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Chapter 9. Looking Ahead: The Core Roadm... > Risk Tolerance Defined in Terms of V...

Risk Tolerance Defined in Terms of Volatility

The Sears case demonstrates how risk analysis is inaccurate unless core earnings adjustments are first made. This examination also reveals that we cannot entirely understand price volatility without also understanding fundamental volatility. At the very least, the underlying causes of price volatility have to be traced back to fundamental causes. Once core earnings adjustments have been made, the fundamental picture begins to emerge; but we are still left with the struggle to understand how price volatility occurred in recent months. In the case of Sears, we cannot know for certain how much of the historical price volatility was related directly to core earnings adjustments, competitive forces, the overall market, or institutional investing trends. We may need to review price trends over the longer terms and pay less attention to more recent price volatility.

We can discount the overall market as a major cause of the price volatility in the case of Sears. If we look at less volatile competitors to Sears, such as Wal-Mart, we do not see a corresponding level of price volatility; in fact, even though the market was volatile as a whole during the three-year period, the Wal-Mart trading range was relatively narrow and consistent. If market forces were to blame, we would expect to see similarities in trading range and price patterns for both stocks. A large change in price in a relatively short period of time could be reasonably explained away by the beta trend. So, Sears's 40-plus point drop in a six-month period of 2002 would be understandable if, in fact, such a drop reflected wider market trends. Wal-Mart experienced approximately 15 points of decline during the same period. On a purely technical basis, does this mean that about one-third of the Sears price drop could be explained away by beta? Perhaps. The two companies began with about the same price level, about $60 per share. Wal-Mart declined to the mid-50s and Sears declined to just under $20. But even if we accept the theory that one-third of the drop in Sears's price was caused by market forces (and if we point to Wal-Mart's price change as evidence), it does not explain the additional 25-point drop in the Sears price. For that, we return to the evidence of core earnings adjustments to make our point: that fundamental attributes of each company largely determined the price trends.


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