Does the market move the stock, or does the stock move the market?
It’s an important question to think about. For, if you believe the market will head higher or lower, you should know how often a stock you own moves up or down with the market. When the market crashed from the highs of 2007 to the lows of 2009, there were days where 99% of the stocks in the S&P 500 moved lower.
But, those numbers were aberrant trades. It is not the norm that anything close to 99% of stocks will move in lock-step with all the stocks around them – which is what “the market” is. The “market” is the collection of stocks, not an entity on its own.
Thus, when you discover that a stock you own moves up or down “with the market,” you really found there is a correlation between the movement of your stock and the great number of others in the trading universe. The term used to describe these relationships is, “BETA.”
According to Wikipedia, By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes, the S&P 500 is sometimes used as a proxy for the market as a whole). A stock whose returns vary more than the market’s returns over time can have a beta whose absolute value is greater than 1.0 (whether it is, in fact, greater than 0 will depend on the correlation of the stock’s returns and the market’s returns). A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.0.
A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market’s returns; when the market’s return falls or rises by 3%, the stock’s return will fall or rise (respectively) by 6% on average. (However, because beta also depends on the correlation of returns, there can be considerable variance about that average; the higher the correlation, the less variance; the lower the correlation, the higher the variance.) Beta can also be negative, meaning the stock’s returns tend to move in the opposite direction of the market’s returns. A stock with a beta of -3 would see its return decline 9% (on average) when the market’s return goes up 3%, and would see its return climb 9% (on average) if the market’s return falls by 3%.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have challenged this idea, claiming that the data show little relation between beta and potential reward, or even that lower-beta stocks are both less risky and more profitable (contradicting CAPM). In the same way a stock’s beta shows its relation to market shifts, it is also an indicator for required returns on investment (ROI). Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% – 2%)) in accordance with the financial CAPM model.
The chart at the top of this article shows the correlation AAPL had with the 30 stocks that make up the Dow over the last 500 trading days. 65% of the time, AAPL closed the day in the same direction as 30 stocks in the Dow. In comparison, EBAY traded 73% of the time in line with the Dow.
You would be surprised at the number of people who say, “I think the market will drop, but I think my stocks will go up.” – This while the stocks they own may have a clear correlation with the universe of other stocks.
There are those who disagree, though.
Seth Klarman of the Baupost group says, “I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment’s volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.” (Margin of Safety, 1991)
There are no perfect indicators. On that point, I agree with Klarman. However, I believe if a stock you own moves in line with the market, you need to consider your position so that you don’t allow your love for your stock to outweigh it’s most-likely moves.
2013 January 18, Friday