preliminaries

The decision to buy an individual stock, or an ETF or an index fund ,for that matter, is the product of a series of increasingly focused judgments.

The first is the investment plan that sets out an asset allocation among cash, bonds and stocks based on your goals and risk tolerances.

The second level is a comparison of the relative returns you judge are available to you from the different classes of liquid assets, namely, cash, bonds and stocks.  (At present, it seems to me the odds are tilted unusually strongly toward stocks.)

The main benefit of cash in a bank or a money market fund at the moment is that the funds are safeguarded; returns are miniscule, although capital loss is extremely unlikely.  The 10-year Treasury bond yields 3.2%, the 30-year 4.1%.  I find it hard to imagine that interest rates will fall further, creating capital gains for bondholders.  If anything, rates will begin rising in the coming year, producing capital losses.  Stocks?  The long-term average, which I regard as the default number, is around 10%.  I think the year-ahead potential is greater than this, but that’s another story.

The third judgment is whether you perceive a reward from deviating from a benchmark stock index–in the case of US investors, it’s typically the S&P 500–to take the extra risk of buying an individual stock.

figuring the percentages

first pass

Let’s say I decide to add equity exposure to my portfolio.  I figure that earnings on the S&P 500 can be $85 this year and $95 next.  I think the market can trade on 15x earnings, which would be an earnings yield of 6.6%.  That compares very favorably, I think, with the 3.2% interest yield on the 10-year Treasury.

If those numbers are reasonable–I think the earnings could be high and the multiple could be low–then the S&P offers 20% upside over the next half year or so.  Downside?  Le’s say that in the current period of market fear the index could drop another 10%.  I think that’s too much, but it allows me to make a point I think is important.  And when people get scared, who knows what their emotions will lead them to do?

Let’s also say that I think both outcomes, up 20% or down 10%, are equally likely and are the highest probability results.  This means I’m risking the loss of $1 in order to gain $2–2 to 1 odds.  This sounds ok but not fabulous.  Should I wait for better odds?

second pass

Suppose the market drops 5% from here.  Then the situation is 25% gain vs. 5% loss.  5 to 1! This looks much more attractive.  But…

third pass

I’m not the only participant in the market.  Others have pocket calculators and can make guesses about possible market outcomes.  In other words, everyone already knows the market is very attractive down 5% from here.  In all but the most panicked markets, there’ll be someone who says to himself that he’ll get a jump on the crowd by buying down 4%.  After all, a 24% gain (eight years of 10-year bond interest) vs. a 6% loss isn’t bad, either.  There may also be someone who not only thinks about the crowd but about the guy who intends to buy when the market falls 4%.  He may think that a 23% gain vs. a 7% loss, or 3-to-1, is acceptable and place limit orders to buy at 3% below the current market.

comments

The reverse regularly happens when the odds favor selling.  In this case, astute sellers forgo the last few percentage points of theoretical upside to be assured of exiting their positions before a decline commences.

The same kind of calculation applies with individual stocks as with the index.  One difference, though:  the risk/reward ratio has to be higher, I think, than that of the index to justify the extra risk of buying an individual stock.

I’ve always found it harder to figure out the bottom of a trading range than the top.  This may partially be my bullish temperament.   But marking the bottom also requires a good understanding of how much risk the market attaches to the possibility of actually achieving, or breaking through, the top of the range.

In the current situation, for instance, the market may still think that the most likely year-end target for the S&P is 1250-1300.  But it clearly now wants to assign a higher risk to this outcome, as the break below 1100 (which had previously been a solid-looking floor) and the current search for support around 1050 show.  Part of the new anxiety comes from the slowing in the pace of growth in consumption in the US over the past month.  Part doubtless also comes from worry about the impact of a slowdown in Europe on corporate profits here.

Both concerns appear to me to be already overly discounted in today’s prices.  But the market, which is always the final arbiter, disagrees.