Things are different in the Internet-era globalized economy today, and rarely there had been so many international incidents occurring in such rapid succession.

In a matter of weeks, Egypt overturned its 32-yr old regime, which in turn fueled civil unrest in Bahrain, Yemen, Libya, Syria and even Saudi Arabia. Then came the devastating double punch of earthquake and tsunami in Japan. And before the dust settled there, USA and its NATO allies began bombing Libya.

Considering Japan’s status as the world’s third largest economy, and America’s dependence on Middle East’s oil supply, little wonder US market feels the strain of such global uncertainty, especially when the economy is on a slow rebound from one of the worst recessions in history. And this may continue for a while, as this CNN Money article muses.

Today’s article on Apple looked into its market valuation based on the high Price/Sales ratio, which drives its unique pattern of fast growth immediately after launching a new product, followed by a period of normalcy until the next new product comes along.

The author questions the sustainability of such growth for long, considering that new products are often only upgrades of the original:

Bear in mind that for several years now, Apple’s growth has really come from what are essentially line extensions on just one product, the initial iPhone. With all due respect to Steve Jobs as an innovator, how many more times can he mount the big stage, tap icons and re-size pictures by flicking his finger while preaching world domination, before it becomes white noise? Ultimately, how many more 50%-plus sales growth rates are in Apple’s future?

I am not too concerned about Apple’s product line though. A company whose growth bounces between spectacular and normal is doing fine in my book. But, one issue that may have a serious bearing on Apple’s management in the near future, relates to Steve Jobs’ health concerns, and speculations about a possible CEO succession.

Uncertainties arising from CEO change is the topic of the other article on Google, which discusses co-founder Larry Page replacing Eric Schmidt as Google CEO in the next two weeks. The author talks about Page’s lack of PR skills that may seriously affect Google’s ongoing love affair with its investors:

I think he and Google investors are in for a rude awakening.  The next 6 months are bound to be bumpy for him as he figures out what’s required from a CEO. For that reason, I wouldn’t touch the stock until at least October.

Read the Forbes articles on Apple and Google.

How does an economist define a recession? According to Wikipedia a recession happens when a decline in the country’s GDP (gross domestic product), or negative real economic growth, continues for two or more consecutive quarters.

Buffett says “people are already feeling the effect” of recession, and how true he is! If you do regular chores, like buying grocery or gas for your car, you know this is mighty tough time we are going through. But well, if there is one thing we learned from economic history, tough times never last.

I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform…and I could just go back and get on with my work.

Coming from the most famous “stock picker” in the world, such drumrolling for index investing may come as a surprise to some. But as I said in this post, he has been advising this for many years, because with index funds you “would feel confident that (you) would outperform” and “get on with (your) work”.

An estimated 30,000+ strong crowd assembled in this meeting to hear from the Sage of Omaha in these troubling financial times. His main message was that it is impractical to expect an earning of 7 to 10% with publicly traded stocks today. Contrast that with past returns: between 1985 and 2004 a simple portfolio of S&P 500 Index fund would have earned 13.2%!.

You can read the meeting excerpt here and here.

EMT or FA – which one is “correct”?

Interestingly, even though Buffett began his session with the Wharton students by criticizing the “misguided” EMT, he later advised average “non-professional” investors to buy-and-hold index funds (the strategy based on EMT), instead of trying to pick value stocks (strategy of FA) because “they are not going to be able to pick the right price and the right time”.

Coming from the Oracle of Omaha, this seeming contradiction can throw you off. But, what he is really saying is that both these investing strategies are in fact correct, but they apply to two quite different types of investors. Value investing is the correct approach for professional investors, whereas portfolio diversification with index funds is correct for the armchair kinds.

A savvy investor, after finding a potentially undervalued stock, must do extensive study of the company – financial statements, annual reports, latest news etc. – before he can be confident enough to buy the stock. A value investor must also execute frequent trading to replace old overvalued stocks in his portfolio with new undervalued ones.

By contrast, an average investor buys and holds a bunch of index funds from different industry sectors to diversify his portfolio (against market risks), and rebalances the portfolio at least once a year to restore the original proportion of funds. This investing method requires very little time and effort from the investor.

If both are correct, who gets more?

A simple portfolio, made up of a single index fund that tracks a broad market index such as the S&P 500 Index, experiences the usual market fluctuations over short times. Over long time, though, the portfolio guarantees the market return (minus the small operating cost of managing the fund), which was more than 10% over several past decades.

A value investor’s portfolio, on the other hand, is expected to grow (despite short-term fluctuations driven by market events) until the undervalued stocks are priced “right”. The probability of a higher-than-market return increases with the expertise of the investor, and with the time and effort spent in researching the stock’s prospect.

Simply put, an average investor with a portfolio of index funds will certainly get at least the market return over long term, whereas a professional investor with his value stocks has only a chance of achieving a higher-than-market return. And unless the difference is substantial, high costs and taxes incurred from frequent trading can eat into the return, often pulling it down below the market return.

There is overwhelming evidence available that achieving such higher-than-market returns on a consistent basis is an extremely rare phenomenon indeed, because no one can “pick the right price and the right time” year after year after year (if you want proof, I suggest reading Burton Malkiel’s classic A Random Walk Down Wall Street). As for me, I prefer certainty over chance, and have been very satisfied with index funds.

It did not surprise many when Warren Buffett, while recently hosting a group of business students for a two-hour question-answer session, began by pointing out the folly of the efficient market theory (EMT). After all, his objection to EMT is as legendary as his support for fundamental analysis (FA), as the foundation for smart investing.

But first thing first: what is EMT, and what indeed is FA? (These are my short-hands, by the way.)

Efficient Market Theory (EMT)

EMT holds that the stock market is so efficient in absorbing the latest developments in the industry – company merger, major product launch, corporate scandal etc. – that the stock prices almost instantly reflect these developments. Thus, there is very little time available to an average investor to act on such “inside information”, before it becomes common knowledge so everyone does the same (thereby quickly driving stock prices up or down). In other words, because such developments are unpredictable, stock prices in turn cannot be predicted, and they execute a random walk down Wall Street.

The investing strategy based on EMT is known as portfolio diversification, where the investors buy and hold a range of stock, and bond, funds indexed to broad segments of the financial market (known as index mutual funds). Because the prices of individual securities in a fund do not move in lockstep with each other, the portfolio achieves “diversification” by spreading the risk of asset downturns, where dip in one security is compensated by rise in another.

Fundamental Analysis (FA)

FA holds the contrasting view that although unpredictable market events drive the stock prices over short times (as in EMT), there is a fundamental value of every stock that can be determined by analyzing the company papers – financial statements, annual reports etc. – and other available information on its management policy, competitive edge and so on. The stock price eventually catches up with its value, which is predictable, and the investor can benefit by trading the mispriced stock and waiting till it is “corrected” by the market.

The investing strategy based on FA is known as value investing, where the investor looks to buy undervalued stocks of otherwise healthy companies. Such a portfolio is expected to grow with time despite short-term fluctuations, and so there is no need for diversification. But, because a company does not generally stay healthy forever (management changes, economy takes a hit, and so on), a value investor must tune his portfolio time to time by selling old overvalued stocks and buying new undervalued ones.

Go on to “Part II – Which one of them is correct?”

He tried to buy $5000 worth of stocks just before the end of Monday, when the stock market was showing a noticeable slide. Fed was making noises of giving it a boost the next day, so he was correct in thinking that stocks will take off Tuesday on this positive news, thereby netting him a tidy gain.

S&P500 index dropped 20 points by the end of Monday, a 1.55% loss. Federal bank announced a $200 billion loan to the banks the following day, and the index soared 47 points by closing time Tuesday, a whopping 3.7% gain. If my friend were to buy a mutual fund that tracks S&P500 index, he could have made 3.7% in a single day!

So, what went wrong? He failed to time his buying. He did send the money before the end of Monday, but the transaction could not be completed before Tuesday, when stocks were already near their peak. And by closing Wednesday (today), the index is again down 12 points, and so he actually ended up losing money.

If I were him, I would have spread $5000 into several small transactions over the entire month, which increases the odds of riding at least one wave from the bottom to the top – the standard advantage of dollar-cost averaging. What is more, you can automate the process, and do not have to spend any time trying to track the market.

This is still only a scratch on the surface compared to what happened this day 20 years ago. In what is now termed the infamous Black Monday, US stock market recorded the largest one-day crash in its history on October 19, 1987. That fateful day, Dow Jones crashed 23%, and S&P 500 dropped 21%.

Dow would have had to lose almost 3200 points today to match a 23% loss. That is a huge number for a single day drop. Can it happen again? Theoretically yes, but unlikely. There is still controversy on what exactly went wrong on black Monday. But there are several safety measures in place today to prevent a similar catastrophe. This includes improved monitoring of stock trading, and also computerized access that allows investors to execute transactions by themselves.

Donald Luskin writes that with S&P 500 index only <6% below its all-time high (a 10% drop counts as a mere market “correction”), the market is still bullish, and this is not the time yet for government intervention. He also reminds us of Bernanke’s 2002 speech, where he said that the interest rate is a tool for regulating economic growth in the long term, not for giving short-term relief to the market every time it slips.

Many do not share Luskin’s optimism on market conditions today, and they do not need to look up charts. The current credit crunch and housing crisis have stressed the investing environment, and it feels particularly hard coming right after the boom over the preceding year.

But this is not a recession yet, and until the overall economy is threatened, the Fed has no reason to step in. I agree with the conservative sentiment that the investors must own up responsibility for their action, and it is not the government’s (and hence the taxpayer’s) job to bail them out. But it is the government’s job to ensure the investors are not duped by reckless actions of private enterprises, as the subprime mortgage mess today shows.

1. Rising oil prices. High energy cost triggers fear of inflation, and Federal Bank typically counters by raising short-term interest rates, which deflates stock prices. Oil price has soared 20% so far this year.
2. Rising Treasury yields. As the yield of 10-year Treasury notes rises sharply, investors often turn away from stocks in favor of the security of notes and bonds. The yield has not changed much this year yet.
3. Falling number of growing stocks. If the broad indexes are being pulled up by only a few large company stocks, while others are falling around them like ninepins, that cannot be a good sign. Over the last few weeks, almost four times as many stocks hit 52-week lows as highs.
4. Falling consumer spending. If we buy less, it stands to reason that the product-oriented industry will suffer. Retail sales dropped almost 1% in June, and the continuing housing market crunch can force consumers tighten their money-belt even further.
5. Falling corporate earning growth. If corporate earning slows, the market will slow down as well. Low productivity growth, inflation fears, high long-term interest – all of them dissuade companies from borrowing money. We won’t know till 2007 earning reports are out.

In short, we do not know. Even though this type of analysis is better than those based on charts alone (the so called “trend analysis”), predicting the future based on past events is still notoriously difficult, if not impossible. The only certainty about the market is in its past, a classic example of “hindsight being the perfect science”.