The Truth is a Matter of Opinion
Stockscores.com Perspectives for the week ending June 26, 2011
In this week's issue:
"The truth is not based on fact or reason; it is simply what people believe."
This line from the Broadway musical Wicked is relevant to the stock market. It helps to explain why the market can go up one day and down the next with no apparent change in the conditions that are supposed to drive price.
The stock market expresses the collective opinion of the people who invest in it. Price is that expression; it moves up and down as opinions change. Each investor casts their own vote on what price should be each time they buy and sell a stock. Often, the individual's determination of price will clash with the opinion of the market. The key to making money in stocks is to make trades based on what you think the market's future opinion will be.
In other words, your estimation of truth does not matter. If the market has a different estimation of the truth, you will lose money.
That estimation of truth is difficult to make. Many people attempt to determine a company's fundamental value using a price to earnings ratio. A stock in a low growth industry might get a multiple of 10, meaning a company which earns $5 a share will trade at $50. A company in a high growth sector could get a much higher multiple, perhaps $50. With the same earnings, the high growth company is valued at $250 for the same amount of earnings.
Who picks the earnings multiple number? There is no central organization to make a decree on what the appropriate earnings multiple for a stock based on its growth rate should be. Fundamental analysts come up with numbers based on growth and comparisons with the past, but that process is highly arbitrary.
What is deemed to be the truth about an earnings multiple is simply what people believe.
What people believe to be true will change over time. The truth was very different at the height of the technology bubble in 2000 when companies with little or no earnings were given very high earnings multiples by very smart, credible people working on Wall Street. When the market collapsed and investors had a very different outlook on these stocks, the multiples were scaled back. The smart and credible Wall Street analysts were no longer smart and credible. Instead, they were recognized as self-serving, a part of that great Wall Street machine designed to reward itself for convincing people that their perception of the truth is correct.
Chart analysis can also be used as an estimation of the truth, but it too is highly arbitrary. You may hear one technical analyst prognosticate that the market will turn higher because it is approaching its 200 day moving average. However, there is no rule written in the big book of stock market predictions which says price must bounce off of its 200 day moving average. It will only happen if enough people believe it will happen, if enough people believe this to be the truth.
Predicting future price movement is more about predicting what people will think is true than it is about finding the truth. The truth is highly dependent on what people feel, since how we judge information is largely dependent on our mood. There are no rules in stock market analysis like there are rules in science. If we put water in a freezer, we know it will turn to ice. If as stock is approaching its 200 day moving average or earning $5 a share, we do not know with certainty what its price will do. We can only make a guess.
This is not to say that we cannot use rules to make trading decisions. If we find that stocks often bounce off of their 200 day moving average or typically trade at 12 times earnings, we can make a trade around those expectations. However, we have to realize that we will only make money if the market agrees that this is to be the truth.
That means we might be wrong and need to have a plan for what to do when we are wrong. If the market tells us that our guess on the question of truth is incorrect then we must exit the trade and take the loss.
Knowing the point that determines whether we are right or wrong is more important, and more difficult, than knowing how to pick the right stock to trade. Have you ever been right about a trade but got stopped out before the trade had a chance to work?
It is very important to understand this because it will change your mindset and how you approach your trading. It takes the emphasis off of stock picking and puts it on risk management. By doing so, it puts you in a better position to make money in the market.
The best success in trading is found when you add to your position as the market proves you right. You make an initial trade based on your estimation of the truth, but do so with a small amount of risk. If the market tells you that you are right (by showing you a profit on the initial position), then you add more shares to the trade. You never add to the position if the market tells you that you are wrong by showing you a loss.
We will all be right some of the time. When we are, we must maximize our profit. When we are wrong, we must minimize our loss. If we trade with this approach, we can do well even in a market that does not seem to know what the truth is.Back To Top
This week, I used a simple process to find some trading opportunities. Using the free Chart Watch tool at Tradescores.com, I looked at the US Gainers Live List to identify stocks that were up on Friday and have charts with good potential. Since the market was down on Friday, there were not too many candidates, but two stocks stood out to be watched next week.
Next week is an uncertain one for stocks as the market is anxiously waiting to find out what happens with Greece and its potential credit default. If there is no good news from the European Union next week, I expect a break down through support for the market, which will make it difficult for any stock to make good gains. However, a solution will take some fear out of the market and allow stocks with good stories to find bids from the buyers.
I don't think it is a good idea to buy either of the following two stocks early next week. It is best to see what happens with the overall market and, if the market shows stability, consider these stocks on a confirming entry signal. That may not come for a few days, it may never come, be patient and cautious given the market condition.
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1. ICOG
ICOG made a break from a decent chart pattern on Friday, however, looking at the intraday chart for ICOG shows that the breakout is a bit suspicious. Most of the strength and volume in the stock came in the final minutes of the day. That makes me concerned that the Friday break was manipulated at the end of the day. Ideally, I would like to see the stock pull back and then break from the pull back, providing a confirmation entry signal. Support at $2.70.
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2. AIS
AIS has been trending higher for the past two months but has been in a holding pattern for the past few weeks. Friday saw it break higher, but again with late day buying that is hard to trust. The sector is strong, but I would rather buy it on a break of a pull back to get that second confirmation that the buyers are looking to accumulate the stock. Support at $1.89.
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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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