The Relationship Between These Major Factors in Investment Valuation
The most fundamental of these three factors is the macroeconomic perspective, because this does serve as a limiting factor to the price movement of investments. With stocks, this means that people will have more or less to put or keep in the stock market in general.
The value of stocks depends on nothing more than market capitalization, which is how many shares there are out there, times the value of each share, determined by the last trade. When more money is infused in the stock market, market capitalization increases, and this is actually by definition and not even a matter of observation. This has to happen because that’s what rising values of stocks imply, more money invested in them.
Bonds and macroeconomic fundamental analysis are even more related, and are related directly, as this is really the only thing to look at when seeking to predict future bond prices. In this case, it’s not just how much money people have to invest in bonds, it is how fast economies grow and what the future rates will be and what these bonds may trade for later given these projections.
The bond market therefore is much more dependent upon fundamentals than the stock market, to the point where we could even say that macro fundamentals are the driving force behind it, directly driving bond prices and yields one way or the other.
With stocks though, macro fundamentals do matter, but only to the point where it may influence the potential for inflows and outflows in the stock market.
This is a lot like looking at household income as representing a potential for spending and then needing to look at what percentage of this income gets spent. Rising or falling macro data will mean that we can invest more or less in stocks, although whether we do so or not will depend.
Given that there is more money to invest, and people are actually investing it in the stock market, to drive prices upward generally, then and only then should we be looking at micro fundamentals, to select from among the choices of stocks out there.
We could think of all this as requiring three green lights in succession. Macro data gives us one by telling us that conditions are ripe for people putting more money into stocks generally, and by observing these effects we need to see this actually happening, giving us our second green light. If we choose to dig deeper and then go into the fundamentals of the company, we can get a third and final green light.
Are Macro Fundamentals Actually That Useful?
We could just skip the first step and look directly at where stock prices are moving, and this is actually what the technical analyst does. Technical analysts, who just study the market itself and don’t even look at any fundamentals, would tell you that this is all there is worth studying, and in a real sense, whatever the macro fundamentals may be, it’s how they drive prices that matters, and solely matters in fact.
This does not mean that macros are not completely useless when analyzing stock markets, but in order for this to be all that meaningful, we’re going to have to have the ability to be out of the stock market or to be short it, in other words do something different than being long the market all the time.
Mutual funds don’t pay much attention to macros when it comes to stocks, because they are duty bound to be long the stock market, and close to fully invested as well. There is no in or out of the market, there is only in or out certain stocks, and this is why micro fundaments are so central to these funds.
This is the case with a high proportion of investors as well, who would be wasting their time trying to figure out how exposed they should be to the stock market when their clear intention is to always be fully exposed.
This has us just deciding between stocks. Funds, who have a lot more expertise and resources than the average investor could even dream of, spend a lot of time and money poring over stock fundamentals, but most mutual funds actually do more harm than good with the stock switching that they do, where they would be better off if they did none of this and just went with a predetermined basket as we would find in an index.
This is testimony to the difficulty in selecting among stocks, and while many amateurs may think that they can do much better than the market by picking their own stocks by just looking at their fundamentals and picking ones with better looking numbers, this isn’t how stock prices go up and down.
There’s only one thing that influences the price of stocks, and that’s the market itself. When you get a net inflow of capital into a stock, the price rises, and when we get a net outflow, the price drops. This is actually true by definition.
If we are looking to time our exposure to stocks, then knowing that the economy will strengthen or weaken may be seen as useful, although the correlation between economic strength and market strength is far from exact.
Hedge funds do use these data to help them make decisions, funds that can and do time both stocks and stock markets, although hedge funds don’t have anywhere near as much agility as individual investors and are committed more to the long term due to the costs involved.
Individuals have the ability to turn around their entire portfolio with a few mouse clicks, where funds with billions of dollars under management require some real time to unwind their positions. This leads to the need to anticipate market movements more than we have to ourselves.
If change occurs, we can just react to it, where institutions need to prepare ahead of time for them. When you have to prepare like this, this introduces uncertainty, which serves to temper returns and increases risk. Hedge funds have to hedge more because it takes so long to turn their huge ships around, where we can turn around ours on a dime.
Individual Investors Should Not Even Concern Themselves with Fundamentals
There really isn’t a need for individual investors to be concerned with either macro or micro fundamentals as it turns out. The macro influences will play themselves out in the arena of exchanges, and we can simply sit back and watch what actual effect they have.
This effect does not just include current fundamentals, but future ones as well, and it is all included in the price movements we see. When future outlooks change, to the extent that this outlook matters, it will be included in the price of our investments.
Investors don’t really spend much time, if any, looking at macros, and if they did, they would learn that none of this is all that simple and this really should be left to the experts who both need this information and know how to use it.
With micro fundamentals, how the company that we’ve invested in or are looking to invest in is doing, that would at least seem to be something that is good to know. It certainly might be if we’re planning on sticking with a company’s stock for the long haul, like Warren Buffet does, and Buffet bases his decisions purely on fundamentals.
If we are investing billions of dollars in a company, there is a need to look to anticipate more, and this is especially true if we’re looking to ride out all the ups and downs of the market. When this is the case, we have to rely on something, and there just isn’t much left to use when we essentially turn a blind eye to macroeconomic factors and happenings.
Microeconomic analysis, like macroeconomic analysis, takes expertise and resources, something we as investors don’t really have. More importantly though, there isn’t really even a need for this, and looking to pick one’s own stocks ends up being a regrettable decision more often than not.
The main reason for this is that we tend to just look at the stock and not the market, and the stock’s price is a product of both its own conditions and market conditions. If we really do want to use fundamental analysis properly when evaluating stocks, we need to look at both and give each its proper regard.
This is a difficult task to say the least, and one that we really should not even be contemplating. People will use all sorts of things in isolation, anywhere from seeing a company’s earnings outperform to seeing an ad on TV for the company to make these decisions, and we end up acting on very incomplete information when we allow these tidbits to influence our investing decisions.
Fundamental analysis should therefore be left to the experts, and in many cases, the experts aren’t doing it that well either and would be well served to broaden their view and at least use market data more than they do.
This does not mean that we should leave analysis itself to the experts, and in fact the analysis of price itself can be simplified to the point where everyday investors can both conduct it and take advantage of it, but none of this has to do with fundamentals, it is about the story that prices tell and listening to it closely enough.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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