20 Truths About the Stock Market

1. Stock prices run in cycles. Periods of re-pricing are usually quick and powerful and then they are followed by trendless consolidation.

2. Stocks are very highly correlated during drastic selloffs and during the initial stage of the recovery. In general, correlation is high during bear markets.

3. Bull markets are markets of stocks, where there are both winners and losers. When the market averages consolidate, there are stocks that will break out or down, revealing the intentions of institutional buyers.

4. In the first and last stage of a new bull market, the best performers are small cap, low float, low-priced stocks.

5. Try to trade in the direction of the trend. It is not only the path of least resistance, but also provides the best profit opportunities. Have a simple method to define the direction of the trend.

6. Traders’ attention (and market volume) is attracted by unusual price moves. Sudden price range expansion from a consolidaiton is often the beginning of a powerful new trend.

7. Opportunity cost matters a lot. Be in stocks that move. Stocks in a range are dead money.

8. Big winners are obvious only in hindsight. Many other stocks shared the same characteristics when they tried to break out. Some failed. Some had a followthrough. Being wrong is not a choice. Staying wrong is. You can only control your risk and how long you will ride your winners.

9. The overall market conditions will never be perfect and when they seem so, it is probably a good idea to decrease exposure and take profits. With that in mind, you don’t have to be in the market all the time. When you don’t see good setups, it just makes sense to watch from the sidelines.

10. Big institutions achieve outsized returns by riding strong trends for the long-term (long enough to make a difference). This is the only way for them. They can’t easily and often get in and out due to their size. Establishing small positions does not make sense for them as it would not make a difference for the bottom line. Big winners can make a difference when they are big positions. Big positions take time to accumulate and along the way institutions leave clear traces.

11. Small losses are often better than small gains. If I sell my position every time it shows me a small gain, I would never achieve a return high enough to make a difference and to cover the inevitable losses. Amateurs go bankrupt by not taking small losses. Professionals go bankrupt by taking small gains. It is absolutely true that a large number of consecutive gains could multiply returns substantially. The point is how big should be those gains. 4-5% is not going to help a lot. 15-20%  gains is something completely different.

12. Prices change when expectations change, but sometimes expectations change when prices change. In other words, there are different types of catalysts that move stocks. In long-term perspective (years), stocks move based on the underlying social trend and the stage of the economic and liquidity cycle. In medium-term perspective (months), stocks move based on expectations for earnings and sales growth. In short-term perspective (weeks and days), stocks move based on price action primarily.

13. If you understand the incentives of the major market participants, you will be able to predict their likely behavior. Technical analysis is a lot about understanding incentives and recognizing intentions.

14. Your first loss will often be your best loss. No one is right all the time and you don’t have to be. There are market participants that are immensely profitable by being right only 30% of the time. It is good to have conviction in your investment thesis, but discipline should always trump conviction.

15. Optimism and pessimism in the stock market are contagious. Investors psychology often loses its logic and become emotional. The news media and the most recent price action play a particularly important role in developing moods of mass optimism or pessimism.

16. Declining stocks often reverse their downtrends near the end of the year, as selling for income tax purposes subsides.

17. Fair value is an illusive concept and hard to calculate. While it is true that you don’t need to know the exact weight of a person to define if he is overweight, applying this philosophy is not going to help you in the stock market. Stocks constantly get overvalued and undervalued. This is the nature of the market. Warren Buffett says that price is what you pay, value is what you get.  I believe that value is what you think you get, price is what other people are willing to pay for it.  Just as beauty, value is in the eyes of the beholder. (there are universally accepted measures too, of course)

18. Liquidity is cyclical. It constantly expands and contracts. When it contracts, capital flows to perceived safety – U.S. Dollars and Treasuries.

19. Rising P/E is an indicator of rising expectations and confidence in the future of the stock. The P/E ratio reflects the enthusiastic optimism or the gloomy pessimism of investors.

20. When you calculate the time you need to drive from point A to point B, you should always take traffic into account.  Traffic is like the stock market. You might pretend that it doesn’t matter, but it will impact you anyway. It doesn’t matter how smart you are, how ingenious your idea is or how cheap your stock is – if the market does not agree with you, you will not get paid. Period.

American Airlines’ Bankruptcy Was an Early Christmas Present for Delta’s Shareholders

Earlier this week, AA became the last major U.S. Airline to file for Chapter 11 in an attempt to renegotiate labor costs with the unions. The event only came to remind us that bankruptcy has become an indispensable part of the Airlines’ business model. Plagued by higher regulation costs since 9/11, crude oil above $100 (it used to be $30 in 2003), exorbitant pension benefits and highly susceptible to the economic cycle, the typical Airlines stocks have historically been terrible investments.

By all intents and purposes, this is not a post to outline the flows of the Airline industry. The mainstream press has already done it. What most missed was that American Airlines’ bankruptcy turned out to be a positive catalyst for any other airline stock. $DAL, $UAL, $ALK, $LCC appreciated 15-20% in a few days. Certainly, part of the move could be attributed to the general market surge aka “a rising wave lifts all boats” effect, but the expectations for AA to cut some of its roads and benefit the rest of the carriers is also a major factor.

Prices change when expectations change. Major changes in expectations are usually caused by external events – catalysts. Minor, short-term changes in expectations are often a function of price. Yes, price and expectations impact each other all the time in “an egg and chicken” kind of relationship.

20 Best Performing Stocks of the Past 6 Months

It is a habit of mine to keep track of the best performing stocks over different timeframes. While the survivorship bias could certainly distort the results, there is no better way to pinpoint the mutual characteristics of winning/losing stocks.

Over the past 6 months, $QQQ and $SPY fell 10%. Correlation is usually high during downtrends or with other words, most stocks tend to move in groups. The so called “all-or-nothing” days, where 90% of all stocks go in one direction or market averages gain or lose 7-8% in a week are typical in such environment. But below the surface, there are always stocks that manage to defeat the status quo and stand out. Below I outline some of the common characteristics of the winners over the past 6 months – traits they had as of May 29, 2011:

18 of them had market cap under $1B 6 month ago. Small caps are naturally more volatile and tend to occupy the first places of most best and worst performing lists.

8 were less than 10% from their 52week high

15 were above their 50-day MA

11 had outperformed $SPY over the past year

4 were acquired over the past 6 months

7 are biotechs or drug manufacturers. Nothing surprising here. The price action in these type of stocks is rarely influenced by the general market