How Wild is the Stock Market?
The Investment View from Prescott, Arizona - By Will Hepburn
A fascinating part of stock market analysis is that the market is driven largely by career risk of institutional money managers – mutual funds, pension funds, hedge funds, that sort of thing. Those managers control the vast majority of stocks that change hands every day. They can make or break the stock market with their collective actions.
Their prime objective, as 20th century economist John Maynard Keynes put it so well, is to keep their job. To do this, he explained that one must never, ever be wrong on their own. To keep this from happening, institutional investors pay ruthless attention to what other investors in general are doing. The great majority go with the flow, either completely or partially.
I sometimes refer to this as “closet indexing”. Although the fund they run is not described as an index fund, one that mirrors a stock index such as the S&P 500**, their holdings and performance will always bear a striking resemblance to the index. In fact if the prospectus on one of your investments has wording like “keeps 80% of its holdings” in a certain category of stocks, then your performance is going to look an awful lot like that index.
With most of the managers doing the same things at about the same times, this creates herding, or momentum, which drives prices far above or far below fair price. There are other inefficiencies in market pricing, of course, but this is by far the largest.
This explains the wide disparity between a remarkably volatile stock market and a remarkably stable economic growth rate (GDP), together with an equally stable growth in “fair value” for the stock market.
This difference is huge – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within 1% (plus or minus) of their long-term trends. The stock market’s actual price is within 19% (plus or minus) of its long term trend two-thirds of the time.
Thus, the market moves 19 times more than justified by the underlying engines of growth. No wonder the stock market can cause so much angst.
To reduce this wild volatility is one of the main reasons that Hepburn Capital strives to use different decision making criteria. Even in times when we are out of sync with the stock market, our returns are usually less volatile.
Will Hepburn is the President and Chief Investment Officer of Hepburn Capital Management, LLC, in Prescott, Arizona. He specializes in developing, implementing and teaching innovative investment strategies that Adapt to Changing Markets®.
Will began helping clients make smart decisions with their money in 1977. He practiced as a Certified Financial Planner from 1994-2006, and currently focuses exclusively on investment management.
His academic record includes a major in business and economics at Ottawa University where he studied under Dr. Wayne Angell, a former Federal Reserve Board Governor prior to transferring to the Institute of Computer Technology in Chicago where he graduated first in his class. He has also completed a number of post-graduate level courses with the College for Financial Planning in Denver.
Will is also a college instructor. He taught classes on investments and estate planning at Yavapai College in Prescott, AZ for 20 years. His articles on financial topics have been published nationally and his ideas have been included in best-selling books such as Rich Dad, Poor Dad, by Robert Kiyosaki and leading investment newsletters such as Dow Theory Letters and John Mauldin’s Thoughts from the Front Line. In addition, he frequently gives expert interviews to national media, including InvestmentNews, Kiplingers, Forbes, Fortune, CNNMoney and The Wall Street Journal. Will is a past-president and currently on the Board of the National Association of Active Investment Managers (NAAIM).
