Some Observations…

Investing or Speculating?

There are hundreds of books with literally tens of thousands of  pages with millions of words written on the stock market. Much of it is interesting. Much of it is empirical and based on past history, which does not necessarily mean the future can be predicted from what you read. There are two basic principals of long term investing. First and foremost is the “Believe in America” philosophy that says despite ups and downs, the US economy over time has grown and corporate America has made greater profits, and thus stock prices have increased. We have survived recessions, depressions, wars etc. Thus the second premise is that despite these setbacks, this long term growth will always continue.

Before we even get to defining/understanding the markets, please understand that what I do, and what you probably are doing is speculating, not investing. If you were in your twenties, were making monthly incremental investments and holding for your retirement, then I’d be inclined to call you an investor. That is the “Believe in America” philosophy, which over time has always worked. So if you want to invest, buy the S&P 500 index (or a money manager who you think can beat the S&P 500) and not worry about yearly fluctuations. At retirement or your death, whichever comes sooner, hopefully, you will have made a lot of money. It has worked and stood the test of time – so far.

But, if you want to make money now – this month, this year, next year, you are a trader – a speculator. Therefore, you need to know what to buy and sell and when to get in, when to get out.

Defining the Market - Simply  

In the simplest terms, there are two things you need to know about how the stock market works. The stock market operates on the greater fool theory. Some fool (you) buys a stock because you think at some future time, a greater fool will come along and pay you more. (The same principal applies to those who sell the market short – they believe there will be no greater fool to come along and the price will not go up. They borrow the shares, sell them (“short”) believing the price will go down. If he’s right he can buy the stock back at a lower price, return the borrowed shares and pocket the difference in price – (his profit.)

The second basic thing you need to understand is that when money comes into a market, prices are bid up. When money leaves the market (more sellers than buyers), the prices decline. It happens by the minute, hour, day, week, month and year.

Are Markets Efficient?

The answer is yes and no. Yes, in that every day the perception of value changes. Is a stock ever too cheap or too expensive? No. A stock is worth exactly what a willing buyer is prepared to pay a willing seller at any one particular moment. Nothing more, nothing less. However, exactly what is happening in the market on any particular day, week or even month(s) may be, and often is, irrelevant and is nothing more than noise in terms of the overall trend. That is the simple truth as to why it is impossible to devise any system to make big profits every day, every week or every month. The Holy Grail of trading does not exist.

There are two ways of analyzing a stock. Neither is foolproof and neither is truly predictive of the future with regards to the price of a stock. A fundamental analyst crunches the numbers of the company and tries to come up with a value today and project what the stock will be worth at some time in the future.  Too many professionals rely strictly on this method only and do not take into account the technical analysis of the stock, which would add the dimension of when to buy and when to sell. Many simply buy these “best” companies and hold on, regardless of what happens. Modern portfolio theory is interpreted by many to say that if you do your homework and truly own the best companies, and if you are diversified enough you will out perform the general market, usually measured against the S&P 500.

Technical guys use all kinds of studies, some of which have merit if kept simple. These “tools” are designed to measure and predict future trends. The problem is that short and long term trends change. That is the reason that moving average systems are so popular as they filter out a lot of the noise. The 50 day moving average is a favorite of the institutional investors.  It has become so watched that it has become a self-fulfilling indicator, albeit often temporary, as fund managers feel that when a rising stock corrects back to its 50 day moving average, it’s a buying opportunity. Thus a 50 day moving average is normally a strong area of price support. Does it work?  I don’t think so. If these managers have access to the best fundamental analysis to pick the very best stocks, then they buy when they dip to the 50 day average, you would think their returns would be way ahead of the S&P 500 index. Mutual fund managers who beat the S&P 500 on any consistent year over year basis are rare. That is why index funds are so popular –  many “investors” have learned to just buy the index and do better than the vast majority of the professional money managers. It’s all pretty sad.

Be Smart – Be a Trader

Markets do have a pulse to them within a trend. It is here that successful traders try to find trading systems that work. Look at a chart of the bull market for 2003.  Forget all the financial and political news. One thing that is quite evident are the cycles – every 4 to 6 weeks the market makes a low in the up trend. Gold stocks have had their own unique cycle characteristics the last few years. When the cycles are coupled with certain chart patterns, they have been very predictable and very profitable.

There is a theory that the first hour of trading each day is dominated by the small investors and that the last hour is dominated by the large institutional/fund managers. I really have no idea if that is right or wrong, but I suspect there is some measure of truth to it. What I do know is that on most days when the stock market is not in a strong trending mode that day, which is most days, the top or the bottom of that day’s range occurs with surprising regularity between 11am and 12 noon. The final direction of the last part of that day’s trade will begin in the afternoon around 2:30 – 3PM.

Different Directions Possible?

There is an old adage that says "a rising tide lifts all boats." Simply applied here, an upward trending stock market will lift prices of stocks, and the falling tide of a down market will depress prices.  There are always many exceptions of course.  But it's worth noting that even strongly advancing stocks will be at least tempered by a down market.  This is especially evident on a daily basis.  For example, the markets open and trade higher most of the day then start to decline with an hour or two to go.  If you watch the market, you will observe many of the strong stocks you have will probably weaken too.  Part of what makes a good set-up for a break out are strong stocks that correct, then consolidate as the overall market still works lower. The stock being watched basically goes sideways on reduced volume. This screen is one I watch closely, as it often portends a strong breakout when the market moves up again. 

There are the stocks that often will be unaffected by the general market trend, like biotechs or stocks that are often actually counter cyclical to the S&P 500 like gold stocks. Then there are the defensive stocks that mutual fund managers pile into during bear markets – drugs, food, utilities - basic stuff we all need. Mutual Funds are not allowed to be short. And they must be at least 65% invested, so they pick the “defensive” issues that are affected very little by a soft economy. Thus, they are hoping to lose less than the S&P 500 in a down market.

OK, we are traders, so we do not have these types of constraints. So, it’s simple, right? Go with the tide? Just stay out of the market when it is going down? Sell short? That sounds simple, but the reality is that we do not know what tomorrow will bring. If you are a fisherman, you look at tomorrow’s, or next week’s, tide tables and you can plan your trip precisely. In the ebb and flow of the stock market tides, you simply never know when the tide will change. So, if the system says to “buy” a stock, I buy it. If it says sell, I sell it. There are great trading opportunities in all market trends. There were a lot of “experts” who stayed out of the Spring 2003 rally because we were in a bear market. And long term technically, we really did not confirm that we were in a new bull market until September. Notice I did not say “are” but “were” in a bull market. I hate to give many of you the bad news – technical analysis can only tell you where we were, but cannot tell you where we are going. Odds are good that this good market will continue, but that could change at anytime. I don’t try to predict the future. I don’t try to buy when a stock is cheap. I play what’s happening today. My system filters noise, reads the pulse and anticipates breakouts. If the breakout fails, I take a small loss and move on.