Wednesday, May 31, 2006

Psychology Moves the Market

After watching Mark Leibovit on Nightly business report, I looked up his website, vrtrader.com

His commentary was interesting to me because what he said made sense to me. He was bearish, suggesting being long on gold and short on the dow. When I read the transcript of his appearance on the show 6 months prior, it was interesting that he was one of the few bullish-on-equities commentators at the time. Given that his forcasts are short-medium term, he appears to have called it very well. (the dow to above 11, 400 from the then 10,766 at least). I also hunted around his site and found this frigteningly accurate description of investor psycology!

"Life is 90% mental and 10% physical. The nine-hole round of golf I just completed was a great reminder. Financial markets are the same, driven totally by human emotion. Let's track the rise & fall of a fictitious stock to examine this natural law in action."

"ABCD company is a tech-widget manufacturer modestly received at IPO. A number of funds buy the early blocks and insiders hold the rest. ABCD rolls within a trading range between $20 and $30 shortly after that."

"Well, tech-widget business is good and initial first-quarter earnings beat the street by several cents. This stock had been mostly ignored but all of a sudden it's now a media hit. Would you believe there are investors out there who blindly buy anything they read or hear about? It's true."

"Most of the current shareholders got in between $20 and $30. After favorable news ABCD shoots up to $40 per share. Some investors who bought early are now sitting on 50 - 100% gains and get itchy. Fear compels them to take profits while greed tugs at them to stay in. Stop orders are placed at $38 just in case there's further downside."

"A few sellers decide it's time to exit and wait for pullback before buying again. This drops the price to $38 and all those resting stop orders are triggered. They become market orders for sale and prices fall to $35."

"Of course most of the recent volume bought in near the high end at $40. These traders aren't happy to be down $5 in a matter of days. Some "weak hands" want out no matter what and sell the stock down to $30. Call it a loss and wait for the next hot play to come along."

"Early buyers sold near $40 and prices now at $30 seem a bargain to them. They buy it back and create "support" at the $30 level. Price action has proven this area will be bought by the dip crowd as prices retest here in the future."

"New buying drives prices up to $40 where all that volume bought in on the first rally. A number of these impatient types are planning to exit close to breakeven at first opportunity. They sell into the rally as prices hit $40 and stall out there. We've just witnessed resistance created. Prices bounce off $40 and fall back to the mid-$30s."

"Our buy-the-dip crowd waits for prices to drift down near $30 while those holding buys at $40 are chagrined to have missed their first shot at exiting without loss and vow not to pass again. A number of other traders bought near $40 last time, jumping the gun in anticipation of a breakout before it fully developed and confirmed with volume. Some of them want out at par the next trip around as well. We could say that overhead resistance has built."

"ABCD price action bounces between support at $30 and resistance near $40 for quite some time. Neither buyers nor sellers are able to push the market outside this range. Those content to trade within this channel glean several points profit each time it cycles."

"One day, an announcement is made by XYZ, the biggest tech-widget Producer. T-widgets are in hot demand and they cannot make enough to supply the burgeoning market. Hot dog, that index is off to the races! Every company involved with t-widget production is bid through the roof, including ABCD. Prices sail above resistance at $40 and climb to $50 in a single session."

"Everyone who owns this stock is extremely bullish; who wants to sell when it's headed to the moon? Individual investors and fund managers will pay any amount to own this company, P/E ratio be darned."

"Prices break out and run straight up to $95 in just a few days time. ABCD is featured in every financial newspaper and TV show. The company's C.E.O. does his first round of interviews. There's our boy - right on the tube being congratulated in front of millions. Who'd want to sell?
ABCD doesn't pause until it reaches the magical $100 mark, a mental barrier invented by traders. The company doesn't construct better t-widgets with the stock at $98 than above $100 but you wouldn't know that by investor behavior. New buyers resist entering the market until it punches through that $100 ceiling on strong volume. ABCD stutters and stalls near this psychological benchmark to form the next level of support."

"Some buyers enjoying this wild ride decide to sell and lock in massive gains as new buyers dry up near $100. This puts added pressure on the stock, driving prices back down to $90. A new trading range develops between $90 and $100 with the same dynamics that held it between $30 and $40 not long ago."

"Most traders value ABCD as a $100 stock because more buyers entered near this point than at anytime during its existence. Is it a great buy at $90 or 300% over-priced from the last dip at $30? Depends on emotional perspective. Those actual t-widgets keep rolling off the assembly line just the same."

"Out of the blue, t-widget giant XYZ is rumored to be in takeover discussions with an unnamed company. All widget companies including ABCD surge on the rumor. Prices pop through $100 and rise to $110. Momentum traders confirm the breakout above $100 on volume and bid shares up past $120 in after-hours trading. ABCD's C.E.O. endures countless interviews as he declines merger specifics but adds that the company would be open to any proposals. Prices now surge to $150."

"Everyone owns the hottest stock in the market and sellers are few & far between. Financial magazine covers are adorned with ABCD in some form or fashion. Just like Ty Beanies, there seems no end in sight."

"However, a few astute technicians note how overbought this stock price is and see the 50 and 200 day moving averages begin to flatten out and curl as current prices stall near $150. A few of them quietly sell at this level and bank substantial gains."

"Meanwhile, the FOMC decides to raise interest rates for the first time in awhile by .50 basis points. The markets are stunned! Everyone expected .25 points at most and a sell off begins. First to go are high flyers where all the gains have compiled and guess who tops the list? ABCD prices dive 40 points to $110 in a single session as traders storm the exits."

"Plunging prices spread panic through holders of ABCD as the weak hands in for quick profits fall like dominoes. No buyers are present for the sellers and market-makers skew the bid/ask accordingly."

"This wild sell off dwindles as ABCD settles near the $50 range. Most buyers who owned the stock bought in well above this price and are actually miffed at ABCD for causing their losses. Meanwhile, t-widgets are methodically produced much like they always were."

"XYZ announces that, due to recent market developments they have backed off possible acquisitions in the foreseeable future. All would-be candidates get pummeled, including ABCD. The stock returns to it's original $30 price range where buyers who made a killing not so long ago eagerly await to buy once again. Plenty of buyers at the high end of that rally still hold shares and wait for prices to rise in order to sell the rally."

"So the cycle continues."

"All along, tech-widgets are produced just like they were from the beginning. Can you see the logic behind this volatile price behavior? I thought so."

Monday, May 08, 2006

Buy vs wait, a rough analysis

Over the weekend someone (very close to me ;- ) said something like -

"When you buy a house, you always have a period at the start where you pay mostly interest and not much principle. So you should buy now and get past that point, otherwise you are putting of the 'painful' period of years of 'mostly interest' payments. "

I couldn't think of a good counter argument to this at the time, but thought about it, and came up with the following graphs to explain why I disagree.

This analysis has lots of assumptions, and is meant to illustrate the point, rather than be 100% accurate.

Let's assume someone wants to buy a house. The can afford about $4100 a month mortgage payment. As the graph below shows, if prices are likely to fall, then it is better to wait, then take out a shorter term mortgage, than buying now at bubble prices.


And of course this doesn't take into consideration higher tax, negative equity etc etc.

So let's look at the median prices for an area of San Jose, ca. (just because I have the numbers!) Also this is full of assumptions and guess work, but should highlight the basic point.

If you believe (like I do) that we are in for a correction of about 20% (in real terms) of prices over the next 5 years (equivalent to much more in inflation adjusted terms) that would equate to a picture something like the one below-

While this is a rough estimate, it highlights the point that waiting for prices to fall does not mean you will be paying the mortgage for longer (for the same monthly payment).