“Therefore
… , why not go after it and make it the best I can?” was my thinking. And test
it by recording it and sharing it with others.
A
year ago, we tried to forecast the Dow. I "surmised" it would end
2011 and start 2012 at 12,700. It turned out to have been amazingly accurate,
the index closing at 12,723 today (February 1, 2012.
Actually,
it closed the year at 12,217, and I had said it would test 13,000 the first of
the year, which it hasn’t done (yet), although it is close.
But
getting the forecast fairly close indicates to me that the market does follow
certain fundamentals after all, those being:
·
corporate earnings (the tangible) together
with revenues and perhaps market share plus cash position - which is considered
relative to the competition in same industry,
·
corporate leadership (the intangible) in
terms of personnel and corporate structure and operations, and
·
multiple of earnings, which is what
investors are willing to pay to own that stock and be entitled to receive,
through dividends plus increase in the value/ price of the stock, based on the
corporation's reinvestment of those earnings in itself.
Perhaps
the "most fundamental fundamentals" then are 1) earnings, 2) the
company's ability to sustain or grown those earnings in the mid-term future
(2-6 years) based on micro-economic (internal to the company) and
macro-economic (external to the company) factors.
It
is said that investors buy the market six months in the future, that is, they invest
based on about as far as they think they can see into the future and what the
company's situation would seem to them to be at that point in time.
So
putting this all together, we can pose and illustration: my target investment
earns $2 per share. My assessment tells me that this company can continue at
this pace and earn the same in six months.
I
am willing to pay 12 times earnings for those shares, that is, $24 per share,
based on my assessment of the risk. If I do in fact, purchase shares at 12
times earnings, I am investing in something based on my personal Price/
Earnings ratio of 12.
Flip
that fraction over, that is put the denominator on top and the numerator on the
bottom, and it gives Earnings/ Price = 1/12. 1/12 in decimal notation = 8.33%.
8.33% is my expected Yield from my investment.
Now
I have a basic or FUNDAMENTAL piece of information, which I can now use to
compare my investment with other (and competing for my capital) investments
that are available.
Finance
teaches us that risk and return are inversely related, that is the greater the
prospective return, the greater the risk that will be associated with that
investment. And conversely, the lower the expected return, the lower the
expected risk.
My
investment has an expected return of 8.33%, but I could have invested in say,
for example, a piece of real estate with an expected return of 15%, but I
thought it was too risky for me. Or I could have invested in an oil well
drilling consortium that "expected" a 23% return, but that one was
way too risky for my taste.
On
the other end of the risk/ return spectrum I have a choice of bank CD's
yielding between .5% and 2.5% based on the term, the .5% CD having a six months
term and the 2.5% CD being a ten-year term. But I chose my investment because I
felt I needed to at least try to earn a higher rate of return than that,
especially considering that it is probably not going to keep with inflation.
But
after analyzing my investment options and choosing the one I did, I was willing
to pay 12 times earnings for my stock, which gave it a price of $24 in the
market.
Throughout
the investment world, millions of decisions are being made, very similar to
mine, and the Market will be determined, IN TERMS OF FUNDAMENTALS, by the
aggregate of these decisions.
All
these investment decisions combined will price my stock at $24 a share, unless
of course, the market is not reacting to FUNDAMENTALS, like when there is a
major event that inspires either "unwarranted" optimism or the same
"unwarranted" pessimism among us investors.
An
event like that could be almost anything, but recently we have seen political
gridlock in Washington really throw the market for a loop. These events, when
combined with computer-generated trading has led to the markets having greater
volatility and greater up and down swings that ever in its history.
As
investors, we must ask ourselves, when it seems that the market is "in the
grip" of excessive optimism or pessimism, "What are the
FUNDAMENTALS?" that is, what are corporations earning, what are their
expected earnings, what are the micro-economic and real macro-economic risks
that apply.
As
investors, we can see wild market swings almost daily, but what guides the
market in the long term? I would say THE FUNDAMENTALS do; they SHOULD, and most
of the time they do.
So
going back to our little game of trying to predict the DJIA one year into the
future, we would want to disregard all the temporarily unsettling events that
throw the market for days or even weeks at a time and focus on the things that
we feel determine the value of the market long term.
That
is why I predicted the DJIA at 12,700. The DJIA was around 11,700, but I felt
there was an excessive degree of pessimism acting on it: all the news was bad,
and investors were discouraged.
But
the world is seldom all bad or all good. When we feel it is all good, it is
probably actually worse than we think. And when we think the world is all bad,
it is most likely better.
The
prediction was based on my feeling that the Fundamentals were actually not that
bad and that the DJIA should really be around 12,300. Then it seemed that we
were not out of the woods in the recession, so any real growth that the economy
had, which would eventually be reflected in the equity markets, would be slow,
probably in the range of 3% GDP.
So
applying this 3% growth to the 12,300 figure gives a figure of around 12,700.
Now a year later, that is just about where the DJIA is today.
So
all this is not meant to really be an inane game or an irrelevant hypothetical,
or worst an exercise in gambling or gamesmanship. It is intended to be a
minimal effort at creating a "backdrop” for making my investment
decisions.
I
have, in fact, acted upon this prediction over the past 12 months, not because
I felt it was certain, but only because it was the best I could do. And I felt
it was necessary for me to at least make the effort.
My
investments have done OK, but measured against what? Measured against complete
disaster, they have done great. Against any one of a number of POSSIBLE
investment scenarios, they have done perhaps poorly.
One
of the things that this forecast led me to, because it portrayed an extended
period of such slow growth in the economy, was to consider buying bonds instead
of stocks. And this has turned out to have been an immensely popular
alternative for many investors during 2011.
I
have tried to invest conservatively and based on my best projections, and then
live with the consequences and, perhaps learn from them.
I
am encouraged to at least have some sort of primitive methodology. I can at
least now work with this method in the future, looking, of course to
indications that it could be improved or altered in any way.
That
brings me up to the present. Looking forward to 2012, the “experts” are
forecasting another year of perhaps 3% growth in GDP. If corporate performance
follows this figure, all things remaining constant, our DJIA of 12,700 should
also increase by 3%, taking it to around 13,100 by year end 2012.
Now
I try to stand back and look at that, and I just simply feel in my gut that we
have had too much bad news for too long. “Been down so long, it looks like up
to me.” And guessing a little about the chartist in us all, I just felt that
the DJIA would go up to just short of 13,500.
That
seems like a nice number that we will not be too frightened of. Then, just
short of 13,500 is 13,450. So 13,450 is my forecast for the DJIA for
12/31/2012.
Now
I can settle down and see what, in fact happens. Hmmm, that’s it for now, I
think. I guess I will not be accused of having been laconic.
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