The obvious answer on ‘when’ questions is to buy when they are cheap and sell when they are dear. Predictably, there are problems involved, including deciding how you define cheap, finding the stock that is cheap and deciding whether it is cheap or just a poor bet. So important is this aspect that experienced investors will tell you it is more important to judge when to buy than what to buy.
One problem with the stock market is the herd instinct that drives it hither and yon on superstition, greed, fashion and uncertainty. So when the market is rising everybody piles in because they fear being left out when there are profits to be made. They are convinced that trends will continue, so no matter what has happened so far, shares are cheap because they will probably go far higher. In the reverse phase, investors private and institutional sell shares which, on most criteria, would be reckoned cheap, because they expect them to go on plunging further.
In 1710 to 1720 a series of ‘bubble’ companies burst onto the stock market, of which the South Sea Company (actually the full and splendidly rolling name of the enterprise was The Governor and Company of Merchants of Great Britain Trading to the South Seas and Other Parts of America and for Encouraging Fishery) was merely the most notorious. Its shares were issued at £100 and started 1720 at £128 10s 0d. By August they had reached £1,050 but finished the year back at £124 before the company collapsed. The boom was generated by mad enthusiasm over a company that took over the national debt in return for having a monopoly of trade in the Pacific. Then people realized the company was more preoccupied with ramping its shares and providing directors with a good life than with any business. That caused the bubble and the company to burst and the shockwaves sent others toppling, as banks, shops and individuals went bust as a result.
In the 1830s it was railway mania, with any company even vaguely connected with trains being relentlessly pursued by investors wanting to put yet more money into it. More recently we have had other enthusiasms. At one time being in computers was all the rage and anything to do with electronics saw its shares knock the roof off. The internet grabbed the imagination to produce eye-watering share price rises. Later the enthusiasm moved on to biotechnology when miracle drugs, ‘silver bullets’ and panaceas were reckoned imminent.
You can recognize a bull market reaching its peak by the unanimity of opinion that happy days are here again. Even the tabloids start talking about the stock market; there are pictures everywhere of champagne-swilling young dealers; serious economists saying this time it is different; people who would not normally know a balance sheet from a bed sheet start buying shares; and the shares themselves are on absurdly high price/earnings ratios and low yields. A sign the market is pretty well at the bottom is when share prices have been discounted for doomsday – prices have allowed for more massive slumps than it is rational to expect. In fact the share prices have anticipated so much bad news that they no longer react to it when it comes. On the other hand, the price does start to stir and rise a bit when even the slightest glimmer of good news comes along. That is the time to start hunting for good value.
The turn happens in one of two ways. There is either a sudden trigger like a huge and swift hike in the price of oil, banks suddenly realizing they have been lending money on fresh-air security, or just a lassitude when nothing seems quite right. The shares fail to respond to good news, but relapse at every sign of adverse news. That is when to stop buying, at the very least. Similarly at downturns institutions and private investors prepare for the end of capitalism as we know it. The bottom is nigh when everybody agrees the economy is sliding and will stay low for at least two years.
To be fair there is also in part a rational reason for all this: during booms people have higher disposable income both for direct investment and for pensions and insurance (with those companies then channelling part of the cash into the market), while during a recession there is unemployment, negative equity in one’s home and an absence of pay rises.
When the market has been sliding for some time the careful investor will start to check whether the bottom can be in sight. You have to face the fact that you are very unlikely to buy at the absolute bottom or to sell at the very top. If you manage either, never mind both, admit it to be a pure fluke. So there are two possible timings: when it (the market, the sector, the individual share) is still heading down but one has a reasonable feeling there cannot be much further to go; and when prices have just tentatively started coming off the bottom. Get the timing wrong in a downturn and the prices will continue to tumble, and it takes a hardy soul with a gambler’s instinct to go in for ‘pound cost averaging’ – putting the same amount in again as the price falls to get even more shares.
That sort of thinking applies to the market as a whole and also to individual shares. A very successful large company into which everyone has put their pension money for years, suddenly stumbles. It makes a few mistakes, loses some orders, miscalculates the market or whatever, and issues a profit warning. The disillusion hits the professionals so badly that they abandon the fallen star in droves.
Though small companies die in dozens and the occasional middlerank company succumbs, it is fairly rare for a major commercial undertaking to go belly up. There have been the Leylands, Polly Pecks and the like over the years, but that is still pretty unusual, and massive collapses such as the 2008 folding of Lehman Brothers, one of Wall Street’s largest banks, are thankfully rarer still. But as that shockwave-causing fall showed, they can still happen. Even if the board cannot immediately retrieve its mistakes, bring in new managers or just get back on its old track, there is a good chance somebody will be waiting to snap up the business in a takeover.
At the simplest level, much of the investor’s aim can be achieved by being just counter-cyclical: see which way the herd goes and head the other way. On the other hand, it takes strong nerves to buy in a bear market when gloom and despondency suggest shares will plunge further and companies will topple over by the score. It also takes stern self-discipline to take profits in a roaring bull market knowing shares may well rise further and one is therefore forgoing some of the extra profit. There is, however, an old stock market adage for such dealing: always leave some profit for the other fellow.
Like all other contrarian views it takes caution and care. The people who specialize in this sort of investment normally wait until the first and second tumbles have worked through the market and the share price is bumping along a steady low, before starting to buy.
There are two sets of timings to consider. One concerns the market as whole, and the second is for the individual share that has already been identified Among the factors affecting the market as a whole are:
- the general economic cycle (and that could be anything from a recovery to a slowing in anticipation of a recession);
- the level of inflation;
- interest rates, since they affect consumer demand as well as the costs of business and hence its profitability;
- tax levels and the changes;
- the relative strength of the currency, since that affects the costs of imports and the competitiveness of exporters;
- the political situation, including the proximity of elections and who is likely to win.
There are other influences as well. For instance, the London stock market reacts in sympathy with US stock markets. This provides the background for looking at and trying to extract information from recent price movements, and sets the context for examining individual companies.
At the end of the 19th century Charles H Dow, who helped start the Dow Jones Index for the Wall Street Stock Exchange as well as found the Wall Street Journal, detected a pattern in share price movements. He reckoned these followed a regular enough progression to be able to forecast where the price will go next.
The Dow Theory says there are great long-term patterns, called ‘primary trends’, which create the bull or bear markets that can dominate an economy for several years. Within that there are shorter-term fluctuations that go against the overall trend, reinforce it, or predict its turn, and these he called ‘secondary reactions’. Finally, there are the daily oscillations that are called, predictably enough, ‘tertiary patterns’.
The accountant Ralph Elliott worked on a grander scale. He talked of ‘supercycles’ lasting 150 to 200 years within which there are shorter fluctuations. There are many books on such topics, but they are probably a touch specialized for an amateur investor.
Within these grand economic cycles are price movements of the market and of individual shares, and if the trend or pattern can be spotted in time there is an opportunity for profit. This is the province of the technical analyst who relies principally on charts of market changes. At the most bloodthirsty these people assert it is not necessary to know even the name of the underlying instrument, whether it is a share, a currency or a commodity, because everything is in the price. More particularly, the price is set by market psychology and, since human behaviour is fairly constant, the pattern can be extrapolated. The trick is therefore to detect patterns in time and then act on them. That requires charts, usually of price movements.
Charts represent one of the two main ways of assessing a share. The other is fundamental analysis – the study of the company and its accounts, the markets in which it operates, and the quality of its management.
The aim of all these is to reinforce other criteria for choosing a share or a time for buying, and not to use them in isolation. That applies also to different types of chart. Checking to see how the price of a company’s share moves in relation to the market as a whole is sometimes an indication to help with the decisions. Shares with a wildly fluctuating relative strength are likely to be unpredictable performers and so a more risky investment. On the other hand, if the company has for some time been sagging, with the shares consistently underperforming the market as a whole, and its relative strength starts improving, this might underline the decision to buy that was prompted by other signals. These may be better at giving added information about individual shares than about the market as a whole.
William D Gann, a mathematician and successful trader in shares and commodities, produced a variant of this, concentrating more on support and resistance levels and the speed of price change, but the explanation is well nigh incomprehensible to anyone with less mathematical expertise. Its link to Chinese horoscopes has provoked some traders into dismissing it as mumbo-jumbo.
The patterns in share prices can be explained by psychological descriptions of the way people behave, and these seem quite plausible, but not to the academics who have used mathematical analysis to produce the ‘random walk’ theory. This says the prices move totally unpredictably and charting the tossing of a coin would produce similar patterns. In addition, the efficient market hypothesis says information is so swiftly and uniformly disseminated that nobody can get an advantage to outperform the market. That, however, ignores the time factor, and the obvious fact that some people do very nicely indeed, thank you.
It is not quite as straightforward as a brief explanation makes it sound. Even if the random walk theory and efficient market hypothesis are dismissed as being not universally applicable, there are problems with charts. For a start they require expert interpretation of shapes that are seldom as simple and obvious as the illustrations in books. Just when does a fluctuation indicate a turn and when is it merely a temporary correction? Even with other financial knowledge to test the plausibility of an indicator, and even with extensive experience interpreting charts, the chances of making a mistake are high. That means making a fallible subjective judgement about a developing pattern, and some people are better at this than others. False signals and easily misinterpreted patterns could lead an investor into penury.
For instance, one task is to assess whether the current trend is likely to continue – if you are in a boom market, will the euphoria continue long enough to buy the shares and reap the benefits, and if it is a soggy bear market, can you predict when it is likely to turn up again? This is made all the harder by the short-term fluctuations within the longer-term movements or, as the distinguished economist Sir Alec Cairncross put it:
A trend (to use the language of Gertrude Stein) is a trend is a trend.
But the question is: will it bend?
Will it alter its course,
Through some unforeseen force,
And come to a premature end?
The second problem is that if charts were really helpful and accessible, they would get widely adopted, other investors would rely on the developing pattern and the self-fulfilling prophecies would run away before the amateur could get involved. There would also be repeated attempts to spot the direction of development before it was complete, which would distort the shapes and cause confusion.
Professionals do not rely on charts as the trigger or guidance, but use them as an adjunct to other investment criteria. What this all boils down to is trying to get additional help on timing. That means timing not just for the individual company but for the sector and the market as a whole. That applies with equal force on when to buy or sell. A measure of how well-priced the shares are is the yield gap. That is the difference between the yield on ordinary shares and the return to maturity of gilts.