In "Security Analysis," Graham and Dodd devoted much time to the idea that irrational decision-making by individual investors can cause significant discrepancies between price and value. Furthermore, these discrepancies happen not only in individual securities, but also within the broader market -- periods of excessive exuberance are followed periods of excessive gloom. The question then is, how does one exploit these cycles?
Exploiting macro cycles
“The best understood disparities between price and value are those which accompany the recurrent broad swings of the market through boom and depression. It is a mere truism that stocks sell too high in a bull market and too low in a bear market. For at bottom this is simply equivalent to saying that any upward or downward movement of prices must finally reach a limit, and since prices do not remain at such limits (or at any other level) permanently, it must turn out in retrospect that prices will have advanced or declined too far.”
Graham and Dodd suggested a simple system for taking advantage of the macro cycles of the market. First, pick a diversified bucket of stocks, such as the Dow. Then, calculate a "normal value" for the list, by applying some multiplier to the average earnings of the index. Whenever shares can be purchased at a large discount from the normal value (the authors suggest two-thirds of value), they should be bought. Whenever the index exceeds the normal value (for example, by one third), they should be sold.
But, the authors noted that such a simple system is very restrictive. Indeed, applying it to the modern day would have caused an investor to miss out on the bulk of the bull market of the last decade. They also pointed out that following such a rigid system will realistically prove to be too great a test of discipline for the majority of the investing public. That said, it can at least provide an understanding of what the intrinsic value of the market should be.
The difficulty of swing trading
Graham and Dodd also addressed the question of whether or not it is possible to profit by catching market reversals. Unsurprisingly, they are skeptical on the issue of swing trading:
“The margin trader is necessarily concerned with immediate results; he swims with the tide, hoping to gage the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster. It is the essential character of the speculator that he buys because he thinks stocks are going up not because they are cheap, and conversely when he sells. Hence there is a fundamental cleavage of viewpoint between the speculator and the securities analyst, which militates strongly against any enduringly satisfactory association between them.”
In other words, trying to pinpoint the exact moment when a bull market breaks, or when a bear market bottoms out is always going to be inherently difficult. Those who try to time market reversals are compressing their margin for error significantly. By contrast, a value investor does not need to worry too much about whether or not they are buying at the exact bottom of a bear market. So long at the price of a security is significantly below intrinsic value, the investment will represent a bargain.
Disclosure: The author owns no stocks mentioned.
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