8. Market Fluctuations

Investors who place their funds in high-grade bonds of relatively short maturity (seven years or less) will be largely sheltered against changes in market prices - even if the bond's nominal rate is below-market, the short amount of time to maturity will tend to even out the present liquidation value. But the portion of a portfolio that is invested in longer-term bonds will have relatively wider price swings in its value, and common stock holdings will fluctuate daily.

The investor should be aware of the causes of market fluctuation and be both financially and psychologically prepare to weather them. While one's natural inclination is to embrace gain and avoid loss, taking a long-term view and setting appropriate expectations is necessary to avoid emotional reaction to the situation in any moment in time. It is relatively easy to recognize the damage that can be done by speculation, but much harder to discipline oneself to refrain from, the practice.

To explore the phenomenon of market fluctuation, the author will first consider the subject of common stocks (which are more subject to frequent fluctuation), then later apply the same consideration to bonds - underscoring that they are of a temporary nature, and that the long-term value of a portfolio will appreciate in spite of short-term advances and declines in the market.

Market Fluctuations as a Guide to Investment Decisions

The investor who seeks to profit from market fluctuations may choose to attempt to time the market - that is, he will seek to purchase when at a time the general market is down and sell at a time when the market is up, regardless of the specific price at which he buys or sells.

The author's sense is that such an approach is doomed to failure, and is next of kin to speculation, as there is no satisfactory objective criteria by which a person can assert that the market is "up" or "down" and will go no further in a given direction - and assertions to this effect are mere speculation about what the future performance might be.

"Time" is of importance primarily to speculators, largely because they are concerned with making a profit in a hurry. The notion of waiting a year for a stock to become profitable is unappealing

Even so, a great deal of attention has been paid to the notion of market timing, though the further one travels from Wall Street, the less enthusiasm one will find. If it is at all possible to time the market in this fashion, it is entirely beyond the capabilities of the average investor to consider the various factors that might be predictive of a turn in the markets - most "professionals" cannot do this with much accuracy.

Buying Low and Selling High

A second approach is the notion of buying or selling shortly after the market has reached a given peak or valley, regardless of the time in which this has occurred. This is based on the notion that the market will continue in a given direction for an extended period of time - that is, a stock can be purchased after it has begun to rise on the assumption it will continue in an upward direction, and when the upward momentum stops and the price decreases, the investor can then unload his shares as the market is expected to continue downward.

Unfortunately, the pattern of bull and bear markets is not consistent - a price may drop considerably, then rise slightly before falling even further, or fall from a seeming peak, only to resume its upward notion after a brief period of adjustment. Just as there is no consistently reliable method of predicting when a stock will gain or lose based on the previous performance, there is also no reliable method as to determine when a stock will continue along a trend or reverse its direction, or for how long.

It's also noted that nearly all the bull markets in history had a number of characteristics in common that served as harbingers of a change in market direction: a historically high price level, high price/earnings ratios, low dividend yields as compared to bonds, much speculation on margin, and many offerings of new common stocks of poor quality. Various statistical models have been devised over the years to assess these factors to predict the changing of the market's general direction - and all have been confounded by the actual behavior of the market.

Formula Plans

Beginning around 1949, there arose a considerable number of plans to take advantage of the stock market cycles, collectively regarded as "formula investment plans." In essence, each of these plans guides the investor to sell stocks in a more incremental manner - in effect, to invest according to the buy-low-sell-high notion, but to hedge against its inaccuracy.

These approaches had appeal because they sounded logical in general, but the mathematical calculations that determined the buy/sell decision were to complex for it to be evident that their fundamental logic was severely flawed. This approach enjoyed some early success, while the market moved in a consistent manner, but failed miserably when fluctuations exceeded the tolerances of the formulas.

Investors took such losses that "formula planners" found themselves out of favor within a period of five years. However, the formula-based approaches of the 1950's are still in existence, modified in some form to make them seem like new ideas, or perpetrated on investors who are unfamiliar with there dismal performance.

Ultimately, the moral seems to be that any approach to making a fortune in the stock market that is followed by a lot of people is likely to be too simple to have lasting power

Fluctuations in an Investor's Portfolio

Every investor in common stocks must expect to see he value of his portfolio fluctuate - not only on a day-to day basis, but also on a year-to-year basis. The author takes the example of the DOW, which itself fluctuate less than the price of any of its individual components, and the variation from 985 in 1968 to 631in 1970 and then to 940 be early 1972.

Any serious investor must remain galvanized against the notion that the day-to-day or month-to-month fluctuations in the value of his portfolio make him richer or poorer - no actual wealth is lost or gained until the shares are sold and, while they remain in his portfolio, merely provide a current snapshot that may not represent the ultimate value he will derive from them.

But over the course of years, the fluctuations that were easily dismissed become more disheartening, and doubt begins to set in: doubt that a position that has decreased in value will regain its strength, and doubt that one that has increased in value will continue to rise. And then arises the psychological need for control - the belief that by taking some action, he will improve his fortune or prevent damage from accruing.

The trading activities of the long-term investor reflect an outlet for anxieties that are otherwise kept in check - and it is not necessarily harmful for him to do so, provided that each trade is rational on its own merit, and that he is refraining from simply following the crowd of panicked speculators.

Business Valuation versus Market Valuation

The price of a share of stock represents the amount of money for which it can be traded, and it's a common misperception that the market valuation of a firm reflects the value of the business, which is instead derived from the value of its present assets as well as the value of the future earnings that are expected. Speculation can, and often does, cause the market valuation of a firm to far exceed its business value.

This difference is a "factor of prime importance" in present-day investing, and it receives far less attention than it merits. The market value of a firm depends more on the changing moods of buyers and in the stock market, not of the value the firm has (by means of its assets) or is likely to create (by means of its operations). And the more successful a company, the greater the fluctuations in the price of its shares.

This considered, a worthwhile consideration for the conservative investor is to select stocks whose market value is close to its asset value - the author suggests a figure of not more than a third higher. Purchases made at that level or lower are likely to be more influenced to the value of the firm than speculation, and should remain more stable as they are related to the firm's balance sheet value rather than speculation.

However, some caution is needed: a stock is not a sound investment solely because it can be bought for nearly its asset value: the investor should demand a satisfactory ratio of earnings to place, and the prospect that earnings will be maintained over the years. This may seem like a lot to demand of a stock, but it is fairly simple to find companies that meet these criteria under most market conditions.

Case Study: A&P

The author considers the example of Great Atlantic and Pacific Tea (A&P) - while it's become a bit dated, it aptly demonstrates a number of principles related to corporate and investment experience.

A&P began trading on the curb of the exchange in 1929, where it sold as high as 494, then declined to 104 a few years later. Bt 1938, the shares fell to 36.

At that price, it was an exceptional deal: the firm had $84 million in cash and $134 million in current assets, and was the largest retail enterprise in America - yet the total market value was $126 million. Primarily, this was due to threats of regulation in chain retail in America, A&P's profits had fallen in the previous year, and the general market was depressed.

Since the stock was priced below its book value, and since the price of $36 being only 2.25 times its average per-share earnings of the past five years (even 12x earnings is a good price), an intelligent investor would have considered the stock to be an incredible bargain, despite the distaste shown by the market for the firm.

By the following year, the price of shares soared to 117.5, and in the years since then, the stock has reached an equivalent high of 705 (accounting for the 10-for-1 split in 1961).

However, by that time the stock would have been priced at about 30 times earnings, well above the level of most Dow stocks in that same year (which were at 23). The intelligent investor would have closed his position sooner, and avoided the plummet of the shares to a low of 21.5 that occurred a decade later, in 1970, when the firm reported the first quarterly deficit in its history.

The point of the case study should be clear: in 1938, the stock was an incredible bargain, but the market paid it no attention. Yet in 1961, buyers were clamoring for shares in spite of the stock's being wildly overpriced. An individual who considered the value of stocks to be based on market demand would have been swept with the tide into buying and selling with the herd, and making little profit, whereas an investor who considers the relation of price to book value and earnings would have been guided to make more profitable decisions in spite of common sentiment.

Aside of the lesson that the market value of a firm is quite often wrong, this case demonstrates the degree to which a business can change over the course of years, swinging to the better and to the worse. Also, an investor who considers rational criteria need not maintain constant vigilance over his shares, but needs only check in periodically (earnings being reported quarterly by most firms) to determine whether the value of shares remains reflected in their price.

Stockholder as Owner

The investor in private stock would be well served to consider his role from the perspective of a person buying partial ownership in a business he intends to profit from owning for a long period of time, that than one who buys an asset with the intent of reselling it at a profit in a short period of time, as the latter is the distorted perspective common to speculation.

Of importance: except in highly unusual situations (e.g., a cash acquisition of one firm by another), an investor is never forced to sell his shares and does so at his sole discretion, when he deems that the price has risen to the point that a firm he currently owns is less attractive than another he might own. The investor who feels compelled to act simply because others are taking action is victim of his own lack of confidence and discipline.

Returning to the notion of business ownership, an individual who owns a firm is not motivated to sell simply because someone offers to buy - unless and until the price they offer exceed his prospects of income from the business, it makes no sense for him to do so, regardless of what offers he is made or accepted by owners of other businesses.

Critics of this approach suggest that common stocks cannot be appraised in the same way as owners of any private business because the presence of a securities market makes shares of ownership more liquid, hence more valuable. But the author disagrees: where there is some appeal in being able to easily obtain or sell a share of ownership in a firm, it does not merit the value of the share - any more than the value of a private business is increased by a large number of people interested in buying it - especially if this mass of interested parties want to pay less than it is worth to the owner. While a desire liquidity is an influencing factor in investing in a public company over than a private company, it does not change the inherent value of the company.

The author spins this into a hypothetical narrative about a man, "Mr. Market," who approaches a person who owns a stake in a local business, constantly telling him what he things the business is worth, and constantly offering to buy his share in the operation. Whether you are willing to sell depends on what you think of the price that he is offering, not the mere fact that he is willing to buy. Nor does it matter that the price he offers today is higher or lower than the price he offered the day before. Beset by such a pesky individual, an owner would find his best recourse is to wait until he is offered a generous price for his holdings - as he can be assured that the same buyer will be back every day with a different offer. His attitude toward the buyers in the stock market for shares in a public firm should be no different.


The most distinctive difference between the speculator and investor is in their sensitivity toward stock-market movements. The speculator seeks a short-term profit and panics in the face of a short-term loss. The investor is largely indifferent to market changes, except inasmuch as the daily price of a stock constitutes a fair price to sell his position and seek better opportunities for his funds.

An investor need not wait for a low period in the general market to buy or a high period to sell - regardless of market conditions, there are securities worth buying or selling based on the relationship of their current price to their current value.

Unless he allows himself to fall victim to panic, the investor will maintain his holdings in firms that demonstrate a potential for future profitability - and need never buy a stick because it has gone up or sell because it has gone down.

Fluctuation in Bond Prices

While the value of bonds is not subject to the same degree of volatility as stocks, they do fluctuate in value over time. This is because a bond's return is determined by an interest rate that is set at the time of its issuance, which remains fixed even as the rate of inflation in the market changes, and its value as an investment is considered in comparison to the value of bonds of equally stable firms that pay different rates by virtue of the market interest rate at the time they were issued.

As stated previously, the closer a bond is to its maturity, the less impact changes in inflation will have, but virtue of the net present value of periodic interest payments over a short period of time. At the moment of its issue and redemption, the bond is worth exactly its face value.

The exception to this general rule is when a company becomes financially unstable, and doubt exists as to whether the firm will be able to meet its obligation to repay its debt, and even the salvage value of the firm, should it become bankrupt, would be insufficient to repay the debt of its bondholders.

Another exception is for convertible bonds, which may at times have an added premium in value if they are redeemable for a fixed number of shares of common stock. When the value of the stock exceeds the value of the bond, a premium is placed on the bond equal to that amount. However, should the value of the shares fall beneath the value of the bond, it will still remain worth its value in relation to the amounts it will render ion interest earnings and the redemption of principle at maturity.

Bonds will also fluctuate in their appeal according to the rate that investors expect to reap from owning stock - bonds being the safe haven to which speculators flee in a bear market, and the stagnant waters they seek to escape in a bear market. Even so, the stability and predictability of their return leaves little room for speculation as to their future value.

For the speculator, the potential for a bond to increase in value may at times be worth switching his investments if he believes that it will generate more short-term value than common stock.

For the investor, there is little point in redeeming a bond before its maturity: the discount or premium would be counterbalanced by his loss of future interest payments. In essence, the buyer of a bond made a firm commitment to accept a given rate of return when he purchased the bond, and the market will hold him to making exactly that much - no more and no less.