One of my early mentors told me the most important advice I've ever learned about the stock market:
"The market doesn't care who you are or what you think; it's simply a crowd of varying opinions trying to figure out the best price with the information available."
I went on to learn that many stock market participants know very little about what they are investing in and what the economy is really doing. Most investors simply form a basic, often subjective opinion of a stock that they may like for some reason or another, but rarely dig deep enough to discover the real "secret" behind stock value.
The "smart money" actually takes the time to not just look deeply at a stock's valuation and health, but uses other smart people to help recognize potential and probable patterns in the future of the stock.
My goal in this edition of Weekend Wisdom is to get you ahead of the herds by uncovering a couple of these secret methods that will help you better understand why and where a stock may be headed.
If you were to look back at stocks over the past 100 years, you'll quickly see that stocks have gotten more volatile as time has moved forward and exponentially higher in the last 10-20 years.
Depending on whom you ask, everyone seems to have a different reason for the increased gyrations as of late. Everything from computers, more people investing, high-frequency trading, derivates products, ETFs and leveraged ETFs and ETNs, a more connected global economy and even the speed at which news travels can all be at least partially blamed for the more extreme conditions we see today.
More . . .
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Truth be told, it's impossible to blame one thing or another. The fact of the matter is that all of these factors are parts of the marketplace that help shape its behavior. For us to better understand how the market works and help rationalize its movements, we need to educate ourselves on the forces involved and stop blaming the market ... because it simply doesn't care!
Think about it this way...
Ever Been to a Car Auction?
Imagine walking into a car auction looking for a new set of wheels. You haven't done your homework, but you know (believe) that you want a Cadillac. Let's also pretend you're not from the U.S. and have never been to an auction before.
So there you are, a clueless foreigner going to buy a car at a hectic auto auction in Detroit. As the auction starts, it's pandemonium. Everyone is screaming, things are moving so fast and all you're wondering is why American cars, particularly Cadillacs, were fetching higher dollars than their overseas counterparts. The prices aren't making much sense; you just know that they seem a little higher than what you thought.
Since you've never been to that auction, let alone been in Detroit, you probably don't realize that this particular crowd tends to favor American cars because of its locale and the beliefs of the people that attend that regular auction.
As a buyer in that auction, you're definitely paying an American car premium as opposed to auctions elsewhere (this auction may have been a better choice if you were a SELLER, we will get to that in a minute).
If you had done your homework, you might have been able to control your impulses. Perhaps found a different auction, a different car or at least walked out of there with some cash in your pocket.
But instead, you're the proud owner of a 1982 Cadillac Cimarron (it was one of the worst Caddys produced) because it was affordable and there weren't too many people bidding. You thought it might be a good deal and liked the paint job (it's a Caddy isn't it?).
Unfortunately, the car is plagued with problems, and the price you paid, while it seemed like a deal at the time, is 30% over what they are selling for on average.
While this analogy may seem silly or extreme, it's almost exactly how stocks trade! You can liken the different auctions and/or locations to different stocks, and the professionals and amateurs at those auctions to the analysts and retail investors, respectively. The Cadillac Cimarron can be likened to just about any junk stock that may look like a bargain, but isn't worth nearly what you paid.
The added volatility can be thought of as a multitude of cars coming to auction faster with buyers from around the world bidding feverishly and skittishly with little or no knowledge of what they are buying (kinda like the markets today).
Calm the Craziness!
The point is that you must get to know your new or old stocks intimately!
Look over the last 2-3 months of news headlines to get an idea of what's been going on with it. Check out the company's financials relative to its peers and determine why it's more or less expensive.
Make sure that the Zacks Rank meets your investment goals, and if it doesn't, try to figure out why (maybe they had a poor earnings report).
Also look at the Beta and ATR (average true range) of your stock. The beta tells you how correlated the stock is to the broad market and the ATR tells you just how much the stock moves (in a day, week, month) on average.
Watch those high beta (1.8+) stocks, as they can really fall apart if the broad market weakens.
If you are buying a $20 stock that has a weekly ATR of $3.00, you've got a stock that can potentially lose or gain 15% in a week's time! That may or may not be comfortable for you.
Know When and What to Bid On
I know that all of us are guilty of buying a Cadillac Cimarron (a poor stock) at one time or another. It usually happens because we lack factual data and control.
In between all the volatility, news flow and confusion, there are four times a year when we get objective clarity on a stock: earnings. Earnings should be considered waypoints in a stock's journey, and they need to be understood before you plunk down any real cash.
Remember how I said earlier that the analysts are similar to the pros at the auctions? Well in the stock world, these analysts spend every waking hour researching a handful of companies. It's their job to know more than you do about the companies they follow and help predict what their earnings reports will look like.
From the data and news they collect, those analysts form financial models and issue price targets on stocks based on what their models are telling them.
As companies grow (or contract), those models may change, forcing the analyst to raise or lower their expectations. These movements are invaluable and, if read correctly, can unlock major opportunity.
The best part is that analysts share all this data with us!
Of course analysts can't be right 100% of the time, but they do have to be right more often than not or likely find themselves out of work.
Use Analysts to Your Advantage
Zacks.com offers you free access to some very powerful data. The detailed estimates page allows you to see just what analysts are up to. If the data is interpreted properly, it can almost be a free look into the earnings report of a stock.
The most important thing to look for when you're long a stock is to ensure that analyst consensus estimates are going in the right direction (magnitude), especially if the stock has been moving higher. You'll want to see those estimates increasing.
Agreement is also a key factor as you'll want to see the majority of analysts revising their estimates higher over the last couple months, and preferably into the report.
Lastly, check the earnings ESP. It can give you a good indication of whether your stock is likely to beat the Zacks Consensus Estimate, and it can also help give you an idea of what guidance may look like.
There are Nuances
I'd be lying if I said it was easy and that earnings season is a walk in the park. The point here is to prepare yourself as much as possible and stack the chips in your favor.
By paying attention to some of the indicators I've outlined above, you can reduce volatility and help prevent a P&L catastrophe.
If you're one of those people who would like the majority of the work done for you and want to get an education along the way, you are welcome to check out my Whisper Trader earnings service below. It's a pure-play earnings service that uses a Zacks proprietary algorithm plus some of my personal technicals from above to select those companies most likely to beat when they report.
It has greater than 82% accuracy in selecting companies that beat estimates. Although these "surprise" stocks don't all turn out to be winners, listening to selected whispers obviously can give investors a substantial advantage.
If you would like to receive our precise buy/sell signals, then I invite you to join our Whisper Trader. But a word of caution. Due to overwhelming demand, we are closing it to new investors Saturday, July 13. The number of investors who share these stocks must be limited. So I encourage you to look into it today.
Being that earnings season is just underway, it's a good time to either brush up on your homework or join our Whisper Trader family!
Learn more about Zacks Whisper Trader.
Jared A. Levy is one of the most highly sought-after traders in the world and a former member of three major stock exchanges. That is why you will frequently see him appear on Fox Business, CNBC and Bloomberg providing his timely insights to other investors. He directs the Zacks Whisper Trader, which has an uncanny record for accurately predicting robust earnings before companies report.