Movie Star Theories To Beat The Market

Walking past a local pub last night, I bumped into a couple of friends having beers.

It’s an easy thing to do in Singapore, considering that many of the pubs don’t have walls, so they spill out onto the main walking areas. Think of a summer vacation area, with perpetual 26 degree (celcius) weather, and you’ve got Singapore (where we live) on an overcast day.

One of these guys is a bit like a movie star crossed with one of those CNBC Squawk Box hosts. He’s extremely sharp, and very, well….”Movie Star-ish”.

To protect his privacy, I’ll refer to him as Tom Cruise—because I think he’ll like that.

Now, Tom was telling me a couple of interesting things last night. First, he was suggesting that if he lived in the U.S., he could easily take advantage of trends in the business world, allowing him to exploit stock prices and beat the market. His example related to data he found on certain technology companies, and that their earnings took dips during a predictable part of the year—something he could take advantage of to buy at cheap prices. I assumed he’d like to sell during the months when those companies had predictably higher earnings, and consequently higher stock prices.

The conversation went something like this:

Me: No Tom, that’s Mission Impossible. There are professional Hedge Fund managers and Mutual Fund managers constantly trying to exploit differences in price and value. If there was such a trend in seasonal sales for a given sector, they’d notice it. And professional fund managers don’t beat the markets, as an aggregate. (In other words, they don’t beat the stock market indexes after all fees) So what makes you think you could do it based on something so….obvious?

Then Tom went into a discussion about a book he read:

Cruise: Andrew, I can tell that you’re not a numbers guy. I can find these sorts of predictable irregularities. Plus, fund managers are like sheep. They all do the same things at the same times. They can’t do what I could do if I lived in the U.S.

To be fair, I think Tom is a lot smarter than I am. But I also think I have the upper hand in this area.

For those who believe they can exploit company earnings, cyclically, by determining that stock prices will react accordingly with information they’re getting exclusively, I’ll explain why you can’t:

1. In the case of Mr. Cruise’s technology sector example, technology sectors have analysts that predict business earnings for those specific businesses. If there was a trend associated with annual earnings cycles, they’re going to know about it. Citing that computer companies have lower earnings during months A,B,C—and that you’re the only one who knows about it, signifies that you’ve likely had a few too many beers, and that you’re talking out the side of your Heineken.

2. Drops in earnings or rises in earnings have nothing to do with short term stock prices. Short term, rising earnings don’t move stocks—not without an added element. Let’s assume that Apple computer’s earnings rise by 50% next quarter. But let’s also assume that the analysts following Apple have expected the earnings to increase by 60%. They will have published their expectations, and Apple would “disappoint the street” if they increase earnings by 50%, and not 60%. The price of the stock would fall (not rise) because the earnings would have fallen below expectations. If the price of Apple’s shares was $400 before the earnings announcement, that expectation of a 60% rise in earnings would have already been priced into Apple’s shares. Reported earnings increases of 60% would likely do nothing to the share price, if a 60% increase was already expected of Apple. As Wharton business professor, Jeremy Siegel points out: “Investors will receive a superior return only when earnings grow at a rate higher than expected, no matter whether that growth rate is high or low”

It’s very important that serious investors don’t fall into these kinds of traps. Beating the market is a very tough thing to do, and it’s nearly impossible to figure out short term price movements—no matter what kind of advantage you might think you have.

Tom Predicted A Market Crash For Today—Or Did He?

Another thing that’s tough to predict, is the market’s movement in any given day. When looking back at the past 90 years, if we examine market moves of 5% or more in a single day, we can only attribute a historical/economic event to a quarter of those big changes. Think about that for a moment. Looking in the review mirror and playing “match-up” only 1 in 4 big market moves can be explained by a world/economic event. The rest of the big, one day market moves were unexplained. So if we can’t explain the big historical moves, we must be very careful trying to play soothsayer, by predicting future market moves based on tea leaves, astrology signs, technical analysis or…even Tsunamis of 8.9 on the Richter scale.

Tom Cruise told me last night that he was going to sell every one of his stocks this morning (except Apple) after hearing about the Japanese earthquake last night. His plan was to sell, and then buy back low, partway through the day…or the next day…or the day after. That second part of his plan wasn’t clear.

Let’s have a look to see what would have happened if Tom sold his stocks this morning. Below, we have a chart of the S&P 500, the day after the Tsunami struck Japan. Tom’s sell order would likely have been filled by roughly 10am. But look at what would have happened. Hoping to buy back the shares at a cheaper price, Tom would have noticed that the stock market increased throughout the day. Tom would have sold on the daily low, and if he wanted to buy back the shares later that day, he would have had to pay a higher price. Tom mistakenly thought he could predict the “obvious”—a stock market drop after the Tsunami.