Don’t Confuse Yourself with the Facts

One of the things we hope to achieve with this blog is to help people understand how the market works. We don’t claim to be the Oracle at Delphi and would never insist we can divine the market’s intentions, but having well over a decade’s experience in watching the market minute by minute and day by day we have developed a keen sense of the market’s rhythms; rhythms that most laymen, indeed many traders, either do not or will not grasp. Without accepting these rhythms your trading career will be unsuccessful.

We have spent over 30 years trading in markets of one type or another. The most surprising observation we have made over that time is that intelligence and success in life have little correlation with market success. In fact, there is nothing worse than a bright accomplished man bringing the traits that made him successful to the market (women are different believe it or not – in our experience they are quicker to hear and obey the market’s rhythms!).

The first mistake is trying to apply common sense to the market. GDP was just reported higher. A stock just reported better than expected earnings. The market/stock must go up. Sorry, but no. Not necessarily.

Next is the idea that you can quantify the market, distilling it to an equation that will come out a certain way given certain stimulae. Again, sorry. That dog, as our southern friends say, won’t always hunt.

The insistence that the market can be solved, that it can be understood with precision, is a canard. In Sunday’s New York Times Business Section, Cornell economist Robert Frank wrote an article titled “Flaw in Free Markets: Humans.” It amazes us that an economist of Mr. Frank’s stature can pen an article with this title. Markets work BECAUSE of humans. They wouldn’t work with a cooperative social species like bees or ants, who all contribute toward the common good. Could you imagine a market led by bees? They’d all wait for the Queen to make her bid, then wouldn’t dare trump it out of deference.

No, Mr. Frank, markets are peculiar to species like us. And as humans we are all subject to the same emotions. It’s very hard to understand the market perfectly when you are subjected to its stresses and pressures in real time.

In order to best understand how stocks will move you first have to understand how the market is moving. A company can release an ugly earnings report during a market uptrend and not suffer severe consequences. It might even go higher. In a bear market that same report could lead to the stock price of the company being crushed.

How can that be? During a bear market the excesses of the previous bull are being worked off. Chances are most stocks have frothy valuations after a bull run of a few years. A disappointing earnings report will cause investors of all stripes to flee the stock. That will include those who rode it to fat gains, understanding it is time to take a profit, and the late comers who desperately need to cut a loss short.

When the bear turns to bull, as we have seen this year, there are numerous factors driving prices higher. Chances are the central bank will have increased liquidity in an effort to stem the tide of recession. That liquidity will help to float all asset prices including stocks. Add to that the anticipation of earnings recovery and then acceleration. And stock prices start to levitate. An ugly report after the market has turned might well be forgiven. It’s reflecting the past and the stock has already been beaten down. The market is looking forward now, beyond the report to better times.

Today we saw this process front and center in the steel industry, something we know a bit about having spent 25 years trading steel. Nucor (NUE), one of the nation’s leading steel producers, released a statement before the start of trading that it’s third quarter earnings, which had been expected to be just below break even, would actually represent a loss of 15-20c a share. Coming into today’s trading Nucor had seen its stock price climb about 57% off the market bottom in March although it was little better than flat for the year. At the opening bell the stock gapped down. It then proceeded to trade higher the entire session, gaining more than 2% on the day.

Why did this happen? The company “explained” its loss in the press release. And it reaffirmed that it still expects to return to profitability in the fourth quarter. So the stock price, which traded in the $80’s last year when the company made almost $6 a share, resumed its march back towards $50. The market is looking forward to better times, expecting the company to post earnings of nearly $3 a share next year.

We are in a bull market. The market will look to interpret all information it receives in the most positive possible light. That doesn’t mean we are immune to corrections. But it means that the market wants higher over time. Traders spending day after day trying to position themselves short for a correction are missing the train. Trade with the liquidity driven, earnings recovery trend. For now, and probably for a good while longer, that’s higher.