By DAVID MOON, Moon Capital Management
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
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).