Beating Average
Stockscores.com Perspectives for the week ending June 25, 2005
In this week's issue:
On average, stocks have returned 7% per year over the last 70 or 80 years. That is better than the appreciation in the average house, or the average baseball card. Of course, there have been times when stocks have fared poorly relative to other investment vehicles just as there have been years when the return on stocks has been far better than anything else. But the long term investor is really concerned about averages, which is why most investors have some interest in the stock market.
Professional investors are not interested in being average. Their quest is to beat the averages, something tried by many but achieved by few. Most mutual fund managers don't consistently beat the averages and few retail investors can boast of annual returns that are better than average.
Therefore, advocates of the efficiency of the market, so called Random Walkers, argue that it is a waste of time to try and beat the average. For all the effort in doing so is futile, and investors should simply buy a market index and aspire to be average.
I have no interest in mediocrity, and I am sure most of you are reading this newsletter because you have an interest in picking those stocks which will do better than average. But what is necessary to be better than average?
If you always do what has always been done, you will always get what has always been got. Flawed English aside, this saying stresses what is necessary to be better than average. You have to do what the average investor is not doing; you need to be ahead of the crowd.
Do you work harder than the average investor? Do you have more knowledge than the average investor? Are you more disciplined than the average investor? Are you smarter than the average investor? If not, how can you expect to be better than average?
My style of investing and trading the stock market is to emulate the actions of the above average investor. By monitoring market activity, it is possible to see the movement of money in and out of stocks. Where there is abnormal behavior, I assume that an above average investor is making a move. The stock is not trading in an average way anymore, and that is what attracts me.
In all aspects of trading the stock market, you must strive to do something that the crowd is not yet doing, but will be doing soon. Buy just before the average investor buys, sell just before they sell.
Making money, in all things, is relatively simple. Do more than the average person, believe you can achieve more than the average person. Yet, most of us are programmed to do what is acceptable, to achieve what everyone else does. We set up average road blocks in our minds and we achieve average results. There is nothing wrong with being average, unless you want to do better.
When you are analyzing markets and stocks, try and figure out what the different crowds in the market are doing. There is the big crowd of average investors, and there is the small group of above average investors. When the crowd that you belong to grows too large, recognize that their actions are moving toward average. And average just won't do if you aspire to greatness.
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The most important factor affecting stock price is information. As information about the earnings potential of a company is made public, prices move to reflect the new knowledge. Often, stocks move in advance of the public release of information because there are market participants who have access to the information early. In other words, the process of information dissemination is gradual and not always fair.
Fortunately, this process often shows up in market activity. If significant new information is available, those with access to that information at an early stage may buy or sell in the market. In doing so, they can cause abnormal market activity.
For example, if an individual learns that Company A is likely to announce an alliance with Company B that will have significant impact on Company A's bottom line, that individual may decide to purchase shares in Company A. If there are enough people with enough buying power doing this, they can cause the price of Company A to move significantly, and trade an abnormal amount of volume.
Mathematically, we can define what a normal price move for a stock is based on its past trading history. A stock like Microsoft may move up or down 3% on average in a day. A smaller, more speculative stock may have a greater range of price movement. Based on their specific trading history, it is possible to extrapolate an expected range of price movement for the next trading session. If that stock moves outside of that range, it is deemed to have made an abnormal price change.
We can apply the same reasoning to the quantity of stock traded on a particular day as well. If a stock trades far beyond the average number of shares that it has traded historically then, statistically, it has traded an abnormal number of shares. Identifying stocks that make statistically significant abnormal price movements while trading an abnormal quantity of shares provides clues that the stock is trading on significant new information. That information may have been made public, market participants may be making an educated guess on future information, or privileged market participants are trading on private information. In certain situations, stocks that behave abnormally are often telegraphing future price trends.
Identifying stocks that have made statistically significant abnormal price gains is an excellent way to find stocks that may continue into up trends. However, using only this filter is insufficient as you will simply find too many candidates and a success rate for finding winners that is too low.
Recognizing that price volatility defines uncertainty, we also want to focus on stocks that have recently been in a period of low volatility, relative to the past trading history of the stock. Market participants are confident about the value of a company that shows little volatility. In other words, the market is confident about the price it has given to all available information. Therefore, if a stock breaks from this period of low volatility with an abnormal gain, we hypothesize that the move was motivated by new information. This new information will take the stock higher as more people learn about it. If the stock makes this abnormal break out of a period of low volatility with strong volume support, we have even more evidence that there is new information causing some investors to get excited.
The concept of resistance is very important to this strategy. When looking at a stock chart, it is relatively easy to see that there are price ceilings that seem to prevent a stock from moving upward. In our previous example, that ceiling was at about $12. This line of resistance is really just a boundary above which the market is unwilling to pay. Based on all the information that the market has about a company, the market is unwilling to pay more than the resistance price.
Therefore, if a stock breaks above resistance, it may imply that there is new information that makes the company worth more, and therefore, the market is prepared to pay more. Therefore, the logic of this strategy is as follows. Identify stocks that are behaving abnormally to the upside and trading abnormal amounts of volume because that is an indication that there is something positive happening. If the stock is moving from a period of low volatility, we can assume that the market was confident about the valuation it has given the stock. Further evidence of new information is found if the stock breaks from this period of low volatility and above a line of resistance to prices beyond which the market was previously unwilling to pay.
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1. NSTC
NSTC has made a break to the upside from a period of low price volatility. Notice the spike up in volume and how the stock closed very near to its high of the day. I like this stock for a short term swing trade where the stock should run up toward $12. There may be a few days of profit taking first, but looking out a week or two, I think it has good potential for a quick trade. If the stock closes below support at $10, then I think the trade idea has gone wrong.
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References
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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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