Index Distortions and Share Investment
Source: Neil Charnock, GoldOz (9/6/11)
"There is hope, but there are traps if you don't understand the deleveraging game or the debt collapse shuffle."
Shares are quick and easy to buy and sell, which is a significant advantage during a debt collapse. You want to stay liquid for a number of very important reasons. Shares are a very liquid investment. We are in uncertain times and if you are not fearful about the economy then your financial education is lacking, or you are invested in gold. Many asset classes that are normally considered safe have been a very risky choice recently, and will remain so for some time to come. There is hope, opportunity and light at the end of the tunnel. However, there are traps if you don't understand the deleveraging game or the debt collapse shuffle.
Superficial long term analysis of share performance often points to the long uptrend of broad index charts like the S&P500, FTSE, DAX or the ASX. The argument goes something like this. "Shares have outperformed housing and all other investment classes by "x" amount over the past 80 years" and "as you see, shares have enjoyed a steady gain over the last 100+ years." "There are ups and downs however look at the trend; even if you buy at the peaks you still make money over time." This is not me talking in this paragraph this is what I hear and read at times, even as a subtle message.
People get into share investing and lose money especially during choppy times like we have faced for the past few years. They also see very intelligent well-meaning Superannuation Funds lose money in this market (some years) and therefore shy away from this activity themselves as "too risky." After all if the professionals get it wrong how can they make a profit?
Self-managed Super has become a major trend in Australia with over 430,000 people taking the choice to go it alone. As a firm believer that economic education is essential at the personal level I applaud this. I suspect many of these people removed their super from the professional funds after 2008 in response to major losses. Now they need to get up to speed and fast if they are to retire in comfort and do the things they worked so hard for over their working life.
There are long economic cycles where average investors can make money buying just about anything and this tends to give a false sense of security. The very notion of long term investment in the market in general is dangerous, particularly during a period of massive deleveraging like we are currently seeing in this debt collapse. Deleveraging refers to the winding down of debt levels in an economy, amongst Governments, States, municipalities, corporations, SME's (small to medium enterprises) and households. Investors that are using models that worked for the last 60 years will get it wrong because this is a very long cycle wave event. I cover this in depth in my newsletter education.
There is another group of glaring mistakes in the long term buy and hold analysis which I want to share with you, in addition to the investment response needed by people who wish to enjoy the spectacular gains that can be made investing in the stock markets.
Companies come and go; they are formed and floated onto stock exchanges, they go into liquidation, they merge to form new larger enterprises or engage in acquisition and hostile takeovers. They can also demerge on exchanges at times, split into two companies in order to create greater value for investors. This is called corporate activity.
Whoa back up a little did I say "go into liquidation" yes that is right gone, money lost, minus 100% return on investment (ROI). They also have their hay day, a time of maximum popularity and profitability when investors pile in; some of them loading up then holding at exactly the wrong time. Their investment never reaches the price they paid, never ever again.
But shares go up over time you say, look at the index chart it is in a long uptrend. Yes they do and no; this does not mean it is easy to make money investing in shares. Here is the reality check in the equation; you can buy the right stock at the wrong time. You can even buy bank stocks and blue chip companies and lose money without research and timing skills. These are two of the primary keys to profitable share investment, part of solution.
Let me explain what an index is and how this works before I come to the investment solutions I have developed. I will use the S&P500 as an example. The S&P500 is a composite index, meaning it is calculated using the total market capitalization of the top 500 companies. The total market capitalization is the total number of shares on issue times the share price of each company.
Without getting too complex the total value of the company's in the S&P are then indexed to a base, which is a previous point in time in this case 1941 to 1943. This is a brilliant index do not get me wrong; there are even Index Maintenance calculations to keep the index comparable over time. As a means of measuring the whole markets performance over time; it is genius. However it has some obvious limitations not understood by the novice and less experienced investors. Many moderately experienced investors may not have understood this fully.
To keep the index from changing due to corporate actions there is a complex system of adjustments. This does not take into account more minor share issuance by companies (less than 5%) which causes dilution of a company and which is not always reflected in the share price. This is another distortion in the long term share investment model; this time not related to individual companies. My point is that it is impossible for any index to keep an exact record for all the variables in an investment model. So don't take the index literally it does its job well however it is not a silver bullet, not a path to riches.
Inflation is not factored in for a start. Periods of high inflation distort the purchasing power of the index. Selling your shares when the index has gone up 5% over 12 months will result in a net loss of 5% if inflation was 10%. This is a whole index distortion as far as profitable investing is concerned. In that long term 100 year chart there are periods when the S&P tracked sideways for a considerable period of time. Inflation devastated the purchasing power of investors that sat for the same of dividends during suck periods. Bankruptcies ripped portfolios apart; bubbles in select sectors and hay day wonders came and went with the hopes and aspirations of many investors.
Whoa back up again. Bubbles in select sectors, there is another whole market distortion. The top 500 companies change over time as bubble participants come and go. Get yourself in the wrong sector at the wrong time and you have yourself the equivalent of the hay day stock on a broad scale. The S&P smooths the performance of the combined leaders over time however it could not possibly smooth the ride you will have in the wrong sector, this is not its task. Again the less experienced do not take this into account when they view the index performance over time. If you think the index loses value once inflation is factored in overtime then think about the loss of sitting in a stock over time waiting for its sector to recover.
Business is fluid meaning that conditions change drastically over time, they are always in motion. Various market forces push business in different directions. This is how bubbles form and collapse. Factors like globalization have changed operating conditions as manufacturing moved offshore out of mature economies. Costs spike at different times, regulation changes operating conditions; there are a myriad of changing circumstances. The business cycle itself describes boom and bust conditions.
This is part of what I talking about when I mentioned long cycle wave above and how investors with a short education span, less than 60 years will get this one wrong. This will continue to be devastating throughout the course of this next ten years for investors who refuse to let go of investment models that are now broken.
I have hinted at the solution. Share investment is not a free ride however it can be highly rewarding and not just from an investment angle. Being right is a pretty nice place to be we all enjoy this it is a good feeling. The markets have a way of humbling all of us even the experienced and this is part of experience itself; you can't afford to get emotional. Tax issues aside you have to know when to buy and sell. This sounds simple however you will find timing the most demanding aspect of this game. Even some highly successful investors I have met were no good at it. Many believe it is impossible, I happen to disagree.
Getting the timing right can make an enormous difference to your return on investment (ROI) in percentage terms. It can enable you to turn a magnificent profit in a ranging market, one that goes nowhere but sideways for long periods. With this skill in place you don't lose on inflation during such periods. More importantly this skill enables you to be able to get out when you need to, closing a profitable investment with your money moved to the bank and the tax man. This is the most important skill in my opinion however it is not essential if you have to other two key ingredients at your disposal.
An understanding of macroeconomics is one of these. In a broader sense it also comes down to timing. You decide to get into gold stocks or dot com or bank shares due to the big picture analysis and you ride the trend. If you have this complex study in hand and stay on top of it you can make your fortune from share investing. This will lead you to choose the right sector at the right time. This study can take on an advanced state with understanding of individual asset classes and their interrelationships and other factors.
The final solution is your ability to study a company in a given sector. How to read the balance sheet, to decide if the strategy will work or not, to judge the Management, in the case of mining the ground position and business of mining itself are all important. If you are to run your own superannuation fund you need these skills. They are not taught in school however the methods by which you will acquire them were. If you want some insight about what we do there is now an option to purchase a look at our Educational Portfolio and 5 Newsletters for only $25 at our store, you can even upgrade from there as part of the cost if you find our education helpful.
Good trading / investing.
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Neil Charnock is not a registered investment advisor. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services. The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.