IN THE STOCK MARKET,
everybody's got a system. Some people use the charts, others follow the fundamentals. Others invest based on the seasons orstars
. Over time, someapproaches
work more than others, but of course, nothing works all the time.
There is no sure thing. But after trading everything from stocks on the screen to futures on the floor, I've come to believe that the most simple and effective way to put the odds on your side when allocating assets is to follow what I believe is the golden rule: Don't fight the tape.
Deciding whether a stock is "overvalued" or "undervalued" is totally subjective. Price, on the other hand, never lies. The tape is the tape and determining weather a security is strong or weak is easily visible to even the uneducated naked eye. When a market is strong, you might not want to invest in it, but I think you're a major fool to stand in its path.
If you're interested in fighting the market friend, you're going to lose. The market has an unlimited supply of capital and patience. We don't. We harbor these fantasies that, now that we've bought our 500 shares, XYZ is likely to bottom out and rebound to all-time highs. Certainly my few thousand shares aren't going to affect the price of IHOP Corporation, and even big players like Kirk Kerkorian who lost a quick $300 million on a position in super-weak General Motors can't influence a market before it reverts to the laws of supply and demand. Unless you're prepared to take a company private and have unlimited resources, the market can outbox you with one hand tied behind its back.
Of course, "the tape" refers to price action, which should be of dear concern even to those who evaluate a company's fundamentals. While you can follow a company's earnings or underlying economics, at the end of the day, it's the stock we actually trade. And, yes, satellite radio has potential and I love Howard Stern, but that hasn't stopped Sirius Satellite Radio and XM Satellite Radio from dropping up to 20% over the last six months. And, while the sector could easily stage a formidable rebound, for my money, I'd wait to see some sign of strength before fighting a persistent trend toward lower prices. If XM is worth $37, why not at least wait until it can trade at $22.50 first? Why do people insist on betting on the old, sickly horse instead of the young, strong stallion?
And that's where my money goes. Opinions are unlimited but trading capital isn't. The disciplined player only puts money into those few high-probability trades in which the odds are on his side. Fighting the tape is always an inherently low-probability trade.
Take, for example, the Dow Jones Transportation Average, which we profiled back in 2003. In recent months, the Transports have become major market leaders, driven by massive gains in stocks such as FedEx, Norfolk Southern and even airlines like AMR.
Maybe you own the sector and maybe you don't. You might think the gains will continue or that the real money has already been made. Regardless of your outlook for future prices, any rational person has to respect the fact that for now the Transports are strong. So don't fight the tape. As long as the price action climbs higher, shorting them, which one could easily do with a security such as iShares Dow Jones Transportation Average, is lunacy. It's a perfect example of a low-probability trade.
And perhaps this is the high for Transports. But if you're bearish on them, I'd say wait until at least you see some signs of weakness before putting dollars on the line by shorting the stocks. For example, as we pointed out recently, you didn't need to short Nasdaq at 5000 in order to make money on its decline. You could have easily waited until the first big break before initiating short positions and still come out with a grand profit in due course.
Bizarrely, it's human nature to fight the tape even on a much shorter time horizon. Armed with a freshly funded E*Trade account, we naturally become hell-bent on standing in front of a moving freight train just to see if it bothers to stop. (Hint: It doesn't.)
So with XYZ down four points within the first 10 minutes of trading, why am I instinctively drawn into the fantasy of buying a few hundred shares at the market and hoping to sell a point or two higher by the time "Morning Call" turns into "Power Lunch"? My experience is that, if you want to make trades, that's by far your best approach. If you want to make money, that eagerness to stand in the market's path is downright insane.
For one thing, as we always point out, playing for the short-term swings a point here, a quarter point there is by definition a loser's game. What inevitably happens is that, because you've clipped your winning trades at such insignificant amounts, even a few big losers wipe out all the wins. The only winner in these "scalper" type of accounts is the broker, who, of course, earns his commission on every trade.
Moreover, what's inherently problematic about this approach is that, by stepping into a stock that's suffered a recent and large decline, you're fighting the tape, trying to catch a falling knife that literally hasn't stopped. And when you look at the sustained fall taken recently by stocks such as Mills and PXRE Group, one is reminded of the danger of the "it'll-bounce-back" mentality. Those who bought the weakness hoping for a quick two-point pop were likely stuck with losers that dropped 50% or more in a matter of weeks. Again, no strategy is perfect, but on average, you generally have less of them when you focus on following the tape, not fighting it.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held no positions in any securities mentioned.>