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The single most important thing that you could ever understand about markets

Jan. 04, 2011 7:10 PM ETAMD
Robert Sinn profile picture
Robert Sinn's Blog
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The education of a speculator/market participant is a lifelong pursuit which is ultimately, only better mastered, never fully mastered. As the market participant gains experience and incurs some battle scars, the importance of the role which market psychology plays in day to day market movements should become increasingly apparent. For example, I recall during my first year of trading, holding a long position in a stock which had just announced quarterly earnings that by all appearances beat earnings and revenue estimates. However, a surprising thing happened during after-hours trading and into the subsequent trading session, the stock price fell sharply much to my dismay. Of course, the stock had been on a big run (over 30% in a few weeks) and market sentiment was wildly bullish which as I soon found out set the stage for a correction (or as financial media calls it, profit taking). This was my first real lesson (a painful one which always makes it more memorable) in market psychology, the lesson is a simple one yet of priceless importance.

Imagine the market is a trading pit with exactly 100 participants. If all 100 traders are long a particular stock and none of the traders are neutral or short then there is no marginal buyer to drive the stock higher regardless of how good the earnings and revenue numbers are. Whereas, imagine a situation where there are only 10 traders long the stock and the other 90 are all short. What would happen if the company announces blowout earnings in this scenario? Exactly, a powerful short covering reverse panic rally ensues as the bears scurry to cover their short positions and bid the stock up to higher and higher prices. This is the reason people care about market sentiment readings and overbought/oversold indicators. If we knew that every market participant was long in a particular market and no one was neutral or short, it would be a no brainer to buy some put options and wait for a big fall and vice versa.

One famous short seller once told me that he will never short a stock that has a short percentage of float above 10%. I believe this is excellent advice and words to live by except in the most unique situations (such as accounting frauds etc.). If a speculator chooses to hold a position (long or short) through a major news event (analyst day, earnings, FOMC announcement etc.), the most important thing the speculator can understand is the mood/psychology of the market headed into the event. Mood and psychology of markets can be summed up by market positioning and expectations. The concept of the marginal buyer/seller is perhaps the single most important concept in markets.

When an investor/speculator makes the decision to buy a share of stock or a barrel of oil, their intention is to eventually sell these items at a higher price at some point in the future (one minute or ten years). Therefore, it is essential to attempt to grasp what would motivate a new buyer to buy the shares of stock or barrels of oil from you at a higher price. In equity market investing this calculation can be made using traditional equity valuation techniques and the assumptions are made over years (discounted cash flow, price multiples etc.) i.e. new investors will enter into shares of companies that continue to earn high returns on assets/equity (ROA/ROE) and trade at appealing book value/earnings multiples. Whereas, in trading every buy/sell decision is made on the margin particularly in news driven, fast moving markets. Markets where expectations are tipped heavily to one side are highly vulnerable to sharp panic reversals if new data doesn’t meet/exceed market expectations. Equity traders have the opportunity to witness this phenomenon at least four times per year during quarterly earnings season.

The most important piece of advice I can impart to equity traders with regard to earnings season is to figure out what market expectations are, not what analyst expectations are. Analysts are usually long biased, they don’t trade and are wrong just as often as they are right. Moreover, equity analysts are usually focused on their long term valuation model which spits out 12-36 month price targets. This sort of analysis is completely useless to a short term trader and instead places more confusing noise in their head than substantive value. Remember, price movement in markets takes place on the margin and market participants should focus on how the market is currently positioned and what the market expects.

Oh, and yeah, I haven’t held AMD into earnings since that first time all those years ago! 


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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