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How the market is priced pt 2 - the law of momentum in the human mind and the possibility of a "supreme valuation"

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January 11, 2011 – Comments (22)

Years ago when my biz partner andI were saving up cash to start a biz waiting tables we had such jobs at many different restaurants and bars (as we basically always had 2 jobs, we kept looking for the best 2nd job and bouncing around a fair bit as a result).  In joining many service staffs, we noticed a certain pattern that repeated itself fairly consistently.  It was this:

1.  you join the new job and generally everybody is fairly chilly towards you.  guys are territorial, girls are distant

2.  after a while, hours, days, weeks, you somehow strike someone as being a fairly cool chap

3.  they tell someone, you make another friend or 3, eventually you get invited to some kind of get together for a beer or whatever

4.  then you're invited to all the get togethers, the staff starts coming to your house for parties and

5.  everybody loves you.  

Its like once you get the ball rolling it takes on a life of its own and just goes, after a while of just going, you can't even stop it if you wanted to, at least unless something really dumb happened.  Remind anybody of the stock market and the way it and individual securities behave?

Having this experience and talking about it alot led me to coin the "law of momentum in the human mind".  Thats what we've called it, it may well have a real name, but I staunchly refuse to read any type of psych text until psych as a "science" makes an effort to make sense, but I digress.  Here is how I would explain it if somebody asked me what I was talking about:

"ok, imagien that you judge someone or something on a bachelors scale, 1-10, with 1 being the worst and 10 being the best.  Now imagine that you meet a guy named Tom, and he is the bees knees, the coolest guy you've ever met, so your first impression is a 10.  Now imagine that you meet a guy named Joe and your first impression is "meh", whatever, just an average nothing 5. 

Now imagine that a couple months later you realize that while Tom is a cool dude, he's not THAT cool, so he's an 8 now in your head.  And then imagine that you got to know Joe a little bit and realized that he's not so boring, he's actually pretty cool, so he's a 7 in your head.  

Well guess what?  You like Joe better than Tom, because the human mind heavily rewards things that are improving and heavily penalizes things that are declining.  Think of it as you add the momentum score to the real score, so Tom is a 6, because he's an 8 but he dropped 2 so you subtract 2 more.  Now Joe is a 9, because he's a 7 but he's improving so you add 2 more"

And I do strongly believe that is true.  The human mind hugely reacts to the momentum of their opinion of others in relationships of any kind, from short ones like talking to a salesperson while shopping to long ones like siblings.  Momentum is a huge, huge factor in our subconscious's process of forming opinions of others.  

We observed the same thing repeatedly in business.  Repeatedly.  You meet someone and they are pumped and psyched about your products and you and so frequently the relationship falters sometime later.  You start a 10 and wind up an 8, now you're just a 6.  The relationships that go the best start level, neutral, and grow from there - putting the law of momentum on your side.  You know the old saying "under promise and over deliver"?  Of course you do.  All that is describing is the law of momentum in the human mind.  

I would humbly offer that this plays a monstrous role in the stock market as well, and this basic reality of how humans view and rate things perhaps plays a huge role in how stocks get momentum and trend in one direction for sooooooo long, sometimes to wild extremely of valuation.  Like ASH at 6, dozens of financials with price/books of 0.1 and no real chance of failure in march 09.  Like the tech bubble and like precious metals at the end of this run and like CRM, or NFLX or AMZN today.  

And, anyway, yesterday I offerd that it had recently occured to me that some people really don't focus on valuation but rather focus on fundamentals (of the biz, the industry, the economy, etc.), while still others primarily focus on momentum or "technicals" and so forth.  

And it occured to me that I may very well be limiting myself by sitting here focusing only on value, owning low p/b and low p/e stocks and that a broader consideration that took into account all three categories:

1.  valuation (pe, pb, p/s, peg, etc etc etc)

2.  fundamentals (of the business, the industry, etc. etc.)

3.  momentum (technicals and so forth)

If one could somehow compile a set of data that somehow related all of this:

A)  for valuation maybe price to normalized earnings, price/sales, price/book, whatever, weight each different component appropriately according to the findings of the research

B)  for fundamentas growth rate of the company, of the industry, market share moves, leadership position or not, etc. 

C)  for momentum some technical indicators or calculatable figures reflecting short term trend, intermediate, and long term trends (gold, for example, is in a huge long term trend, having been more or less straight up for almost ten years, but was recently in a short term downtrend, having fallen af ew percent).  

...  it would be a massive amount of work, weighting and calculating and moving and number crunching until the data fit, but I humbly submit to the group that if you did it, with a clear head...

...  I honestly think that you would come up with a number that more accurately reflected the likelihood of a stock going up than any in existence today.  I do.  I do think the market can be ... solved, not perfectly, but ot the point where a reasonably distant approach would beat the indices without too much trouble.  I wouldn't be surprised if even a reasonably dilligent attempt along these lines yielded some great results.  

Anyway, I submit my belief in the possibility of a "supreme valuation" combining these 3 things.  I am not, at this time, about to start working on it, but maybe...  maybe someday.  ;)

22 Comments – Post Your Own

#1) On January 11, 2011 at 10:04 PM, checklist34 (99.69) wrote:

maybe like this:

SVU

valuation:  good, its very cheap to sales, ev/ebitda, price/normalized earnings

fundamentals:  awful.  its whole industry niche is under pressure and its under pressure and it has turnaround work to do

technicals:  totally awful, but possibly so oversold that they are now good?  long and intermediate and short term momo is down

 

AMZN:

valuation:  awful, priced into the stratosphere

fundamentals:  great.  industry leader, growth industry, great growth, good balance sheet

technicals:  supreme long and intermediate term momentum, short term momentum paused

And somehow add these things up into a score.  SVU will go alot higher than 7 bucks someday, I'd wager, but maybe a score like this could help us understand theo dds of it going lower first.

AMZN will "underperform" over, say, the next 20 years with its pie-in-the-sky valuation, at somewhere along the way it'll probably make a good short at least once, but maybe a score like this could help us understand when that might be.  

see what I mean?

Hair brained thoughts, maybe, but I do na theenk so  ;)

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#2) On January 11, 2011 at 10:11 PM, anchak (99.84) wrote:

Hmm...very very nice - why am I having some deja vu feeling?  :)

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#3) On January 11, 2011 at 11:18 PM, checklist34 (99.69) wrote:

i don't know???  

I will most likely never get around to this in my lifetime.  

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#4) On January 12, 2011 at 12:58 AM, checklist34 (99.69) wrote:

i am wanting to buy svu and winn

they are certainly valued cheaply...  

I am wanting to buy financials, but for 22 months now I've been more than 50% financials

I am considering buyin solar...  believe it or not, even though I a global warming disbeliever

I am still toying with the idea of shorting alot of stocks, with covered calls as protection... to take in some cash...  which I can toy with. 

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#5) On January 12, 2011 at 2:29 AM, NOTvuffett (< 20) wrote:

checklist34, great post, but it is hard to respond to it with a brief comment.

I try to do something like this in my real investing but as you say it is difficult to give weights to the individual factors.  I usually start with a top down approach, look at global markets, identify interesting sectors, then valuation, and only then look at trend analysis for entry and exit points.  It doesn't matter if you buy the best company in a sector, if you pay too much for it, it is a rotten deal.

Aside from the factors you mention, there are other unforeseeable ones.  An example would be the Gulf oil spill.

Sometimes the market is just totally irrational. 

Sometimes I think I don't place enough emphasis on trend analysis since high frequency trading algorithms account for such a large number of trades.  People bitch about them because they think it is "unfair", that the market is "rigged".  They don't bother me, they provide liquidity, and I suspect ride trends to unreasonable levels giving us Foolish mortals favorable entry and exit points.

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#6) On January 12, 2011 at 2:44 AM, Valyooo (99.33) wrote:

I agree with your central thesis, but I think trading is more of an art than a science, so I don't think this model would work out too well.  IMO, you only need a few details to make an informed decision about investing, not an overly complex model.

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#7) On January 12, 2011 at 11:22 AM, JaysRage (88.94) wrote:

Check -- I love your posts.   The more you post, the more I appreciate your insights into investing and the world at large.   Thanks for posting this.   It was a nice read. 

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#8) On January 12, 2011 at 2:16 PM, Option1307 (29.63) wrote:

+1!

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#9) On January 12, 2011 at 2:16 PM, mechincl (77.61) wrote:

I really like this post. This very accurately describes what I am attempting to create with the software I've written that that drives my mechincl portfolio. Though this portfolio only really applies the valuation piece of the equation. I'm in the process of putting together another portfolio based on value and industry strength. I'm really excited about that portfolio. From there, I will have all the components to do almost exactly as you have described here. I've got components in my software at present that can rank companies based on many different factors and criteria. A composite ranking based on value, fundamental strength of the company and it's industry, and finally technical strength of the company price history... could be a very potent mix. The best of that list probably wouldn't be enough to create a CAPS profile, but would probably represent a very good starting point for real world money.

it would be a massive amount of work

It has been. I've been working on my stuff for months. :)

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#10) On January 12, 2011 at 2:21 PM, SkepticalOx (99.42) wrote:

Check. Behavioral economics and finance does a pretty good job of explaning a lot of the phenomenon's you mentioned, and it's not that hard to understand. Humans are predictably irrational who have a lot of cognitive biases, which suprise suprise, affects their investing and trading too! 

Technical analysts have even begun to include a lot of research in these fields to explain a lot of the tools they use, such as the anchoring bias to explain why people attach themselves to a stock price (that's not really meaningful) and affects things such as breakout/resistance.

Lots of good stuff out there. :) 

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#11) On January 12, 2011 at 4:59 PM, Valyooo (99.33) wrote:

Skeptical,

Have you read "predictably irrational"?  I just finished it yesterday- very good stuff.

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#12) On January 12, 2011 at 5:06 PM, SkepticalOx (99.42) wrote:

I haven't read the book yet, I plan to pick it up. I've seen TED videos where Ariely gave speeches and have read several of his published studies (for a behavioral finance course in university no less). 

 

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#13) On January 13, 2011 at 12:52 AM, checklist34 (99.69) wrote:

notvuffet,

    I also disregard trends too much, frequently to my chagrin.  I bail on stocks when they hit my price targets even if they are rocketing up, and they usually rocket up for a while...  I sold out of ASH for about 50 bucks on average, it went to the 60s.  TCK was a HUGE part of my portfolio this summer nearing 20% and I bailed on alot of that at like 47, held the rest to 62 (i'm learning).  

    I bailed on LVS largely at 28 bucks, bailed on WYNN at like 80 bucks, etc etc.  

    I also practically inevitably wind up down on positions when I buy them, often hugely, because I catch so many falling knives.  There is an upside to that, like march 09 when the rally began and the moves in those first 2 weeks were so violent that I went from down I can't remember, like 25% to up like 50% in 3 weeks.  had i not caught those falling knives, and waiting for a trend to establish, I'd have been waaay behind.  

      I like your comments about yourn approach.  I tend to run screens for cheap stocks by p/e, forward p/e, p/b whatever, and then try to figure out whats going on with the company.  I almost invariablystart doing that the lazy way bygoingto the yahoo message boards in the hopes that somebody smart has written a nice summary, or that I can divine a summary by reading for an hour.  And if that doesn't work I listen to some conference calls and stuff.  I read seeking alpha, but ... in general the content there is much lower quality than the best YMB content because everybody is pitching someting and trying too hard. 

cool cool, maybe i'll try it your way one day...

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#14) On January 13, 2011 at 12:53 AM, checklist34 (99.69) wrote:

valy, for sure art over science but, for example, just buying the lowest 20% of stocks by p/e, p/b, yield, etc (from i think the S&P stocks) has been shown to outperform by quite alot over time relative to the market.  And I Think a system like this could outperform more, in the same way.

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#15) On January 13, 2011 at 12:55 AM, checklist34 (99.69) wrote:

jaysrage, thank you.  I like to blog here because, I guess, I don't have anywhere else to blog, and there are alot of smart people around here.  Its cool you dig it man

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#16) On January 13, 2011 at 1:00 AM, checklist34 (99.69) wrote:

thanks option

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#17) On January 13, 2011 at 1:02 AM, checklist34 (99.69) wrote:

mechincl, that is awesome.  I hope you get riich.  Do you plan to sell it or just utilize it for your own investment work?

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#18) On January 13, 2011 at 1:08 AM, checklist34 (99.69) wrote:

skeptical, I may check that out.  I got an email a little bit ago that suggested another investing text, and the truth is i've only read Dreman, articles on SA or yahoo finance, and these blogs. 

It couldn't hurt!  I love the psychology aspect of Dremans book, he talks about alot of stuff.

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#19) On January 13, 2011 at 1:22 AM, checklist34 (99.69) wrote:

recent talk of short selling aside, netflix is pretty cool.  I got it in december and most nights I watch a streamed movie.  for 10 bucks a month for streaming + mail, its an incredibly good deal.

IF someone gave me the stock I would punch an old lady if she was in the phone booth so I could call in a sell order...  but its pretty cool.  

The problem is, its the streaming part of this thats ultimately going to survive.  and can't apple or amazon spend some cash and jsut do this better than netflix can?

if I was the CEO of NFLX, I would do a secondary immediately, with explanation of what the funds would be used for, to try to expand this streaming service, as that pie-in-the-sky stock price has got to be the easiest way to raise cash ever.  I suppose that would kill the pps ...  but it'd help the company.

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#20) On January 13, 2011 at 6:05 PM, mechincl (77.61) wrote:

I hope you get riich. 

Me to!

Do you plan to sell it or just utilize it for your own investment work?

Not really interested in selling it, either as a product or as a service. I'd rather use it for my own personal use and possibly in a money management capacity of some kind once(if) it has matured and proven its worth.

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#21) On January 14, 2011 at 2:18 AM, RallyCry (< 20) wrote:

Great post. I think there's probably a few momentum stocks in many of our portfolios. The key is to set realistic exit points. I look to capture a 20% move or cut losses at 20%. Rather than relying on the trend to continue indefinitely, I like to use near the money call/put options a few months out where a few days of trading can get me to my end goal or stop loss. This is only 10% of the portfolio which I consider speculation. The other 90% is dedicated to common stocks with good value propositions. Many money managers have  a universe of 100-200 stocks or more that they track on a daily basis. I feel the caps game is a nice way of sorting this data relative to the index. More often then not, I find myself researching 5 star  names that I've picked that are beaten down relative to the index. A few that have compelling fundamentals are bought in real life.

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#22) On January 17, 2011 at 12:44 PM, B1ll1am (77.86) wrote:

I used a search engine for stocks that allowed you to enter search criteria. For instance: P/E under x, share price over $5, P/B, etc, etc. Such strict parameters. Were there any in the universe? Yes, it came up with 10 stocks that fit. So, I wrote the symbols down and checked them in 6 months time. All were losing money! Lesson to be considered is: There is no system that is for sure. Only ones that would make it less likely to lose than gain. I like the momentum idea as once the cattle are running in one direction, it takes another gunshot to scare them in another direction. You therefore must be a trader of stocks and not a holder in this enviornment.

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