Ross M. Miller
Miller Risk Advisors
November 1, 2004
Regular readers of this swatch of cyberspace know that my MBA students
have been charged with predicting what the price of Google will settle at
the end of the month of November. They also have to create a
"hedge" for Google over this period and justify their choices in
1,000 words of less. This week's commentary can be viewed as my
This assignment is devious because Google defies not
only logic but also the direct application of textbook financial theory.
The method behind this deviousness is simple—no one really understands a
theory until they understand its limitations.
If Google were a nice company like GE, one could use the
Capital Asset Pricing Model (CAPM) to get both a reasonably future price
and could hedge out most of the "market risk" by shorting SPDRs
against it. CAPM uses GE's beta, which is conveniently the slope of the
line created by fitting a straight line through a graph of GE's returns
plotted against the index's, to project future returns. For GE, beta is
Traditional data vendors use five years of monthly
returns to generate their beta—I find that a few years of weekly returns
gives a more useful number. Because this estimate is biased, an
appropriate adjustment factor must be applied to it, making the entire
procedure seem like voodoo. (My more "clever" students have
already learned the CFO's old trick of figuring out what you want the
answer to be and working backwards from there.)
To add to the voodoo, a risk-free rate of return and a
market rate must be fed into the CAPM formula. The bottom line is that an
average large-cap stock can be expected to increase at a rate of almost 1%
a month, a typical tech stock can be expected to increase at a rate of
1.5% a month, and a thrilling tech stock can top 2% a month. The added
returns are not free money, they are compensation for bearing market risk
according to the CAPM and its many variants. The "error bands"
around these estimates tend to be rather wide, so one can follow the
cookbook (oops, textbook) and yet be totally wrong—a common occurrence
in the financial world that textbooks never address.
No one publishes a beta for Google and there is barely
enough daily data to rough out an estimate. (Beta mavens tend to eschew
daily returns because they are noisy.) Even with the liberal exclusion of
outliers, Google appears to have little regard for what the rest of the
market, with the possible exception of Yahoo!, is doing. Any kind of
reasonable estimate for beta leads to the conclusion that Google will end
November in the ballpark of 195. When one takes into account the current
implied volatility of Google (about 17% a month), however, one find that a
two standard deviation ballpark has a range of 134 points, from 128 to
262. Darts anyone?
There are two good reasons to believe that Google's
price has nothing to do with textbook finance theory. First, Google could
be caught in a speculative bubble and textbooks do not like to talk about
bubbles. Second, given that the majority owners of Google's stock are in
the position to dribble out their shares, they have an ongoing interest
to prop up the price of the stock. Google will see some shares emerge from
lock-up in November, but several times as many shares are waiting in the
wings. The best state of affairs for the Google insiders is for the stock
to rise at a steady, but sustainable, clip.
Even though I lack complete confidence in the ability of
the Googlers to manage their stock price, I have to go with the sustained
bubble for the next month. Predicting where a bubble will be in one month
is not easy, but the number is certainly over 200. (Technical analysts
must be pleased to see that Google bumped up against
"resistance" at 200 on Friday. So what?) Based on a log-linear
trend line (which the stock is currently well above) and the use of the
MBA's best friend, the Excel FORECAST function, I come up with a November
30 price of 221.24.
Creating the hedge is more difficult. During its rise
into the stratosphere, Google has dragged Yahoo! (YHOO) with it. Google is
only tenuously linked to the Nasdaq 100 (as represented by QQQ) and seems
to move without regard to the S&P Index (SPY). The students who listen
to me spout the conventional financial wisdom tend to find that based on
Google's brief history, YHOO is the only hedge that stands the test of
statistics. The main problem with using YHOO as the sole hedging
instrument is that it introduces unnecessary noise into the hedge,
something that has troubled some of my more sensitive students.
My best guess is that Google will begin to link up with
Nasdaq, most likely because Google will drag the rest of the tech market
up with it. My unscientific hedge is to short 3 shares of YHOO and 5
shares of QQQ against each long share of GOOG. Sometimes gut feelings must
triumph over statistics (and reason).
If the presidential election is resolved in short order,
my next commentary will give my post-election stock market outlook;
otherwise, I'll write about grocery stores.
Copyright 2004 by Miller Risk Advisors. Permission
granted to forward by electronic means and to excerpt or broadcast 250
words or less provided a citation is made to www.millerrisk.com.