The Fundamentals Matter, Sort Of
Stockscores.com Perspectives for the week ending October 15, 2004
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In this week's issue:
The Fundamentals matter.
For those who look at Stockscores and see a lot of technical analysis charts, that is probably not something you expect me to write. But the reality is that the fundamentals of business and the economy in general are important in determining where stock prices are going. Now the caveat.
The Fundamentals that most of us have access to don't matter.
The problem that many investors have is that they are using publicly available information to judge the fundamentals of a stock. I was on a plane the other day and the people in front of me were discussing a stock. The one guy said that stock XYZ was cheap, that it was a great buy and that the stock had to go higher. His claim was based on what he read in the company's annual report. The person he was talking to nodded her approval, and said that it made good sense, she was going to buy some.
It took a lot for me to not stand up and ask the gentleman what he saw in the annual report that he felt no one else did. I wanted to know how fine the print was, how could the true value of the company be so obvious to him but not to the thousands of others that had read the same report. It seemed a bit suspicious that he could find evidence in the annual report that the stock was so cheap, and yet the collective minds of the financial community that all followed this well known company could not see this opportunity.
If the annual report shows that the company is worth more than what it is trading at, shouldn't the stock price have gone up as soon as the annual report was released to the public? Shouldn't the big money mutual funds and hedge funds buy the stock aggressively to take advantage of the "hidden" value?
If you are still not sure of my argument, try the following experiment. Take a twenty dollar bill and lay it down on the floor of your local shopping mall. Do people walk over top of it, or does someone pick it up? I should apologize in advance; you are going to lose your $20.
The stock market does not move on what happened in the past. The fundamentals that are in the public record are old news, and are unimportant. The market moves on what the fundamentals are going to be. With that in mind, most of us are at a serious disadvantage.
Most of us don't have the insight necessary to know what the fundamentals are going to be. Some of us, with some companies, do have this insight. They have an advantage. If we want to be successful, we have to do what these people are doing.
But wait, there is more.
It is not enough to know what the fundamentals are going to be in the future, we also have to know how the markets are going to interpret the fundamentals. You see, we humans are a finicky lot. Most of us are slaves to our emotions.
As a result, how the market will judge fundamentals in the future also depends on the collective psychology of the market. Knowing the fundamentals of the future is important, but understanding how investors will react to them is also important.
Ultimately, there is a simple way to know what the fundamentals are likely to be and how the market will judge them. Reading the message of the market tells us a lot about what people know about a company beyond what is public knowledge. To read the market's message, go look at stock charts. Now, that sounds more like me, doesn't it?Back To Top
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.
I ran this Market Scan Strategy on Friday, and found a couple of stocks worth considering:
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1. V.CMH
V.CMH is not a really liquid stock, and is risky, but the chart looks good. The stock is breaking from a rising bottom consolidation with good volume support, and look likely to reverse it's recent weakness. Support is at $2.30, and I expect it will stall at $2.80 but should go back to a little better than $3.
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2. CYBS
CYBS has been on a real roller coaster ride over the past six months, but it looks like investors are getting excited again as the stock appears to want to climb the hill. The stock will probably be volatile along the way, but upside potential is to $8, and support as at about $5.20.
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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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