You can download this podcast in audio format at the iTunes Music Store by clicking here.

DONATE

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world.  My name is Patrick and I’m your host.  You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location.  Today, we’ll be looking at some basic truths about the stock market – unavoidable realities – so let’s get started.

Most people agree that the stock market is only “trending” about 1/3 of the time and it’s basically going sideways the remaining 2/3 of the time.  Now, this is important for a number of reasons.  In particular, the trading strategies for a trending market are quite different than the strategies for a sideways market.  For example, moving averages will give a lot of false signals when the market’s going sideways and identifying trend lines going either up or down is difficult.

The stock may indeed trend upwards from the bottom of its current trading range towards to top but that process doesn’t usually take that long and remember that trend lines gain significance with time.  A perceived trend line that’s only a week old isn’t being watched by very many people and it’s precisely the number of people watching it and placing their buy and sell orders on the line that makes it more reliable.  With only a few eyes watching the line, it would take only a small hick-up for the price to break away in an unpredictable direction.

In a sideways market, the lines everyone’s following are the support and resistance lines so all the buy and sell orders are located on those outer boarders.  So within the trading range, the price can fluctuate up or down pretty freely but an advance towards the top is met with stiff resistance and a drop to the bottom is met with firm support.  The only remaining option is to try and follow the overall market sentiment from the bottom of the trading range to the top of the trading range, and that type of trading activity is best quantified by oscillators.

As we discussed, oscillators follow the natural shifts in market sentiment and provide buy and sell signals based on over-bought of over-sold market conditions.  Although there may be a lot of false signals, a nicely optimized oscillator providing sharp signals can still facilitate a profitable trading strategy.

A trending market is better followed using trend lines and moving averages.  The problem is that you never know when the market’s going to switch from a sideways market pattern to a trending market pattern.  If trend lines and moving averages are ignored entirely as the market goes sideways, it will eventually move back into a trending phase and you may miss the early gains as a result.  In a sense, the false signals during the sideways market are the price you pay to catch the big trends when they finally materialize.

Using the same example we used in earlier chapters, assume you placed a buy order at $26 for the stock, knowing it’s been trading between $20 and $25 for a while.  That’s a good strategy but you may end up waiting for weeks or months before the price finally breaks through the upper resistance.  The stock might incur weakness and eventually break through the $20 support, leaving your $26 buy order unfilled.  Finally, assuming the upside break-out DOES take place, you’d own a newly moving stock at $26 but if you had been using an oscillator to trade the channel, you might have picked it up at $21 and already enjoyed a 23% gain by the time your buy order would otherwise have been executed.  There’s always a balance between indicators and we’ll consider some specific strategies in later chapters.

Now, a lot of this discussion depends on your definition of trending versus sideways.  For example, if your time horizon is shorter and you’re looking at a 50-HOUR moving average as opposed to a 50-day moving average, the channel that a regular investor might be watching could easily be considered a series of up trends and down trends to a day trader.  In other words, the shorter your time horizon, the more a stock could be considered to be trending.  To a day trader, a stock is almost always moving up or down, even though a regular investor might consider it “sideways” movement.

If you look at an hour-by-hour chart, where the standard 50-day moving average is automatically changed to a 50-HOUR moving average and the 13-day moving average is changed to a 13-HOUR moving average, the stock price doesn’t appear to stay in a trading range nearly as often.  Even the moves within a trading range on the day-chart would appear as trending behavior on an hour-chart.  Now, of course, the number of buy and sell signals will go up dramatically and the possible gain on each will be much smaller but it’s always worth considering a shorter time horizon to minimize the challenges of traditional channel trading.

Here’s another reality to get comfortable with.  In the stock market, things can ALWAYS get worse.  Don’t ever THINK the stock can’t possibly go any lower.  Yes, it can.  Believe me; it can.  And if it’s been trending downward already, it probably will.  The trend is your friend.  If a stock is trending lower, assume it will continue doing so until proven otherwise.  Many new traders make the mistake of bottom guessing; trying to identify the bottom and buying the stock at that point.  I’ve done this myself and it’s a losing game so please take my word for it and abandon the effort going forward.

Here’s the problem.  When a stock is trading in a range and there’s resistance above you and support below you, you can usually guess the point where the price will change direction – sometimes down to the penny.  But when a stock is trending into unknown territory – either climbing to new heights or dropping to new lows – there’s no support or resistance to rely on.  You have absolutely no idea how far the momentum will carry the stock.  It’s all emotional at that point.  It’s a crap shoot and nothing more.  That’s why the trend line of a dropping stock connects the high points of the stock’s descent and the trend line of a climbing stock connects the lows of the stock’s rise.  You really can’t draw a line on the other side because there’s no support or resistance to keep the price within a certain range.

The point is; finding bottoms or tops in price movements should only be done when you have support, resistance, a trend line or a moving average to point to.  If that doesn’t exist, wait for confirmation of a trend reversal before pulling the trigger, even if it means missing the early action.

And by the way, these trends apply to the entire market.  Like I said in the last chapter, if the market is trending downward, it will affect every single stock, even the ones that are doing really well.  If the market sentiment is dropping, everyone will be affected.  All boats fall in a falling tide.  And the opposite is also true.  All boats rise in a rising tide.  Assume a stock has some good news that would NORMALLY drive the price higher by 5%.  And then assume that on that particular day, the greater market drops by 2%.  Well, based on those two assumptions, I would guess the stocks price probably only went up by 3%.

The pull on the market – either up OR down – affects every single stock.  So if the market is going down, I would be very cautious about going long on ANY stock.  Again, the trend is your friend.  I don’t mean to repeat myself but I swear this is one of the most important rules in stock market investing.  Invest WITH the trend, not against it.  If the market is trending down, invest short.  If the market is trending higher, invest long.

Now, is it true that some stocks have huge rallies while the rest of the market is going down?  Sure.  Absolutely.  It can definitely happen.  But why try to find that one needle in the haystack when you could pick a stock from the majority and have the prevailing tide push prices in your direction.  The trend is your friend.  ALWAYS invest WITH the trend.

Here’s another one.  And this one’s important.  Every investor needs to understand that at least 70% of the volume on the stock market is institutional.  So we’re talking about professional money managers who are investing billions of dollars.  Those folks have a very different set of challenges than you and I.  They’re trying to move money into and out of particular stocks and that’s not easy to do when you’re working with billions of dollars.  When you’ve got that much money involved, your buy or sell orders could influence the market directly.  As a result, these money managers CYCLE money in and CYCLE money out of particular stocks.

There are a number of implications of all this.  For starters, rest assured, your trading activity on the stock market will NOT influence the price one bit.  Unless you’ve got millions and millions of dollars, the liquidity of a particular stock is all but certain.  If you want to get into a stock, you can do so immediately.  And if you want to get out, the same holds true.  Secondly, mutual funds strengthen the connection between fundamental analysis and technical analysis because it’s the professional money managers that do all the research.  Their detailed analysis is reflected in their buy and sell orders and the massive volume they control ensures all available information is reflected in the daily price-volume action.

Third, the process of cycling money into or out of a particular stock fuels the trending nature of stocks in general.  If an institutional investor believes a particular stock is a good long-term investment, he or she will cycle money into the stock over a period of time.  Presumably, that buying volume will drive up the price, attracting other buyers – perhaps other institutions as well.  The growing buy pressure keeps the trend moving forward.  The same is true when an institutional investor believes a stocks day in the sun are over, and starts cycling money OUT of the stock.  They can’t do it overnight so they cycle the money out over a period of time.  All that contributes to the reliability of the trend, making it easier to watch and react to.

It’s also worth noting many of these money managers have limits to what they can do.  For example, the manager of a technology mutual fund is bound by the fund’s constitution to keep all the fund’s money invested in technology stocks.  Think about this from the investor’s perspective.  If someone decides to invest in a technology fund, that’s exactly what they want.  They want a fund that focuses on technology stocks and that’s the market need these mutual funds try to fill.  Each fund has a constitution that dictates what the fund can and CANNOT invest in.

This was interesting during the dot-com bust in 2000 and 2001.  Most of these money managers knew full well these technology stocks were going down but they had no choice.  They were forced to invest the money into technology stocks because that’s what the fund is based on.  So the trick was to find the technology stocks that would go down the LEAST.  This must have been incredibly frustrating for the money managers.  I mean; these guys aren’t stupid.  They saw what was happening.  But they were forced to buy into the bloodshed anyway.

Anyway, this reality actually moderates the markets somewhat.  It essentially provides a floor for different market sectors, ensuring some money remains invested in those stocks even if the rest of the market is completely disgusted with the sector.  This was obviously happening during the dot.com technology bust.  The interesting thing is that the money ends up clustered onto a few leading companies, moderating their declines while the rest of the sector gets completely trashed.  Ebay was a good example of this back in the day.  They had a business model that was actually WORKING and generating revenue so everyone jumped onto their stock while the rest of the technology sector was being flushed down the toilet.

Incidentally, this same type of thing happens with the increasingly popular “exchange traded funds” or ETFs.  They’re bound by the index they follow so no matter how bad that index is doing, the money invested in those ETFs stays put on those stocks.  We’ll be discussing this in detail in a later chapter but I’ll simply tell you today that these ETFs function much like mutual funds.  They invest money into a predetermined market segment, even if that segment is performing poorly.  And with their increasing popularity, the actual dollar volume is substantial.

If you’d like to see what I’M doing in the market, just create a FREE account and login at FinancialAudio.com and then click on Market Position.  Now, it’s important I tell you that I’m NOT a licensed Financial Advisor.  This is FREE information and I do NOT accept money to give investment advice.  I’m just giving you a little glimpse into my own trading activity, that’s all.

You can also read market commentary on the blog page.  If you’d like to see a list of upcoming topics, just click Podcasts on the homepage.  If you have a suggestion for a future topic, please use the Contact form to let us know.  And finally, all the websites referenced on this podcast have been included on the Links page.

Okay, thank you very much for listening.  If you like what you hear on these podcasts, please tell a friend about them.  Modern technology like podcasting can help elevate new and innovative thinkers but we all have to play our part to help spread the word for those who deserve our endorsements.  If I am deserving of yours, my thanks.

Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick [at] FinancialAudio.com for more information.  I’m also doing a series on innovative marketing and strategic business positioning.  That series is called Tactical Execution and you can find it on iTunes.

Stay tuned.  There’s a lot more to come.  In the meantime, think big, take action and invest strategically.  Bye for now.