When either investing or trading the markets, we must recognize that most investors believe markets are random and unpredictable. To a point, this is not necessarily and entirely true. All markets move up or down based on probabilities. However, within the confines of those probabilities, we can determine the most likely movement based on a number of factors within the price, pattern and time framework.
The dominant method used to determine the highest probability of movement that an investment or market is likely to make is a combination of psychology around the current price, the recent pricing pattern and amount of time elapsed since the last trend change. What does all that mean in English?
I’m going to outline two extreme scenarios that will demonstrate what this means without a bunch of technical and fundamental jargon.
First, think back all the way to 2007 – before the credit crunch, market collapse, sub-prime debacle, Lehman Brothers failure and all the other financial dirty laundry that took place. What was the real reason for the stock market downturn? Was it any of those items? Remember back to when Bear Stearns failed? That was in March 2007. That’s when “sub-prime” became a household name. Then between March and October 2007 the market brushed off all the bad real estate news and proceeded to make a new high. The financial media would have you believe that the reason for the subsequent decline was sub-prime, then the credit crunch and ultimately Lehman Brothers. While those things certainly played a role in psychology and excuses for the downturn, I would suggest that by October 2007, the bullish sentiment was at an all time high which does a number of things. For one, people experienced the bad news and the market proceeded higher which gave the impression that no matter what happens, the market is resilient and will always go up. Not true. By that time, the cash levels in mutual funds were at an all time low which meant everyone was basically fully invested. With sentiment at an extreme high, a one way, rising market for months in the face of bad financial and economic news and finally an all time price high in the market – what happened next – the turn. The market registered an all time high yet to be visited again.
So we have an all time high (price), rising one way market (pattern) for months (time). Most people view a rising market for months despite bad news as bullish, but my view of market psychology says otherwise.
Here’s another example during another extreme. In short, the stock market continues down for about a year and a half from about the end of 2007, throughout 2008 and beyond. Everyone thought the world was coming to an end. Money market funds “broke the buck” maybe for the first time ever, banks looked like they were going under, auto companies were bailed out, unemployment was rising faster than we’ve seen in 80 years – it certainly looked like a depression was underway. Everything was as dire as could be leading to March 2009. The market had gone down about 60%; sentiment was at the lowest and worst level of the crisis. Every day the stock market was going down farther and farther, yet all of a sudden, one day with no apparent jolting news we made a turn and haven’t looked back since. Here again, the market was at the lowest level we’ve seen in years (price), it had been going down every day for months (pattern and time). Once the psychology got to a level where people were selling at any cost to “get out,” we experienced an extreme in the other direction and the tide turned.
Moral of the story – markets usually do the opposite of what the majority of people think will happen, which is why most think it’s a mystery and totally random.
Why are people surprised when a company beats “earnings estimates” and then the stock goes down? How could this be? Simple – most investors including fund managers and other professionals continue to view the markets incorrectly.
First, earnings were from last quarter, so what does that have to do with the current stock price? Second, whose estimates did they beat? Well, the analysts with their sophisticated models containing numbers that will make your head spin are still only guessing because after all, the company earned what they earned and if the analysts estimates were different, then I submit – The analyst was wrong! In short, if a stock is rising into earnings, then conventional wisdom would say, who’s left to buy after earnings? It usually cools off.
Price, Pattern & Time tied together with market psychology is the number one method I use to determine the highest probability of what might happen next in any market. Of course, this is based on probabilities and doesn’t always work perfectly, but certainly gives an enormous edge over most of the market participants.
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