The trend is your friend

In the early days of my investment career, a senior trader told me something I never forgot. “How we think impacts our investment returns.” Some investors are rather surprised by this. They believe profits result from buying low and selling high. But it’s actually their thinking that determines whether prices are low or high. As the old trader told me: “Prices are numbers on a screen. They aren’t high or low. We trade trends, not price.”

After 46 years in the investment business, I learned this is a simple market truth. But many of us fight it. We want to believe we know when prices are high or low. That’s due to our biases about market action.

A few years ago, I wrote about “anchoring.” This psychological bias influences buy decisions. You may see a stock trading at a new 52-week low and think it’s cheap. Your impression of value is anchored at the 52-week high. Convinced that the price is low, you buy. The stock keeps falling. So you hold your shares. Now you are trying to avoid the pain of a losing trade, which I have written about many times over the years.

These interesting ideas may appear impractical at first. But when we look more carefully, we see they really do have practical applications to the market. How investors feel is the most important factor defining stock prices. And there’s even a formula that explains exactly how this works.

In the formula, price is equal to the intrinsic value of a stock multiplied by the square of bullishness or bearishness of the average investor. Squaring the opinions makes that the most important factor in the equation. Got that? Me neither. Or maybe you’re better at math than I am. I’ll just take their word for it and spare you from having to look at it.

Either way, this formula makes sense. If sentiment is extremely bullish, we may be in a bubble with prices completely disconnected from fundamentals. In environments where sentiment is extremely bearish, everything might look like a bargain, although it seems like no one is buying.

Let’s look at a specific example. Say a stock has an intrinsic value of $42.08. You know that because you completed a discounted cash flow analysis of the company. You estimated sales, operating costs, the cost of capital, interest rates, and many other variables. Your work looks sound.

But the stock’s not trading at $42.08. It might be trading at $29.04. That’s a 31 percent discount on the intrinsic value. This means the stock is undervalued to you, so you buy. Notice the phrase “to you” in the previous sentence. The intrinsic value is your opinion. Other investors seem to have a different opinion. It’s safe to say the majority believe the value is lower than $42.08. Otherwise, the stock would be priced higher.

Before buying, you should ask a very important question: Why is the stock undervalued? Some investors never ask this. They buy undervalued stocks and watch the stock get more undervalued. They think of this as a buying opportunity. But if the stock keeps falling, it’s not worth buying.

Or the stock just doesn’t move much at all. That’s also bad. A stock that doesn’t move is “dead money.” It’s money that’s not earning money. Since most of us have limited capital, we can’t afford dead money. We need to own stocks that are going up rather than stocks that “should” go up. Simply thinking about why the stock is undervalued could help avoid some losses or dead money.

The formula I described above helps us understand the reason why stocks are undervalued. A large number of investors have a bearish opinion of the stock. They aren’t buying that stock, so that makes it impossible for the price to go up. Remember, in that formula, opinions are squared. This makes feelings about the stock the dominant factor determining a stock’s price. Until opinions change, an undervalued stock can’t go up.

On the other hand, if opinions are bullish, the stock could be overvalued. You may look at a stock’s price and know it’s not worth that much. Yet it keeps going up. In these cases, you’re right — the stock is overvalued. But you aren’t making money in that stock because you allowed your opinion to overrule the market action. With these simple examples, you see that opinions really are the most important factor in pricing. That’s a crucial investment lesson.

So what do you do if you’re the average investor who has no clue how to determine the trend versus intrinsic value? Subscribe to some research that gives you technical information that you can use alongside fundamental analysis. There are many good ones out there.

In July 2007, Charles Prince III (then CEO of Citigroup) explained how his bank was handling the obvious bubble in subprime mortgages. He said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

In stocks, market sentiment is the music. Whether it’s bullish or bearish, you should listen to the market’s music and dance like no one’s watching. Thanks for reading.