Forecasting

Free stock tips come with experience. During 1956 the peak price reached on a share of some common stocks listed on exchanges was as much as ten times as high as it had been three years earlier, in August 1953. Even in some broadly diversified investment companies, the price of a share was more than doubled in those same three years. Over a longer time, the fluctuation has been great­er. Back in 1942, just after the United States entered World War II, the price of a share of a diversified fund was one fifth or one sixth as much as at the peak of 1956.

Obviously an investor's timing can make an enormous dif­ference in how many shares his money buys and, consequent­ly, in how much income he receives. And his timing of selling can cause just as much difference in the amount of cash he receives for his shares. This chapter discusses the timing prob­lem as it confronts a buyer or seller of shares in a broadly diversified fund, whose value naturally varies more or less in line with a stock-market index. The question of when to switch from this stock to that stock is another story, not covered here.

A graph or a table of the past history of stock price levels shows clearly that if an investor had bought at certain times, and had sold at certain other times, he would have made a big profit. Any amateur can see this at a glance. But he can study the historical record of fluctuations and their causes until he is blue in the face without learning when, in the fu­ture, the price level will rise or fall, or how far.

The record does show a long-term tendency for stock pri­ces to rise gradually. The average price for any five years is usually considerably higher than a similar average of prices twenty years earlier. But that trend is distinct from the short-term ups and downs discussed here. On fluctuation, about all that the historical record proves is that, from time to time, prices have risen and fallen, with considerable varia­tion in the time and distance moved in one direction before the trend was reversed. Looking to the future, it seems fairly safe to predict that irregular fluctuations will continue, and a sensible stockholder plans so that they will not bother him unduly.

More than free stock tips, in many aspects of life, an expert is able to forecast the future, at least approximately. Official weather forecasts are usually somewhere near correct, and are improving in accu­racy. In vital statistics, by keeping track of the current birth rate a jeweler can estimate fairly reliably how many young men are going to buy engagement rings around twenty years hence!

In the stock market, ability to forecast reliably would have such great financial advantages that many efforts have been made in that direction. Apparently most buyers of stock ex­pect a professional adviser to be able to forecast the gen­eral market price trend. And a professional, even though he knows better, may feel that in order to hold his clients he must claim prophetic ability.

Beginning early in 1962, most stocks declined steadily and selling reached near-panic proportions at the end of May. A sharp recovery followed. According to Louis H. Whitehead, people are now trying to decide whether this is merely a "normal" technical rally in a bear market or the beginning of a more significant advance.

As far as the writer has been able to learn, proved, long-term, consistently successful forecasting of the general market level is as scarce as hens' teeth.

As to why the task of forecasting is so difficult, here is an explanation offered with some diffidence. Stock prices are partly the result of facts, such as

1. The volume of sales by corporations, this in turn being affected by such things as change in size of population and in average income, primari­ly in the United States but also in the rest of the world;

 

1. The corporation's expense of doing business, including labor, material, and taxes;

1. Profits or losses, the difference be­tween corporate income and expense.

 

As free stock tips go, you should never forget that factors are 75% psychological. Stock-market people guess at facts not yet revealed; and they form opinions on the effect of past facts, on probable future developments, and on what action other market people are going to take. A short-term trader in stocks is not the least interested in obtaining dividends. He centers his attention on guessing which stocks other people are going to be interested in buying or selling, and at what prices. Then he tries to outguess everybody else.

Finally, Wall Street opinions affect the future facts of busi­ness. A rise in the stock-market level tends to cause stockholders and business managers, and indirectly the general public, to spend money more freely. A drop in stock prices does the opposite. But the Federal Government, in the effort to avoid booms and busts, may make moves tending to con­tradict the stock market's forecasts. Obviously, it's a pretty complicated game.

Published discussions of stock market prices usually sound as if everyone were on one side of the market. "Heavy selling lasted all day." Such a statement misleads by telling only half of the story. A sale of stock is impossible unless someone buys. If selling is heavy, then so is buying. All of the people taking part in the stock market at one time, including brokers and dealers buying and selling on their own account, are always divided into two groups, one group believing this is the time to buy, the other group believing the exact oppo­site. The great majority of the people involved may be on one side, but in the number of shares moved, the buying must equal the selling.

This balance of opinion proves nothing as to whether today is actually the smart time to buy or sell. But to a cautious in­vestor, the fact of the persistent disagreement may suggest that perhaps there rarely is a day when it is clearly wise to move a large portion of his capital either into or out of the stock market.

In investing, as in other affairs, a man naturally prefers to remember his successes, and conveniently to forget his mistakes. Whenever he happens to make good guesses in the stock market, in his memory this overbalances his bad guesses. If an investor believes he is a good forecaster, he might guard against the tricks his memory plays by making a careful record of every move he makes in the stock mar­ket, and checking back, months and years afterward, to see how often he was right. (In another chapter we suggest how to use a mutual fund's performance record as a standard of comparison.)

You may think: "Granting that stock-price forecasting is a tough nut for an amateur to crack, still the experts must know the right time to buy and sell; how do they decide?" Strange as it may sound, some, at least, of the best ones don't try!

The mutual-fund investment companies with the best long-term average-performance records keep their assets nearly all in common stocks all the time. A few of them have rules limiting their portfolios to common stocks only, but in most of these funds the management have the right to buy bonds or preferred stocks, or to hold assets in cash, if they consider this desirable. So here we have a group of organizations specializing in investing, some with more than thirty years of experience, some with more than a billion dollars of as­sets, and with managers authorized to switch into and out of common stock at their discretion. But they do not use this privilege. By not acting, they practically admit they don't know how to make reliable forecasts of the general stock market. These fund managers do some switching from one stock to another, but that is quite a different matter from taking a stand on common stocks in general.

In 1955 and 1956 the stock market reached a price level higher even than in the crazy boom of 1929, and much high­er than at any time in between. To a manager waiting for a time to sell out at a high price, 1956 offered a fine chance. But among these common-stock mutual funds with high per­formance records, not one seized the opportunity. Incidental­ly, using hind-sight, if they had sold out in 1956, they could have bought back in late 1957 at lower prices. Apparently withdrawal from common stock in general is considered by these managers as a wise move only in a wild market such as has not occurred since 1929.

A Standard Ratio for Buying Stock

When looking at free stock tips, it is common to ask, "if forecasting is dangerous, then how can an investor time his buying and selling of stock?" The simplest answer, and by no means the worst one, is to ignore the price level, to buy stock whenever he has savings to invest, and not to sell un­less he must, for reasons outside the stock market.

Here is another answer that requires a little more figuring, but is more reliable under varying conditions. One reason why an investor should own both common stock and fixed-dollar items is that it opens an opportunity to buy stock at lower-than-average prices and to sell at higher than average, without forecasting.

Momentarily ignoring the question of timing of stock pur­chases, let us suppose Mr. A has $100 of new savings to in­vest on the first day of each month. With half of this he buys common stock, and the other half he treats as reserve, put­ting it into a savings deposit. From a cost viewpoint, his savings are always divided equally between stock and reserve. During the first year he deposits $600 in the savings bank and pays $600 for stock, buying 120 shares, an average of 10 shares a month, at an average price of $5 a share. (To simplify this illustration, we ignore the expense of buying and selling stock, also the income on investments.)
Now let us look at Mr. A's market or redemption values. On January 1st of the second year the withdrawal value of his savings deposit, disregarding interest, is the same as his cost. But the market value per share of his stock has dropped to $4, giving his 120 shares a value of $480, or $120 less than his savings deposit. With this drop in price, his usual $50 monthly purchase would pay for 121/2 shares, as com­pared to his previous average of 10 shares.

But suppose at this point Mr. A decides he wants the market value of his stock to equal his savings deposit, and that he should adjust his buying to accomplish this. As a first move, on January first he makes no savings deposit but puts all of his $100 monthly saving into stock, thus raising the total stock value to $580, as compared to $600 in the savings deposit. With the $100 he buys 25 shares, 21/2 times as many as his former monthly average. Later on, when a rise in price causes his stock value to exceed his savings deposit, he offsets this by putting all or most of his new savings into the savings deposit.

Now let us expand Mr. A's action into a plan. First, an investor selects a standard ratio that he will maintain be­tween the market value of his common stock and his re­serve. Merely for simplicity, the ratio used here is $1 stock to $1 reserve, but the idea can be applied to any ratio an investor prefers.

Remembering that some reserve may be needed for per­sonal emergencies, outside of investing, an investor might put all of his first savings into reserve, up to some dollar figure, and omit this amount in figuring a standard ratio be­tween reserve and stock values. On starting to save $100 a month, he might adopt a standard ratio of $4 stock to $1 reserve, but not counting $1000 in emergency reserve. For the first ten months all his savings go into reserve, thus completing his goal for emergencies. In the eleventh month, observing his standard ratio, he puts $20 into reserve and $80 into stock.

Having chosen a standard ratio, he must not allow current stock-market conditions to persuade him to change the ratio. If he adopts one ratio when stock prices are dropping, and changes to another ratio when prices are rising, he is slipping into forecasting. A standard ratio has no chance of success unless, after an investor adopts it, he parks his emotions outside. Buying under a standard ratio goes this way: When an investor has new savings available, before placing them he finds out what the current values are of his total stock and his total reserve. Then he puts his new savings into whichever one is low in value compared to his standard ratio, as Mr. A did with his $100 monthly savings.

When an investor has little or no new savings, he can gain the benefit of the standard-ratio plan by applying the same ratio to both selling and buying stock. Suppose Mr. B's annual spending is exactly equal to his income, so that he has no new savings, nor is he spending any capital. His standard ratio is 1 to 1, and the current value of his capital agrees with this; 2,000 shares of stock at $10 a share total $20,000, and $20,000 reserve in a savings deposit.

Then the value of a share drops to $8, making his total stock value $16,000. To restore his values to agreement with his standard ratio, he withdraws $2,000 from savings deposit and buys 250 shares of stock. This cuts his reserve to $18,000, and also raises his current stock value to $18,000.

Next, the value per share rises to $10, the same as the orig­inal figure, and his 2,250 shares have a current value of $22,500. Again acting to restore his values to his standard ra­tio, he sells 225 shares of stock for $2,250, and adds this to his savings deposit. This leaves him with 2,025 shares of stock, valued at $20,250, and $20,250 in reserve, his total capital being $500 larger than at the start. (For accuracy, the expense of buying and selling should be subtracted from this gain.)

A switch of old capital between stock and reserve should not take place until stock value has moved far enough away from the standard ratio to justify the expense and trouble of changing. In the above example, Mr. B bought stock when his stock value was 20 per cent below his reserve value. And he did not sell stock until his stock value was 25 per cent above his reserve value. The desired gap can be provided au­tomatically by setting up a standard ratio for selling stock that is different from the buying ratio. This is explained below.

A Second Standard Ratio for Selling Stock

The advantage of having a difference between the standard ratios for buying and for selling stock - when it comes to free stock tips - is more evident when an investor has sizeable new savings and also desires to sell stock when appropriate.

Returning to Mr. B, suppose that not long after he sold stock and while the price is still $10 a share, he has some new savings available. Since his stock and reserve values are already equal, if he applies his standard ratio on the new capital he invests half of it in stock. But this causes him to buy stock at the same price at which he sold recently; so he has wasted the expense and trouble of buying and selling.

To reduce this risk, Mr. B adopts a second ratio. On buy­ing stock, he continues using his old standard ratio of 1 to 1. But for selling stock, he sets a higher standard ratio, $1.20 stock to $1.00 reserve. The gap between the two ratios can be set at whatever amount an investor desires. The larger the gap, the less often the price of stock will rise or fall enough to cause him to act, but the more profit he will have when he does act.

With this dual-standard plan, let us restate Mr. B's reac­tion to the same changes in stock value as discussed above. When the current price per share of stock drops from the original $10 to $8, he acts the same as under the single-standard ratio, buying enough stock to bring his stock and reserve each to a value of $18,000. But after that, when value per share rises to $10, his selling ratio tells him to sell only enough stock to make his stock value 20 per cent larger than his reserve value. This calls for selling 41 shares of stock, leaving 2,209 shares with a value of $22,090, and raising his reserve to $18,410.

After this, suppose Mr. B has new savings to invest. His standard stock-buying ratio, 1 to 1, prevents him from put­ting any new money into stock unless the value of his 2,209 shares has dropped again to at least as low as reserve, $18,-410, and for this the price per share must be down to $8.33 or lower. Mr. B's experience brings out the main purpose of having separate standard ratios for selling and for buying stock. The difference between the two ratios causes him to sell less stock when the price rises, and this, in turn, pre­vents him from putting new savings into stock until the price drops again.

When new savings are sizeable compared to reserve value, they tend to complicate the working of dual-standard ratios. Mr. B sold enough stock to bring his stock value down to $22,090 and his reserve up to $18,410. Now suppose that during the ensuing year he is so fortunate as to have new savings totaling $3,680, and the price of a share of stock remains at $10 throughout the year. Complying with his stan­dard stock-buying ratio of 1 to 1, he puts all of these new savings into reserve, adding to the reserve value until it equals the stock value. Thereafter, half of any additional new savings would go into stock at $10 a share, the same price at which he sold some stocks a year earlier. This might sug­gest that Mr. B's standard selling ratio should be more than 20 per cent above his buying ratio.

But here is another aspect of the picture. Before Mr. B added the new savings to reserve, his standard stock-selling ratio, $1.20 stock to $1.00 reserve, allowed him to sell some stock at $10 a share, and he could have sold more shares whenever the price rose above $10. But now, the new sav­ings having raised his reserve value to $22,090, equaling his stock value, he cannot sell stock unless the value of his 2,209 shares rises at least 20 per cent above $22,090, and this will not happen unless the price per share rises above $12. So the adding of new savings to reserve has quite an effect on the price at which he can sell stock. Setting a gap of more than 20 per cent between standard selling and buying ratios would raise his minimum selling price still further.

The idea of two standard ratios is applicable no matter what the buying ratio is. If a man's standard stock-buying ratio is $5 stock to $1 reserve, a selling ratio 20 per cent higher would be $6 stock to $1 reserve.

When an investor is spending some of his capital, he can continue using the same dual standard ratios as before. Sup­pose that Mr. C has been following standard ratios of $1 stock to $1 reserve when buying stock, and $1.20 stock to $1.00 reserve when selling stock. He owns 2,000 shares of stock and has $20,000 in reserve. He is now obliged to spend from capital, $100 each quarter year. Whether he obtains this cash from stock or reserve depends upon how actual val­ues stand in relation to his standard selling ratio.

Suppose the price per share of stock rises to $12.50, giv­ing his 2,000 shares a value of $25,000. He needs to sell enough shares to let him have $100 to spend, and also to restore his remaining capital to standard selling ratio. He sells 40 shares, value $500, and from this he adds $400 to reserve. Then his capital values are reserve $20,400, stock $24,500, about in line with his standard selling ratio.

In the next quarter, the stock price drops to $12, giving his 1,960 shares a value less than 20 per cent more than reserve value. This time, he spends $100 from reserve. If stock value drops below reserve value, he uses reserve both for spending and to buy some stock. These examples are intended to show that an investor can profit by using dual-standard ratios, no matter what his circumstances.

Presumably the dual-standard-ratio plan can be adapted satisfactorily to any common stock whose price fluctuates appreciably. But we have tested it only on shares of broadly diversified funds, because that is the only kind of stock we own or recommend.

Since you are wise and you are looking for free stock tips, maybe you think possibly there is some sense to this idea of standard ratios but more proof is needed. You might make your own test, this way:

1. For whatever stock you are interested in, obtain a ta­ble of the highest and lowest prices for each of the last ten years or more. Any stock-dealer should be glad to give you printed matter containing such a table. Accuracy would call for a price every month, at least. But using only the price extremes of each year will save work, and will give you a condensed picture of how the ratios would work.



2. Adopt standard ratios for buying and for selling stock.



3. Pretend you are back at the beginning of the period for which you have prices, and then move forward, buying or selling each year, as indicated by your standard ratios and the then-current prices.

After this test, if you still are unconvinced, then try de­signing a better plan, and if you succeed, tell us about it!

Restraining Rules

When a home-owning family decides to move to another house, normally the sale of the old house, the purchase of the new one, and the moving of household goods are all put through together, if possible, to avoid the expense and trouble of owning and living in two places at once. Moving cautiously and testing the new place, one room at a time, be­fore becoming committed to the rest of the house might have advantages but is hardly practical!

When it comes to free stock tips in investing, no matter how carefully a man has chosen his purchases, some day he is pretty likely to decide he has made a mistake, or he learns for the first time of an issue that sounds much better than what he owns. Then, to make up for lost time, or in fear that a rise in price will spoil the chance, his impulse is to jump quickly into the new investment. Brokers and market advisers may be glad to see him in this frame of mind; because that's the way they make commissions. But in changing from one stock or bond issue to another, switching whole hog is unnecessary, and is prob­ably reckless.

A careful man learns that in investing, as in other walks of life, being dead certain of what is the best thing to do, and being ale to bold that view unchanged for a long time, is an experience he is rarely able to enjoy. So if he switches today from this investment to that one, he runs the risk that tomor­row, or next week or later, he will wish he had not moved so fast. Even though an action turns out eventually to have been a good one, a man can do plenty of worrying mean­while.

An investor needs to study his own emotional tendencies and to set up private rules designed to prevent his momen­tary feelings from being translated into acting too much, too soon. Here are the rules the writer has found effective on himself:

1. On the market value of stock you own, as compared to your reserve value, follow a dual-standard ratio, as ex­plained in this chapter.



2. Before selling an investment, decide exactly what you are going to buy in its place.
3. Buy or sell at one time investments amounting to no more than your new savings accumulated in three months, or 2 per cent of your total capital, whichever is larger.



4. After deciding to buy or sell, but before acting, make tentative entries in your records to be sure that all the results of the action will agree with what you planned mentally.