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Truth In Psychology And Lies In Numbers

I received an email from a reader today asking why I am not citing “the numbers” when it comes to companies that are trading at values that are deceptive? It is not difficult to access the 10-Q for any company and run through the various measurements as to that particular companies health. You can also pull up various opinions as to the valuation of that particular company on the internet and form your own conclusions. It is an interesting form of analysis, one that eager, hard-working Gordon Gekko wanna-be’s go to school for years in an attempt to duplicate. However, for the purpose of picking turning points in a stock and therefore, making extraordinary returns in the financial markets…it’s no better than using fibonacci ratios or moon cycles.

The fact of the matter is that financial instruments do not put in major tops or bottoms based on fundamental numbers. The numbers can be a warning sign, but often times that warning sign comes and the stock continues in its original direction for months and possibly years before its legs are hammered out from under it. If the intense study of valuations proved fruitful, then every CFA from San Francisco to Singapore would be managing a hedge fund and collecting 1/ 20.

The absolute same thing applies to technical analysis. I have studied price analysis and trading systems from every angle possible. I am a believer in price analysis, to a certain point. I use it in some of my current work, but it’s very limited. I have seen stocks, futures and currencies form major tops and bottoms with every pattern possible on both poor volume and very heavy volume. I have seen trends run for years on poor volume, while blowing through every topping formation in the book. Similar to fundamental analysis, technical analysis has its uses, but it should not be used for discovering turning points in any financial instrument.

I heavily skew my analysis to the psychological study of the market and its participants. In any substantial move up or down you have a number of factors influencing different stages of the move. The middle of the move or when an issue is trending, if you will, is driven by both fundamental and technical factors. This is the area that most of those who make the study of fundamentals and technicals the basis for their investments will do well. Psychology doesn’t play a contributing role until extremes are reached either to the downside or the upside.

Once the financial instrument begins making waves, in the form of headlines, increased chatter, analyst notes etc. a significant change begins to take place. Investors who are more driven by psychological factors, i.e. fear and greed, begin appearing in the marketplace. This begins a self-reinforcing cycle for the financial instrument and the participants in that particular instrument, as the volatility increases and the participants who were originally in the investment based on fundamentally or technically sound principals start catching the fear and greed bug that has been spread by the momo players.

Eventually this bug begins spreading like the flu in a snot eating contest. The final stages of the bug even begin to effect management within the company. You begin to see management become more active than they have in the past out of fear (see there’s that word) that the price of the stock will not be able to sustain it’s current price trend unless they become more active through acquisitions, increased investment, diversification etc. Moves that work for companies like Google due to their dominance in the marketplace, but won’t work for all others who attempt to emulate this form of management brought on by the hubris created by a rising stock price. It’s similar to when your average NBA fan watches Kobe Bryant score 42 points and then goes out and thinks he score 42 points on his buddies by driving to the right, dribbling between the legs and charging into the lane. It usually ends with the poor chump holding his ankle while on his back staring up as a group of 5 other guys gather around to make sure he’s OK. Companies that try to act like Kobe Bryant when they are Kevin Bryant usually end up the same way.

Psychology as measured by the actions of participants, whether investors, management or the analyst community in any equity issue are firm confirmations of what is to come in terms of a turning point for the price and therefore, fate of the company. It is more useful for picking tops as opposed to bottoms. I don’t necessarily use this type of analysis for bottom picking, as it is exponentially more difficult.

You will see Dr. Kellegro pointing to psychological factors in his analysis of stocks time and time again. Issues of hubris, greed, fear, and gluttony all become apparent when a company begins experiencing tremendous success, which is often the precursor to its fall. The truth lies in the psychology of the markets, whereas the numbers are there to be manipulated, toyed with and disputed. Psychology as judged through actions is the truth…and Dr. Kellegro only seeks truth in the markets.

I am Dr. Kellegro…this is day 7.

Disclosure: None