Stock research is a valuable and accessible tool for any investor

By DAVID MOON, Moon Capital Management
May 27, 2001

An investment advisor recently commented that the decline in stock prices would be over when the NASDAQ Composite broke through its 10-day moving average. His audience was impressed since, indeed, the NASDAQ broke through its 10-day moving average and has steadily improved.

(For the statistically challenged, a 10-day moving average is an arithmetic average of 10 continuous observations ' in this case the closing values of the NASDAQ Composite. Each day, the oldest observation is dropped as the new closing number is included in the average calculation. Statisticians often use moving averages to differentiate between short term aberrations and changes in trends. Investors often use moving averages to impress their friends and colleagues.)

Imagine a paid investment professional basing a decision or recommendation on such a calculation! The NASDAQ Composite includes 5,000 stocks of widely divergent sizes. Each day, the closing prices of those 5,000 stocks are put into a formula that tries to capture the overall price movement of all of the companies. Two weeks' worth of this data, or 50,000 observations, is used to calculate a single 10-day moving average. To imagine that this data provides any clue as to whether or not a specific company or companies from among the 5,000 is over or under priced is laughable. The historic price movement of a stock or group of stocks provides no clue about future price movements, even if you apply elementary algebra to those historic prices and give it a fancy name.

I often presume some people turn to simple concepts with fancy names to impress someone or hide a lack of knowledge in an area. If looking at a chart of the past price movements of a company gives clues about the attractiveness of an investment, what difference does it make about the business of a company? Earnings and revenues would be irrelevant. Balance sheets would be useless. Cash flow statements could be dismissed. All an investor would need is a picture of the past and a unique sounding moniker for the picture.

If a fair coin is flipped and turns up 'heads' 10 times in a row, what are the odds of a 'head' on the eleventh flip? Fifty percent, because the previous flips have no bearing on future flips. Using the 'moving average logic,' we could observe the outcomes of previous coin tosses and draw a picture of our coin flipping exercise and predict future coin tosses. But real logic tells us that the odds will not change, regardless of previous outcomes. If the coin turns up heads 100 consecutive times, what would you do? I suspect you would ask to see the coin or more closely observe the technique of the coin tosser. This is called research.

Research is precisely what an investor ought to do when trying to understand the relationship between a price of a stock and the factors that give that stock actual value. If historical price movement data (like 10-day moving averages) are the only or primary factors in predicting future price movements, then a coin toss 'investor' would never wonder if the coin is two-headed or if the tosser is rigging the game.

The stock market is merely a mechanism for buyers and sellers to swap assets; the swapping of the assets establishes a price for those assets, but does nothing to create or impair the value of the underlying assets. If the stock market closed for the next five years, what impact would that have on the value of the Coca-Cola company? None. It would not cause more or fewer people to drink Cokes, it would not affect the price of caramel colored sugar water nor would it increase or decrease the value of the business. But without a stock market we would not have daily price quotations, so we could not calculate moving averages. How would an investor know if the value of Coca-Cola was increasing or decreasing?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).