Nov 30, 1999
Market Mood Swings Report
By Andrew Mickey, Q1 Publishing
Have you ever shouted at someone in anger? Then apologised and tried to make amends the next day for overreacting? The same scenario occurs in the market dozens of times a day (a dramatic decline – followed by a sharp rebound) – and each time it happens is an opportunity for profit.
It makes no difference whether it’s a bear market or a bull market. The ritual keeps repeating itself. And each time, a small group of savvy investors make money off these predictable rebounds. You can be one of them.
Just look at the recent activity in Fannie Mae (NYSE: FNM). The stock plunged 76% on July 15, 2008 amidst news that the mortgage lender was on the verge of bankruptcy and the U.S. government wasn’t going to step in. The stock would be worthless at that point. Investors were running for the exits.
When news about Fannie Mae hit the markets, there was an overreaction. What happened next? Traders and investors took a couple of deep breaths and realised that if Fannie Mae blew up, the entire US economy would go with it. Cooler heads prevailed. Fannie Mae bounced back 212% in the next five days.
It was a simple case of market overreaction, followed by a correction. The market does this every single day. And there’s a strategy you can employ to exploit these mood swings for profit.
It’s simple. It doesn’t involve any high-risk options trading. It has shown the potential to turn $10,000 into $314,322 in a year. Most importantly, any investor can do it.
In about 3 minutes you can learn how to identify the stocks which are poised to rebound. This probably sounds like one of those notorious “black box” systems devised by a Harvard Ph.D.
We’ve all seen the infomercials featuring some rube from Arkansas on a speed boat surrounded by beautiful women, bragging how he’s making a million dollars a week, just sitting on his boat drinking martinis.
But the suspicious thing about these “systems” is that you are never allowed to see inside the box. It’s a magic act. But what I’m going to do is open the lid up. And you can peer inside the box. Understanding how it works will make you a better investor.
Market Mood Swings: Trample the Herd
You see, one of the easiest most reliable ways to make money is to capitalize on the predictable herding behaviour of most investors.
“A herd appears to act as a unit,” explains evolutionary biologist, W. D. Hamilton, “but its function emerges from the uncoordinated behavior of self-seeking individuals.”
It’s a natural survival instinct (hiding from predators in the middle of the pack). The instinct is deep rooted. In fact it’s in our DNA. It feels good (safe) to do what others are doing. But it turns out to be one of the worst ways to invest. The big gains are made by investors who resist this instinct and break away from the herd.
“Buy on Bad News.” “Sell on Good News.” It’s easy to say. Much harder to do. But historical data confirms that when a stock plummets more than 10% in a single trading day, it tends to bounce back the next day. It’s all about volatile market mood swings.
This is how it normally goes. A company releases disappointing news (lower-than-expected earnings, CEO defection, a lawsuit, etc). A few stockholders take this as a signal to sell. The herd rushes for the exits and the stock price falls.
Now all the traders across the world watch their charts and see the stock moving down. The more it falls, the worse the news is perceived. More people jump ship. And on it goes.
Market Mood Swings: Reaction vs. Overreaction
The market is no longer reacting to the initial bad news. It’s reacting to the reaction to the bad news. The herd is gaining size and momentum and an overreaction is in progress.
What happens next is predictable and often very lucrative. After the closing bell rings the analysts look at the company and realize it got hammered harder than it should have. With the stock no longer in freefall, it suddenly looks kinda cheap. The next morning, the traders fire up their screens and start putting in bids.
This is precisely what happened on July 16, the day after the Fanny Mae shares plummeted 76%. When the markets opened, there was a line up of buyers looking for a quick profit.
Now the Fannie Mae stock surges upward, propelled by a bunch of motivated buyers who have targeted it as undervalued.
Think of it like a rubber band. The more it stretches, the more stored energy is building up. And this stored energy eventually has to release. This is the foundation for the Wall Street “quantitative” hedge funds that throw around billions of dollars every day.
And if you think professional traders are too savvy to join the herd, think again. About 81% of professional traders get caught in “market drift.” Richard Wiseman of the University of Hertfordshire in England proved this point in a recent experiment. He gave a $10,000 stake to a professional stock analyst and a five year old girl. After a year, the professional analyst's picks were down 46.2%. The five-year-old girl – who picked stocks with pretty names – had a portfolio growth of 5.8%.
More often than not, the professional traders’ portfolios simply move up and down in tandem with the Dow. What does this teach us? That herd behavior is so destructive you have a better chance of surviving in the markets by just picking stocks randomly.
The trick is to lead the herd, and not get stuck in the middle where it feels safe but you’ve missed the big profits.
As you see in the chart, it is more than twice as likely that a stock will go up than down following a big decline.
When you consider that casinos run profitably on a “house advantage” of 2%, you can see that these odds are very good.
You’re probably wondering, “How does the 2/1 ratio convert to a 90% win rate?” That’s where the rubber band comes in.
The stocks that went up did so much more dramatically than the stocks that went down. After a big drop, 29% of stocks stayed flat and 22% of them fell. But the 49% that go up, go way up. One day rebounds of 11%, 26% and 41% are quite normal. Whereas the majority of the stocks that went down on the day following the initial drop usually fell between 0.8 and 2.5%.
Market Mood Swings: Playing the Odds
Trading is all about odds. In this case, when stocks are making big one-day downward moves, the odds are definitely in our favor. And that’s a must for being a successful trader.
Trading on market mood swings requires no software, no delving into annual reports, and little trading experience. It works in bear markets and bull markets. Best of all, high volatility usually amplifies the upside. All the data you need is available for free on the web site of every major stock exchange.
To get started and watch market overreactions, just hop on your computer any time after the market closes and follow these five simple steps.
Step 1. Go to the home page of the New York Stock Exchange (NYSE) and CLICK on “For Individual Investors”.
Step 2: CLICK on the “NYSE” tab.
Step 3. CLICK on the GREEN drop down menu. SELECT “NYSE DECLINES” and then further down on the screen CLICK on “View Top 30 Declines.
Now you will see a LIST of the 30 STOCKS on the NYSE that have been hammered on this particular day. You may wish to PRINT this list.
On the far right under “% Change” – you can see the size of the decline. If it says, “- 20%” – and the company was worth $10 billion at 5 a.m., then it is now worth $8 billion. The stock at the top of this list – has suffered the biggest percentage loss of any stock on the NYSE on this particular day.
Step 4. Now we are going to ELIMINATE (cross out) some of the stocks on this “Top 30 Decliners” list.
Look at the middle column which says, “VOLUME”. This tells you the number of shares of the stock that traded that day. If that number is LESS than 500,000 then CROSS THE STOCK OUT. We are not interested in it.
The column that says, “LAST TRADE” – gives you the PRICE of the last trade. If this number is LESS than $5.00 then CROSS IT OUT. The stock price of small companies, and companies that don’t trade much, often have high bid/ask spreads that make them difficult to trade efficiently.
Step 5. Pat yourself on the back for successfully completing this exercise. You have about 20 stocks (out of the original 30) left. About 70% of them will go up the next day. Nine times out of ten, the 20 stocks you have left will REBOUND as a group. But don’t take my word for it. Pick your own stocks and watch them move.
If you follow these simple steps for a few days, you’ll quickly see investor sentiment is the single biggest driver of stock price. Key indicators to this sentiment are available free on the web site of every stock exchange.
Market Mood Swings: Psychology of Success
The stocks that have been shouted at angrily one day will usually be spoken to encouragingly the next day.
Understanding this and acting on it, is a great way to grow your wealth. But it takes a bit of courage. It’s not easy to break from the herd and reverse direction. Or to leap ahead of the herd into the unknown and trust that others will follow you.
Trading in this fashion takes more time than most of us have. But this exercise proves you don’t have to be a genius to make money in the stock market. The key is to learn to trust your own instincts. That’s where a lot of smart people stumble and make bad investing decisions.
Warren Buffet always trusts his own instincts and refused to follow the herd. In the late 1990s was ridiculed for refusing to join the “dot.com” euphoria. He explained calmly that he didn’t invest in businesses he couldn’t understand. What he meant was that he didn’t understand how they would make money.
After the 2001 tech melt down that destroyed the portfolios of so many investors, he was hailed as a genius once again. His company Berkshire Hathaway (NYSE: BRK-A) is now worth a healthy $182 billion. But Buffet’s “aw shucks” routine isn’t faked. He’s a successful investor because he sticks to what he knows and doesn’t get emotional.
Identifying opportunities like this where beaten down stocks are poised to rebound, and the odds are in your favor, is what my free e-letter, the Prosperity Dispatch is all about.
Understanding the psychology of the market mood swings will go a long way to making you a more successful investor.
Chief Investment Strategist, Q1 Publishing