The Perception of Fundamentals Matter

The Perception of Fundamentals Matter

The Perception of Fundamentals Matter

What moves a stock’s price? At the most basic level it is Information.  Unfortunately, life is not that simple.  Arguably, one of the most important market moving components is not the actual data but the perception of the data that matters.  It is the perception of fundamentals that determines stock price, and it is changes in the perception that leads to changes in price (technicals).

Fundamental Analysis:

Investors who make decisions based solely on fundamentals alone use various methods of interpreting the company’s business to arrive at the value for their stock. If this logical value of the stock is higher than the price the stock trades at, the stock is deemed worthy of purchase (or undervalued).

This analysis process leaves little room for the artful interpretation of value. Fundamental analysis tends to be black or white (e.g. overvalued or undervalued), leaving little room for the color of reality.

What makes the financial markets colorful are the characters, motives and moods that taint the process of logical deduction. A stock whose fundamental value is $20 may only trade at $10 because a large investor has lots of stock to sell, a group of short sellers may have the stock gripped in fear, or investors may simply not like the color of the story.


Investing is an Art:

The Perception of Fundamentals MatterThere is an art to predicting stock price change.

From our perspective, it is not enough to know what the fundamentals will be tomorrow.  We must also know how the market will judge those fundamentals. It seems obvious that a company announcing positive news will go up in price, yet we as investors have often seen the opposite happen.

How Will the Market Judge The Fundamentals:

Investors will judge fundamentals not only on their merit, but also on how they relate to expectations. Sometimes, fundamental change will be ignored in favor of more pressing macro economic issues.

Suppose you are told that a mining company will announce the discovery of a significant gold discovery. In anticipation of news, and based on your information, you buy the stock. You are excited by the prospect of what will be easy money, to materialize when the news is made public.

Two days later, the news is announced and you watch the stock with excited anticipation. But instead of jumping higher and higher, it goes up for a couple of minutes, and then suddenly begins a free fall lower. Your expectation of quick and easy profit quickly and easily turns to loss.

You can not understand why, it seems to make no logical sense.

5 Reasons Why Markets React Differently Than You Think They Will:

Here are some of the possible reasons why the trade did not work:

1. The stock market is not fair. 

The information that you received was obtained by others weeks earlier, and the stock already priced in its value. Your stock has been going up in anticipation of news for some time.

2. Expectations rarely live up to reality. 

Investors have a wonderful imagination, and the visions of those who were buying the stock in anticipation of the news pushed the stock beyond what the news was worth.

3. Without a reason to own, investors will sell. 

Many short-term investors bought this stock in anticipation of news. When the news came out, so went the reason for owning the stock. Investors who buy in anticipation of news often sell when it is released.

4. The exit door is only so big. 

When a stock starts to do what investors don’t expect it to do, investors panic and all try to get out at once. This creates emotional selling that has no regard for fundamentals.

5. Every stock correlates to the market. 

If the market is going down and pessimistic, buying a stock is like trying to paddle up stream. Some can succeed, but most eventually go with the flow. In fact, most studies show that over 75% of stocks follow the major averages, up and down.



Fundamentals are important but only one part of the overall equation. From our opinion, it is imperative to ask, what does the market think? How will the market judge this company? What effect will the mood of the market have on the perception of fundamentals? How is the market behaving? When will I exit if wrong? How much do I want to risk on this idea? How are the technicals (price action)? Etc… Etc.

Fundamentals alone are one part of the equation, the more important factor is the perception of the fundamentals.


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7 Questions To Ask BEFORE Buying a Stock

It is sometimes difficult to know where to begin when deciding whether a stock is worth purchasing or not. Here are 7 questions that I think everyone should ask before buying a stock, as well as what I look for when answering the questions in the most basic form.

1. Is The Market In An Uptrend? 

Stocks go up because investors are optimistic about the future. This is shown on a stock chart in a number of ways. The most important and easiest way is to look for whether the bottoms on the stock chart are rising and if the market is in a general uptrend (moving from the lower left to the lower right). That means that the buyers are in control of the market, making the stock more likely to go higher than lower.

However, it can also happen that conditions are right for a stock to go up if the tops are falling if investors are motivated by fear. When investors are afraid of prices going lower they will sell with emotion and accept too low of a price. When a stock’s in this situation find a catalyst for emotional change, they often bounce back quickly.

2. Do Investors perceive significant fundamental change may be likely in the future? 

It is important to realize that stocks do not go up because of what happened in the past. They go up because of what will happen in the future. We also need to accept that the stock market is not fair and that some people use information better than others. These investors will create abnormal trading activity in a stock when they expect significant fundamental change in the future. To beat the market, we have to leverage this break down in market efficiency and focus on stocks that are showing abnormal trading activity in both price and volume. Remember perception is reality and the market always knows best.

3. Is the probability of the stock going higher strong enough to justify the trade? 

While the market may be showing optimism, as evidenced by rising bottoms on the stock chart, we also need to know that the probability that the optimism will continue is good enough to justify entering the stock. The best way to determine this is by using chart pattern recognition. Patterns such as ascending triangles, pennants, flags and cup and handles are very helpful (because human nature doesn’t change) so it is essential to learn how to recognize them.

Often, investors will buy a stock that is well into an upward trend because the stock is showing a lot of optimism. However, because stocks that have been trending higher don’t usually have good chart patterns any longer, they may not be worth entering. We want to find stocks that are starting upward trends so that we can maximize the probability of success.

4. Does the reward potential of the trade justify the risk? 

All signs may indicate that the stock is likely to go up but if there is a limit to how high it can go then we should evaluate whether the reward potential is significant enough to justify the trade. Stock’s will often stall at historic ceiling prices which chart readers call resistance. We should exit a trade if the stock falls below its historic floor price, which chart readers call support. If resistance is not twice as far away from your entry price as support is, the trade is probably not worth taking.

5. How Much Will I Risk? Can you, the investor, handle the risk of the trade? 

Always know exactly how much you want to lose if you are wrong and where you are going to exit if the trade moves against you. The greatest enemy of any trader is emotion. Emotion causes us to avoid taking losses when the market tells us the stock is likely to go lower. It causes us to sell our strong stocks too early. Emotion is at the root of almost every break down in our trading discipline and it is the reason most people fail to beat the stock market. If you take more risk than you are comfortable with on any trade you will likely make emotional mistakes. Therefore, it is essential that you are comfortable with the risk of every trade you make. To be successful, you must not care about the money.

6. Is the overall market condition right for your trade? 

Every stock has some correlation to the overall market. No matter how good your analysis or disciplined your trading, you will do better if you go with that thing that is out of your control. Trade with the mood of the overall market and buy stocks aggressively when the overall market is going up. For long-only investors, being conservative when the overall market is in down tends to be a highly rewarding proposition. Remember, 3 out of 4 stocks follow the major averages and if the market is falling trying to find a stock that will buck the trend is not ideal.

7. Does the stock have enough liquidity to justify the trade? 

The public listing of a stock does not mean it will be easy to buy and sell. A stock needs buyers and sellers to create the liquidity of the investment. Stocks that trade with little volume or not on a regular basis are best avoided simply because the costs of entry and exit are too high.


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If You Do Not Have a Sound Trading Plan, Stop Trading


If you do not have a sound trading plan, stop trading!  When you think of the best run companies in the world, what names come to mind? Wal-Mart? Amazon? Perhaps Apple? Think of the worst run companies and you might think of a company like Enron, which is now out of business because it was run so poorly.

If we compare Wal-Mart, a model of incredible cost efficiency, with Enron, the once high flying energy firm that ultimately burned out on bad deals, we see that the price paid for leadership meant little. Wal-Mart executives, by Enron standards, are poorly paid. Enron sought the brightest and best and paid them very well. Wal-Mart grows their leadership internally and pays their highest earners with modest salaries. Enron went bankrupt despite their smart and talented people.

What is the difference?  Does money not buy quality..?

With my very limited knowledge of either company, one thing that stands out to me is the difference in systems and processes for (e.g. risk management) that each employ.  Employees at Enron were allowed to sort of do what ever they thought would help the company succeed. A noble idea, but the lack of standards allowed for individual goals to take priority to the detriment of the company.

Planning & Processes Take Precedence Over Talent!

From this example, it seems that plan and process take precedence over talent. A disciplined, highly calculated and planned business is able to do well even though it may not have the smartest people running the business.

And so it goes for trading.

I have taught aspiring traders from every possible background. The well educated and the drop outs, Mensa level IQs and those who might be referred to as not the brightest bulb on the tree. I have taught those who have already achieved financial success and those who are in pursuit of that dream.

Anyone Can Succeed or Fail

And what stands out, after teaching a few thousand people, is that there is nothing about a person’s background that predicts trading success. When trading, anyone can succeed or fail.

Sound Systems (Plans & Processes) Win

So what does matter? At the very top of my list would be having a sound back-tested system (plan + process). Having a detailed, well tested and constructed PLAN for making money in the market is a must. Every aspect of the plan must be well thought out and based on prior market action. The more steps in the trader’s plan that are left to human judgment, the greater the chance that the plan will achieve a poor result.

With a good plan, can anyone get the job done? If you ask Wal-Mart, the answer is probably yes. They hire thousands of people to do the various jobs that they employ and could not possibly expect that talent will allow each employee to get the job done. Their people succeed because their jobs are well defined.

Define Your Tasks

What is important is how the tasks are defined. Wal-Mart succeeds in part because they have so much retailing experience. Their employees and management use their experience and resources to develop the very best processes. With those processes, even people who lack experience or talent are able to succeed.

This is exactly how it works for traders. I have seen so many successful and bright people fail in the stock market simply because they did not have the experience to develop the right plan.

Is Your Job Hard?

Think about what you do in your career. Is your job hard? Most people would answer no to this question since doing their job is what they are experts at. To the surgeon who has performed 1000 surgeries, the 1001st surgery is not particularly difficult. For the person who has never done one, it is a great and dangerous challenge, no matter how smart they are.

Can Anyone Succeed on Wall Street? …Most Lose!

Does this mean that anyone can succeed as a trader if given a good trading plan? No, at least no better than anyone could succeed at removing your wisdom teeth if given a step by step process for doing it. You still need to practice the plan before you can achieve success.

Having a planned process helps us shorten the time it takes to learn something. The Wal-Mart employee or the surgeon can each do their job well by combining a good plan with some time for practice. The Enron employee might have had better success if they had a good plan to work from.

If You Do Not Have a Sound Trading Plan, Stop Trading!

If you do not have a trading plan, stop trading. You might argue that you have done really well in the market over the past couple of months and you therefore do not need a plan. I would respond with some of the examples of people who gave back all their profits and more when the stock market was not working in their favor. Remember the old adage: Everyone is a genius in a bull market. A trending market can make the inexperienced look like they know what they are doing.

You can either create your own plan or you can buy one from someone who has put in the time to create a good one. I think that everyone should try to create their own plan because you learn a lot by doing so. Investing your time and money in studying what other successful people on Wall Street do (and have done) is a great way to find success on Wall Street.

Simplicity in a Plan Usually Works Best

Your plan must be written down. It must be tested. It must be practiced. It must have a positive expectation. All trading plans should evolve with the market and as you gain experience. They need not be complex, simplicity in a plan usually works best. Plan the trade and trade the plan.


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Few Make Money; Most Lose:

People frequently ask me, “How much money can you make trading stocks?” I understand why people ask the question but it is a question that does not have one easy answer because there are so many variables.  It is like asking, “How much money can you make playing a professional sport?” For some, it is millions, for others, it only costs them money.

Improve Your Trading Skills; Most People Can’t Control Their Emotions 

Of course, trading skill is the most important factor. Trading is not complicated, in fact, it is the simple things that work the best. This is not to say that trading is easy; it is actually quite hard but not because it is intellectually demanding. It is just hard for most people to disconnect themselves from their emotional attachment to money.



Learn Rules & Follow Them

The rules for most of my trading strategies could be written down on the back of a napkin – they are simple. Executing them properly takes practice and emotional control. For some, that is not too hard. For others, it can be close to impossible.


It Takes Discipline, not Genius To Beat The Market

You do not have to be exceptionally smart to be a good stock trader; I think most people are smart enough. It does take more determination and hard work than a lot of people are willing to invest but the great thing about both of those things is that neither is exclusive. No matter what your age, gender, looks, intelligence, nationality or social status, hard work and determination are achievable.


Risk and Reward Ratio

Before I go into the economics of trading, let me first explain a few important concepts. The first is risk, the difference between the price you buy a stock and the stop-loss point. If you buy a stock at $20 and have a stop loss at $19, you are risking $1 a share.

The reward is the difference between the entry price and the profitable exit price, assuming you are not stopped out with a loss. That stock you bought at $20 has a reward of $5 if you sell it at $25.

The reward for risk is the reward divided by the risk. In this example, the reward for risk is 5 since the profit was $5 for a risk of $1. How much you actually make depends on what your risk tolerance is.

If you are willing to lose $500 on a trade then you would have bought 500 shares in this example. $500 of risk tolerance divided by $1 of risk demands you buy 500 shares. With an exit at $25, you earn $2500 or five times your risk.

Leverage Works For You & Can Work Against You

How much money did it take to make the $2500? 500 shares of a $20 stock costs you $10,000, assuming you only use your capital. If you use leverage, which most brokerages will give you at 2 to 1 and some brokers will give you at 3 to 1, you lower the capital requirement. With 2 to 1 leverage, you need $5000 to make the $2500 profit. With 3 to 1, you only need $3333. With more leverage, the percentage return goes up but so too does the potential percentage loss.

Now, what can you expect to make in terms of reward for risk? This is where there are variables outside your control that have a big effect on performance. If the market is hot, it is much easier to find winning stocks and the size of those winners will be greater than if the stock is dead. No matter how hard you work or how skilled you are as a trader, you can not control how many opportunities the stock market is going to give you.

Risk Vs Reward:

As a general guideline, on average, the goal for a skilled trader in a reasonable market is to earn at least 5x-10x the amount you risk on a trade. So, if you risk $500 on each trade, you should be able to make $2500-$5000. I want to stress, however, that your skill and the state of the market are two very important variables in this calculation.


How Much Capital Do You Need:

The final question is how much capital do you need to risk $500 on each trade? Again, the state of the market is an important part of this equation. There are times when the hot sector of the market is the low priced stocks. The size of your position in these stocks tends to be smaller because these stocks are more volatile. You may be able to take $500 or risk with a $5000 position (which with leverage may require less than $2000 of your capital).

In a market where the large cap stocks are the hot area you could need 10 times as much capital to achieve the same amount of risk.

As a general rule, take your risk tolerance and multiply it by 100 to get the required capital, before leverage. So, if you risk $500 you will need $50,000 of capital to take the trades that come to you. With leverage, that could be half or one third of that amount.


Avoid The Gamblers Mentality:

Above all else, none of this works if you are a person who approaches the market with a gamblers mentality. Losses are part of trading and you have to be prepared to take the small loss when the market leads you astray. When you get a winner you have to be willing to let the profit run so that the winners can pay for the losers and still leave you some overall profit.


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Technicals Lead, Fundamentals Lag

Apple & Netflix Case Study: Technicals Lead, Fundamentals Lag

Conclusion: Technicals Lead, Fundamentals Lag.

This is a case study I performed in 2013.  The lessons still apply just as much today as they did then.
The following two case studies illustrate a very important point: The market and individual stocks (i.e. technicals) move months BEFORE the fundamentals move (up or down).  The reasons “why” are lengthy and outside the scope of this article. Instead of discussing the “why” we shall focus on the “what.” The reason is simple, we care about intelligently operating with “what is actually happening,” not why people think things are happening.
There are countless examples in history of markets and individual stocks turning months before the fundamentals turn. Every major top or bottom in the stock market happened months before the fundamentals turned.  Moral: The market always knows, ignore the market’s opinion at your own risk.
Apple (AAPL) and Netflix (NFLX) are two examples of the technicals turning months before the fundamentals turn.

Apple- AAPL: 

 Technicals Lead, Fundamentals Lag
A. All-time high $705.07 on 9.21.12.
* 3-Months Before Earnings Flatten Out
*6-months BEFORE earnings turn Negative For The 1st Time In 10 years!
B. Breaks 50 DMA Line Almost Never Gets Back Above It
C. Death Cross- 50 DMA line Undercuts 200 DMA Line
D. Enters Bear Market: Defined by A >20% Decline from Recent High
E. Q1 2013 Earnings fall -18% which is the first year-over-year quarterly decline in 10 years.
Moral: The market always knows, ignore the market’s opinion at your own risk.

Netflix- NFLX:

 Technicals Lead, Fundamentals Lag
A. All-time high $304.79 July 2011
*6-months before earnings turned negative
B. NFLX Breaks Below 50 DMA line & stays below it for months
C. Death Cross: 50 DMA line Undercuts 200 DMA Line
D. NFLX enters bear market and then plunges 82.6% before bottoming!
E. NFLX Bottoms then jumps back above its 50 DMA line
F. Golden Cross: 50 DMA line crosses above 200 DMA line
G. Earnings Accelerate in Q1 2013 vs Q1 2012 AFTER a 300% rally off the low!
Moral: The market always knows, ignore the market’s opinion at your own risk.

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