Wrong, Wrong, Wrong!
Many books have been written about how to make a million dollars in the stock market. Unfortunately, I do not know anyone who succeeded in this, but I do know a lot of people that lost money in the stock market. This book is dedicated to them. Hopefully I can shed some insight into the stock market to avoid such disasters and maybe give you some ideas that may result in making money in the market.
First, I want to give you an entire new perspective of the stock market. As with most sports it is easier to teach someone who has never played a game than someone who has played and developed bad habits. If it were possible to hit the erase button in that part of your brain that has any information concerning the stock market, push the button.
Prices in the stock market are determined by buyers and sellers, real people with real emotions. Buyers want to buy low and hope the price will go up. Sellers want to sell high and anticipate the price will go down. If there are more buyers than sellers at any moment in time the price will go up as there is a momentary shortage of stock, if there are more sellers than buyers at any moment in time there is a momentary oversupply of stock for sale and the price will go down. You will notice that nothing has been said about any financial statistic relative to the company. For every buyer there must be a seller and visa-versa, they determine the price.
Analyzing thousands of stock’s various patterns will become apparent. Each stock moves in a variety of patterns, frequently these patterns are repeated over and over again. If you go to the beach and watch the waves there are a variety of wave patterns. The waves will roll in and then roll out. Sometimes the outgoing wave interacts with the incoming wave creating foam and chaos. Sometimes one wave will climb on top of another wave adding extra strength. Other times an outgoing wave will undermine an incoming wave decreasing it’s strength .Then there is the tide causing the water to move in a long slow cycle up and down the beach. There is a cycle to the tide, it climbs and descends the beach twice a day. If you closely watch the wave action you will start to see a rhythm to the movements. The patterns of movement are never exactly the same but nevertheless the movements are identifiable and to a degree predictable. Of course there is always the possibility of a tsunami but the probability of such a wave is very minute.
Stock prices move in wave patterns. There are very short cycles creating patterns that may last a few days, there are slightly longer cycles that may last a few weeks, there are intermediate cycles that may last a few months and there are long cycles that can last several years. The purpose of this book is to help you recognize these patterns; there is nothing high tech involved, no magic formulas, and no magic black box programs. This is not an exact science and it takes countless hours of study to make intelligent judgments in pattern recognition. Before getting into that let’s look at some of the generally accepted methods of picking stocks.
The Hot Tip – Maybe a broker calls and recommends a quick purchase of a particular stock. Most likely this stock was put on a list from the broker’s firm of stocks to push. Maybe the firm’s analysts see some merit to the stock but since it is being recommended probably by hundreds of brokers to thousands of clients what is the likelihood that you are going to buy the stock at a good price and make a profit? Toss a coin and you will probably do just as well.
Visit the Company – Maybe it is a retailer, a restaurant or whatever. Maybe there are crowds in the store and the cash registers are blazing away. Surely buying stock in this store is a good investment? Unfortunately you have no idea if the store is making any money on the sales, maybe they are losing money on every sale due to high overhead or are trying to undercut the competition to gain market share. Maybe the store you visit seems to be doing well but it is only a small sector of the company. You really have no idea what the company’s profitability is.
P/E Ratio – This is the price divided by earnings, one of the foremost indicators used by analysts to determine stock value. Surely this is an indicator of where the stock price is going. Wrong, maybe it is an indicator of where it has been. How about all those P/E tables that may show one company in the same business has a lower P/E ratio than the others? A good buy, probably not. The lower P/E ratio indicates investors outlook of that company’s future prospects are poorer than the other companies in the table. Understand, the market is a huge pool of very astute analysts, investors, and financial institutions. Most likely they know more about the company and it’s future prospects than you. So the current P/E ratio is a reflection of their opinion of what the stock is worth and unless you have some special knowledge, the valuation they place on the company is going to better than yours.
At a racetrack gambling odds reflect the future prospect of a horse winning. The experts have studied the horse’s track record and taken into account all the factors including the condition of the track and the weather. I suggest that the probability of projected future prices of stock based on future projected P/E ratios is about the same as gambling at the horse races, maybe you will hit a winner but the odds are against you.
Dividends – Choose a stock that pays a high dividend. Wrong! To understand why, try to mentally take a step back and view a typical group of stocks, some paying a very low dividend, some paying a middling dividend and some paying a very high dividend. Choose the high dividend paying stock. Wrong, wrong, wrong. Why? First understand a dividend yield is the annual dividend divided by the current price. Thus, if a company pays an annual dividend of $1 and the stock sells for $100 the dividend yield is 1%. If the stock sells for $50 the yield is 2%. If the stock sells for $10 the yield is 10%.
Before rushing off to buy the stock with the 10% yield ask yourself why is the stock only selling for $10 which produces this high yield? The answer probably is because few investors want the stock, they think the company’s future prospects are poor and the stock price will probably go down. The company’s earnings may go down, the dividend may go down or the company may go out of business. If the stock price goes down just $1 from $10 to $9 that wipes out the entire yield for a year
The middling dividend returns result from investors pricing the stock with middling future prospects. The very low dividend returns result from investors bidding up the price of stocks they perceive as having excellent prospects for growth and higher stock prices. The best stocks probably are those that pay no dividend, the companies reinvesting all there earnings in research and development which will result in the greatest stock appreciation.
To summarize, the price of a stock at any moment reflects the actual value that investors attach to that stock, reflecting current and future prospects. The stock market is enormous, hundreds of millions of investors, thousands of professional analysts that are constantly analyzing companies. The current price of every stock is the cumulative opinion of everyone as to what that stock is worth at any moment of time. We are thankful there are professionals that do this type of analysis, but it does not help in projecting where the stock will be tomorrow. There is another way!
Greed and Fear
Perhaps a course in psychology would be more beneficial in predicting stock prices than studies in financial analysis. Try to get into other investor’s brains. Try to imagine what they are feeling as the price of their stock goes up or down. Mixed passions of fear and greed will oscillate thru the investors head as the stock prices vacillate up or down. Imagine the joy as the price goes up, and up, and up. What is motivating the investor not to sell and take a profit –greed. The investor is frothing with greed to make more, and more and more.
Understanding investor motivation at any moment is the key to successful stock market investing. Assume an investor purchased a stock at $50. The stock then goes up to $52 is he likely to sell? Absolutely not, then the stock goes to $54, now what does the investor think? He is hungry for more, get inside his brain.
