FinTekNeeks

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Irrational Markets

Posted in Trading

The following article covers trading financial securities, such as stocks. The world of trading often comes with rises and declines of securities, and most things do not rise or fall in a straight line. By the time this article is published, circumstances involving what we mention may h ave changed. Often, changes in securities can be to the detriment to the traders – seldom is it beneficial. A person should only trade with money that they’re willing to lose because losses are guaranteed. By reading this post, you agree that you’ve read our disclosure.

Introduction

If you believe in market efficiency, then one can assume that the price of any stock is the true value representation of that company. However, I propose that the price is the representation of buyers and sellers of the stock. In my opinion, the price represents the value in the stock itself, and not the value of the company as many tout it to be. Buyers representing demand, while sellers representing the supply. If there is more sellers, the price falls as there is more supply. As there are more buyers, the price goes up, since there is more demand. The price action of any stock is representative of the number of buyers and sellers, not the perceived value of the company. It may be counter-intuitive, but money can be made/saved by thinking in these terms.

Strange Market Behaviors

“The market can stay irrational longer than you can stay solvent” – John Maynard Keynes

Using fundamental analysis, one may think a company is under-valued. Like Warren Buffet, one may invest in this company for the long-term, thinking (more like hoping) that the stock will truly reflect the “value” of the company. However, no one is like Warren Buffet because:

– He has Charlie Munger as an investment partner.
– He reads hundreds, if not thousands, of SEC filings a year.
– He has GEICO/Berkshire Hathaway that brings in endless amount of insurance premiums every year (and now many other companies with cash flow) to invest.
– He lives frugally even though he is a billionaire.
– He likes to eat hamburgers and drink coke, even when traveling through China at a nice banquet function.
– He gets special deals and has influence over wall street, like the deal with Goldman Sachs during the 2008 financial crisis. [1]

How long does one wait for the stock price to go up? What if the stock price does not go up, but actually go down? A prudent, disciplined investor would have rules in place to sell in any of these scenarios.

Let’s take a look at an example of Valeant Pharmaceuticals ($VRX). Valeant has increasing revenues and was once over $200 per share in 2015. As the stock price went down, the fundamentals may have said the company is under-valued. Even Pershing Square Capital Management LP invested into the company, actively seeking a board seat. As it dropped to around $25 per share in early 2016, one would think this was a good time to buy. However, this chart shows that you would have paper losses of over 30% if held through today.

$VRX Source: finviz.com

$VRX
Source: finviz.com

No matter how good the company is, when bad news come, more sellers will appear on the exchange and the price goes down. Some may take advantage by “buying the dip,” but more sellers may come day after day, and then the buyers who thought they bought the bottom are now considered “bagholders,” with large losses. Conversely, companies with high P/E ratios, may reach all-time highs. The price of the stock continues to go up, making it “over-valued” or too expensive. But, the price action may show that there are more buyers than sellers, so the price continues to go up. Whatever the reason, even with no news, more buyers shows up driving the price higher.

Selling Is Better than Buying

Fundamental analysis (FA) is not a complete tool for trading. One problem I have with FA is that it is mainly used to figure out what stocks to buy, but it does not give a clear picture when to sell. Like “death and taxes,” I believe that all stock prices will eventually drop to zero. Either they will go bankrupt, get bought out, or maybe even the exchange will become insolvent.

A sell strategy is more important that a buy strategy. When you buy something, money is taken out of your pocket and in return, you are given virtual stock. Traditionally, stock purchasers were given physical stock certificates, literally “buy and hold” investing. Now, if you want them, you actually have to pay for them and it is a long process as most brokerages will not be able to process the request. Most likely, there will be no way for you to obtain stock certificates.

When you sell something, money is received for product you are selling, or money goes into your pocket. This is where you make money, unless you sell the stock for a loss. In stock trading or gambling, losses are inevitable. Obviously, if you have more wins than losses, you are a successful investor (or gambler). More importantly, success involves having a positive expected value, more winning profits than losses. This is different from a win/loss ratio, the number of wins to losses. We will get to the details of these at another time.

Next week, I will offer some insight on addressing and taking advantage of market inefficiencies.

 

[1] http://blogs.marketwatch.com/thetell/2013/09/30/buffett-to-make-2-billion-on-crisis-era-investment-in-goldman-sachs/

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