Safe bets on stock market?

Risk-averse investors tend to put all their money into safe instruments – mainly bank deposits and government bonds. The stock market, on account of its characteristics, exposes investors to much bigger variability of returns, tempting with gains much higher than on bank deposits, but also scaring away with prospects of losses that can wipe out large chunks of invested capital.

Risk profile of investments in equities is not homogenous. The two factors affecting the risk undertaken by an investor are, in my opinion: type of security an investor trades in and timing of transactions.

As for the former, the risk, commonly measured by volatility of returns, is lower for: bigger (blue-chips), counter-cyclical (sectors such as telecommunication or utilities) and sound (i.e. not grappling with financial difficulties) companies. The low-risk stocks usually are said to be a good-quality equity investments and offer expected return a few percentage points above risk-free rate and relatively low standard deviation of returns.

In the case of the latter, the issue is far more interesting. In terms of risk, timing of trade might matter more than other characteristics of an asset. You may pick out an excellent security, with absolutely firm fundamentals, no skeleton in the cupboard, etc. and lose money on the investment, if you pay over the odds. This is what happened to investors who were buying shares of sound IT or telecom companies at the peak of dot-com bubble in late 1999 / early 2000 and lost over 90% of invested capital. The companies whose stocks were trading at sky-high levels are still alive and generate profits, but fourteen years ago were… mispriced.

Now let’s consider two concepts essential in comprehending what I am getting at – the value and the price.

There are plenty of definitions of value put forward by economics academics, in my consideration I will narrow down to only one – the intrinsic value, or fundamental value, which is to some extent objectively justified by characteristic features of an asset. In the case of a share of a company, it is primarily determined by the company’s capacity to generate income to its owner, or in simplest words, to make profits. In valuation theory, a company is worth as much as discounted stream of positive cash flows it can generate to its equityholders.

The price, in turn, is the amount of money one party (a buyer) pays to another party (a seller) when they trade in an asset. The price is driven by several factors, including two of utmost importance – demand and supply. For a stock-listed security, a price is technically set by forces of demand and supply and most of the time (except for extreme cases when trading is on hold to prevent extreme movements) reflects the balance between supply and demand, which in turn is unstable over time. If supply exceeds demand, the equilibrium goes down, if the opposite holds, the equilibrium goes up.

It has to be underlined price does not have to equal value. In the long run, if a market is efficient, the equation above should hold true. In the shorter run deviations are very likely to occur and, if discernible and evident, can be exploited to earn.

Let’s look at two examples from the Polish stock market.

First days of September 2013. The Polish government unfolds its plan to curtail operations of private-run pension funds operating under the public pension system. Market participants react with panic sell-off. Let’s examine the motives / rationale behind the sell-off. This could have been an act of revenge of foreign financial institutions, whose risk-free business in Poland had just been undercut. 

The mini-crash could have also been sparked by fears that pension funds would dispose of some of the stocks they hold and that they would not generate additional demand for stocks in the future. The former argument could have served as incentive for speculators who could sell (short) stocks in order to buy them back at cheaper prices from pension funds. The latter theory was actually favourable for the stock market, as without artificial demand from pension funds, risk of overvaluation and market bubbles on Warsaw Stock Exchange diminishes.

A cool-headed analyst should ask a question, whether existence and scale of operations of private-run pension funds in Poland has any impact on fundamental value of stock-listed companies. For some financial services companies who deal with pension fund management, the answer could be affirmative, but for overwhelming majority of companies, dismantling of pension system has no impact on value. The conclusion is then simple – even if forces of supply and demand bring prices of some securities down, the situation creates investment opportunity – you can get the same value for lower price! A wise investor should grab such opportunity.

14 January 2014. Before trading commenced, Vattenfall announces it intends to dispose of its stake in Enea quickly. Trading opens 8% below previous day’s close, then the price of Enea slides further down, total 1-day loss reaches 14%. The accelerated book-building ends on the same day. The next day stocks of Enea rebound, yet still trade at discount to 13 January 2014 close. 

The rationale behind the sudden drop was the fear of increased supply of stocks from Vattenfall, or expectation if the stake is to change hands quickly, the vendor would have to accept a discount and market quotations would follow the price at which Vattenfall transacted with its counterparties. You could argue the price at which the vendor and several buyers agreed is an indicator of the company’s intrinsic value. I would counter-argue price in a fire sale is a poor valuation measure. Again, does the increased supply of stocks from Vattenfall affect income generation capacity of Enea? My answer is ‘no’. Does Vattenfall’s presence in Enea’s shareholder structure affect its income generation capacity? Given all facts and circumstances shaping the company’s operations, my answer is ‘no’ Again, probably the price deviated negatively from value. A shrewd investor should have grabbed this opportunity.

The strategy illustrated above is not foolproof though. There are 3 major traps an imprudent investor can fall into.

Firstly, you should be considerably confident the when price of a security plummets, it drops below its intrinsic value. Such sudden shock can occur as well when an asset is overpriced and its price is being abruptly adjusted towards the fundamental value. You have to carefully analyse the information that triggered the sell-off – maybe on second thoughts you realise it affects not only price but also value. Upward potential is then limited.

Secondly, the rebound might not be a matter of days. It might take weeks or months for a security to climb back to pre-plummet levels. In September 2013 losses of stockholders were quickly offset by subsequent gains, but it I would treat it as an exception that proves the rule. If you cannot accept the fact your money might be frozen for a few months before it fetches a decent profit, better give up on this strategy. Remember the market might stay irrational longer than you can stay liquid.

Thirdly, even if you are pretty sure you have just spotted an underpriced security and you will not need some portion of your money for a while, do not execute the strategy in one shot. Do not buy securities for all the cash you have at hand. Divide your holdings and be prepared to buy even more at even lower prices if the decline continues. Such approach reduces both potential gains if the price bounces back quickly, but can maximise them if the price keeps falling, as your average buy price also gets lower. Anyway, remember you are playing with turbulent market, so caution, cool head and restraint are advised.

The ship that weathered the storm is sinking?

No longer than a month ago I extolled Polish economy for its resilience in the context of the first interest rate hike in the current cycle of monetary tightening, but over the course of last two week I mulled over the issue, took it apart and now I feel like taking back what I wrote then, although I cannot deny I did believe what I wrote was true and reflected my opinions.

What prompted my recent change of heart was a market analysis. I observed the performance of Warsaw Stock Exchange blee chip index (WIG20) and compared it with performance of other major indices (German DAX, US S&P 500, Japaness Nikkei 225). All the foreign indices this year hit their many months' highs repeatedly, whereas Polish WIG20 barely climbed to 2,809 points, peaked there and retreated. Polish stock market's relative performance has been very poor in the last weeks and this seems to be a distrurbing signal.

Stock market performance is one of Leading Economic Indicators, what in simple words means its changes herald changes in the whole economy. It has to be said stock market performance is not unfailing and if "Wall Street predicted nine out of five recessions after WWII", signals it sends might be misleading. But if we look at recent happenings in a broader context, Warsaw Stock Exchange does not have to be wrong this time.

Please note that performance of stock market is correlated not with GDP but with the pace of GDP growth. Economy may contract, but if the contraction is not as deep than in the previous quarter, stock prices should rise. This rule works also the other way round - if economy grows, but not as fast as earlier, stock prices should decline. To be precise, stock market should precede real economy by one or two quarters, although in the recent crisis there was no lag (rebound in 1Q2009 and peak in 3Q2007).

Let's have a look at some facts.

1. A lion's share of the turnover on the Warsaw stock market is generated by foreign investors and speculators. They generally buy the most liquid stocks and therefore their interest focuses on securities that make up the WIG20. Their decisions are generally based on their perceptions of prospects of Polish economy. Buying stocks is actually about buying future, as all present information are already incleded in a price. So if speculators and investors are optimistic about Poland, they buy Polish stocks; when they turn pesimistic, they dispose of Polish securities. If their perception of Poland worsens, it is not because they have it in for Polish stocks, but because something might be amiss with Poland. What is happening now is not a reprise of speculative sell-off of Polish currency and assets from early 2009, when market sentiment was overtly negative, now it has only fallen back.

2. Why? One reason are the proposed changes in the pension system. Regardless of what I think of it (I am in two minds about it, I will try to present a subjective evaluation of those changes before they take effect), the motives behind the government's decision to transfer a part of pension contribution from private-run pension funds to state-run pay-as-you-go social security system are clear. The government did not concede private pension funds are too expensive and too ineffective (as they in fact are!) are did not wish to save poor citizen's pensions from being squandered by greedy fund managers. Polish state gripped that money to curb the increase of outright public debt and swept the problem of its obligations towards future pensioners under the carpet. It does not mean I fully disagree with their decision, but this time a drowing man was desperately trying to catch a straw. The move also reflects upon the pitiful state of Polish public finances and interminable shortage of money in the system, which results from years of mismanagement.

3. What could have scared the investors and speculators away? If the government seizes the money, situation in Poland must be quite bad. Private sector fares well, but if things keep getting worse it will have to bear more and more burdens and so the consumers will. Higher taxes will impinge on lower investments and consumption and thus will hamper GDP growth...

4. Another factor is connected directly with mechanics of capital markets. Pension funds every months have bought stock on the market to their portfolios. After the reform, if they get less money, they will buy fewer stocks, what consequently will weaken the demand side on the market. Without demand from pension funds rates of return on the market will be lower. This assumption could have deterred some market participants.

5. Many economists say the best year in the current business cycle will be 2011. Growth will be stimulated mainly by investments, in a large part financed from EU funds and aimed at EURO 2012 preparation. Poland has reached its limits as a free-rider - it fared well during the crisis, but the current pace of growth is unsustainable without structural reforms.

6. Rising interest rates also might negatively affect the economy, but with inflation as the overriding target, we have no choice, but to accept monetary tightening.

7. Appreciating zloty may harm our exports and contribute to the slowdown in pace of GDP growth. If interest rates disparity increases (quite probably, as in the Eurozone and in the USA interest rates are said to be kept near-zero to sustain the recovery), carry traders will do their job and no central bank interventions will help. Only a shift in market sentiment towards Poland can bring Polish exporters relief.

Neverthelss Polish GDP should be on the rise for the next three years, if only nothing unexpected happens, but we should be prepared that the growth will be sluggish (2% - 3% p.a.) rather than robust. Warsaw stock market might be already discounting these information. In turn German economy proves its perfection - our Western neighbours have turned around their public finances and they proved again their economy stayed competitive. Over the last decades competitiveness was the crucial performance driver. Here we can take leaf out of German's book. On the other hand I would not wish Poland to follow the example of the USA. Their stock market is soaring just becuase the US central bank is carrying out quanitative easing to buoy up US economy, what in simple words means guys from FED are printing money, economy still is in the doldrums and speculators borrow money at 0.25% and drive prices of equities and commodities up.

Paradoxically, even if Poland underperforms in comparison to other countries in the coming years, it may give it a soft landing. Other economies, affected by asset price bubbles (if nothing changes in terms of regulations and monetary policy they are bound to inflate, but not in Poland, Polish economy will suffer from rising food, petrol and gas prices) will go through another, even more severe financial downturn and Poland, if run wisely, might be again the only green country on the economic map of Europe.

The Intelligent Investor

The book my colleagues bought me a month ago is one of those which trigger the perennial question “who am I”? It may seem at least weird that a book about managing your personal finances can make you ponder upon a part of your identity, but this particular one definitely does it.

So who am I as a market participant? On the market there are two major groups of participants: investors and speculators. Usually market commentators call everyone who trades in securities an investor, which is a palpable insult to all true investors. Those two terms must not be used interchangeably, as their meanings are worlds apart. In short, an investor is someone who seeks out profitable companies, analyses their financial statements, the way they are run, industries in which they operate, estimates their fundamental values and puts his money into companies he picks out for a long period of time. Hence, an investor feels and acts like a co-owner of a company. A speculator in turn seeks quick profit, doesn’t care much about fundamentals of companies he buys and sells, falls back on various sets of rules that, as he believes, will enable him to reap profits. His only goal is to earn as much as possible in a possibly short period of time. Money never sleeps…

So who am I? Both. Impossible? I bought some stocks a few months ago and still hold them, but I also trade in stocks on a daily basis. I have to plead for some time now I have been faring better as an investor than as a speculator. Whenever buying companies for a long time I sought out those markedly undervalued and settled on middle-term investments in them. The strategy proved right and bore robust fruits. Most of my profits actually come from proper investments. How about speculation then? Here I have to confess I made an error almost everyone makes just before starting to run through money on a stock exchange. My over-confidence led me astray. I thought nothing bad would happen to me and eventually I sank around 1,000 PLN in risky, volatile stocks. It was still wiser than lending it to the ex-classmate, but has taught me a lesson of humility, a very precious one.

Speculation means risk – the odds to reap a quick profit are lower than to cover a position with a loss. Why is it more probable to incur a loss even if we assume stock prices follow a random walk? The answer lies in transaction costs. At my brokerage firm fee for a transaction is 0.39% of its amount. Hence, to let me break even, a price of a security has to go up by over 0.78%, if I buy a stock for 100.00 PLN and sell it for 100.50 PLN I lose. I even dread to tot up how much I have spent this year on brokerage fees. The sum is unfolded when the tax report (necessary to fill in the tax return on which traders report their capital gains on security trading) from my brokerage firm is delivered to me.

I think my colleagues had discerned all perils and traps of speculation and gave me that book to dissuade me from trading strategies which sooner or later would do me out of money.

Has reading the book changed my investment “mindset”? It was a kind of eye-opener, but I remain critical about some theses set there.

Firstly, I began to look at myself as at a co-owner of companies I invest in (or even just trade in). Those are not just securities which I buy to sell later at a higher price. I own a minuscule part of a company so I should have a stake in it.

Secondly, it changed my perception of investment horizon. As a young person I still find it hard to imagine that I could freeze money for thirty years in stocks. Alright, it might not be the best choice to buy stocks and sell them after a few days, but my plans have never reached beyond five years…

I remain wary of long-term investments. OK, I may stay on the market (provided my portfolio is made up mostly of blue-chips) during the whole bull market, but I feel it is wiser to sell stocks when the next bear market is imminent. It is not a stupid strategy, because everyone buys then and pays over the odds for stocks. Benjamin Graham has a recipe for bear and bull markets – you should always buy stocks for the same amount of money every month. If market prices are high, you buy fewer stocks, if they are low, you buy more and in the long run you will rake in profits. Surely an ideal recipe would be to buy in the dead of bear market, but who can grasp the moment when it cannot be worse?

I see two major drawbacks of the book. It was first released in 1949, then had several updates with the last one dated 1970. The Polish edition (unfortunately they would have to spend more and take some extra effort to get the paperback in English) includes commentaries made in 2003, after the burst of dot-com bubble which triggered the worst (until then) bear market in post-war history of NYSE. But… it has not been updated in the ongoing financial crisis in which the bear market wiped out profits from the whole previous bull market. From mid-2007 to March 2009 the peak-to-trough decline of S&P 500 was 57%. On Warsaw Stock Exchange indices fell by 67%. Was there any investor not put to a very tough test? The bear market of 2007 – 2009 was unprecedented in its scale, some economists predict an even more severe meltdown around 2015. In the light of the recent events, the book seems a bit outdated, even despite the fact its author rode out the Great Depression and came burnt and bruised, but stronger out of it.

The second downside is that it is relevant to developed American capital market. Warsaw Stock Exchange is not yet twenty years old, Poland remains and will remain for some time an emerging market, it is not possible to find companies listed on WSE that meet all investment criteria set out by Mr Graham. Polish stock market is totally different from the American one, so it ought to be handled in a different way, although many principles outlined in the book will always apply.

The book condemns speculation, but doesn’t get with the times. Today speculation is far is easier. When everyone has access to online brokerage accounts and transaction fees are much lower (in Graham’s times they stood at 4%, today they are below 0.5%), cost-effectiveness of such actions is higher, but it is hard to determine whether the risk has also gone down.

Finally, the author advises the readers to keep away from short-selling. This makes another difference between investors and speculators. Only the latter indulge in and profit from “betting against the stocks”, but I do not denounce it. Short selling after all only improves market efficiency because it allows market participants to bring the market value of a security down towards its fundamental value. Of course going short entails a far greater risk than taking only long positions, but hang on. The risk is what stock market is also about!

Miracles happen

“Those “three witches” are just a myth, nothing unusual is going to happen” – I said today around midday, while disputing the possibility of turmoil on the Polish stock market. Indeed, three, six, or nine months ago third Fridays of last months of the quarters were absolutely normal in terms of stock volatility.

Those who are not interested in the stock market deserve an explanation. Today futures and option contracts on WIG20 were settled. Futures contract is pure bet – you buy or sell it and try to bet what the value of stock index (in this example) will be. If you go long and the value is higher than you bet, you win, if you go short you win when the index drops.

A small investor can use them speculate on WIG20 or to hedge their portfolio of stocks. A fat guy (as we call in Poland those big players who sway the market) who has a big portfolio can rig the market and thus reap profits of billions. Futures have a built-in leverage of ten. To put it simply, if you go long in such a contract, if a stock index goes up by 0.8%, you gain 8%, but if it declines by 1.4%, you lose 14%.

Now let’s look how a big investor rigged the market today. An index value used for settlements is an average value of WIG20 in the last hour of trading session. It was quite easy to place a few substantial purchase orders to push the index up by two per cent and get the benchmark value much higher than the futures value. Before the end of trading the same stocks were sold, WIG20 plummeted as unexpectedly as it had soared and closed 0.16% below yesterday’s close.

Upshots:
A big investment bank or investment fund raked in profits or around 17%
Thousands of individual investors are licking wounds and counting up losses also of around 17%.
Polish financial supervisory body has launched an investigation over market rigging.

Meanwhile the trading volume has been the highest in the history and exceeded 4.3 billion PLN. The foregone conclusion is that stock market is not for widows and orphans. Someone who doesn’t know the rules of the game and doesn’t realise the risks shouldn’t enter this casino.

Bubbles and bursts

If you don’t have an idea what to write, it never hurts to find an anniversary and make it a topic of your post. This exactly what I did today and the event I’ve found is one not to be sneezed at. I bet few of you, even those who have been keeping track of capital markets for years remember well that the dot-com bubble burst exactly ten years ago, on 10 March 2010 2000.

Dot-com rally is a quaint example of the role of psychology on financial markets. Stock prices soared not because fundamental values or companies had been rising rapidly, but because of what investor had believed in. They had seen the Internet as a breakthrough invention. Indeed, it revolutionised our lives, made it much easier, but they had overestimated its role. No new era had begun, not every company which had begun to operate in the Net turned into gold. Many of them were actually worth very little.

The history of speculative bubbles, back from tulips in the Netherlands four hundred years ago, up till the last officially recognised crude oil bubble in 2008 (the mortgage bubble was penultimate, it’s still early to say whether what is under way on stock exchanges all over the world is a new bubble or not), is a long record of human folly and misperception, mostly notably is how the risk has been underestimated or forgotten about.

The major beliefs that underlie the growth of speculative bubbles are the ones that a new era has begun or that a price of an asset can rise endlessly, which strengthen with time (I still find it mind-boggling). This funny but destructive mechanism works orderly until it loses momentum the moment when there are no more suckers eager to buy a certain asset (please note this is one of possible explanations). What causes a rise of a bubble and what pops it have been subject of numerous debates among economists. I will be trying to explore those issues in my MA thesis. From time to time, I’ll be sharing with you some my new discoveries and conclusions. This topic is a really fascinating combination of economics and psychology.

And at the end I have to eat a humble pie. Once again, what shouldn’t have even surprised anyone, my stock market forecast was far off mark. In late January I forecast much lower levels of stock indices. Today they are a step away from reaching their new peaks in the current bull market. I can make out where the markets are going, but what drives them in such a direction remains beyond my comprehension. Have we forgotten about the ‘R’ word once again? This word is RISK.

Investments and morality

The concept of moral spine, when taking investment decisions, usually neglected, is strongly emphasised in principles of Islamic banking. It seems it is one of sparse significant examples when ethics affects financial system on a level of banks, brokerage firms and other entities that are involved in large-scale banking operations. Their codes of practices forbid earning (excessive) interest, investments in shares of companies whose core business is deemed to be unethical, or trading in derivatives which are said not to be a real money. As you drill down in the superficial description from wikipedia, you will see the system is full of loopholes that enable to get round the rules.

And in our non-Islamic world, are there any rules? I worked out a short (and subjective) list of investments I would refrain from. I wouldn’t list there derivatives as Muslims do. Those financial instruments have been conjured up for three purposes: to hedge risks, take risks and speculate. As long as you don’t beg anyone for help because you have lost your capital this investment is ethical, but if try to socialise the losses or shift the costs of your flawed decision to someone else, who is not guilty, you are a typical product of modern “distorted capitalism”, “remnant of what used to be capitalism”, or whatever we have witnessed during the last financial crisis is. This stance can be described shortly: as long as your business goes well you tell the state and regulators to mind their own business, when your house of cards collapses, you seek their protection. A fine example of hypocrisy…

The first type of what I find unethical is not even an investment, because what I disapprove of is a pure speculation on real estate. If you buy a house or a flat to live in it, everything is alright, even if its price soars. If you buy a flat to pass it on to your child who is now in a nursery school, you do not do anything wrong, even if you will be subletting it for twenty years. But if you buy it only to sell it in a few years and take profits, I denounce your investment. By taking such a decision you contribute to rising real estate prices and make flats less affordable for other people, who will become slaves of mortgages for next thirty years. Dwelling is after all one of basis needs of a human being. Speculation deprives many individuals of their chance to have their own one.

Your own flat or house is your biggest financial asset, so it is an investment, but I wonder what would happen if mortgage became almost totally unavailable. How much would flats in Warsaw cost? The scenario doesn’t bring a picture in bright colours – flats would be bought be rich people who would let and the rest would have no choice but to rent it, rents would go up then. Not a good future prospect anyway.

The second type is a pure investment, unfortunately very common and used as a benchmark of risk-free rate of return. The government bonds. You keep your money in a bank, bank pays you interest from what it has earned from other clients – customers whose folly made them take out consumer loans or enterprises which had taken out loans to develop their businesses and have a higher rate of return than interest paid on the credit. This system of brokerage works well, mostly as the bank is the institution which takes a risk. Meanwhile you pay taxes and your neighbour buys government bonds. Interest he earns is financed from taxes you pay on what you earn as a worker as well as from your capital gains tax.

If you want to invest your money, do it on the market, let it work for a private business, don’t sponge on fellow taxpayers. State is not a saving bank, it’s role is to maintain law and order, provide public goods, depending on you economic views its role should be limited to minimum or cover a spectre of spheres like education, health care, social security. But it should not be a participant of financial markets. Another story is that it also should not spend more that it can afford to and consequently issue bonds. But as a balanced budget idea enthusiast I can talk my head off and I bet the day I die some of my neighbours will have their money invested in gilts. Damn it!

If I have touched upon taxation, I cannot leave out the new popular method of tax avoidance – antybelki – bank deposit which are constructed in a way that you don’t have to pay capital gains tax – either it is an insurance policy or the interest is paid daily and if it doesn’t exceed 2.50 PLN, calculated tax is rounded down to 0 PLN. It is absolutely legal, but if moral? You will save some money, but state budget will lose its revenue. Who will lose? A monster called “State” who lives in a cave and gobbles poor taxpayers? No, your neighbours will lose, your friends will lose, your family will lose, you will lose and the next generations will lose. They will have to pay higher taxes, because current lower revenues means higher budget deficit in the future. I realise the workings of Polish state are far cry from perfect, costs of maintaining bureaucratic apparatus are tremendous, but many public goods are finance from public purse, if you want to consume them, you shouldn’t evade paying taxes. (though the rational decision is not to pay taxes, because you’ll get them anyway).

My apologies to my readers. In the second year of blogging posting frequency will not be as high it used to be. But I pledge to try to focus on quality and publish at least two concise posts each week. I’m simply more busy this term and have less time for writing (what doesn’t mean less time for musing about politics, economy and society).