Friday, April 01, 2005

2005's two rules of stock "investing"

In the first quarter of 2005, the stock market has largely obeyed two rules:
  1. If oil prices rise, the general stock averages fall; and
  2. If a company does not exceed earnings estimates and raise its guidance each quarter, the stock will instantly lose at least 5% of its value.

Operating on these two basic rules, it appears that stock investing has become an oxymoron. While the recent trend in oil prices has been up, every time the price of oil drops, the stock market goes up and oil-related stocks go down. And as a student of the history of the oil industry, I realize that massive swings in the price of oil have been an intrinsic part of the industry ever since Colonel Drake made his first commercial discovery back in 1859 in Titusville, PA.

Even oil company executives are reluctant to invest their cash hoards in exploring for more oil. So how can we mere mortals expect to make a profitable long-term investment in oil?
Having said that, it appears that for the foreseeable future, the factors pushing oil prices higher seem inexorable. Indeed on
March 31st, Goldman Sachs predicted that the price of oil would hit $105 a barrel. Is Goldman’s prediction a signal of a market top or a prescient call on even higher prices?

The second rule is equally problematic for investors. There is no way to know whether analysts’ earnings estimates are too high, too low or just right. Nevertheless, these estimates clearly set the bar for investors each quarter. And if a company succeeds in beating estimates and raising guidance, then analysts keep raising the bar each quarter until it becomes impossible for the company to deliver – thus whacking the stock.

This is what happened to
Guitar Center’s stock which had enjoyed a great run until mid-March when it announced that its revenue growth would be roughly 1% lower than it had previously guided -- prompting investors to slice 10% out of its market capitalization.

There is probably no way for investors to know ahead of time whether such adjustments to expectations are imminent. But this dynamic does suggest a way for investors to trade on the uncertainty. Investors can construct straddles in which they purchase put and call options in proportion to the probabilities assigned to exceeding and missing earnings and guidance expectations. For example, if an investor believes that there is a 70% chance that the company will miss expectations, then the investor would place 70% of his ‘hedging premium’ in put options and 30% in call options.

It’s hard to call this investing since it really amounts to short-term gambling. And most likely the gamble would not have very good odds because the price of the options would reflect the market’s best estimate of the chances for beating or missing Wall Street’s expectations.

The basic problem for investors is that there is a serious dearth of new, industry-creating ideas. The economy is highly leveraged and is being choked by unchecked increases in energy prices. Until leadership emerges to lessen our dependence on this depleting resource and to create new growth opportunities, stock investing is likely to be a tough game to win.


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