Chapter 52: Market Analysis and Security Analysis

Graham addresses the question of market analysis – forecasting security prices – and the extent to which it may seriously be considered as a substitute for or as a supplement to security analysis. If one can dependably foretell the movement of stock prices without any reference to the underlying values, then it would be more profitable to master this technique rather than to devote painstaking efforts to forming conclusions about intrinsic value. Two kinds of market analysis: (1) Predictions exclusively based on the past action of the stock market – technical analysis (2) Predictions based on all sorts of economic factors i.e. business conditions, money rates, political outlook – Macro forecasts.

1. Technical Analysis: The implications of using past price movements to foretell the future can be considered to see if this is viable approach.
1. Chart reading cannot possibly be a science – If it were a science, its conclusions would be as a rule dependable. In that case everybody could predict tomorrow’s or next week’s price changes, and hence everyone could make money continuously by buying and selling at the right time. This is patently impossible.
2. It has not proved itself in the past to be a dependable method of making profits in the stock market – Because of the above fact it follows that there is no generally known method of chart reading that has been continuously successful for a long period of time. If it were known, it would be speedily adopted by numberless traders.
3. Its theoretical basis rests upon faulty logic or else upon mere assertion. You may learn a great deal about the technical position of a stock by studying its chart, and yet you may not learn enough to permit you to operate profitably in the issue. Security analysis and market analysis are alike, in the fact that they deal with data that are not conclusive as to the future. The difference, is that the securities analyst can protect himself by a margin of safety that is denied to the market analyst.

Undoubtedly, there are times when the behavior of the market, as revealed on the charts, carries a definite and trustworthy meaning of particular value to those who are skilled in its interpretation. If reliance on chart indications were confined to those really convincing cases, a more positive argument could be made in favor of technical study. Buy such precise signals seem to occur only at wide intervals, and in the meantime human impatience plus the exigencies of the chart reader’s profession impel him to draw more frequent conclusions from less convincing data.

4. It vogue is due to certain advantages it possesses over haphazard speculation, but these advantages tend to diminish as the number of chart students increases.

The appeal of the chart reading to the stock market trader is something like that of a patent medicine to an incurable invalid. The stock speculator does suffer, in fact, from a well-neigh incurable ailment. The cure he seeks, however, is not abstinence from speculation but profits. Despite all experience, he persuades himself that these can be made and retained; he grasps greedily and uncritically at every plausible means to this end.

The plausibility of chart reading derives largely from its insistence on the sound gambling maxim that losses should be cut short and profits allowed to run. This principle usually prevents sudden large losses, and at times it permits a large profit to be taken. The results are likely to be better, therefore, than those produced by haphazard following of market tips. Traders, noticing this advantage, are certain that by developing the technique of chart reading further they will so increase the reliability as to assure themselves continued profits.

The more intelligent chart students recognize these theoretical weaknesses, and take the view that market forecasting is an art that requires talent, judgment, intuition and other personal qualities. They admit that no rules of procedure can be laid down, the automatic following of which will insure success.

2. Macro forecasting: Mechanical forecasting systems sound vaguely plausible on the basis of a priori reasoning and rely for its convincingness on the fact that it has worked for a number of years past. The necessary weakness of all these systems lies in the time element. It is safe and easy to prophesy, for example, that a period of high interest rates will lead to a sharp decline in the market. The question is “How soon?” There is no scientific way of answering this question. They are not truly scientific, because there is no convincing reasoning to support them and because, furthermore, really scientific (entirely dependable) forecasting in the economic field is a logical impossibility.

Disadvantages of Market Analysis as Compared with Security Analysis: Security analysis is also an art, and it, too, will not yield satisfactory results unless the analyst has ability as well as knowledge. The security analyst has several advantages over the market analyst:

1. In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety. The underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove a satisfactory one. In market analysis there are no margins of safety, you are either right or wrong, and, if you are wrong, you lose money.
2. Less trading involving less transaction costs.
3. Market analysis is essentially a battle of wits. Security analysis seeks to buy from someone who has not made an equally painstaking analysis of its value. Securities analyst examines a far larger list of securities than does the market analyst. He selects the exceptional cases in which the market price falls far short of intrinsic value.

Market analysis seems easier than security analysis, and its rewards may be realized much more quickly. For these very reasons, it is likely to prove more disappointing in the long run. There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.

A good part of the analysis and advice supplied rests upon the near term business prospects of the company considered. It is assumed that, if the outlook favors increased earnings, the issue should be bought in the expectations of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide. The market prospect is thought to be identical with the business prospect.

• This theory of buying stocks chiefly upon the basis of their immediate outlook makes the selection of speculative securities entirely too simple a matter.
• Its weakness lies in the fact that the current market price already takes into account the consensus of opinion as to future prospects. When a stock is recommended for the reason that next year’s earnings are expected to show improvement, a twofold hazard is involved. First, the forecast of next year’s results may prove incorrect; Second, even if correct, it may have been discounted or even over discounted in the current price.
• If markets generally reflected only this year’s earnings, then a good estimate of next year’s results would be of inestimable value. But the premise is not correct.

Graham expresses skepticism about the ability of analyst to forecast the market behavior of individual issues over the near term future. More satisfactory results are to be obtained in the following

1. The selection of standard senior issues that meet exacting tests of safety.
2. The discovery of senior issues that merit an investment rating but that also have opportunities of an appreciable enhancement in value.
3. The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value.
4. The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations.

Investment Policy for the Small Investor

1. Investment for Income: The only sensible investment for safety and accumulated income, under current conditions, is in US Savings bonds.
2. Investment for Profit: Four approaches
1. Purchase of representative common stocks when the market level is clearly low as judged by objective, long term standards. This policy requires patience and courage and is by no means free from the possibility of grave miscalculation. Over long period it will show good results.
2. Purchase of individual issues with special growth possibilities when these can be obtained at reasonable prices in relation to actual accomplishment. Where growth is generally expected, the price is rarely reasonable.
3. Purchase of well secured privileged senior issues. A combination of really adequate security with a promising conversion or similar right is a rare but by no means unknown phenomenon. A policy of care selection in this field should bring good results, provided the investor has the patience and persistence needed to find his opportunities.
4. Purchase of securities selling well below intrinsic value. Intrinsic value takes into account not only past earnings and liquid asset values but also future earning power, conservatively estimated – in other words, qualitative as well as quantitative elements. These may be found in bonds, preferred stocks and common stocks.
3. Speculation: The investor is privileged to step out of his role and become a speculator. He is also privileged to regret his action afterwards.
1. Buying stock in new and virtually new ventures. Graham condemns this unhesitatingly and with emphasis.
2. Trading the market. It is fortunate for Wall Street that a small minority of people can trade successfully and that many others think they can. Graham thinks that, regardless of preparation and method, success in trading is either accidental and impermanent or else due to highly uncommon talent. Hence the vast majority of stock traders are inevitably doomed to failure. He does not expect this conclusion to have much effect on the public.
3. Purchase of growth stocks at generous prices. He considers this approach to be inherently dangerous  but the changes of individual success are much brighter here than in the other forms of speculation and this is a better field for the exercise of foresight, judgment and moderation.