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TRADER'S NOTEBOOK


Investing With Trends

09/16/03 03:33:27 PM PST
by Thomas L. Dussault

Does investing simply mean following obvious price trends? You may find that periodic price trends and sensible stop-loss and entry price points are far better trading guides than price forecasts.

Anyone who believes in the trading maxim "The trend is your friend" might conclude that success in securities requires so little understanding of your purchases that nearly anyone should be able to make money. These investors would rationalize all they had to do was to believe observable security price trends and invest in a similar direction. And they may have a point.

Over the past 50 years, securities investing has returned about four times as much profit as a traditional savings account. Yet, if you were to ask most investors of previous generations how much they really knew about McDonald's, Coca Cola, and General Electric, their honest answer would have been: very little. Investors bought these companies' products, and they saw their ads, but it's doubtful that they (for example) pored over each 10-Q quarterly report to note whether pretax profit margins were increasing.

THE INFORMATION AGE

Nowadays, investors have access to information that even the Securities and Exchange Commission (SEC) didn't have decades ago. Does all of the extra information available today mean it's easier to succeed in investing? Isn't it possible that investors merely watch their shares move higher with the hope that the price trend will continue? It's likely that baby boomers of the past 20 years did just that. They caught the fever for equities with only a casual idea of what their investments were all about, yet massive upward price trends brought them wealth. These "successful investors" thrived, even though most were by no means Wall Street-savvy.

Every company has complex factors affecting its success: how its product mix from various parts of the world affects profits, whether its efficiency level is maintained, how a new product is accepted, and so forth. Even if everything seems to be going according to plan, that doesn't mean the next quarter or year will see business results exceeding expectations, or, more relevant, that the price of its stock will continue to go up. If it were that easy, fundamental analysts would target bottom-line earnings figures almost every time — but they rarely do.

OBSERVING PRICE MOVEMENT

How you think the investing public will react to your holdings is irrelevant if the information that you base your decision on has had time to be acted upon. While legal proprietary information can be useful, when it becomes public, it will rarely lead to a lasting advantage. The markets can factor such information into pricing almost instantly. Valuation measures such as price/earnings and book value may offer a hint about what the price may become, but the price you see today is fair evidence to its real worth.

These days, the price response to news is pretty much immediate. The markets are simply too efficient to delay processing newly public information. If you want to profit from trading a stock, your ability to understand the company's management, estimate value, and interpret news items may be nearly irrelevant, because your assessment of that company's business is difficult to change. As the price of a stock crumbles, does it benefit you if your research suggests the stock nevertheless should still sell 20 points higher? What if the company makes an announcement that things at the company are good and the price soars? It's better to exit your position by ignoring bullish hoopla long before the price starts to fall.

Those investors holding the stock of Cisco Systems, once arguably the leading technology company, from the time of its public debut in 1990 through the spring of 2000 might have amassed an immense fortune. Yet if those investors had kept their stock during the following 18 months, they would have squandered 82% of 10 years' profits! There would have been meager comfort in the thought that they might recoup 100% of their investment — someday. Wouldn't it have been far better to have begun exiting when the stock dropped 10% to 15% from a predetermined price level, and to exit completely when it dropped 20%? Then those investors could have waited patiently for a new entry point, while their still-massive profits were put safely aside to earn interest.

In the same vein, never be deluded into thinking that an investment in the greatest of US companies will be any consolation if they fail to perform. Not only that, don't give such investments any leeway if you see their prices melting away.

Remember: Your investment results will never be changed by anyone's comments or opinions, or even your own research. These observations are still subordinate to the vicissitudes of the market. True, a skilled management team can tweak estimates or they could decide to change business strategies. Investors can always bail out from companies that are doing poorly and reposition their holdings. Ultimately, however, both are dependent on the market's pricing decisions. Most successful investors who make money do so by simply jumping aboard a rising trend in price or by being attentive and directing money where price movement is obvious. They may even admit their sudden fortunes had little to do with their active efforts.

FOLLOWING THE TREND

There is an educated difference between buying into great companies and investing in companies just to capture a profit from a price trend. A lot of money can and is made during price trends, regardless of the internal aspects of ongoing businesses.

From late autumn of 1998 and into mid-1999, the Internet sector of the market soared. "Irrationally exuberant" to some, it exceeded all price targets. Many of Wall Street's old guard found themselves mystified because the sector price rise made no sense intellectually, but that didn't matter. For those who grasped the concept that you make money from price awareness first and not the business model, it made sense to follow the price trend. The trend-followers asked: Could they make money from this uptrend even if the company eventually failed as an ongoing business? Since price momentum was on their side, they argued, why fight obvious price behavior?

Price manias almost always end badly because sooner or later, investors come to their senses. Nevertheless, in the case of the Internet mania in the stock market, there was nothing wrong with participating in that upward momentum for as long as it lasted. And since these huge, attention-grabbing price trends never end overnight, there is always sufficient time to exit when any trend becomes substantially overextended.

As long as a stock price retreat was nowhere in evidence, there is no need to sell, even if a company or market pundit issues a price warning. Preselected exit and entry price levels are based on forthcoming events and human reactions, both unknown and uncontrollable. No one can know when investors might take prices up or down. These days, the transmission of information is so swift and price reaction so dynamic, those in and out first or who endure profitably throughout a price trend may earn returns that would have taken, in prior decades, years to earn.

If you thumb through Forbes, Fortune, Barron's, or The Wall Street Journal, collect a few trading ideas, and in the end make a few dollars, that profit doesn't necessarily come about because you worked hard and did your research and deserved a payoff. If you know nothing (or everything) about biotechnology or technology in general and decide to invest in those areas, how do you ultimately plan for investment success? Do you really need to look at anything other than price?

Investors can make money by monitoring price reactions. They can simply follow the public expression of value — or price trends — on a periodic basis. If traders practiced active price observations and exited their positions as price continued to run down, they could have prevented a lot of disappointment during the 2000-3 period.

Let the price trend be your focus rather than your own expectations of what should be occurring. Individual investors are, at best, believers, then reactive followers. The broad market's directional price bias, and the frequent waves of secondary price sentiment within equity groups, are forces worth monitoring above all else.

Thomas L. Dussault is president of Financial & Investment Management Services. He can be reached via email at tldoct20@aol.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Thomas L. Dussault


E-mail address: tldoct20@aol.com


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