Wall Street's Dumbest Metric

In Nate Silver's new book The Signal and the Noise, the young statistician attempts to separate the wheat from the chaff in the wide world of predictions.

Silver's main point is that we often confuse the noise (distractions) for the signal (the answer), which is why so many predictions in a diverse array of fields fail. Silver is most famous for taking on the political punditry establishment by predicting a comfortable victory for Barack Obama in this year's election. He was pooh-poohed by a number of commentators who said the race was much too close to call, but in the end, of course, Silver was right. His mathematical model predicted the winner of all 50 states, giving President Obama victory by more than 100 electoral votes, while the pundits, whose claims were based on nothing but hot air, were left to eat their words.

Though it was Silver's takedown of the political forecasting universe that brought him into the limelight, his insights can be just as useful in the financial world. As investors, we struggle to separate the signal from the noise. What led to one stock's rise may not prove the same for another. We are inundated with media, and any number of strategies for making picks, such as fundamental analysis, technical analysis, or mechanical investing. Unfortunately for us, predicting the stock market is much more difficult than predicting the winner of the next presidential election. Silver simply looked at polls and their accuracy in past presidential elections, which gave a sense of the predictability of those polls, and built his model accordingly. In investing, there are no polls. We would all like to know the future price of a stock, but that is largely based on future events, which of course are unknowable until they happen.

So it may be impossible to detect the signal in investing, but there is still plenty of noise we can eliminate. And one of the most egregious offenders, in my mind, is the endless reporting of the "most active" stocks of the day -- those with the day's highest trading volume. This figure is prominently reported on websites such as Yahoo! Finance and The Wall Street Journal, as well as on business news programs such as PBS' Nightly Business Report.

The most active list appears to provide important information for investors. By telling us which stocks had the highest trading volume, it presumes to inform us that there was big news surrounding these stocks on that day or that they were particularly "hot" for whatever reason -- maybe a large investor dumped a lot of shares that day.

However, scanning this list reveals many of the same stocks day after day. Bank of America (NYSE: BAC  ) , for instance, almost always tops the list. Other usual suspects include Ford (NYSE: F  ) , Facebook (NASDAQ: FB  ) , and Sirius XM Radio. Like other timely pieces of information, the list's repetitiveness underscores its uselessness. If the weather report is the same every day, then we don't have to pay much attention to it.

The market, however, is anything but repetitive. The problem with the "most active" list is that it's subject to two major biases: It favors stocks with low share prices and high market caps. Essentially, the more shares outstanding in a stock, the more likely it is to be considered "active."

Take Bank of America, for instance. The company is a behemoth, worth over $120 billion and the No. 2 bank in the country by assets. Yet its shares trade for only $11. No other U.S. stock with a market cap of $100 billion or more has a share price anywhere near that low. GE comes closest at $20. Moving down the largest-market-cap list, Ford is the closest at $12. It's no surprise that the carmaker is also a regular on the most-active list. In fact, all five companies mentioned rank in the top 25 for total shares outstanding, and Bank of America tops the list, which helps explain why it's often the most active in terms of share volume.

Of course, volatility plays a role also. There's a reason that Procter & Gamble (NYSE: PG  ) is less active than Facebook, despite having more shares outstanding. The defensive investors who tend to invest in paper towels and shaving cream are less active traders than those who buy and sell shares of the world's largest social network, which has also been one of the most intensely debated stocks of the year.

A better way
All but the most beginner of investors know that the price of a stock on its own tells you little. Neophytes tend to assume that Apple (NASDAQ: AAPL  ) and its triple-digit price tag mean the company's shares aren't as good a value as Sirius XM, considered a penny stock, but that's not true. Valuation ratios such as the P/E are the real indicators of how pricey a stock is. There are times when actual share price is relevant on its own, but in general, it's mostly noise, as is the list of most active stocks and stand-alone volume.

Below is a short list of suggestions for ways financial outlets can improve investor understanding of volume and the day's most active stocks.

  • Instead of simply reporting the number of shares traded, tell us how that compares to the average trading volume. If my stock's trading volume is four times its average on a given day, I'll know that it's probably worth reading up on that day's news.
  • Similarly, instead of telling us just the number of shares traded, I want to know what percentage of shares outstanding was traded that day. This will give me a better sense of how much of the stock actually turned over that day, and how much turns over on average. This figure plays a big role in bid/ask spreads, which will grow tighter as trading volume goes up. It also affects short squeezes.
  • Finally, instead of telling us the most active stocks in terms of number of shares traded, tell us the most active in dollar value as well. That way a stock like Apple, which remarkably still has more than 20 million shares change hands every day despite its $500 price tag, will be appropriately recognized as the most widely traded stock. Over $10 billion in Apple stock gets traded on the average day, far ahead of the $1.5 billion in Bank of America shares changing hands daily. That helps gives you a sense of the iPhone-maker's importance in the stock market, and makes the current "most active" list look like a distortion. No wonder Apple dominates financial news coverage.

Foolish takeaway
It's often the little things that make us better investors, and knowing what information to ignore can be as valuable as knowing what to follow. As Silver says in his book:

Information is no longer a scare commodity; we have more of it than we know what to do with. But relatively little of it is useful. We perceive it selectively, subjectively, and without much self-regard for the distortions that this causes. We think we want information when we really want knowledge.

For investors, in this era of digital media and high-frequency everything, separating the signal from the noise is more important than ever.

Despite investors' wishes, Apple still plays by the above rules. We would like the glut of information on the company to be easy to decipher, but that's anything but the truth for the world's most valuable public company. Get an in-depth look at the hard data behind Apple's future in our new premium research report all about the tech titan. This isn't the spin you're used to seeing in the financial media. It's deep research you won't find in other outlets, detailing the company's opportunities and risks with analysis and charts to help you understand the whole picture of Apple's future and potential. You can get your copy of this new premium package now. All you have to do is click right here.


Read/Post Comments (15) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 28, 2012, at 6:33 PM, fc3worships wrote:

    I love your 3 metrics...awesome article! Maybe Fool.com can be the first to use them.

  • Report this Comment On December 31, 2012, at 6:33 PM, Wade32ru wrote:

    Agree on all 3 suggestions!

  • Report this Comment On January 03, 2013, at 10:47 AM, TMFBlacknGold wrote:

    Awesome! I always thought that the standard dashboard displayed to investors on any ticker page should be changed. For example, do we really need to view the 52 week range? That can be a dangerous trap for young investors who may think "Gee! This should be trading at $X like it was 6 months ago". In reality the range has little bearing on what actually occurred to the business in the past 6 months.

    Why not show growth metrics on a ticker page? Why should I have to click on a balance sheet page to view these? Changes in revenue, shareholders' equity, net income, etc. are always more important to an investment than P/E, 52 week ranges, or number of shares traded. Too often we accept these numbers (noise) as the basis of an investment.

    Great article and thanks for challenging the status quo that we just come to accept.

    Best,

    Maxx

  • Report this Comment On January 03, 2013, at 1:54 PM, adamlevy wrote:

    This article and Silver's book make really interesting reads. I too believe there's a lot of noise from the media, but that's to be expected in this age of 24-hour news cycles and internet publishing.

    However, I think the markets also provide us with a lot of signals. For example, you say there are no polls in investing. Would it be interesting to consider every buy and sell order a vote? That goes back to your point that you'd rather see roundups on shares that traded at unusually high volumes for the day. Higher than normal volume plus a big change in stock price (votes up or down) can "signal" a change in a stock's course. I believe this is similar to one of the principles of William O'Neil and IBD.

    Just my $0.02

  • Report this Comment On January 03, 2013, at 6:53 PM, HomeGamer1856 wrote:

    " Higher than normal volume plus a big change in stock price (votes up or down) can "signal" a change in a stock's course. I believe this is similar to one of the principles of William O'Neil and IBD"

    You are spot on, good article but I disagree, the volume does let an investor get a sense fore who is buying, large volume=institional investors. Also, low volume is a warning flag-"you about to invest in the roach motel"-easy to get into, hard to get out of.

    My two cents.

  • Report this Comment On January 03, 2013, at 10:28 PM, Darwood11 wrote:

    Then there is the daily report "the DOW is up by 35 as investors respond to the [whatever]" followed by the usual "expert" comments. Never mind that it might be down 3% over the last month, and that 35 points represents an uptick of perhaps 0.2%.

    Noise is usually measured in very short time duration. My opinion? Look at the metrics and ignore the short term information. That includes the daily market statistics.

    My opinion? For most of the normal people, including myself, the real issue is long term results. That means long term thinking, long term planning and long term preparation. Apparently that's not what most want to hear. Unfortunately, the universe doesn't really care what we think and neither does the market.

    Noise may be short duration stuff layered on top of good information or it may be poor information. It depends upon one's perspective and measurements. Both are bad for long term financial success. That's my opinion.

  • Report this Comment On January 03, 2013, at 10:44 PM, aappllee wrote:

    These metrics are available thru most brokers

  • Report this Comment On January 04, 2013, at 1:18 AM, TerryHogan wrote:

    @TMFBlacknGold

    I'd have to disagree with you when you say:

    "Changes in revenue, shareholders' equity, net income, etc. are always more important to an investment than P/E, 52 week ranges, or number of shares traded."

    But I tend to disagree with sweeping generalizations (particularly the use of 'always') just on principal.

    I think the tech bubble might be a good case where P/E should have been heeded more than changes in revenue and in many cases shareholders' equity and net income. Pets.com had phenomenal revenue increases in it's early days, but a quick look at it's -ve or non-meaningful P/E would have given you a better idea of its worth as an investment. I'm sure you can also find examples to the contrary, but I don't think you can say that P/E is always less important than the factors you list.

  • Report this Comment On January 04, 2013, at 8:05 AM, TMFBlacknGold wrote:

    @TerryHogan

    I actually paused when writing "always" and tried to come up with a better phrase, but decided to go with always. I also hate using those loaded words...

    The deciding factor for me is that all a company has to do to lower its P/E is perform a split, and veolia!, the P/E is lowered (halved or more even!) without changing anything about the company. P/E is certainly a good indicator. Also, different metrics work better in different sectors and industries.

    But yes, I shouldn't have used "always". This is investing after all.

  • Report this Comment On January 04, 2013, at 8:05 AM, JiminyBillyBob wrote:

    Great article, but I'm only posting so that the spam message above won't be the last comment. Seems to always end like that.

  • Report this Comment On January 04, 2013, at 9:01 AM, Hoopz wrote:

    @TMFBlacknGold

    "The deciding factor for me is that all a company has to do to lower its P/E is perform a split, and veolia!, the P/E is lowered (halved or more even!) without changing anything about the company."

    Not quite. When a stock splits, the P/E stays the same. Not only is the "P" split, the "E" is also split. Just more pieces of the same total pie.

  • Report this Comment On January 04, 2013, at 9:03 AM, pondee619 wrote:

    BlackGold:

    When a company splits its stock, the number of shares change as do the earmings per share. I believe that a stock split leaves the P/E ratio unchanged.

  • Report this Comment On January 04, 2013, at 11:36 AM, TMFBlacknGold wrote:

    Aw crap you're right. Silly me.

  • Report this Comment On January 04, 2013, at 5:30 PM, MCCrockett wrote:

    "Doh!" An Elmer Simpson quote that is appropriate for most occasions.

    Quants and your average retail investor are more concerned about price per unit and the changes in the price per unit than any other factor.

    Getting 13,000 shares of Bank of America is better than 1 share of Berkshire Hathaway is obvious to the most casual observer.

    I've been employed in the computer industry for the last 40 years. It has always amazed me the power that price has over decisions. I recall a colleague that asked me for a recommendation on a modem to buy.

    Given what he wanted to do, I recommended one with a price tag of $150. He found a modem for $22 and purchased it. He, then, had the gall to complain to me that the modem didn't do what he had expected. "Doh!"

    He wasn't particularly unusual. Most Americans seen more concerned about price than value.

  • Report this Comment On January 05, 2013, at 12:58 PM, SkepikI wrote:

    Two of your metrics, trade vol vs average and % of outstanding shares traded are info I tend to use and are readily available. I find the second % metric easy to id off a mental calculation if not explicitly stated. These still do not offer a magic bullet (no I did not say you believe so, just my opinion) as they have no particular correlation to good or bad things. However, along with my other Information, they just might cause me to abort a decision.

    The third, most active either in number or dollar vol, I don't consider worth much on its own and only mildly informative in combination with other factors. I am suspicious of it since the advent of computer based trading and day trader philosophy.

    I do suggest you might want to re-read Nate Silver's commentary on Wall Street and P/E ratios. His work as well as others suggest that of all of the metrics, P/E has the most correlation with performance, and even that is NOT VERY GOOD! Still, it is worth noting that its "better" than all the other metrics you named and anything else proposed.

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