Pattern recognition

It’s arguably the most powerful force in the universe. It enables scientists to make seemingly miraculous advancements. It enables coaches to align their defenses so they stop their opponent’s play as if they were standing in the huddle and overheard the quarterback’s exact play. It enables all the animals of the world to communicate with speed and efficiency. And, it enables professional investors to profit from the laws of supply and demand.

Have you ever wondered why a stock goes up or down? It’s simple, really. Supply and demand alone control stock prices. So if we’re to have any hope of picking stocks that increase in value and of avoiding stocks that decline in value, we must first understand the factors affecting supply and demand for the stocks we’re evaluating.

There’s an old saying on Wall Street, “don’t fight the tape.” It refers to the old ticker tape, which, now in our modern-day electronic form, provides streaming price quotes for stocks. This simple saying contains sage advice. It means that if the entire market is selling off, you should not fight against that current of supply. Swimming up stream can be costly.

You may be surprised to learn that the direction of the overall market accounts for half of the movement of each individual stock within that market. In other words, if a stock rises by $10, we can attribute $5 of the increase to the fact the entire market increased in value. Sure, there are plenty of exceptions to this rule as there are with all rules, but this holds true on average. You will also want to note that another 40% of a stock’s movement can be attributed to the performance of the stock’s industry sector. By example, if pharmaceutical stocks are under pressure due to fear of government price controls, it is highly unlikely that one stock in that industry will buck the trend and trade up in price. Again, exceptions occur, but they’re infrequent.

Let’s review.

We’ve now determined that 90% of the movement of a stock can be explained by the market’s direction combined with the direction of its industry sector. Only 10% of a stock’s movement is attributable to the company itself. Why then does Wall Street spend so much time and money on knowing every little detail about each company it follows? Why, then, do investors hang on every word that an analyst says about a particular company? If 90% of our success (or failure) as investors will be determined by the market and the sector, should we not focus more attention on macroeconomic issues rather than microeconomic issues?

Money flowing in and out of the market and the perception that some industries will fair better than others in the period ahead is what drives the balance between supply and demand. As it turns out, we are in luck as investors. The flow of money in and out of the markets and the sectors follows very predictable patterns. Once we learn to recognize these patterns, we increase our odds of success immeasurably.
One of the most important patterns an investor can learn is the pattern currently developing in the market, and in many individual sectors, today. It is called an oversold condition. It refers to the fact that the database of all stocks in the market is now exhibiting a pessimistic outlook. Returning to our supply and demand equation, we can forecast where the market might be headed. If everyone (remember the exceptions caveat) is feeling bad about the market and is selling their stocks, eventually all those who intend to sell will have sold. At that point, what has happened to the supply of stocks? It becomes exhausted. No one left to sell. As the professional investors who recognize such patterns emerge from the shadows, demand slowly overtakes supply. The market begins to rally. As more and more individuals, of varying degrees of conviction, recognize what is happening join in the buying, demand becomes stronger, supply virtually absent. We are fast approaching this inflexion point where the market clears out the last remaining sellers. It’s known as capitulation.

History is littered with periods of crisis. Some countries, some religions, some peoples have risen to the challenge, others have faded away. America has been hit with another crisis, certainly not the biggest in our history, but meaningful. This is a defining hour.

America will not fade away.

Our economy is not only the best and strongest in the world, but also built on the strongest foundation of all: capitalism. In time, we will rebuild our destroyed buildings and our damaged industries. Time after time, crisis after crisis, America rises to the occasion and shows a doubting world why we prevail. We prevail not because all of us are strong, but because some of us are strong.

Yes, we need strong leadership from our religious, financial and government institutions. But far more importantly, we need leadership from among ourselves. As far as investing goes, we can see it in action. Even though the recent terrorism struck only blocks from the NYSE itself, we see savvy investors buying shares these days, speculating that America will, indeed, rebound from the attack. The market has been marked down significantly in the last two weeks, as is customary (the pattern) in these situations. But know this, as we hit bottom in the market and our economy, shares are transferring from the hands of the weak to the hands of the strong. The strong will be rewarded for their faith. This is now, and always will be, the land of the free and the home of the brave.