I have two semi-contrary ideas. The first is that the market, on average, over some long run time span, renders a realistic estimate of a stock's true value. Of course, that estimate, though realistic, might not be accurate. And, as Keynes said - in the long run, we’re all dead. The second is that in real time the market varies wildly in the accuracy of its estimates. The idea that ties these two concepts together is that the market makes its worst value estimates at tops and bottoms. A corollary is that the panics which follow extreme under or over valuations tend to drive the estimated value to the other extreme.
My other, related, idea is that markets are fueled by emotion, or, in Elliott wave terms, social mood. I’m not quite ready to buy into the entire social mood paradigm of human behavior, but I do think it’s useful to consider in the context of asset pricing.
As an example, let’s look at Apple Inc. [APPL] Now, I think Apple is a great company. My wife and I own and use several of their products every day. I am using one to write this essay. You may well be reading this on an Apple device. And their stock performance, for the most part, has been stellar for a long string of years. But I think the stock has recently soared to an unsustainable level. And I base this not on any kind of fundamental analysis, but on the price action of the stock itself. Let’s have a look at its chart [Graph 1.]
Graph 1 - APPL Closing Values, 1/04/10 through 10/30/20
The red line estimates a best fit exponential curve through daily closing data from 2010 to now. However, since the big decline in the spring of this year the stock price has deviated dramatically from that curve, going up in almost a straight line. Reminds me of Icarus.
Another way to think about this is that on February 12, Apple stock peaked at 81.80. Then, after the end of the world in March and the excessively exuberant recovery, it peaked at 134.18 on September 1. So, speculators [at this point we can hardly call them investors] decided that Apple was worth 64% more on the first day of September than it had been just 6 1/2 months earlier. This, not to put too fine a point on it, is nuts!
Whatever the rational valuation price for Apple might be, even in the bizarro world of 2020, at least one of these numbers has to be wildly wrong. The average over/under of daily prices, as compared to that best fit exponential trend line is +11.1%. So the price growth over that entire period has been on average, a bit above exponential. On Feb 12, it was over trend by 11.6%. At the low on March 23, it was under trend by 29%. But at the September 1 high, it was 68% over trend. My guess is that this was too good to be true, and now the stock price is indeed falling.
Yet another way to look at this is the stock price relative to Its own moving average. Since the stock has trended up over time, it runs above its moving average more often than not. But not all the time, and not by the same amount. As graph 2 shows, the price [blue line] seems to be pretty tightly contained in a envelope bordered by two Standard Deviations above [red line] and one Standard Deviation below [green line] the 233 day exponential moving average [not shown.]
Graph 2 - APPL closings in an Envelope of +2 and -1 Std Dev.
Graph 3 shows the difference in standard deviations units between the daily closing price and its 233 day exponential moving average [EMA,] with the Standard deviation computed over that same 233 day period. The mean value of that difference since the beginning of 2010 has been 0.92 standard deviations above the EMA. This is indicated with a red line on the graph. The orange line is the 89 day EMA of that difference. It seems to track the values fairly well. The graph shows that whenever the difference gets above 2 units, the price is in a danger zone, and will likely revert towards the mean. At the extreme, on the two previous occasion when it got above 3 units, there was a sharp reversal to a price more than 2 units below the EMA. Similarly, when the price drops more than 2 units below the EMA, there is a reversal toward 2 units above the EMA If this pattern plays out again, it suggests a coming low somewhere near 80, per Graph 2, about where it was in February, and a potential buying opportunity at that time.
Graph 3 APPL Daily closings difference from 233 EMA, in Std Dev Units
A Final thought, and no disrespect to Benjamin Graham and David Dodd, nor to Warren Buffet. There is an idea that you’re not buying a stock, you’re buying a company. That's Buffet’s approach, it’s worked very well for him, and that’s what you’re attempting to do with fundamental analysis. But unless you have deep pockets and a time horizon of several decades, this is probably not why you are in the market. If there had been equities markets in 10th Century B.C. Israel, the Book of Ecclesiastes would have had a verse saying that there is a time to buy and a time to sell. The time to buy is when all the excess has been wrung out of the market for a particular stock or stocks in general. My hope is that the ideas I’ve presented here may be helpful in identifying those times.
Note: Daily closing values from Yahoo Finance; calculations and graphs by me using the Open Office spreadsheet program.
Disclaimer: I do not own Apple stock, though I may at some time in the future. Except for a couple managed funds, I am out of equities markets for now. There will be a time to buy.
More disclaimer: I am not a financial advisor nor stock market professional; nor am I in any way qualified to make recommendations. I’m just an old man with curiosity, an attitude and an internet connection. I realized long ago that I see the world differently from most people, and l am looking at these things for my own amusement and amazement. Maybe you will be amused, as well.
Note 2: I almost managed to avoid saying that Apple's success stems from their core competence. Now I leave you with these thoughts: invest wisely, speculate cautiously, avoid crowds, wear a mask and wash your hands.
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