zakat

Noise

April 24, 2008 by  


By Bob Wood, MMNS

As I write this column, the stock market is enjoying a wonderful rally with the Dow up almost 300 points for the day. This market advance is in response to positive earnings announcements from several large companies whose shares trade in large volume each trading day. Last week, the market ended on a sour note with a big one-day drop, due, in large part, to disappointing earnings from General Electric. Is this the environment envisioned by long term investors?

Can news from one company such as G.E. really give investors meaningful information about the overall stock markets and the larger economy? I really don’t think so, yet the crowd — many of them professional money and fund managers — seems to react aggressively to what will almost inevitably be seen later as nothing but “noise.”

I am continually amazed with how much money flows into and out of stocks based on temporary events such as one company’s earnings announcements. And sometimes, it’s worse than that! Last week the market was cheered by the earnings announcement from tech bellwether Intel, which not only met its earnings expectation but also noted that gross margins would be slightly higher in the coming quarter.

How can anyone look at such a small data point — one company’s gross margins — and infer that conditions will be better across the board for all domestic companies? Of course, we shouldn’t, but, all too often, investors do just that. Amazing!

I wonder how investors can react so strongly to Intel’s gross margin story as though that one point overrides the massive structural problems our economy now faces. Will Intel’s gross margin improvement offset the damage done in our housing and mortgage markets? If Citigroup loses only $5 billion for the quarter, when analysts estimated it could have lost more, is that really a good sign and enough to offset damage caused by steep rises in our energy costs?

These reactions to bits of data happen almost daily and make investing very confusing for investors. The stock markets shoot higher for a day, based on information that is subject to change or revision — within weeks, if not days.

If you spend any time watching financial news programming, you know what I am talking about. On Wednesday mornings, we can watch a “live update” on energy inventories. One week will show an unexpected build in crude oil stocks that surprises analysts, who had anticipated less. On this news, oil prices will fall somewhat to reflect the increase in available supply. A week later, the inventory number may come in with lower supplies than expected, and oil prices will rise in response to the new news.

Do these fluctuations change long-term trends in the price of energy products? Heck no! But they certainly keep investors trading — in and out. Increased trading activity occurs in other sectors of the stock market, too, based on morning announcements about which stock was “upgraded” or “downgraded” by one of the big Wall Street firms.

You may recognize the patter: the reporter alerts us that Merrill has added Intel to its top buy list, adding that they like the company’s valuation and the way reports of higher computer sales will positively affect its stock price. Am I the only one wondering how many times one broker or another has upgraded that stock in the past 10 years? In the past 10 years, that stock has gone nowhere, yet it is almost universally admired by the analysts covering it.

In recent weeks, our stock markets were flying higher on days when rumors were circulating about the credit ratings of monoline insurers like MBI and Ambac. Supposedly, they faced possible downgrades by rating agencies, but bailout schemes were in progress and would soon be announced. Days later, those rumors proved unfounded, and the markets sold off again.

To emphasize how bad these reactions are getting, consider this past April 1st, when stock markets rocked higher, due in part to a research note issued by noted hedge fund manager Doug Kass, who has been famously bearish for quite some time. Kass put out an alert of sorts, saying he had become wildly bullish and was now buying stocks in earnest. His comments later proved to be nothing more than a good old fashioned April Fool’s joke, yet few bothered to question them before rushing to buy stocks!

As I write today, while keeping an eye on my TV screen, I see a CNBC graphic showing performance of the stock market in the months following a reading on the VIX, a measure of volatility, when it falls below 20. Honestly, I don’t know where they find this kind of stuff, but they do — in never ending supplies.

So what exactly happens when the VIX suddenly rises above 20? What happens when the next large company misses its earnings estimates? What happens when one of those monoline insurers is downgraded, which could happen any day now? Should investors just forget the data points of the previous few days — and reverse their course again?

Yet each week, investors sit on the edges of their seats, waiting for announcements of transitory data points coming from jobless claims, CPI readings on inflation, speeches from Fed officials, analyst upgrades, trade deficit figures, retail sales numbers, etc. That each and every one of these points is subject to revision or change within days or weeks seems lost to so many who put their savings at risk in the markets.

How can so much information of such transitory nature have so much meaning to so many? It does, though it really should not. This type of information constitutes nothing more than “noise” in too many instances. None of the weekly or monthly data points are significant enough to offset the structural mess in our economy, which gets worse as time passes.

None of them offsets the massive losses incurred by so many of our largest financial companies. None offsets the debilitating effects of rapidly rising energy and food prices. And the news would have to be stunningly perfect to justify buying stocks with the S&P 500 sporting an average P/E of close to 20, as it does now.

If you are willing to put some real effort into your investing activities, I suggest that you read the book Fooled by Randomness by Nassim Nicholas Taleb. The same author has now written another excellent book worth reading, The Black Swan.

In Fooled by Randomness, he writes about ‘’breaking news’’ and cites an appreciation for ‘’distilled thinking, by which I mean the thinking based on information around us that is stripped of meaningless but diverting clutter.’’ He continues with this:

“The problem with information is not that it is diverting and generally useless, but that it is toxic… if there is anything better than noise in the mass of ‘’urgent’’ news hounding us, it would be like a needle in a haystack. People do not realize that the media is paid to get your attention. For journalists, silence rarely surpasses any word.

“On the rare occasions when I boarded the 6:42 train to New York I observed with amazement the hordes of depressed business commuters (who seemed to prefer to be elsewhere) studiously buried in the Wall Street Journal, apprised of the minutiae of companies that, at the time of writing now, are probably out of business…

“But while early on in my career such focus on noise would have offended me intellectually, as I would have deemed such information as too statistically insignificant for the derivation of any meaningful conclusion, I currently look at it with delight. I am happy to see such a mass scale idiotic decision-making, prone to overreaction in their post-perusal investment orders – in other words I currently see in the fact that people read such material an insurance for my continuing in the entertaining business of option trading against the fools of randomness…

“Like a health club membership taken out to satisfy a New Year’s resolution, people often think that it will surely be the next batch of news that will really make a difference to their understanding of things.’’

Taleb certainly sums up what I think about breathlessly reported bits of information that pass for news in the financial media. But such “news” does help to explain why so many shares trade daily in a stock market that has gone nowhere for the past eight years.

Few, if any, have made money investing in domestic markets during this decade, but great volumes of trading go on anyway, and trading volume increases by the year. But at least the brokers are making money! Hey, you don’t suppose that’s why … nah. That would be too obvious, wouldn’t it?

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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