Financial news

We have shown how to estimate VAR for an individual security holding but most investors hold a number of different securities or positions. They are less concerned about the changes in the value of individual holdings and more concerned about changes in the total value of all their holdings. In general, VAR for a portfolio of financial assets cannot be calculated from the simple sum of the VARs for the individual holdings.
We need to take another statistical diversion and introduce another concept, that of the correlation (or the relationship) between changes in a number of different variables.

Sooner or later, even the most complacent holder becomes disturbed by the downward drift in prices. Selling pressures increase and become more widespread. Volume increases as shares of stock (or futures contracts, or option contracts, and so forth) pass from weaker, now nervous hands into the hands of aggressive buyer who are stepping in to take advantage of the developing selling panic.
This transition from slow, steady, complacent decline to aggressive, nervous selling and finally to nascent aggressive buying is referred to as a sellmg climax. It is largely driven by aggressive and fearful selling-the urge to sell at any price. Buying climaxes following extensive market advances sometimes take place as well. The demands of aggressive buyers are met by savvy traders who are perfectly willing to part with the stock that is being demanded. Buying climaxes are less usual than selling climaxes, but one did take develop in certain areas of the Nasdaq Composil Index in March 2000.
Again, market declines of any magnitude, even during intraday price swing (day traders, take note) frequently do not come to an end until trading volum increases, often dramatically.
Take note of the declines in the Dow Industria that came to an end in September 2001, in July 2002, and in October 2002. Each or of those significant market low points developed on sharply rising volume compared to the days and weeks surrounding the actual market lows of those periods To sum up once more, although market declines sometimes end with a Ion; quiet, base-building process, low trading volume during market decline is, at best a neutral indication. The most bullish development that can take place during major or serious intermediate market decline is a dramatic build-up of stock mark, volume following a period of falling prices. This build-up often develops during that sort of terminal downside spikes that characterize stock market selling climaxes.

True or false: Conditions are bullish if market declmes take place on low volume? As a general rule, tlus is false–very false. This is a very common misconception. Long-term and serious intermediate declines that take place on low volume ten, to continue for some time. Low volume during market decline signifies two things. First, there is probably little panic on the part of investors; instead, there’s complicency Prices are likely to be declining not so much because of active selling, because buying demand is drying up. When buying demand slows, prices frequently fall under their own weight. Second, prices have not yet fallen to levels that will attract aggressive buyers. Buyers are remaining on the sidelines while the typical, still complacent investor retains positions even through periods of slowly falling prices.

Head and shoulder top and bottom formations are usually confirmed by measures of market momentum, such as the rate of change. Momentum generally declines as the formation develops along. Positive divergences (at market bottoms) and nega-tive divergences (at market tops) provide additional evidence that significant changes in market climate might be developing.
Bearish head and shoulder formations often take place in Stage 3 (market topping), and bullish formations typically take place during Stage 1 (market base building). The t i e required to complete of such formations provides the opportunity for investors to carefully reduce or to accumulate positions.

Head and shoulder bottom formations can appear as a formation that develops inversely to the head and shoulder top formation, in which case the pattern becomes a buying rather than a selling formation.
The same basic descriptive patterns occur, though reversed to the head and shoulder top.
1. A market decline takes place. At its conclusion, a high-volume spike often occurs. This ultimately becomes the lee shoulder in the formation. Such a decline took place during June and July 2002.
2. A rally takes place, which is then followed by another leg down on lower volume than the first decline. This leg down generally carries to below the leg down that precedes it. When the decline ends, a rally carries to the area of the previous advance, with trading volume still decreasing.
3. The completion of this second market recovery provides the opportunity to define the neckliine of the formation. A final decline from the new neckline on still-diminishing volume leads to the final and right shoulder of the formation. The formation is complete when the neckline is penetrated from below.
4. Minimum price objectives for the inverse head and shoulder formation, a bullish pattern, are secured by measuring the distance from the neckline to the head and projecting this measurement upward at the area where the neckline is penetrated. A very significant longer-term inverse head and shoulder formation developed in the Dow Industrials between the summer of 2002 and the spring of 2003. The price objectives of that formation were achieved during December of that year.
Head and shoulder bottom formations are among the more accurate of chart patterns, but there are occasional failures nonetheless. Sell stops should be placed below the lowest level of the right shoulder in the formation.

Risk management is still an art as well as a science. We have seen the use of sophisticated models based upon correlation between different risks and assets. Many of the parameters are numerical and objective. These provide real benefits when applied properly. We also have to realise that these tools only handle certain types of risks adequately, mainly market and credit risk. When new products are introduced and increasing complex financial modelling overawes us, we deem it fit to call in the investment risk experts.
If computers and automatic limit systems worked all the time, then no one would have to go outside for specialist help, except for the occasional risk management and dealing system supplier. Mechanical-type systems only account for a small part of the entire risk management business process. Many companies do not possess all these skills in-house and there are reasons why they must hire outsiders.
This means that in major change projects, some element of accountability and control are reduced because of taking in outside help. Also, cost-effectiveness is not the top criterion in these projects at all. In essence, it is ironic that we hardly place checks and controls over those who are hired to control our errant staff.21
More products and mathematical modelling techniques are brought on the market every year. This creates a buoyant market in certain dealing areas. The prospects for derivatives and futures contracts are bright in many ways, but what do they offer fund managers in the way of real value? Many are confused as to the exact answer, so they bring in outside derivatives experts to help them. Some of the problems lie in the complexity of these financial instruments, the extreme leverage they can possess and the manner in which people have been mis-selling them. The deep mathematical foundations underpinning derivatives and financial futures instruments mean that more scientific knowledge is needed to understand them. Thus, a breed of mathematicians and intellectuals sometimes known as “rocket scientists” or “quants” appeared in various brokerages, banks and funds. Investment risk is not a question of solving solely by mathematical or scientific means. Nevertheless, the use of mathematics in investment theory seems to be addictive for many.
So, we have to identify the risk style of the professional investment manager. Then, we have to pick the type of fund that our risk appetite allows. It seems that many investment meals do not match the risk appetite appropriately. Another critical look at the menu can rebalance the investment fare.

Profits are created through business activity, with bread often used as slang for money. Risk and business come together more often than a peanut butter and banana sandwich. Yet, risk is the banana skin upon which many businesses slip. Look at the recent crashes of those considered as “safe investment vehicles”. As if the collapses at Enron, Andersens, Worldcom and Equitable Life were not enough, these came on the public crashes of dot-coms. A lot of banana skin, but no bread for those poor investors.
Thus, it is surprising to some that the financial sector, while claiming to be well risk-managed professions, continues to experience losses on a significant scale. The increasing public opinion is that Wall Street (or the City of London) is a road that leads from a shark-filled pool at one end, to a graveyard at the other. Maybe, we have to get used to conducting risk management for ourselves to ward off attack. Investing is becoming akin to swimming with sharks.
However, spectacular corporate implosions need not be attributed to political chicanery or dot-coms. SwissAir and Equitable Life are examples of highly respected companies that had the gloss taken off in no uncertain terms. Investors should take the responsibility to arm themselves with the required company information to beware the hazards that lurk under the label of “operational risk”.
Sources of historical data could prove beneficial for potential investors. We have to go outside the usual ambit of corporate profits or financial losses quoted in the newspapers and online media. We need analysis to determine actual company performance, as distinct from company PR and spin.

Irving Fisher was a celebrated American economist who was at the origin of numerous concepts in finance. Nonetheless he was vilified at the time of the Great Crash, because he maintained that stock prices had reached a plateau. In autumn 1929, the market value of all shares listed on the New York Stock Exchange plummeted by 30 percent. Many analysts then and now have taken the view that stocks were overvalued and that the market stood in need of a correction. Irving Fisher argued at the time that in fact the fundamentals were sound and the market was undervalued. In a paper published in December 2001, Ellen R. McGrattan and Edward C. Prescott, both of the Federal Reserve Bank of Minneapolis, estimated the fundamental value of corporate equity in 1929 and compared it with actual stock valuations. They came to the conclusion that the Great Crash was not attributable to overvaluation. The evidence strongly suggests that on the contrary, even at their 1929 zenith when the Dow Jones reached 379.61, stocks tended to be quoted low. However, the Dow fell to 41 in June 1932. In another article the same authors demonstrate that in the first half of 2000, the overall value of US corporate equity was close to 1.8 times that of GNP and that because it was equal to the value of all productive assets in the US corporate sector, at that price it was correctly valued. In 2000 the Dow Jones was at around 12000, only to fall to 7500 two years later. Two tales of a bubble that wasn’t! As Adam Smith observed in the Wealth of Nations, the word value has two meanings: the value in use measures the utility of an asset,the value in exchange its purchasing power. In one of his afterthoughts on the history of capitalism, Fernand Braudel explains that everything that stays outside of the market has only a value in use, all that pass the footstep of the market acquires a value in exchange. The value in use can be defined as the value of an asset calculated by discounting the future cash flows obtainable from its continued use. Many market economists in America explain that the market price reflects long-term cash flow prospects, a value in use. On the contrary, there are a number of economists in Europe who consider that the stock price is only a value in exchange. They are very critical of the so-called investor’s rationality in determining market prices. They have adopted Keynes’ view that investors are concerned, not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. For most European economists everything depends on waves of irrational psychology. The relationship between price and value is a puzzle that has baffled economists since times immemorial.

There are two basic approaches to financial markets and their fundamental logic. The first (which will be considered again when we analyze investor behavior, corresponding to passive or index fund management) draws on double diversification in space and time. Diversification in space involves a multitude of financial instruments designed to reduce the risks proper to each and to accept only non-controllable, systematic risk. When investing in stocks you should remember that it is important to diversify into more than 20 of them to make the most of the diversification effect in accordance with the correlation existing between these different stocks. However, this is equally the case when you invest in gold, real estate, bonds or Treasury bills.
Concerning possible stocks, observe the way in which the firm defines its ‘‘corporate strategy’’. Choose those that are focused, as Zook and Allen showed,33 on expanding and innovating in and around their core business. It is up to the investor – and not to the company – to diversify. Such reduction of risk is accompanied by diversification in time; you have got to invest over a long period. If you go for the long haul, you tend to render your investing steadily less hazardous. This is a form of passive investment corresponding both to Warren Buffett’s practices and to the classic definition of the speculator. Speculate on the future, invest and stay invested.
The second approach is more speculative in the sense of speculum, a mirror; Keynes’s beauty contest comes immediately to mind. In this case, a speculator buys stock only for the sake of short-term capital gains rather than for long-term income. Keynes used the term ‘‘speculation’’ for the activity of forecasting the psychology of the market and ‘‘enterprise’’ for the activity of forecasting the prospective yield of assets over their whole life. He despised speculators’ gambling instincts. He felt that they were simply trying to outguess and outwit one another ‘‘to beat the gun’’, rather than striving to project and compute the cold mathematics of future cash flows and associated risks. This analysis explains the highly erratic stock variations registered from one day to the next. Keynes claimed that the valuation of capital assets consequently established was ‘‘arbitrary’’ in so far as it had devolved into a forum for speculation rather than entrepreneurship. This is still the case. But since Keynes’s time, the financial world has learned how to measure the state of confidence with which we forecast the prospective yield of financial assets over their whole life. We now know that long-term investment in a well-diversified portfolio bolsters our confidence in financial investments. Within this framework, the selection of assets relies on more subjective and qualitative factors.
Thus there are two approaches at work. The first is long and diversified; the second is necessarily limited in time. There exists a quantitative philosophy predicated on the past history of returns and volatility as well as indicators of responsiveness such as the beta coefficient. There also exists a qualitative philosophy through which one endeavors to identify factors that will orient prices in the near future. In the end these two philosophies come together. Expectations for the future are based on statistical analysis of results recorded in the past. The short-term qualitative approach fits into Chinese boxes with regard to the long-term quantitative approach. Asset allocation is in conformity with long-term quantitative analysis and selection of individual assets remains qualitative and short term.

The second way of demonstrating the risk factor is to note standard deviations for investments in stocks, bonds or Treasury bills. The first are in principle riskier than the second, which are in turn more risk fraught than the third. Once the holding period lengthens, the variability of these three types of assets tends to diminish. For a one-year investment the standard deviation was 18 percent for stocks, 9 percent for bonds and 6 percent for Treasury bills. The standard deviation for equities fell to 12 percent for two years, to around 8 percent for five years, to slightly more than 4 percent for ten years and to 2 percent for twenty years of holdings. Over twenty years the risk associated with stock investment becomes even less pronounced than that associated with bond investment; over thirty years, stock volatility is a third less than that associated with Treasury bills.
If one sticks to stocks for a sufficient amount of time, the returns on such an investment grow less and less subject to chance. Little by little, they go back to the statistical average. Their behavior is that of a parameter gravitating around its average value and never cumulatively breaking away. Think of a rubber band that may be stretched to a certain point and yet never snaps. The longer the duration of the investment, the less the pressure put on the rubber band, that is the less returns vary or depart from the norm. In contrast, the longer one remains invested in fixed-income instruments, the more the volatility of real returns grows. In fact, this divergence betrays a tendency of cumulative distancing from the average.
The deviations of these quantitative instruments are explained by the negative cumulative influence of inflation on the reward for investing. The disastrous real returns on German state-issued bonds in the 1920s and on Japanese state-issued bonds following the Second World War correspond to periods of galloping, double-digit inflation in the two countries. These are also to be found – but to a lesser degree – in US and UK government bonds dating from the 1970s. Once inflation picks up, the process becomes cumulative and bond investors have no chance to compensate for the loss in purchasing power by dint of returns on their investment. Quite the opposite, inflation penalizes long-term securities and increases nominal interest on new ones. This helps to explain the cumulative distancing from the average that characterizes fixed-income instruments. Risk measured in terms of volatility goes down as investment duration lengthens. It nonetheless seems to be the case that risk pertaining to the riskiest of assets diminishes more rapidly as time goes by than is the case with those entailing minimal risk. The more the investment duration lengthens, the fewer the risks presented by a given security. What appears paradoxical is that while volatility is calculated in terms of yearly rates of return, it in fact diminishes the longer the investment lasts. Yet investment horizons play a prominent role in the evaluation of risk. Institutional investors are judged in terms of their monthly performances. Retired people may well require a steady monthly income. Forty-year-olds readying themselves for retirement are thinking of terms of a twenty-year horizon. From their point of view, price variability does not constitute a risk factor. Given the period of time involved, for them stock volatility amounts to next to nothing. The way volatility is measured does not take this into account. The above analysis, according to which stock market investment over a sufficiently protracted length of time always turns out to be the best, has led some commentators to wonder why there should be a risk premium that would compensate an investor for the risks incurred on his portfolio of stock. The historical variability of prices, that is the amplification of market variation, is certainly one component of risk. As we have already seen, volatility is a risk for the investor who may be compelled to sell off his shares at a time not of his choosing, for example when the market is in the throes of a crisis. But in that case, why is there a risk premium for stock investment when waiting long enough means playing it safe? Why does the market require higher returns on stocks than on bonds, even though the former turn out, in the long run, to be more profitable than the latter? The same reasoning may be applied to specific risk: it can be eliminated through diversification; it need not be remunerated by the market. Why, to put it briefly, should the market remunerate the evanescent risks incurred by stock investors? Let time pass and your investment becomes less a Pascalian wager and more a minutely calculated risk; elapsed years ensure a form of diversification. No premium appears to be called for.
That is one of the explanations put forward for stock market rises occurring during the bull market at the end of the 1990s. Investors apparently agreed to buy high-priced stocks because they were resigned to rather low returns on their investments. Hoped-for profits would be low, as were interest rates; the risk premium was all but negligible. The disappearance of the latter may be explained by statistical analysis demonstrating that that waiting game pays off; returns on stock investments are bound to overtake those obtained by bond or Treasury bill investments. And yet, polls performed at that era showed that institutional investors were aiming for risk premiums of an average of 4 percent, a figure aligned to historical averages of great duration. The one other explanation would consist in claiming that investors were expecting ever-higher profits amounting, as subsequent developments would make clear, to ‘‘pie in the sky’’. In reality, stock investment had grown more risky; investors should have insisted on a heightening of their risk premium. At that time Caps, a consultancy for British-based pension funds, had demonstrated that from 1995 – 2000, stock market volatility had been twice that of the preceding five years (1990 – 95). Yet the real return from investing in equities had been halved over the same period. The fact is that investors had not taken into account the risk increase accompanying the price increase. Had they been more perspicacious, the bubble could not possibly have been formed. In the long run – but one must wait 15 or 20 years – volatility tends to disappear and the risk premium should no longer exist. Long-term investment is an investment in the market, in a portfolio that faithfully reproduced market variations. Long-term portfolio risk gradually diminishes, so CAPM does not apply. For short periods (three to five years), investments are performed on the basis of growth prospects and not as a function of volatility. In the short term, there is no required rate of return, no long-term analysis, no fundamental valuation; all value is marked in the daily revaluation of the stock exchange. And so, rather paradoxically, CAPM could be utilized neither for the long haul nor the short term. It nonetheless constitutes an irreplaceable analytical framework when establishing anticipations.