CNBC 24/7 Trading: Around the Clock, Around the World / Edition 1 available in Paperback
- Pub. Date:
"Marshall McLuhan said, 'We have become a global village,' CNBC has helped lead the way in creating a global village for the financial markets. Readers will finish CNBC 24/7 Trading feeling smarter about the markets and really understanding how important it is to be in the information flow." -Mary Meeker, Managing Director, Morgan Stanley Dean Witter
"CNBC 24/7 Trading unlocks the mystery of how individual investors can invest and trade everywhere all the time. This book will become the investment bible that levels the playing field between Wall Street and Main Street." -Robert J. Froehlich, Vice Chairman, Kemper Funds Group Managing Director, Scudder Kemper Investments
"TD Waterhouse has operations in eight countries, so we see that growth in international investing is accelerating. To be successful investing around the globe, investors need both information and insight. CNBC 24/7 Trading covers what individual investors need to know in a thorough, easy to understand way." -Steve McDonald, CEO, TD Waterhouse
From the Foreword
"CNBC 24/7 Trading . . . embraces the reality that the markets never stand still . . . this book is a guide to the emerging 24/7 marketplace, a road map to the potential rewards for investors who can grasp that marketplace's opportunities and understand its risks."-Sue Herera
"This definitive book on investing in the 24/7 markets provides the comprehensive tools for active investors and market pros alike. Offering information and advice on trading, obtaining research, measuring market volatility, and assessing local market risk, no smart investor should venture without it." -Linda R. Killian, CFA, Principal, Renaissance Capital
About the Author
CNBC is the recognized global leader in business news, providing real-time financial market coverage and business information to more than 175 million homes and offices worldwide.
BARBARA ROCKEFELLER is the founder of Rockefeller Treasury Services, an independent research firm specializing in international financial market consulting with an emphasis on foreign exchange forecasting and currency management.
Read an Excerpt
Note: The Figures and/or Tables mentioned in this sample chapter do not appear on the Web.
Getting started in 24/7 trading requires you to review all of the factors that contribute to the way you invest and your choice of investment vehicles. What's your investment style? Do you want quick returns, or are you more interested in long-term capital gains? Are you a value investor or a momentum investor? What's your risk comfort level? You should carefully consider all of these issues--and more--before getting started in the extended-hours market or in researching and buying foreign securities. This chapter provides some food for thought to help you answer these questions.
As a practical matter, most people split their portfolios between two baskets. One is held for the long term and the other is actively traded. The actively traded basket is usually considered to carry more risk, sometimes to the extent of being designated "mad money." Trading 24/7, which encompasses extended-hours trading and trading in foreign stocks, is usually--and logically--consigned to the actively traded basket. Long-term holdings can more easily be bought and sold during the regular working hours of the exchanges, when there is maximum liquidity. Foreign stocks, unless they are in the form of ADRs, iShares, or mutual funds, are traded during the exchange hours of their home countries. Aside from the Americas and a few hours of overlap with Europe, foreign stocks are traded outside regular U. S. market hours.
With the two-basket model, we assume that the composition of the long-term basket changes very little and the actively traded basket changes continuously, depending on how much time the investor spends on it. There is a tendency to regard the long-term basket as low-risk by virtue of its having a long term and low turnover. This may or may not be true in the statistical sense. Similarly, the actively traded basket may or may not carry a higher risk. A stock doesn't become low-risk because it is consigned to the long-term basket; its riskiness is inherent and measurable. Likewise, a stock isn't high-risk because the investor chooses to trade it actively. A long-term basket comprised of high-risk stocks can easily have a more variable return than an actively traded basket that is managed with discipline. Thus, theoretically, we could design a low-risk long-term basket consisting entirely of foreign stocks and pair it with an actively traded basket of Fortune 100 stocks--the exact opposite of how we usually imagine the two-basket model to be distributed.
One goal of this book is to demonstrate that each combined portfolio has a distinctive risk-return profile. Trading 24/7 forces investors to examine the riskiness inherent in each stock and in how the stocks are combined to form a portfolio. Together, the long-term basket and the actively traded basket constitute a portfolio, and investors may be surprised when they evaluate the risk and expected return of the combined portfolio.
The evaluation process may change the way you think about investing and trading in general. You may choose to reallocate funds between the two baskets. You may decide to trade more actively--or less actively.
WHAT'S YOUR INVESTING STYLE?
Choosing an investment style is the first important decision you have to make. Active trading is inherently different from buy-and-hold investing--not in the analytical process, but in understanding risk and applying trading rules. If you're trading 24/7, you're most likely an active trader. Electronic domestic and international extended-hours trading makes execution efficient, but it also magnifies conceptual and execution errors. These are your errors when you're doing it yourself, so you will need to tread carefully. Extended-hours trading and international trading are qualitatively different from in-hours domestic trading or investing. For example, when you're buying a Chinese dot-com at midnight, you do not have the same investor protections that you have when you buy 100 shares of IBM from your local U. S.-registered broker at noon. "Trade like a professional" means more than being able to click "okay" on a computer screen.
The good news is that once you develop a global worldview, you will be able to see opportunities more clearly and steer clear of profit-draining investments and strategies. You can take charge of your portfolio or decide against doing it yourself and hire a professional. This book focuses on how to trade yourself or, at a minimum, how to gain the information you need to speak confidently and knowledgeably with financial professionals. You can make sensible deductions about risk by performing your own research via the Web, cable news networks like CNBC, and newspapers and magazines. You can understand and conquer foreign exchange risk. You can use technical analysis to avoid bad timing (at the very least) without becoming a slave to charts. You can become an evolved trader who calculates both the upside and the downside risk in advance, and exercises the discipline to exit trades at preset limits. Professionals know that losses are inevitable; the trick is to trade in such a way that gains far outweigh losses.
WHAT'S YOUR TARGETED HOLDING PERIOD?
Investing is a dynamic process, whatever the pace of your portfolio turnover. It is a process of getting from point A (your initial equity) to point Z (your ending equity). When you view investing as a lifelong process, the distinction between "trading" and "investing" becomes a thin line. Many people think of "trading" as an irresponsible, high-risk speculative endeavor, whereas "investing" connotes a more disciplined, low-risk approach to "saving." Although speculators may seem to have a higher risk tolerance, they may, in fact, have a lower risk tolerance, which accounts for their short holding period (especially if they use leverage). In other words, they trade more actively to lower their risk by being out of the market some of the time. Traders and investors have the same goals and engage in the same thought processes and actions; they simply have a different expected holding period. Short-term traders can be highly disciplined and risk-averse, and long-term investors can be reckless and take more risk than they realize. For you, the important tasks in 24/7 trading are: assess your risk realistically, estimate your profit goals, and determine your holding period.
Determining your own expected holding period is the hardest decision you will ever make. Let's say you research the Widget Company and it looks like a bargain, based on the product, management, earnings outlook, competition, and some key ratios. You believe its price will rise 20 percent over the next year. You buy the stock. It rises 20 percent in the first week. Now what do you do? You have achieved your expected return. Should you take your profit and look for another bargain, or will you be captive to your expected holding period of one year? You have a major investment in this company, in terms of the time you spent researching it. If you take your profit early, you have to do research again; besides, maybe Widget will rise 40 percent.
But remember: The only reason to invest is to make money. This brings up the issue of the pace at which you make money. Some investment advisors like to use a version of the fable of the tortoise and the hare. The tortoise makes 10 percent per annum over a 25-year investing life and ends up with more than the hare, who makes 100 percent one year and loses much of it the next year. This may be a comforting story, but it doesn't always hold up to scrutiny.
If the tortoise and the hare start out with equal equity and the hare makes 100 percent in the first year, he may be permanently ahead. The mere fact of having doubled his equity changes his behavior. The wealthy person will bet less, in any situation, than the poor person, simply because the expected return if he wins is such a small proportion of his total wealth that it is not worth any risk of loss. The poor man, on the other hand, tends to underestimate the risk of loss because the gain that is possible if he wins is a significant chunk of his total net worth. In a way, the millionaire is financially conservative (risk-averse) because he is rich, and he remains rich because he became conservative.
Meanwhile, if the tortoise started in a down year and lost 50 percent in that first year, he has to make 100 percent to get back to his starting equity. How can he lose 50 percent? Easy. The tortoise made a decision to hold his securities for a long time because he fancies himself a long-term investor. He believes his stocks will come back after a big fall, and beliefs become wishes. But the tortoise's strategy is flawed because his basic assumption is a statistically normal return of 10 percent per annum over the next 25 years, and that doesn't take into account a bad first period. He can never catch up. The 100 percent return he needs, to get back to his starting equity, is unlikely to occur according to his own assumptions about expected return.
This outcome raises several very thorny questions to which there is no single correct answer. One solution is to assume that the 10 percent per annum target will be achieved over the longer time frame by catching up with a higher rate of return in later years. In other words, a statistically abnormal higher rate later on will compensate for the statistically abnormal lower rate in the first period. It is risky to assume two statistically abnormal events, but, historically, we do find occurrences of reversion to the mean. Their frequency encourages many investment advisors to recommend that the best practice, in the face of a first-period loss, is to "stick it out"--an approach that focuses on the characteristics of the security itself. If the stock is a good long-term "value" stock on a fundamental basis, it will revert to its rising trend line. The "buy and hold" money management rule derives from the high quality of the security.
Another approach is the stop-loss order, a money management tactic that derives from the investor's personal tolerance for loss, whatever the quality of the underlying security. For example, suppose you determine in advance that if you have a 10 percent loss in Security A, you will sell it, even if everyone says it's the best stock in the world and is sure to recover. Setting stop-loss limits is difficult because you need to blend your personal feeling about losses with the statistical variability of the security. It's hard to exclude consideration of the security's quality. You will feel differently about exercising a stop-loss rule when the stock is a bluechip rather than a dot-com. Exercising stop-loss limit rules is agonizing. Emotional neutrality becomes very difficult to maintain.
In sum, the outcome of the first period of investing can be crucial to the total outcome of a lifetime of investing, and, equally important, critical to the evolution of the mind of the investor. A big up-front gain is always arithmetically superior to small and steady gains--unless there is a catastrophic loss.
Fortunately, the new investing environment is alerting people that there is a trade-off between expected return and holding period. If you are an unlucky soul who has had a bad first year and thus must play catch-up just to get back to your starting equity, you have the choice of selecting from the high end of a menu of expected returns, even if, temporarily, that gives you more risk than you normally would take. More than 40,000 securities in the world today trade on recognized exchanges. Somewhere out there is a combination of securities that will likely return your equity to its starting point. In short, you might first want to determine your expected return, and then derive a flexible holding period that suits you. The 24/7 trading environment offers an opportunity to trade in different time frames, beyond the two-basket approach.
RISK IS ALWAYS PERSONAL:
WHAT'S YOUR RISK COMFORT LEVEL?
If you perform extensive research on a stock and have determined that it is a "value" stock according to conventional fundamental criteria, is it OK to buy the stock on margin? It's important to know where you fall on the holding period continuum if you use leverage--whether you have a margin account or you incurred other debt to get a "stake" for trading stocks. The risk of a specific trade may be quantifiable, but your perception of risk is always personal. The classic numbers game illustrates the point. Suppose you choose a three-digit number from 000 to 999 and $1 gives you a chance to win $500 in the next 24 hours. The probability that you will win is 1 out of 1,000, or 0.0001. What is the expected return? Pascal told us the answer back in 1653: It is the probability of winning multiplied by the reward, or 0.0001 × $500 = 50 cents.
When you are in "investment mode," you can think in terms of return. Return per unit of time is the benchmark, but once you focus on return itself, you will find that the unit of time becomes less important. If 20 percent per year is your target and you make 20 percent in the first week of owning a stock, you have achieved the return you expected. That it took less than a year is less important. Putting time limits on your investment emphasizes the less important criterion. If making a million dollars is your target, you may think it would be nice to make the first million in the first year, instead of making a little each year for 24 years and completing the entire million in the twenty-fifth year. But making a million in any year--from a modest starting point of, say, $100,000--necessarily requires taking extraordinary risk--akin to "betting the ranch" on a single throw of the dice. You may choose to do precisely that, and the probability of winning may be considerably higher than 1 in 1,000, as in the lottery example above, but such a gamble would be an exceptional one-time bet. A good example of such a bet was George Soros' sale of British pounds ahead of a major devaluation of the currency. He was knowledgeable and experienced in currency trading, and he correctly analyzed the political and economic situation. Soros' gain from that single trade was reported in newspapers at the time at $1 billion.
Aside from exceptional cases like this, in nearly all circumstances we have to keep in mind the tortoise-and-hare fable. It can and does happen that "value" investors who are investing their savings get stuck with a losing first year and never catch up. It also can and does happen that a speculator puts together a brilliant portfolio using leverage that beats "the market" with lower risk because his or her holding period is short. Logically, the safest investment strategy of all is to be in the market and to put the stake at risk for the shortest possible time. The longer you stay out of the market, the safer your money. The longer you are in the market, the more risk you are taking.
The logic of this observation may be bothersome to those who believe in buying value stocks with an indefinitely long holding period. This is an insoluble paradox facing the financial industry today. On the one hand is evidence that buy-and-hold is a winning long-term strategy when the stocks selected are true "value" stocks and do not lose that status because of big-picture changes in the economy, or other evolutionary events that are difficult or even impossible to observe until after the fact. The advent of 24/7 means that the universe of "value" stocks has now been increased manifold because foreign stocks are now directly available. The analysis and monitoring that are needed to ensure that they are now, and will remain, value stocks have been increased many times, too.
On the other hand, active trading has the virtue of keeping you out of the market some of the time, which, by definition, reduces your total risk regardless of the inherent risk characteristics of the individual securities being traded. If you buy a very risky stock and its price varies an average of 10 percent per day but you hold it for less than one day, you are taking less risk than if you buy a stock and its price varies only 2 percent per day but cumulatively could vary by more than 10 percent over a longer holding period. Many investment advisors recommend against active trading, in part because they perceive that the average investor does not adequately take into consideration the risk of loss in any single trade and does not exercise the discipline needed to cut losses short. This is why many day-traders end up losing money. The 24/7 environment is even riskier than the standard daylight environment because there is reduced liquidity in extended-hours trading, and less information (and less timely information) is available in trading foreign stocks.
When you enter the 24/7 environment, you are automatically taking more risk, whether you are seeking value stocks for your long-term basket or trading opportunities for your actively traded basket. The benefit of embracing the 24/7 trading world is that it forces you to consider those extra risks and, in the process, to evaluate risk in general and your own perception of risk and return.
WOULD YOU CREATE YOUR OWN MUTUAL FUND?
Every analysis of stock market returns uses equity index benchmarks. The S&P 500 is foremost among them. It is stated as a fact by some that "You can't beat the market," at least not over any extended period of time. If you buy an index-tracking mutual fund, you are buying all the companies, so of course you can't beat the market. The market is all the companies. But, if you stop and think about it, at any point in time, an index-tracking fund reflects "market sentiment" as well as the composite value of the market. Market sentiment is determined by real corporate events such as earnings, but also by developments in the overall economy, such as inflation and the level of interest rates. The market can be temporarily up or down on external factors that momentarily distort the true value of the underlying holdings. In fact, the true value is hardly ever achieved; the market is never in equilibrium. The track records you see for index-following funds require a long holding period to show high annual averages. Depending on where you enter and exit, and on how long you hold such a fund, your actual return can be very different because of these effects.
Mutual funds--which outnumber U. S. stocks by some 11,000 to 7,500--come in two basic varieties: (1) passive index tracking funds or (2) actively managed funds that are periodically rebalanced (some more frequently than others). Actively managed mutual funds try to identify hidden treasures within a sector or class, and combine them in such a way as to maximize returns while reducing risk. Rebalancing is where the professionalism comes in. The analysts employed by funds spend all day, every day, either digging into companies' financial statements or engaged in heavy-duty quantitative analysis. Still, an investor's return depends on a buy-and-hold strategy, even if the experts are changing the mix of securities within the fund from time to time.
Today, investors have another choice: concocting their own mutual fund at Netfolio. com or Folio( fn). com. The first step is to define what kind of risks you're comfortable with. The program then screens the universe of stocks to assemble a basket of stocks that should, together, give you the return that is desired at the risk that is named. For this, you pay a flat fee per year and no transaction commissions, but you are expected to stick with your portfolio through thick and thin (and hope to get the expected return that you specified at the beginning of the exercise). In short, you have no ability to respond to "market sentiment" on a short-term basis without rebalancing the portfolio, exactly as professional fund managers do. If you choose to rebalance the portfolio more than once a year as the investment environment changes, you must pay the fee every time (and come to deeply appreciate the many diverse analytical requirements of the professionals).
Each kind of fund--index-tracking, actively managed, or do-it-yourself--has its own advantages and disadvantages. To buy index-tracking mutual funds is to be at the mercy of market sentiment at any given point in time whenever you need to liquidate some of your stock market holdings. To buy funds that rebalance and then hold for a long time is to get the benefit of professional expertise, but also to trust some strangers to perform in the future as they have in the past. Creating your own mutual fund gives you control over both strategy and tactics, but it is expensive (if you rebalance more than once a year) and requires a good analytical mind.
The cost of mutual funds is a hairy subject that is fraught with hot debate. The standard passive index fund is perhaps best represented by the Vanguard Index 500 Fund, which returned 20.9 percent per annum in the seven years that ended June 30, 2000 (according to a letter in The New York Times on July 30, 2000, from John Bogle, founder of the Vanguard Group). Five advisors tracked by The New York Times over the same period had returns averaging only 15.7 percent, a difference of 5.2 percent. Bogle states that 3.2 percent of the difference can be attributed to the higher costs of the advisors (for performing periodic rebalancing), compared to the Vanguard index-tracking fund. In fact, on a cash basis, the Vanguard index-tracking fund returned a hypothetical $188,750 on an initial investment of $50,000. The others returned an average of $138,500, showing that the index-tracking fund made $50,000 more, the amount of the original investment. Those who say passive index tracking is boring and lacks the excitement of stock picking may be right, but they can't deny that the returns may be consistently superior. Bogle points out that " the magic of compounding" is critically important. Even if the advisors and the index-tracking funds earned the same 10 percent per annum over the next 13 years (for a total of 20 years), the index fund would still be ahead $652,000 to $478,000.
Clearly, it is not easy for the professional or do-it-yourself investor to beat the indexes over a long period of time, systematically. 24/7 trading offers more opportunities to beat the index, but it requires more active trading: exploiting short-term opportunities in the extended-hours market, or venturing overseas, or both. Choosing a portfolio of individual stocks, whether you include mutual funds or not, is the most difficult investing task, albeit the one with the greatest flexibility. You will need to aquire the same mindset as professional fund managers and learn to use most of the same analytical tools. Truly professional fund management is a full-time job, and professional firms have the added benefit of being able to hire specialists in everything from financial statement analysis and analyses of market and economic environments to statistical modeling. As a practical matter, you cannot expect to duplicate all these skills and absorb all that knowledge.
What you can do, however, is learn enough about the risk/reward trade-off to avoid the worst drawbacks of amateur investing. To buy and sell stocks indiscriminately without ever knowing the risk and return of your total portfolio is dangerous. to buy and sell in the context of portfolio management is to aim for professionalism and, hopefully, increased reward.
WHAT ASSUMPTIONS HAVE YOU MADE ABOUT
24/7--AROUND THE WORLD--INVESTING?
To manage risk and return yourself, you need to choose your assumptions about how the world and its stock markets behave. It is generally assumed that international investing is riskier than domestic investing. This can be true or not, depending on the specific stocks chosen and the holding period over which they are owned. Another assumption you need to question is whether multinational companies' stocks provide all the international diversification you may want. They may or may not, depending on the company. A portfolio that contains U. S. companies with big international operations doesn't necessarily reap the benefits of global diversification. When you buy a stock, you are only indirectly buying its future sales and revenues. More immediately, you are buying the market's perception of the stock today, and that is colored by perception of the overall market today. If the international component of sales and revenues do not affect the stock price, then your assumption is probably incorrect. In fact, many multinational companies' stocks behave like domestic companies' stocks. For instance, Figures 1.1 and 1.2 show that Coca-Cola and McDonald's, both major multinationals, trade very much in line with the S&P 500.
Global firms may or may not have steadier sales and revenues because of their international operations. They have an additional risk not shared by purely domestic companies: currency risk (which is covered in detail in Chapter 7). For example, a company selling into Japan has seen the value of the yen bounce from 120 to 80 yen per dollar and back again. American shareholders care only about the consolidated (company-wide) dollar value of sales and revenues. In 1995, when it took only 80 yen to buy a dollar, the results of operations looked good. By May 1999, it took 120 yen to buy a dollar--a 50 percent change. Even if sales and revenues were identical to those in 1995, the company appeared to have results 50 percent worse than four years earlier, just because of the change in the exchange rate.
It gets more complicated, too. The 50 percent reduction in sales and revenues is stated only on a translation or accounting basis. A Japanese company may have bought its dollars for future remittance to the parent company in advance of the actual accounting period when the translation effect was to take place. Such a currency hedge affects the true cash flow of the company. Some international companies excel at hedging currency risk, and some don't bother to try, on the premise that "Nobody can forecast exchange rates." Unless you read the small print in the footnotes of the annual report, you won't know whether you are taking a desirable or undesirable risk when you buy a multi-national company's stock.
ARE YOU WILLING TO INVEST IN
EMERGING MARKETS AND GROWTH REGIONS?
Business cycles come and business cycles go. When South Africa is booming, Thailand may be tanking. As of mid-2000, Europe claimed that it was entering a period of outstanding growth that would outshine growth in the United States for many years to come. In contrast, Japan, which has been in a recession since its stock market crashed in 1990, seems to be tentatively coming out of it as of mid-2000. Even though the United States has not had a recession in a decade, one is always possible. By diversifying your portfolio to the growth regions of the world, you can benefit from the observation that corporate earnings are generally highly correlated with national gross domestic product (GDP) growth.
Alternatively, if the United States does not experience a recession and the consumer/ capital goods boom continues, foreign suppliers may be a good investment. For example, the French luxury-goods company LVMH (LVMHY) has a lock on Champagne, Cognac, and the Louis Vuitton trademark, among others. LVMH is traded on the Nasdaq in the United States and has considerably higher volatility than the S&P 500 (see Figure 1.3), but it is a truly international company. It remains to be seen whether it has immunity from a general slowdown in the United States.
The opportunity to buy individual foreign stocks allows you to give free rein to your ideas about the way the world works. Diversification is a good thing in its own right, but smart diversification will allow you to pick out the global winners, not just the American ones. If you think the U. S. market will turn down but you want to be invested in stocks, you may choose a higher proportion of foreign stocks for your portfolio. On the other hand, if you think the U. S. market will see significant growth, you may choose a lower proportion of foreign stocks from among those that are less richly priced.
Mark Mobius, head of the Franklin Templeton Emerging Markets Fund, says in his book, Passport to Profits (Warner Books, 1999), that he travels 250 dayCould not acquire words on page 20 s every year seeking stock bargains. His first rule of investing is that "your best protection is diversification." In all markets, he is looking for "FELT," which stands for markets that are fair, efficient, liquid, and transparent. Mobius also points out that the best profits are to be made after a crisis or market crash, and quotes Sir John Templeton: "If you buy the same securities as other people, you'll get the same results as other people" (p. 43). Think outside the box; be contrarian--but plan for a five-year holding period, he advises, to let your stock choices mature.
CAN YOU AVOID THE TRAP OF
Foreign stocks are not only an untapped opportunity; they may offer protection from a meltdown in the United States. In December 1996, Alan Greenspan questioned whether the U. S. stock market was in the grip of "irrational exuberance," a phrase inspired by Yale economist Robert Shiller, whose book with that title was published in May 2000. As of mid-2000, this was yet another complaint, complete with impressive charts and statistics, that the market was overvalued and would crash. Speculation was rife, and speculation is defined as mindless crowd-following. Endless talk of speculative gains can induce normally levelheaded people to succumb to greed and to inject ever more money into the market. As soon as a really big scare comes along, the tight feedback loop will cause an even faster market drop as fear becomes the dominant emotion.
Even if we agree that what existed was a speculative mania that created a full-blown bubble, we don't have to agree that a general market crash would be the only outcome. For the sake of argument, though, let's say that the U. S. market enters a downward trend. Do foreign stocks offer a refuge? Yes; but not on an index basis. A comparison of the Dow Jones World Index Ex-U. S. with the Wilshire 5000 (the broadest U. S. market index) shows that the rest of the world follows the U. S. sentiment lead (see Figure 1.4).
The implication is that to diversify into the international arena, you need to scan the stock universe for individual candidates that match your desired profile, and the first criterion on your profile list should be a negative correlation with the overall U. S. market.
ARE YOU A VALUE INVESTOR
OR A MOMENTUM INVESTOR?
The demise in March 2000 of "value investor" Julian Robertson's Tiger Management hedge fund renewed debate about value investing vs. momentum investing. Robertson said he was withdrawing "from an irrational market where earnings and price considerations take a backseat to mouse clicks and momentum." It is a bit frightening when a major investor makes such a statement. How can we expect to succeed as value investors if this famous hedge fund manager was not able to? In 1999 and into early 2000 it seemed as though the only way to succeed was as a momentum investor--the antithesis of value investing.
The key to understanding this situation is to understand the value investor's assumptions. First, the value investor assumes that a high-value stock will yeild a normal return that is close to the average return over the past x years. If the market returns 15 to 20 percent per annum, then the stock should return 15 to 20 percent per annum. The mistake in clinging to value stocks in 1998-1999 was to miss the simple fact that they faced a new class of competitors for the pool of investment money that was available to the stock market at large. It was a growing pool, but the emergence of the new class reduced the share that could and would be allocated to value stocks.
Some value investors missed the emergence of the new competitors for capital, for two reasons. First, many of the stocks were new. They were real initial public offerings (IPOs), and, by definition, they were excluded from the value investor's universe. No past earnings, no past price performance--no value, And it is true that IPOs are high risk. Almost 20 percent fail and are no longer around after five years. Only about 30 percent outperform the market after five years.
The second thing the traditional value player probably missed was the importance of the electronic revolution. "Just a fad," many scoffed. When the stock of new or even already established companies took off to the moon, they called it a mania. To price a stock because it offers hope of future earnings is just not the right earnings ratio to use, they believe. And yet, supposedly inflated earnings expectations have in many cases been met, because the electronic revolution is the real thing, on a par with the railroad, the radio, and other major inventions. Fed Chairman Greenspan has likened the effect of the new information and communications technologies to the effect of the telegraph around the time of the Civil War.
The arrival of new-age companies reduced the expected return of old-economy companies. It may not have diminished their intrinsic value, but it did divert capital and the stock market return reasonably to be expected. This drives home the point that expected return is a forecast, not a given that can be taken for granted. Investors can know that a new company has become a value company only after the fact. To detect value while the technological change is taking place requires imagination and a futurist outlook.
Some value investors assumed the electronic revolution to be a fad and may have clung to an outdated idea of what their return should be. They also may have underestimated the risk they were taking in their value stocks. The expected return, based on past average returns, includes periods of loss. They are vital components of the risk measurement process.
Loss may be normal (consistent with the historical pattern), or abnormal (higher than the historical pattern). Investors who hew to the assumption of a long holding period can expect minor, temporary losses from time to time. When those losses become extraordinary-- higher than normal--something unexpected is happening. Abnormal losses are the market's way of telling you that you may have made a mistake. "Value" is not fixed forever, and you need to beware a buggy-whip mentality in the age of the automobile.
In the face of an abnormal loss, you have two choices. If you prefer a long holding period (and are sure you don't have a buggy-whip company), then you will have to reduce your expected return. Individual investors can do this, with varying degrees of pain. Professional fund managers have a harder time explaining to their clients that their expectations of gain should now be reduced from past levels because the manager prefers to stick with old-value companies.
Alternatively, when an old-value company disappoints on the downside, you can simply get out. Investment success requires a cold-hearted estimation of expected return--by definition, a number that will happen in the future, whatever its history--and of risk. When either one changes dramatically, you should probably rethink your assumptions. The same thing happens if your Widget Company stock makes 20 percent in one week instead of one year. On the basis of risk and return, the thing to do is "take profit." You have achieved your expected return. More to the point, you have achieved the return that can be expected from this stock, as you yourself determined only a week ago.
This leaves you with at least two problems. The first is a lifestyle problem rather than an investment problem. It takes time and energy to research the next investment that will give you the next 20 percent, and you may prefer to expend that time and energy on other activities. In economists' jargon, you may get less "utility" from researching investments than you get from (say) painting. The second problem is that now you have to reconsider your entire portfolio, not just replacing the one stock that gave you a big loss or a big gain. If a loss, do you now buy a riskier stock with a higher expected return, to try to make up the loss? If it was a gain, do you now buy a less risky stock to protect the gain?
The distinction between "value investing" and "momentum investing" is not a false one, but we have a tendency to attribute to value investments a longer holding period than they may warrant, given rapid changes in the environment. Momentum investments have, in many cases, transformed themselves into value investments because of those same changes. Trading and investing are dynamic processes, and you should be watchful of big-picture developments so that your actual risk and return do not get out of sync with your expected risk and return.
In summing up, new technologies always come along to replace old ones. When these new companies seize the imagination of the public, the market typically bids up their stock prices well beyond the norm, judging by P/E and other conventional measures. Some of the new technology companies are successful and do catch up to outsized earnings estimates, and others fail. The individual investor faces the problem of whether to jump on the bandwagon. There is no single correct answer, since by definition we don't have historical performance to use as a guide. In fact, the emergence of hot new companies will subtract from the historical risk-and-return performance of established companies in ways we cannot foresee and measure. Economics historian Joseph Schumpeter called capitalism a process of creative destruction. This phrase has become very popular--but we tend to neglect the "destruction" part at the same time we celebrate the "creative" part. Contrasts are not always as black-and-white as the buggy whip example; there is also the cruelty of competition. Hardly anyone today remembers the Hudson Automobile Company.
KEEP IN MIND YOUR ULTIMATE GOAL:
HIGH RETURN ON YOUR INVESTMENTS
The transformation of the investment environment empowers you to be flexible in your decisions if you are well-organized and clear-thinking. What are you really looking for? You are not looking to trade outside regular U. S. market hours simply because you can; you are looking for buying opportunities. You are not buying Japanese stocks; you are looking for great value in a larger universe. You are not looking for the best three stocks in the tech sector; you are looking to get a specific return.
You are not looking to "participate" in biotech; you are looking for securities that will give you a return commensurate with the risk you want to take. You seek a specific return for a specific risk over an unknown holding period regardless of whether the investment vehicle is Cisco (CSCO), soybeans, or Swiss francs. In the August 2000 issue of Smart Money magazine, Roger Lowenstein points out that Bill Miller, of Legg Mason Value Trust, has been a long-term superior performer not because he was a tech investor, but because he saw a bargain. To quote Lowenstein, "The best investments are made when someone sees a bargain. It is that simple." We now have a larger universe in which to seek bargains.
The starting point for investing is not the fundamental or momentum characteristics of a security. It's not market segment, product, management, earnings, or ratios. It's the expected return for a given level of risk, or the expected risk for a given level of return. This doesn't mean you shouldn't learn about these things; you should. But, first think about expected return and its associated risk.
There's a valid reason for this sequence. All we can know for sure is the historical record. When an analyst predicts an extraordinary return, he or she can't tell you the downside risk at the same time because there's no way to know what it is--for you. Risk depends on the holding period. If the expected holding period is five years, the appropriate risk measure is an annual one. If the expected holding period is one week, the measure is the average weekly risk, not annualized. Moreover, if you are using leverage, statistical risk is increased by the amount of the leverage. You need a higher expected return to offset the extra risk of catastrophic loss when you are leveraged.
With new securities that have little or no track record, the best tactic is to impute a risk factor. Common sense is handy. The evolved trader does not accept an estimate of extraordinary future return without also factoring in high risk--which, by definition, dictates that the holding period will be less than forever. This knowledge liberates the trader from all kinds of traditional assumptions and irrelevant information. After all, you cannot be led down the wrong path if you determine the known risks and compute an educated guess of probable risks.
The evolved trader is indifferent between a bundle of securities in East Asia and another bundle from Europe or the United States with the identical risk-return characteristics. If you view the investment process in this light, you become aware of an infinite number of equally valid, high-value portfolios for any single risk-return profile. None of them assumes a holding period of forever.
Because 24/7 broadens your world of opportunities it also exposes you to more risk (as we'll see throughout this book). In a 24/7 world it is even more important for you to review how you invest and your choice of investments--to identify your expected return and your holding period ahead of buying a stock. Today investors must hone in on risk. And you have choices--to take on the risk (and the potential reward) yourself by "doing it yourself," or to invest with the pros. Diversification may lessen your risk and increase your rewards--or not. Ultimately, if you keep your eye on the bottom line--a high return on your investments--you will be able to navigate the 24/7 markets more easily. To find opportunity, you must first understand the basic mechanics of the electronic world available to you, whether U. S.-based or global, and the pros and cons of venturing 24/7 which we'll now examine as we look at the extended hours marketplace and electronic trading.
Table of Contents
Introduction: Getting Oriented in the New 24/7 World.
DOING RESEARCH AND ANALYSIS AROUND THE CLOCK.
Getting Started in 24/7 Trading.
VENTURING AROUND THE WORLD.
Finding Stocks 24/7.
Why Go 24/7?
Assessing Country Risk in the 24/7 World.
24/7 at Home.