If you are like me, you are nervous about the future of our economy. What happens to the stock market after QE2 ends and we are left with a cheap U.S. dollar, low home prices, and high food and energy costs? Not to mention high unemployment and spotty top-line growth for many American companies?
Some are even calling for a repeat of 2008… scary!
We will come out of this. But the question is not only when, but how volatile will the exit be? How do you trade and invest in such a confusing landscape?
To compound the problem, we live in an age of information overload. All that chatter creates noise and hides the truth behind the action.
How Do You Trade With So Much Uncertainty in the Financial Markets?
In Burton G. Malkiel’s book A Random Walk Down Wall Street, he pointed out three potential flaws in fundamental analysis:
- Information and analysis may be incorrect.
In gathering objective data, we may rely on many different sources to aggregate, sort or help us interpret data. During this process, data points may be bad, misinterpreted or miscategorized. - Analysts’ forward estimates of value may be incorrect.
Analysts must make certain assumptions. Even with quality, organized, objective data, the analyst must make a subjective forecast that is dependent on a multitude of factors, none of which have to come to fruition and even if they do, the market may have already priced in that data. - The financial market doesn’t have to “find” estimated value.
So let’s assume that your thesis and the analyst’s thesis is correct and that all of your assumptions become reality — your stock of choice may still decline in value. Perhaps because the “market” wants more from the company, maybe where value today is a P/E of 15, six months from now, the market thinks 10 is the right number (that might equal a drop in the stock’s price).
This is not to discourage you or make you think that all fundamental analysis is bunk; you must have a strong fundamental foundation. More importantly, these flaws are the precise reason I became an options trader.
We don’t have to be “exactly” right to profit.
You do not have to be a visionary or have an immense wealth of knowledge to trade the financial markets. In fact, overthinking can prevent you from not only making a trade, but also exiting a winning or losing trade. Either way the consequences are catastrophic.
If you have a strong conviction about a stock, don’t be afraid to act — remember, professionals and the media can be wrong.
Invest in What You Know
This is key if you are a newbie or unfamiliar with certain concepts or economic data.
Investing in companies that you have faith in or know really well and believe will thrive is certainly a method that has been proven to be somewhat successful over the longer term (10 or more years). Although his market-timing skills come up short, this is one of Warren Buffett’s mantras and has made him one of the most successful investors in history.
Simplify the Headlines and Look Around You
When it comes to my own investing, I look out of my proverbial window to make predictions in my little world. I look for trends and concepts I can comprehend. If I don’t fully understand something, I learn everything I can about it or stay away from it.
Because the stock market generally leads the way in and out of economic cycles, you need to put its movements into context. The movements, whether up or down, need to be supported by facts.
Think of economic data, consumer sentiment and corporate earnings strength as the “legs” of a table, which represents the stock market. The less support you have from your indicators, the less sturdy the table. As stocks move higher and higher the table becomes heavier and heavier, requiring more and more support.
If the market has been rallying and seems overbought, the failure of one or more of these legs can be catastrophic.
(Sign up for Smart Investing Daily and let me and fellow editor Sara Nunnally simplify the market for you with our easy-to-understand articles.)
Don’t Believe the Hype — Well, Not All of the Time
I am intrigued and amused at the same time when I hear analysts make extremely specific predictions about a stock’s price. How can a single individual accurately predict the emotions and actions of millions of people? What is more feasible is making an estimation and taking or giving odds where appropriate.
To an extent, I am guilty of this as well. In many of my appearances on CNBC for example, I speak with such conviction, not because I am trying to mislead anyone, but rather because I want to offer a firm, believable rationale that is the basis for my method of investing and risk management. Without it, I would never make the trade myself.
You see, no rationale, theory or method is flawless or without error. In playing the market game, the key is having a method that you can follow and rules that you can adhere to and that make sense to you. The rules can be bent, but your method and plan should tell you precisely how much they will bend.
The difficulty is finding the perfect balance between understanding the beliefs and behavior of market participants and combining that with the fundamental story of the individual stock. In other words, does the fundamental story and predictions coincide with the value the market has given to the company (price/earnings)?
Have a Plan!
Before entering a trade, you must decide how long you will maintain that opinion and what will cause it to change. Then once you are in the trade, you should be able, at any given moment, to act on a signal (in profit or loss) to exit that trade.
The most common issue with retail investors is that they are often either too late to finally make their trades or they lack conviction in that trade to maintain their position and stick to their plans (if they even have one at all).
I am a believer in investing and I believe in investing in quality companies that have demonstrated not only growth, but adaptability and viability over the long term with good future prospects. Companies that possess these qualities (think Apple, Google) can be strong candidates for longer-term investments when markets are volatile.
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