Section 3: Truth Revealed

This is one of the most important chapters in this book, because your success or failure may very well depend on the degree that you grasp the concepts in this section. I will be asking you to throw away some of what you think you already know about stocks, or at least what most people will tell you about stocks. If you are like anyone else, you may have to unlearn what you have been taught, or to challenge conventional wisdom.

In Pursuit of the Holy Grail

As long as financial markets have existed, the hopeful investor has been in pursuit of that one angle that sets himself above the others. Billions upon billions are spent on research and other forms of analysis, looking for an edge that can lead to financial success.

Like so many others, I pursued this goal as well, looking for an angle that would work consistently in all situations, in all markets and under all conditions. I was in pursuit of the Holy Grail, that one piece of knowledge that would give me an edge to beat the market. And, like so many others before me, I lost continuously in this pursuit. Was there really a Holy Grail? What was I missing?

My basic error in this pursuit was the same one made by countless other investors, analysts and traders: I mistakenly assumed that stock prices were driven by the value of a company.

What I am saying here is a bombshell that smacks right in the face of everything people are taught about stocks. Everyone knows that a company's fundamental value is reflected in its stock, and this assumption is so entrenched in the minds of investors that it is never questioned. Millions of investors mull over balance sheets and earnings reports, looking for the very best stocks; thousands of analysts and financial advisors talk endlessly of company fundamentals when making their recommendations. Yet I am telling you that none of these things matter.

It took me several years—and tens of thousands of dollars—to grasp this ridiculously simple concept:

Stock prices are controlled by speculators, and nothing else.

The last I checked, the company isn't driving the stock price—people are, people who are speculating on the stock. And, what makes it even more interesting is that people, being human, are subject to emotions and reactions — which is all a major component in the game of speculation.

 

And what, exactly, is speculation?

 

It is the estimate, or "guess" of what something will be worth in the future: It is anticipation of some event or condition that has yet to occur. Someone who thinks real estate will boom in a particular area will invest in property on speculation that the property will be worth more tomorrow than it is today. An investor, by definition, is a speculator, because if he or she is betting on the future, not the past or present. Speculation, or a bet on what might happen in the future, is what drives the stock market, and in the final analysis, there is no other force at work.

 

Close Yet Far Away

 

Looking this over, it may seem obvious that stock prices reflect the composite opinions of speculators, yet it amazes me how difficult this concept is for most investors to grasp, or at least how little importance they place on it. If you have ever listened to a stock recommendation from a professional analyst, they will name a dozen reasons why such-and-such stock is a good "buy," with every one of their reasons being tied to company fundamentals. "This company shows consistent earnings...," or "We feel that its stock is under valued compared to its earnings," or "They have good, strong management" are common remarks.

 

Not one of these analysts ever considers the most important factor of all, which is how the crowd will speculate on the stock. Yet, it is the speculation of the market that drives the stock up or down in the first place.

 

Certainly, company fundamentals (earnings, growth, management, etc.) play a part in all of this, but only because the speculators think so. In other words, a company's earnings are reflected in its stock price only if the speculators believe that it should be. Again, it is all speculation, regardless of any other company condition.

 

My point is that all the factors that analysts think are important are all secondary to the most important factor of all, which is the human factor of speculation. In all the years I have been following the market, not once have I heard a single commentator say something like, "This stock is a good buy because the public will think it is cheap, and they will probably drive it sky high."

 

It would serve professional analysts quite well if they spent less time studying company fundamentals, and instead, studied the psychology of crowds.

 

The Psychology of Crowds

 

If we have learned that speculation is senior to all other aspects of a stock and its company's fundamentals, then how can this knowledge be used to our advantage? The answer lies in understanding what motivates the speculator, or in the broader sense, how the psychology of crowds usually plays out. To the degree that you can understand why the crowd behaves the way it does, to that same degree you can predict future behavior. In effect, by anticipating the next move of the crowd, you have speculated on the speculators.

 

While investors might place bets on companies, you, as a trader, place bets on the investors! That is the true, Holy Grail of trading.

 

Human Emotion and Reaction

 

Stocks are bought and sold by people, not by companies or computers or by any other apparatus. And, people have human emotions and reactions, especially when it involves financial matters.

 

It is strange that the study of human behavior is completely omitted by stock analysts, yet it is the primary force that sends a stock sailing into the clouds, or plummeting into the pits of hell. The human factor is what makes or breaks the market's trend, yet it is rarely mentioned in any prediction of market direction.

There are thousands of examples of this, and many examples occur each and every day in the market.

 

Consider the technology bubble of the late 1990's, where hundreds of stocks were driven up to levels that borderlined financial insanity (many were trading at thousands of times their earnings, with some companies showing no earnings at all). Did the company fundamentals justify these prices? Absolutely not. Were prices way out of line? Of course they were, but this frenzy went on for years. It drove financial analysts crazy, because it made "no sense" (it didn't follow the model that the analyst was accustomed to). It is one example where stock prices had nothing to do with true valuations and sound fundamentals, but rather, had everything to do with the bandwagon psychology of the crowd.

 

One might argue that company fundamentals will matter in the long run, and that sooner or later, wild speculation has to give way to common sense, and the market will correct itself to reflect the true, underlying value of stocks. While there is some truth to that assumption, it can never undermine the fact that speculation, as crazy as it might be, can (and does) override sound financial judgment more times than not, and for very long periods of time. And, that fact alone is what makes trading for profits even possible.

 

Speculating on Speculators

 

Now, how do we put this knowledge to use? How do we take advantage of speculation? The answer is that you step away from the crowd, you observe what they are doing and thinking, and you anticipate the next move of the smartest speculators. In effect, you have to successfully speculate on the speculators.

This doesn't mean that you "go with the crowd." Quite the contrary, because the crowd is wrong about the market, more often than not. Rather, you learn to spot the "smart money," the action of the more astute speculators, who frequently exploit the weakness of the majority (more on this in subsequent sections).
 

 

The G-H-F Factor

 

Behind almost all speculation is human emotion, especially when speculation turns into a frenzy. And, the emotions that dominate all others are greed, hope and fear. Let's call the composite of these three emotions the "G-H-F" factor (Greed-Hope-Fear).

 

It may be important to point out that the term G-H-F is not intended to be derogatory. Greed, for instance, includes all instincts and driving forces toward financial success. Hope may include a notch above despair, holding on for dear life, but it can also include an upbeat, optimistic outlook of the future. Fear, while generally negative and often irrational, can also be financial prudence and the urgency to reduce losses.

 

The point is that the G-H-F factor is not to be considered a commentary on the weakness of Man, but rather, as a factual energy that drives all financial markets. It is understanding this force that unlocks the mystery of markets, and enables a workable system of prediction to be developed.

 

The truth is that the G-H-F factor is the only thing that never changes, it is the single constant that has held true since the dawn of time. Financial markets can change, companies can rise and fall, and various industrial groups can go in and out of favor. But the one thing that holds up over time, regardless of any other factor, is human emotion and reaction, or G-H-F.

 

The Formula

 

Almost all successful trading strategies use a formula (whether the strategist is aware of it or not), which can be simply stated as follows.

Hope + Greed is greater than Fear.

This single formula unlocks a many riddles about why the market behaves the way it does. For one thing, it explains why the stock market is predominately bullish more often than bearish, and it certainly explains why the market trends upward over long periods of time. While Fear can ravage a market, it is up against Greed and Hope, and a frightful downtrend is eventually overcome by the predominate forces of Greed, backed by Hope, and a new bullish trend sets in.

At the individual stock level, this formula opens the door to trading opportunities nearly every day. Company 'A' issues bad news about its earnings, causing Fear to set in, and the stock plummets from massive selling. Astute investors, always looking for opportunity, see the tumbling stock as a chance to pick up something for next to nothing (Greed), and they buy the stock in anticipation of its gallant comeback (Hope). Eventually, Greed + Hope overcomes Fear, and the stock recovers.

 

Cycles like this occur over and over again, and they happen nearly every day. The cycle of G-H-F, and its recognition, is one of the many ways to speculate on the speculators.

 

Wild and Crazy Speculation

 

The idea that stocks are driven by speculation alone, and not companies, is so alien to most investors that this point needs to be further illustrated.

 

One example that comes to mind that clearly indicates the power of speculation—versus real, company fundamentals—is the pharmaceutical companies versus the "dot-coms" and technology stocks between 1998 and 2002.

 

If company fundamentals were all that really mattered, then pharmaceutical ("drug") stocks, some of the most consistently profitable companies in the world, should outperform many groups in the market. Yet, during the great technology bubble of the late 90's, drug stocks underperformed nearly every other group.

The above chart shows the price fluctuations between two stock index values from 1998 to 2002 (an index value is a composite reading of a group of stocks, such as the "food stock index" or the "transportation stock index", etc.). The red line represents the NASDAQ composite index, which is composed mostly of technology and Internet stocks; the black line represents the pharmaceutical (drug) index for the same period of time.

 

Notice the strange anomalies in this chart. In box 1, you can see that the drug index sharply rises above the NASDAQ in late 1998 through early 1999. In box 2, the NASDAQ soars—and the drug stocks plummet. Then, in box 3, the NASDAQ crashes, and drug stocks rise again. Finally, box 4 shows that both the NASDAQ and drugs wind up in the same place—after a long, agonizing bear market.

The point is that none of this action had anything to do with the condition of companies, but rather, pure speculation drove these two groups flip-flopping all over the map. If nothing else, no fundamental changes took place in the pharmaceutical industry, and at the same time, many companies in the NASDAQ had no basis of value (some of them had no earnings at all!), yet major discrepancies exist between the two performances—in the opposite direction than the underlying fundamentals would indicate.

 

As an added note, notice that "buy-and-hold" for either group would have returned you a net gain of $zero (or a slight loss). So much for "investing" in the growth story of these companies; your only workable strategy would have been to speculate on the speculators and go with what's "hot," and riding the temporary swings.

 

Once again, it is all about speculation. Don't listen to any analyst who tells you otherwise

 

The Market's Weakness

 

A perfect stock market, in a perfect world, would accurately reflect the monetary value of each company through the price of its stock. And, if a company improved its value by virtue of its earnings, including well-computed earnings projections, the stock would improve proportionally. Similarly, if a company lost market share to its competitors, resulting in lowered earnings, its stock would fall in tandem, proportional to the company's lost value.

Analysts base much of their valuation of stocks on this ideal model, yet the model doesn't exist anywhere in the real world. Rather, a stock almost never reflects the true value of its underlying company, and for one simple reason:

The market consistently overreacts to news and other influential events.

In fact, it is this overreaction that makes trading possible! If the market were perfect, which is to say, if each and every stock were a true reflection of a company's value, stock prices would instantly reflect any change that occurred in economic conditions, and you would never be able to capitalize on anomalies of price.

 

By anomaly of price is meant that a stock's value is exaggerated in one direction or another (it is grossly overpriced or underpriced, based on any reasonable  valuation); in a perfect market, no such anomaly would ever exist. But the market is not only imperfect, it often makes mistakes, sometimes of an alarming nature.

 

For example, suppose there were an outbreak of war or some other national catastrophe. The illustration below shows what happened to the Dow Jones Industrial Average during the subsequent weeks that followed the 9-11 terrorist attacks. While this event was certainly tragic by historical proportions, the public, nonetheless, grossly overreacted to the situation, sending stocks far below a rational level. An astute trader, realizing the market's weakness, could have bought baskets of stocks near the bottom to ride them back up for an 18% gain in only a couple of months.

 

The Dow Jones Industrial Average following 9-11. The market overreacts to
the event, sending stocks to depths far below rational valuation.
Then, realizing the error of its ways, stocks rebound sharply.

 

Overreactions to major events can also work in the other direction. During the same time period following 9-11, investors loaded up on the bomb detection equipment company, Invision Technologies, thinking that these types of companies would profit greatly on the fight against terrorism. This was also an overreaction, only it was to the upside.

 

Invision Technologies, a bomb detecting equipment company, looked so attractive
after 9-11 that investors drive it sky high. Realizing they overreacted,
the stock falls 50% from its high.

What is interesting about Invision Technologies is that a skilled trader could have made substantial gains in both directions, merely by anticipating the crowd's reaction during the 9-11 aftermath. Shortly after the tragedy, such a trader could have ridden the stock up over 400%, realizing that the "G" part of the G-F-H (Greed) was fully in force—the public viewed the bomb detection company as an opportunity for a windfall. As usual, the public was wrong (or at least they overreacted), and after it peaked out, the same trader could have sold the stock short (a method that traders use to profit on a stock's decline). On the way down, Invision Technologies lost 50% from its peak.

 

Daily Overreactions

 

The examples shown above are only two of many. Fortunately, there does not have to be a major, tragic event to capitalize on the market's overreaction, and in fact, price weakness can be spotted nearly every day. A company might issue a warning about lowered earnings, or an influential analyst might make a negative comment about a stock, any one of these events can send a stock plummeting from overreaction.

 

Whatever the event, and regardless of which direction the market will go, the one constant that remains throughout time is that the market overreacts—first, last and always. And, as an expert trader, it is your job to locate such market weaknesses and to use them to your advantage.

 

Market Sentiment

 

Market sentiment can be defined as the general tone, or "mood" of the market. As a rule, sentiment is either positive or negative, and it can fluctuate daily. In a sense, the market behaves like an individual, it has a personality, it goes through mood swings, and it can be happy or sad. The proper recognition of sentiment is a key component to successful trading.

 

There are a number of factors that push market sentiment up and down, but it is not the job of a skilled trader to know about each of these factors. Rather, it is only important that the sentiment is properly gauged, and to act accordingly. The general rule is the following.

• If the market sentiment is negative, most stocks fall in price.
• If the market sentiment is positive, most stocks rise in price.

Part of the reason this occurs is the herd mentality of the crowd. "If everyone else is selling, I should too," an investor will reason, or "If everyone else is buying, I don't want to be left out." This is what usually creates momentum, in either direction, and it is the anatomy of crowd psychology.

 

But another reason that stocks will follow the market's lead is that institutional traders (big money from mutual funds, pensions, etc.) tend to buy or sell baskets of stocks. Try watching a a dozen or so stocks on a real-time quote streamer, and you will see what I mean. Most of the stocks you watch will rise and fall—in tandem. Initially, you might not find this peculiar, until you realize that the fluctuations, going in complete parallel, is far from coincidence. The institutional money tends to buy or sell whole portfolios, all at once. And, depending on the size of the portfolio, these heavy hitters can literally move the market. Quite literally, the institutions can create the market sentiment.

 

How to Gauge Market Sentiment

 

There are several ways to determine what the market sentiment is at any given moment, or perhaps more importantly, to gauge what the sentiment will be in the immediate future. The following is a list of techniques that I find useful for measuring the mood of the market.

• To determine the mood of the market before the opening bell, observe the market futures. The market futures reflect the trading of special contracts for delivery of stock in the future. Futures trading reveals a very accurate picture of sentiment, at least at the open. The best place to observe the market futures are on CNBC. Each morning before the opening bell, the futures for the Dow, NASDAQ and S&P-500 display on the bottom-right of the screen. Use the table below to assess the level of sentiment.
   

 

Note that the ranges shown in the table are only approximate, there is no ironclad rule about these numbers. Use these ranges only as a general guideline to measure the sentiment that will occur when the market begins trading.

• Watch pre-market trading. Also on CNBC, trades that are occurring in pre-market activity are shown at the bottom of the screen. "Red" colored ticker symbols indicate down trades (stocks trading lower than the previous day's close), while "green" colored tickers indicate up trades (stocks trading higher than the previous day's close). By watching these roll by for a few minutes, you can get a pretty good feel about the mood of the market.
• During the day, watch the trend of the Dow or NASDAQ index values. By trend is meant an overall progression in one direction or another. An uptrend consists of the index making higher highs, while a downtrend consists of making lower lows. For example, consider the following snapshot values of a major index, taken every 10 minutes. The first series, from left to right, indicates an uptrend, because the values get progressively higher; the second series indicates a downtrend, as the numbers get progressively lower.
   

 

Note that you can also determine the direction of an individual stock. If the stock is trending higher, it will log higher highs as the day progresses; if it is on a downtrend, it will keep hitting lower lows.

• During the day, never gauge the market sentiment by whether an index is "up" or "down." Rather, determine the overall sentiment by its direction, or trend.

Sentiment as a Tool

 

Once you are able to accurately determine market sentiment, how do you use this information to your advantage?

 

The answer may surprise you. If you are a rational thinker, you will likely conclude that sentiment could be used to determine the best time to buy or sell stocks. Logic would indicate that if sentiment is positive, you should buy, and when sentiment is negative, you should sell (or simply not buy). However, nothing could be further from the truth!

 

Winning trades are accomplished by assuming the opposite position of market sentiment. As a trader, you will make most of your money by going against the crowd, not with them!

 

The cold truth of the matter is that most people lose money on stocks (except in extreme bull markets). A stronger way to state this is that the crowd is wrong about most things in the market most of the time. Assuming this is true, then it follows that you can only make money by doing what the crowd does not.

 

The Contrarian Principle

 

A fascinating market phenomenon is the Contrarian Principle. Simply stated, it is the concept that the market will generally flow in the opposite—or contrary direction of the majority opinion.

 

For instance, when the overwhelming majority is optimistic about the market, stocks usually fall. In reverse, when market sentiment is severely negative, stocks tend to rally.

 

Some traders swear by this principle to such an extent that an integral part of their strategy is daily monitoring of bullish/bearish sentiment. If the consensus of stock advisories (analysts, newsletters, stock sites, etc.) is clearly bullish (positive), that is a good indicator that the exact opposite will occur—a market decline. When the same group grows increasingly bearish (negative), the market is near a bottom and will soon recover.

 

Extreme Reversals

 

The first time I became acutely aware of the Contrarian Principle is when I first began studying stock charts a number of years ago. One peculiar pattern that seemed to emerge over and over again was that the heaviest trading of a stock occurred at its top and its bottom. In other words, when the stock hit its yearly low, the heaviest selling occurred; at the stock's highest point, the heaviest buying took place.

 

Intuitively, you would think that the exact opposite would occur, that a stock that is reaching an all-time low would have an increasing reluctance to sell, and a stock that approached new highs would have increasing reluctance to buy. Yet, in actual practice, people want "out" at the bottom, and "in" at the top.

 

The chart above was chosen at random, and shows the peculiarity of heavy action at the
two extremes of the stock’s range. The heaviest volume was
right at the stock’s peak, the second heaviest at the bottom.

The chart shown above, chosen at random, illustrates how the heaviest action occurs at the two extremes of a stock's cycle. While one may argue that the strong volume on opposite peaks could be buying or selling, I should point out that for every buyer there has to be a seller, and visa versa. With record volume occurring at the top, 100% of those trades had to have investors willing to buy at those prices (which, in hindsight, were grossly inflated prices), and at the bottom, 100% of the trades had to have sellers who were eagerly willing to give up shares at rock-bottom levels. In either event, the fact that the top and bottom manifest the heaviest volume of the year is noteworthy in itself, as it shows you how an alarming number of investors can make some very stupid choices.

 

The Cause

 

I used to believe that the simple, underlying truth behind the Contrarian Principle is that most people are wrong about most things most of the time. Indeed, there is some truth to that concept, particularly when it comes to stocks, except I have come to learn that there is more scientific reason for the principle.

 

Stock prices are driven up when the demand for the stock is greater than its supply. Stated simply, there are more buyers than sellers. Suppose that a stock creates a demand great enough to cause everyone who intends to buy stock to own it. Yes, the price goes out the roof, except now there is a problem that didn't exist before: there isn't anyone left to buy!

 

Without any buyers, the stock has no more momentum to rise. That leaves nothing but sellers, which in turn causes a chain reaction of more selling and the stock crashes.

 

The entire market goes through a similar cycle on a broader scale. Once everyone is "in" the market, there isn't enough new money to sustain the inflated prices. The market tops out and a long, painful decline sets in.

 

It is interesting to note that prior to the top-out, optimism is usually at an unprecedented high. The whole world just had to get in—irrational exuberance. So went the fate of the market in October of 1920, in October of 1987 and in April of 2000. Optimism was at its peak, stock investing was at an all-time high and bullish sentiment was rampant.

 

The same phenomenon occurs at market bottoms, only in reverse. As the market makes its decline, more and more people abandon their portfolios and negative sentiment increases. Eventually, the toughest buy-and-holders cry "uncle" and throw in the towel as well. By this time, the bearish sentiment is overwhelming, except the Contrarian Principle is about to unfold. Everyone who wanted out of the market is now out, which creates an absence of sellers. That leaves nothing but buyers, so the market can finally rally — and the whole cycle begins anew!

 

Contrarian Trades

 

The Contrarian Principle can be applied to individual stocks as well as the broader market, and in fact, this is one of the most powerful trading strategies you can deploy.

 

For instance, suppose a high-flying stock issues some negative news that sends investors running for the exit, sending the stock into a plummeting free fall (this happens all the time). After a lot of heavy selling, what do you suppose will happen? The stock will not only halt its decline, it often rallies—sharply and handily.

 

What happens is that everyone who wanted out of the stock sells relatively quickly, sometimes at a panic level, leaving only the die-hard investors that want to hold on to their shares. Since that equates to an absence of sellers, the downward pressure abates, and the stock has nowhere to go but up!

 

This is a 1-minute interval chart that shows an example of a Contrarian trade.
Those who want nothing to do with the stock sell their shares, causing a huge
spike in volume. Soon, the selling abates, and the stock is free to rally.

The chart shown above is one of many examples of a Contrarian play. In this particular situation, the industry group this company belonged to (Healthcare) was very much out of favor during the trading session. With conventional "wisdom" dictating that you should sell this stock, many headed for the exits, as depicted in the large volume spikes during the first hour — and the price plummets. But once the selling pressure lightens up, the stock reverses direction and gallops over 7% from its low.

 

Still another example is shown below. Again, heavy selling is indicative by the massive "red" (selling) spikes in the volume portion of the chart. Needless to say, after the big sellers become exhausted, the stock has nowhere to go but up.

 

Note that another inalienable truth about the market plays its hand into this scenario as well, which is that the market always overreacts. The fact that the number of sellers are finite adds fuel to the fire.

 

Another thing that gives these kinds of reversals an extra "kick" is the fact that not everyone in the market is an idiot; astute traders, looking to exploit the market's weakness, wait for opportunities just like this one, and jump on board to ride the stock back up.

 

Your goal is to become one of these astute traders—to speculate on the smartest speculators in the market!

 

Tying it Together

 

Let's review the key points from this section, The Holy Grail of Trading.

• Stock prices are driven by speculators, not by companies they way most people think.
• The perfect model used by stock analysts does not exist in the real world. Rather, the market is subject to anomalies driven by human emotion and reaction, and by grossly overreacting to various events.
• The smarter speculators exploit the market's weaknesses by waiting for an anomaly, then moving in to take advantage of that anomaly. This exploitation is helped along by the Contrarian Principle that creates an exhaustion of sellers on a market or stock decline, or an exhaustion of buyers on a market or stock rally.
• The Holy Grail of Trading is to successfully anticipate what these smarter speculators will do, that is, to speculate on the speculators.

 

Stock Screening