Know What People Do, Not What they Say They Are Doing

PeopleKnow What People Do, Not What they Say They Are Doing

Source: Perspectives for the week ending March 20, 2013

This week’s Trading Lesson
Investors have many choices on how to analyze the stock market. Most use some form of fundamental analysis, looking at company information to determine whether the stock’s price is more likely to go higher or lower in the future. This approach makes the most intuitive sense and appeals to our need to make an educated decision. However, it is seriously flawed for most investors.

When considering information about companies, it is not enough to know the news. It is also essential to understand whether that information has already been priced in to the stock. Ultimately, using information is only valuable if the rest of the market is not yet aware of it.

Small investors doing fundamental research are competing against large, institutional investors who have considerable resources, industry knowledge and relationships to uncover hidden value. This is sort of like bringing a knife to a gun fight, although it is probably more accurate to say that you are bringing a stir stick to a nuclear war.

Rather than study fundamentals, I prefer to analyze what the market thinks of the fundamentals. Using price and volume activity, it is possible to understand what investors think about the fundamentals. Since the markets are extremely efficient, they tend to price in information long before it is part of the public base of knowledge. Most importantly, studying a stock’s trading history looks at what all investors are doing with their money, not just what some are saying.

When doing analysis, I begin by collecting information. For me, this means looking at all of the relevant charts and assessing what the message of the market is. In this process, it is important that you avoid biasing the research.

It is a common for people to only look for what they want to see. An investor who is long a number of oil stocks will seek out information that confirms the oil market is going higher. You can be a great reader of charts, but if you don’t look at the right charts, you will get a tainted impression of where a market is headed.

Let’s do this process for analyzing the overall market right now. Here is a list of the ETF charts I focus on:

UUP – US Dollar Index
TLT – 20 Year Treasury Bond
GLD – Gold Trust
OIL – Crude Oil
VXX – Volatility Index Futures
SPY – S&P 500
T.XIU – TSX 60

In each of these charts, I look for a few simple characteristics:

Rising bottoms – the buyers are in control
Falling tops – the sellers are in control
Price volatility – if there is a lot of price volatility, investors are uncertain. If the stock is trading in a narrow range, investors are confident
Price relative to a trend line – price far above an upward trend line indicates buyers are emotional. Closer to the trend line shows investors are rational
Price relative past price ceilings and floors – recent breaks through important areas of support and resistance show a change in the perception of fundamental value

We need to look for these things in the charts and the piece together the puzzle of how different factors work together. Let’s go through the list of ETFs and highlight the characteristics:

UUP – the market has been Bullish on the US Dollar for about six weeks and the trend remains up. The recent volatility here indicates the market is getting more uncertain about whether the strength is justified.

TLT – US Treasuries remain in a downward trend, a positive for the stock market since sellers of Treasuries have a good chance of putting the money to work in the stock market.

GLD – Gold is in a downward trend but was oversold until last week. The precious metal is now bouncing back but this strength is not a change of trend yet, I remain Bearish on Gold.

OIL – Oil is in a sideways trading pattern that oscillates up and down without a sustained trend. That deserves a Neutral rating.

VXX – The VXX represents Fear which continues to be on the decline.

SPY – the S&P 500 is still in an upward trend, the recent weakness is thus far only a pullback in that trend and not a break of the trend.

T.XIU – the TSX has been trending sideways over the last couple of months but is slowly building optimism. A break higher will take the index through resistance and likely indicate a broadening of the rally that has occurred in the Banking and Telecomm stocks.

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