Understanding the Influences on Price
Stockscores.com Perspectives for the week ending June 17, 2005
In this week's issue:
There are two components to stock price behavior. First is the Beta component, which is the correlation of the stock to the overall market. As the market moves, so too does the stock. The second component is the Alpha component, which relates to the company's business specifics. Understanding these two components is important for success in the market.
As a general rule, the larger the market capitalization a stock has, the greater its Beta component will be. Microsoft tends to closely correlate to the movement of the Nasdaq market in general. As a result, it has a Beta component of close to 1, which means that if the Nasdaq goes up 1%, then so too should the price of MSFT.
Smaller cap stocks tend to have a higher Alpha component, which means that they will move with less correlation to the overall market and more on the fundamentals of the company's business.
Consider two oil companies, one an established producer of oil and the other a small exploration company trying to find oil to produce. The established producer's share price will go up and down with oil prices since their earnings will be closely tied to the price of oil. However, the small exploration company will go up or down based on the success and failure of their exploration programs. Their stock price could go up very quickly if they find oil, regardless of how strong oil prices are. The established company is a Beta stock and the exploration company is an Alpha stock.
In my own trading, I have found it easier to trade Alpha stocks, which are those trading on their own story. However, this does not mean I can only focus on small speculative companies, because all stocks will have a period where they have a high Alpha component to their pricing.
For example, some of you may remember the abnormal activity that we saw about a month ago in the shares of General Motors. The stock jumped significantly on news that a large investor was offering to purchase a large block of stock. Suddenly the shares of GM started to trade like a small speculative company because of the abnormal changes in market fundamentals.
As a general rule, I like to trade Alpha stocks because they are easier to predict. So this begs the question, how do we find Alpha stocks?
To simply the answer, investors should look for stocks trading abnormal share volume and making abnormal price changes. These characteristics represent a breakaway from a correlation to the market.
On Stockscores.com it is possible to scan, using the Market Scan tool, for stocks trading with statistically significant abnormal volume or price change. It is from this filtering of stocks that I find my best trading opportunities.
Of course, if the market factor or Beta factor, is also helping your stock pick, then the probability of success with the stock pick improves. If I find a stock with a high Alpha component that appears likely to go higher and the market in general appears likely to go higher then I have a stock opportunity that has a very high probability of success.
If the market appears that it is going to go sideways, then it is essential to trade Alpha stocks. When the market is trending, then you don't have to be as good of a stock picker because the Beta component will serve to raise stock prices in general.
When trading, always consider these two components of price influence, and put a greater emphasis on the Alpha component when the market factor is not helping your stock picks along. You can be less fussy about what you trade when the market factor is helping since the Beta factor serves to raise most stock prices.
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Bottom fishing is the quest for stocks that are inexpensive relative to previous levels, but show signs that the bargain is going to end soon. We want to look for stocks that are a showing a break from pessimism, an increased level of confidence that the stock is undervalued, and signs of optimism for the future. Filtering for these situations gives the investor a short list of companies to perform their necessary due diligence on before speculating on a change in trend.
Buying a stock that is in a long standing down trend can be as dangerous as stepping in front of a freight train. It takes time for stocks to reverse trends, and buying what seems to be a bargain can be a crush to your portfolio. However, bargain hunting can be profitable if the timing is right. To effectively bottom fish beat-up stocks, you have to enter when there are signs that the downslide is slowing and a move back upward is imminent.
Market psychology takes time to reverse. When bottom fishing, we want to focus on stocks that have suffered a sell off and are cheap relative to where they once were. However, we want to also look for signs that market psychology is turning favorable on these stocks and that they are ready to head higher again.
This strategy focuses on three stages:
Stage 1 - a break from the show of pessimism
Stage 2 - a show of confidence
Stage 3 - a show of optimism
Stage 1 is essentially a breaking of the downtrend. If we draw a line along the top of the declining trend, we have defined the downtrend. A break of the trend arises when the stock can break upward and through that declining trend.
In Stage 2, we want to see signs that there is confidence in the break from pessimism. The market needs to show resilience that the downtrend is indeed slowing, and that the potential for an up trend is real. A consolidation following the break is a good show of this, and is more significant if it as at a level higher than the previous low. This is a rising bottom.
Finally, we want to find signs that there is optimism about the future of the stock. A breakout from a rising bottom is Stage 3.Back To Top
1. TBUS
If you draw a line across the tops on TBUS from September to May you will have established the downward trend line that represents investor pessimism. Notice that the downward trend line was broken in May and the stock is now showing rising bottoms. Friday brought a breakout through short term resistance from a trading range. Volume was not great on the breakout, but I still think this stock can come up in to the $3.35 price range, provided support at $2.09 is not violated first.
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2. CHFC
The three stages of a turnaround are also in place on CHFC, which is breaking from a rising bottom consolidation with good volume support. Reasonable potential for it to go to $36, with support at $31.25.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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