 you use to make the purchase. When the $20 was offered at $20, the market completely vanished; the value was in equilibrium. There was no motivation for anybody to do anything.
As simplistic as this story was, we saw four factors relied upon across the board to value the asset and assess the price at which Mr. Market was offering it:
- The potential return one might realize through owning the asset
- The length of time it would take to realize the return
- The risk that something could go wrong and cause the expected return to not be achieved
- The potential risks and returns available from alternative investment choices that could be made (adjusting, where necessary, to differences in features)
The coffee break is now over. The auction participants are back in place and Mr. Market is back at the podium. Let’s check in.
An Auction – Chapter 2
John announces the second item up for auction.
“I have here a debt security issued by Apple Computer. It matures in two years. The coupon, the rate or interest the bond pays as a percent of its $1,000 face value is fixed at 8%. Rather than accept bids in terms of prices, I’ll ask that you express your bid as a particular yield to maturity given the $80 annual interest, payable in two $40 payments each year. We’ll calculate the price later, when the transaction occurs.”
Mr. Market pauses to give participants opportunities to reach for their tablets or smartphones and open whatever apps they feel they need to use. He also allowed time for the professionals in the audience to whisper to the others about how it was normal for price levels to be vocalized this way in the bond market.
“I’ll open the bidding at 0.10%. Who will bud for this bond at a yield to maturity of 0.10%?”
Silence. No paddles go up.
“Just kidding,” says Mr. Market. “I wanted to see if you were paying attention. OK. Let’s get real. I’ll open the bidding now at 18%.”
Pandemonium erupts. As when they thought they could buy a $20 bill for $25, everybody wants in on the action. Mr. Market chuckles.
“Got ya’ll again. I’m such a character. Heh, heh. OK. Enough fun and games. Let’s get serious and get this thing sold. I’ll open the bidding, for real this time, at 6%. Who’ll bid 6%?”
No paddle went up immediately. Instead, all heads turned down and zeroed in on mobile screens as fingers tapped vigorously. Finally, some paddles started going up. Not everybody bid. But Mr. Market quickly saw knew he’d have to raise the price (i.e., lower the yield to maturity) because he only had one bond and well more than one bidder.
He lowered the yield to 5.5%. Some bidders dropped out. Others stayed. He kept the auction going and finally, sold the bond to the high bidder (the one willing to tolerate the lowest yield that would still be acceptable to him as a buyer), which turned out to be 4.25%.
Did the buyer get a good deal, make a good investment? There was much chatter during the next coffee break and ultimately, much difference of opinion. But nobody was vehement either way. Everybody had their view on what a fair price should be, but all could understand how others might have differing views. Finally, somebody summed it up to the satisfaction of all.
“Well, the market said it was worth 4.25% today, so that’s the price. We’ll see what happens tomorrow and in the future.”
That Was Different . . . Or Was It
Actually, what happened with the auction of the Apple bond was EXACTLY the same as what happened with the auction of the $20 bill. In both cases, a financial asset was offered for sale and participants judged how much they’d be willing to pay, thereby establishing a market price. The criteria in both cases were the same:
- The potential return one might realize through owning the asset
- The length of time it would take to realize the return
- The risk that something could go wrong and cause the expected return to not be achieved
- The potential risks and returns available from alternative investment choices that could be made (adjusting, where necessary, to differences in features)
The difference was in how easy or hard it was to evaluate each asset under the four criteria.
The $20 bill was extremely easy to evaluate. That’s why everybody had the same idea of what it was worth and why the market for it eventually vaporized. A market can’t exist unless there are varying views. In the case of the $20 bill, everybody knew that asset was worth $20, and everybody could explain exactly why they thought so. And all the explanations would be the same. That’s why nobody would bid above $20 and at a price below $20, everybody wanted to buy. At exactly $20, there was complete apathy. Nobody loved it. Nobody hated it.
The market for the $20 bill what it was because the asset was incredibly – ridiculously – easy to value.
For the Apple bond, the valuation considerations were exactly the same. But the asset was more complex than the $20 bill. The complexity was manageable so we experienced a functional market. Everybody had a general idea of what the answers should be, but there was room for right-thinking people to disagree. That said, the challenges were mild enough for the asset to have found a buyer in one quick auction and for nobody to have acted as it the buyer was insane.
This is important so it’s worth repeating: The workings of the market for the $20 bill and the Apple bond were exactly the same and equally rational. The markets differed only in the sense that the $20 bill was easy to precisely value while the Apple bond upped the ante a bit with more, but a still-reasonable level of difficulty.
By now, you probably know where this is going, but let’s quickly play it through.
The Auction – Part 3
The second coffee break is over, the audience is back in place and Mr. Market is ready to re-start the proceedings.
“The third item up for auction,” he says, “is this share of Facebook stock.” I’ll start the bidding at . . . “
Moving On
Let’s fast forward here.
Once again, we have a financial asset. But this one is much harder to value than the $20 bill or the Apple bond. But the additional difficulties do not change the thought process of market participants. They still think about:
- The potential return one might realize through owning the asset
- The length of time it would take to realize the return
- The risk that something could go wrong and cause the expected return to not be achieved
- The potential risks and returns available from alternative investment choices that could be made (adjusting, where necessary, to differences in features)
The nature of Facebook stock, or nay stock, is such that it’s harder to answer these questions in ways that will produce either completely uniform agreement (as with the $20 bill) or a quick general sense of what the right answer is (as with the Apple bond). With the Facebook share, we’re likely to wind up with a large range of opinions and, perhaps, a bit more vehemence on the part of various opinion holders when it comes to expected return, expected risk, holding period and alternative investments under consideration. But that doesn’t alter the fact that we know, with complete certainty and confidence, that the same processapplies for valuing Facebook, as it does with all stocks and all financial assets:
- The potential return one might realize through owning the asset
- The length of time it would take to realize the return
- The risk that something could go wrong and cause the expected return to not be achieved
- The potential risks and returns available from alternative investment choices that could be made (adjusting, where necessary, to differences in features)
The So-Called Random Walk: Really?
As of this writing, Facebook was priced in the real-world market at $137.21 per share. The prior day, it closed at $137.42. The day before that, it closed at $137.17 and the day before that, it closed at $136.76 and the day before that it was $137.42 (the same number as yesterday).
While I cannot explain why each specific price was what it was (Why was the most recent price $137.42 yesterday instead of $136.99?), it’s more important to note the kind of numbers we were not seeing in the days before today’s $137.21 close. We haven’t seen umbers at, or anywhere near $25, $346, $78, $193, etc.
If stock pricing was random, Facebook’s four prior closing prices could have been 25, 346, 78 and 193 just as easily as 137.42, 137.17, 136.76 and 137.42.
A widely revered theory of stock pricing has been dubbed the “random walk.” To be fair, the author was talking about the sequence of returns (percent changes from one price to the next) rather than the absolute price levels. But looking at the world, does randomness make any more sense there than with prices. A completely random sequence of daily returns for Facebook could be -60%, +336%, -93% and $350% just as easily as the one we actually saw: -0.5%, +0.32%, +0.18% and -0.10%.
Clearly, there is no random walk. We know the value of Facebook shares is, as of this writing, hovering in the vicinity of $137, that being the result of countless market auctions in which participants collectively react to their assessments of:
- The potential return one might realize through owning the asset
- The length of time it would take to realize the return
- The risk that something could go wrong and cause the expected return to not be achieved
- The potential risks and returns available from alternative investment choices that could be made (adjusting, where necessary, to differences in features)
Many participants address these issues directly through fundamental analysis. Others (traders, quants, practitioners of technical analysis, those who play fads and rumors, etc.) address them indirectly by working (some diligently, some sloppily) to decipher and ride piggy-back on the efforts of those who do the fundamental analysis.
A year ago, Facebook was at $104.78, making for a pretty good 31% one-year return.
Is there any reason to believe that was random? Or could the one year return just as easily been -46%, +418%, etc.?
Doctrinaire cynics and quants will insist on what they insist on, and perhaps do so more boldly today given the rise of so-called “alternative facts.” Some might even rig Monte Carlo simulators to strongly discourage or out-and-out eliminate the possibility of “outliers” such as -46% or +418%.
But those who invest real money do not stand to gain from such classroom or coffee -shop exercises. The most productive course of action is to recognize that there is a process through which we evaluate financial assets and decide for ourselves, based on our own capabilities, reward goals, and risk tolerances, whether, how, and to what extent we respond to the difficulties and challenges presented by various kinds of assets.
The goal of this course is to do precisely that for stocks. Topic 1 will refine the often-mentioned financial asset evaluation criteria by translating it into parlance more directly aimed at the particular qualities of stocks, the financial asset of interest to us. We’ll see that the stocks-oriented version of our general process is quite easy to articulate but very difficult to apply. The goal of this course is to arm you with a set of ideas as to how you can use Portfolio123 to help you address the challenges. That is what strategy design is all about.
Acti-quant 