How To Profit From Irrationality And Stock Market Abnormalities
Stock market abnormalities are one of the best methods of spotting great investment and trading opportunities. The problem is this, how do you know what’s normal or not, and then what do you do when you know? We’ll fill you in on all the details in our guide to trading stock market psychology.
Stock market psychology is the beginning and the end of stock market success. What you may not realize is that your psychology is as important as the market psychology, if you can’t control yourself you might as well go throw your money in a lake as try to invest in stock market anomalies.
When you trade stocks fear of missing out can often lead to big losses, at the very least it can result in paying too much for your trades. Fear of missing out (FOMO) is when you chase prices higher; if you can recognize FOMO in yourself you’re already learned how to recognize one kind of anomaly that can save you money, and lead to profits.
This Is How To Make Money From Stock Market Abnormalities
Stock market anomalies, bubbles and crashes, irrational reactions, and neglected stocks; these are the things that bring windfall profits to day traders. Anomalies are abnormal times in the market, times at which price has reached extreme lows or highs and by definition peculiar and hard to classify. Despite this, it is possible to learn to recognize anomalies within the financial market and to profit from them.
What are stock market anomalies? They are irregularities and deviations from the norm and come in many forms. In all cases, they result in abnormal valuations for stocks and that is an opportunity to buy or sell when the time is right. This concept is described in detail by the theory of mean reversion. Mean reversion assumes a stocks price will revert to an average or equilibrium price over time. If you buy when prices are low, or sell when they are high, you can make money.
- Fear of missing out, FOMO – Fear of missing out is a condition that plagues most traders. When an assets price is moving it’s hard to sit and wait for it to move to a target entry point and that drives traders to buy too soon, at the wrong time, and on the wrong signals.
There are many tools for measuring what “average” is in the market, including both, but not limited to, technical and fundamental indicators.
The signals given by anomalies can be further classified as long or short-term, as in how long they are likely to affect prices, and whether they are trend-following or not-trend-following, or bullish or bearish. The trick to recognizing anomalies, and knowing what to do when they appear, is having a firm grasp on what normal is for the stock, sector, market or index you are trading.
The Most Important Types Of Stock Market Anomalies You Need To Know
This Is Your Introduction To Fundamental Stock Market Abnormalities
You have to dig to find anomalies in the fundamentals. The fundamentals are the metrics that reveal the financial health of a company, sector, market or index. They include business metrics like revenue, earnings, price multiples, and dividends as well as economic indicators like tax rates, job creation, and consumer health. When you spot a change in one of these metrics you can be sure a change in the assets price is on the way.
The key to recognizing fundamental anomalies is knowing which fundamentals affect the stock you are trading. While most stocks are affected by revenue, earnings, and price multiples they don’t all pay dividends, and they aren’t all affected by the same economic data. An energy company may be affected by changes in consumer sentiment but not nearly as much as a business in the consumer discretionary or retail sectors. Here is a list of the most important fundamental and economic indicators you should know about and keep track of for investing success.
Revenue – Revenue is the amount of money a company makes and is referred to as the “top line”. It is called the top line because it is the first number listed on a business income statement and tax return, and is the number all other metrics are derived from.
Revenue can be measured by business, sector, index or the entire market and is a leading indicator of stock market prices. When revenues are on the rise there is a good chance that stock market prices will rise too. If revenues are falling there is a good chance that the stock or market will fall in tandem. A business that is making more than expected, or more than its competitors, or growing/shrinking faster/slower than its competitors, is anomalous and an opportunity for traders.
Earnings – Earnings are the profits a corporation makes. As a shareholder, you would be entitled to a portion of the earnings, also known as EPS. The more money a company makes the more its stock is worth so anomalies in earnings and earnings reporting can be strong catalysts for price movement.
Naturally, when a company’s earnings are growing, or when they are outperforming a peer, or when they beat expectations the catalyst is positive and the stock price will move up. If a company’s earnings are shrinking, or when they are underperforming expectations, or when revenue grows but earnings do not (a sign of bad management, uncontrolled costs) the stocks price is likely to decline.
Financial Metrics – Earnings and revenue are reported once per quarter for every stock listed on the regulated US market, not counting penny stocks, along with revenue and other financial metrics. In most cases, it doesn’t take an accountant to understand the basics of the income statement, balance sheet and appendices provided by each company but helps to have some experience.
Digging deeper into the financials is a way to spot improvements in the forward earnings expectation before the news is widely known. A trend of improving margin you can link to an external source could be the ticket to explosive gains.
Adjustments To GAAP Reports – Most stock market earnings reports come in two forms; the GAAP and the non-GAAP. GAAP stands for generally accepted accounting principles and represents your actual results including one-time and non-recurring events like legal fees and charges, acquisition, and divestiture of assets. These events have a material effect on current operations that often does not compare to performance in the previous quarter or year.
In most cases, when earnings are reported by the news or media, they are reporting the adjusted earnings and not the GAAP earnings.
As anomalies go, adjustments are usually expected but can sometimes take the market by surprise. A decline in earnings may not be the big news the market thinks it is if it is tied to a one-time event and not detrimental in a long-term way. For example, a business may experience a decline in margins after purchasing a smaller business until the merger is completed and yet expect margins to improve once the two companies are fully integrated. If the market sells off on news of this type you can use that weakness as an opportunity to buy at a low price with the expectations margin will improve and expand in the future.
Dividends – Dividends are the most common method for a company to pay its shareholders their portion of profits. Dividends are delivered on a per share basis and referred to as yield. The yield is the annualized amount of profit you receive relative to the price of the stock.
A stock with a higher yield should be more valuable than a comparable stock with a lower yield, and a stock in a cycle of dividend increases should be worth more in the future that it is today. Dividend anomalies include things like dividend health, the yield relative to stock price, and expectation of dividend increases or decreases.
Dividend health refers to a company’s ability to pay the dividend, how they pay it and if they are expected to increase or decrease the distribution. Most major stock market websites include some form of dividend metrics so get familiar with the tools available on your platform.
The yield relative to price can be a profound catalyst on a stocks price. If news sends a stock to new lows and yield rises but the dividend health is still good you can expect to see price move back up over time. Likewise, if you expect a company’s dividend to be increased or decreased you can also expect to see the stocks price move correspondingly.
Market Ratios and Multiples – There are dozens of “key” market ratios and multiples by which to measure the value of a stock. The most common but by no means, the only one is called the price-to-earnings ratio or P/E. To get the P/E divide the price of the stock by the annual earnings. It can be a TTM P/E (trailing twelve months, actual earnings) or a forward P/E based on expected earnings. Regardless, the P/E is used to gauge the value of a stock relative to its peers, its sector, other businesses of the same size and the broad market.
The S&P 500 is the most often benchmark for stock value and tends to trade around 17 times or 17X forward earnings. Sub-sectors may trade at higher or lower multiples, and certain types of stocks, or companies that have high institutional ownership, may do the same so beware when making these comparisons. However, a low P/E relative to peers is an indication a stock is undervalued while a high P/E indicates it is overvalued.
Regarding TTM P/E and the forward-looking P/E, a low forward P/E relative to TTM P/E is an indication a stock is undervalued relative to its expected earnings, or earnings growth. Other metrics that may help you discover anomalies are Alpha, Beta, Book Value and Insider/Institutional Ownership.
Insider/Institutional Ownership – Insider and institutional ownership is the amount, as a percentage, of the number of shares of a stock are owned by owners, board members, certain people of record, and other large shareholders. What it tells you is how much confidence the broad market has in a stock and can be a telling figure. The idea is that the more insiders and large shareholders there are the safer a stock is, a stock with lower insider ownership relative to a peer is, therefore, less attractive than one with a higher relative insider ownership.
Another anomaly you can look for in this data is rising or falling institutional and insider ownership. If the management and large-scale owners of a company begin buying a stock you can assume things are good and they expect to see the stocks price rise over time. If insiders and large shareholders begin trimming their positions you can assume that a stock’s price will soon fall.
These Economic Indicators Can Help You Find Anomalies
The Economic Indicators You Need To Know
Economic data are among the leading sources of stock market abnormalities. Economic data and economic conditions are the backdrops upon which business operate. When economic conditions are good then business is good and when economic conditions are improving business should be improving along with it.
The catch is that, while a rising tide will lift all ships, that doesn’t mean a bad stock is going to do well during good economic times, or that a great stock will do well in bad times. These are the data points you need to know about, be familiar with and keep track of if you want to take advantage of stock market psychology.
Gross Domestic Product – Gross Domestic Product or GDP is a measure of the total output of the United States (or any nation, or the world) net costs and imports. When GDP is positive the economy is expanding and that is good for business. When it comes to stock market psychology and trading anomalies the expectation of economic growth is even more important than current growth.
If the market thinks that GDP is going to be positive and expand or accelerate from current conditions the value of stocks will increase. If the market thinks that GDP is going to remain flat, shrink or turn negative the value of stocks will decrease. When it comes to the reports themselves a figure that is better than expected can lead stock market values higher while one that is worse than expected will do the opposite.
The Index of Leading Indicators – The Index of Leading Indicators is a composite index of ten economic indicators commonly known to improve ahead of economic expansion. It includes unemployment claims and hiring data, manufacturers new orders for supplies, building permits, and stock prices. As an individual indicator, it has little effect on stock prices but can have a resounding effect on outlook. If the Leading Indicators begins to weaken during an economic expansion that can lead to slower growth and weaker than expected corporate profits.
The Labor Market Conditions Index – The Kansas City Federal Reserves Labor Market Conditions Index is a composite index of 24 closely watched labor market indicators. It does not get a lot of attention by the market but is an indicator you need to watch. It is a broad measure of labor market conditions and has predicted each of the last three major bull markets. When it is on the rise conditions are improving and when it is in decline they are slowing, if it falls or rising above zero it is giving an uncommon and strong indication major change is afoot within the US economy.
Weekly Jobless Claims – The weekly jobless claims figures are a volatile data set. Their impact on a week to week basis is minimal but the longer term trends are what count. If jobless claims are trending lower the market should be reassured the economy is on sound footing and that US businesses are making money.
If the trend in jobless claims changes and claims start to rise the data will point to change within the economy. What market watchers need to remember is that there is seasonality in the data that needs to be accounted for. There are two major cycles of hiring and firing each year that coincide with the fall and spring hiring seasons. If claims rise unexpectedly it may not be so unexpected.
The Manufacturing Business Outlook Survey – The Philadelphia Federal Reserves Manufacturing Business Outlook Survey or MBOS is one of two heavily watched gauges of manufacturing activity in the US. It is a diffusion index composed of subcomponents that include current activity, new orders, unfilled orders, hiring, and prices. It serves as a barometer for broader US manufacturing and has been known to move the market.
When business conditions are better than expected, improving or trending higher the US equities market is likely to trend higher too. When business manufacturing conditions are deteriorating, contracting, or trending lower equities prices are likely to trend lower too.
The Empire State Manufacturing Survey – The Empire State Manufacturing Survey is conducted by the New York Federal Reserve and is the second of two gauges of manufacturing heavily watched by the investment community. It, along with the MBOS, provide a deep insight into manufacturing conditions. One important subcomponent to pay attention to is inventories. If inventories are rising and near high levels relative to past activity it can be a sign of impending economic slowdown.
Chicago PMI – The Chicago PMI is a purchasing managers index maintained by the ISM or Institute of Supply Management. It is issued in two reports, manufacturing and services, and a gauge of business-related spending.
When the PMI is rising businesses are investing money in the economy and a sign of positive economic growth. When the PMI is falling businesses are spending less money on business needs which is a sign of slowing or contracting business activity.
The PMI data is not a major market mover but is an important piece of the economic puzzle. If PMI isn’t in line with expectations it can be a sign of market anomaly.
The Consumer Price Index – The Consumer Price Index or CPI is a measure of consumer-level inflation. The FOMC, the Federal Open Market Committee, likes for inflation to run about 2.0% on average. The CPI is an important part of the inflation picture because it shows what the end-users are paying and how price pressures are affecting their spending power.
Upward pressure in inflation is good because it means positive economic activity and that means corporate profits. The problem is that too much inflation can be harmful to growth and worse, it may lead the FOMC to raise interest rates. A hike in interest rates is bad for most businesses because it makes doing business more expensive.
The Producer Price Index – The Producer Price Index or PPI is a measure of producer level inflation. It is the second of two key components of the inflation picture as it shows the effects of inflationary pressure at the business level. The PPI is the leading indicator of the two as prices for manufacturers often increase ahead of those for consumers. When PPI is trending near 2.0% the FOMC is happy to leave interest as they are but if it rises or falls it can lead them to alter rates. Regarding stock prices, the PPI data is important as it can point to expanding or contracting economic activity and the effects of inflation on corporate profits.
Personal Income And Spending – The Personal Income and Spending data otherwise known as Personal Consumption Expenditures or PCE is a measure of income and spending in the US. This data is important as rising wages leads to increased spending and increased spending is good for consumer products companies and the economy in general.
More importantly, this data set includes the PCE Price Index which is the FOMC’s favored tool for measuring inflation. PCE prices and core PCE prices are the number one factor determining the path, pace and trajectory of FOMC interest rates today. If it comes in too hot it will scare the market into thinking the FOMC will raise rates, if it comes in too cool the market will fear economic slowdown. A Goldilocks number, one that is not too hot or too cold but just right, will assure the market there is nothing to fear.
This Is What Drives Stock Market Psychology
Stock market psychology is easy to understand if you accept that the market is fickle, it’s often dumb, and often behaves like a wild animal. The good news for traders and investors is that if they can stand aside, keep track of business and economic health, they can spot stock market abnormalities when they happen. Spotting abnormalities when they happen is the best way to make money, the only way really because if you wait for someone else to tell what’s going on you are probably too late.