FEAR AND GREED
Virtually every movement in the stock market is created by one of two human emotions: fear or greed. This aspect of stock market movements cannot be overemphasized. Remember, when you buy or sell stock in a company you are buying it because of “fear” or “greed.” If you really believe a company has the potential for making a lot of money, your purchase would fall under the greed category. Conversely, you sell because of fear. Yes, you’ve been greedy—your stock is up—so you sell before it goes back down. In short, fear and greed are the underlying emotions of all stock movements. Now, multiply this by the fear and greed embedded in millions of investors.
THE LAW OF SUPPLY AND DEMAND
I was getting ready to go play basketball and my young son of 14 came in to see me while my wife and I were talking. We were discussing some reports I had just read about the up-trending market, about which I had just written a new book. He said to me, “Dad, what makes stocks go up?”
We only had a few minutes to talk so I basically told him that stocks go up and down because of the law of supply and demand. I continued briefly that there are only so many shares in any one company, and when there are many people who want a particular stock, the price of the stock will have the tendency to go up. Conversely, when a lot of people do not want the stock, but want to sell, that emotion will create more selling and the stock price will have the tendency to go down.
All I had time to explain was that there was a middleman, like a warehouse. In this case it would be either the Specialist on the New York Stock Exchange or the Market Makers on NASDAQ. That person is the middleman in buying and selling stocks, similar to a warehouse in buying and selling groceries. For example: at a certain time of year there is a big demand for oranges, and the warehouse is getting low, they could raise their price and people would be willing to pay the higher price because they want oranges. There is a demand for them. If the oranges have aged, or if nobody wanted them for whatever reason, then the warehouseman would lower the price in order to create a level where people would finally want to buy.
This explanation, while simplistic, still answers most of what goes on in the marketplace every day. As a matter of fact, to make it even more simplistic, let me share with you what my stockbroker frequently tells me. I know that he is very busy and when I call him about the market and/or a particular stock and it is up to $30, I usually ask the question “Well what caused that?” He is probably at that point in time typing away to get the stories or related information about the stock so he can give me a good answer. But while he is doing this he has this cute little answer he gives in a non-committal way. He says “More buyers than sellers.” Within that simple statement are deep implications. Conversely when stocks go down he answers, “More sellers than buyers.”
Many years ago when I was teaching real estate seminars and other aspects of wealth accumulation from maintenance to retirement, I would frequently tell people that one of the keys to wealth is to own things that other people want to own. I am sure that anyone reading this has owned something that has no value to anyone else. It could be an old car in the garage. It could be a 20-year-old mink coat. It could be a host of other things you have lying around the house. They have no value because nobody else wants them.
The way to accumulate wealth is to constantly accumulate things that other people want. The stock market uses substantially the same wealth principle. One of the keys to wealth accumulation, especially if you want to do it in a more rapid manner, is to buy stocks that a lot of other people want. There are different types of stocks, let me make a quick list:
1. Cyclical—these are stocks that either go through a two or three year cycle of expansion and then go bust. Sometimes the cycle completes a lot faster, say within calendar quarters.
2. Value stocks—these stocks are found by comparing them to other stocks in the same sector or in the market place in general. One calculation for this comparison is the price to earnings ratio, or P/E. P/E basically determines how many dollars we are spending for one dollar of earnings. This is a barometer of how well the company is doing because we can get the P/E on any stock and determine if the stock is undervalued or overvalued.
3. Growth Stocks—I would put virtually all value stocks under the growth stock category, but there is a separate category for pure growth stocks. These are the ones that are in an industry which has the highest likelihood of increasing in price, because the company has the highest likelihood of being profitable, not only now but also in the future. These are companies which have a great product in its early stage of development and marketing.
Some companies are expanding into new competitive areas. Other companies are dominant in their field, and virtually have a monopoly-like aspect to them. Many mutual funds and ETFs (Exchange Traded Funds) and financial professionals specialize in these growth stocks and are constantly putting out lists of them. They are not only easy to find, but they are easy to study. I love growth stocks, but as you can tell from the last five or six years in particular, there has been such a rapid increase in business innovation that some of these stocks have faltered as of late. Today, innovation is still king.
4. Income stocks—some stocks are purchased for the dividends. Dividends are usually paid out on a quarterly or annual basis. Some large companies have MIPS, or Monthly Income Preferred Securities. In today's marketplace many investors are turning to dividend-paying stocks.
Underlying all four of these approaches is the fundamental principle of finding value, or bargains. I go looking for stocks that have the highest likelihood of going up so I can answer my son’s question: the law of supply and demand, coupled with the concept of fear and greed, takes over. We want to get our money in the way of a large demand. Then we simply need to look for great companies which have current cash flows, and the highest likelihood of continuous cash flows. It is not just earnings now but the future earnings and even earnings growth.
“The current stock price is based on the anticipation of future earnings.” —Wade Cook
You can take any one of the four types of stocks listed above and fit the particular stock you are looking at into a test model. Pose the following questions: is this company going to make money? And, as the company starts to make money and the stock starts to move up, will that create a momentum in and of itself? Will there be a likelihood that many people will be attracted to this stock and want to get involved and own it? One of the core aspects of all of this is a company that has a product which is easy to explain.
They need a management team who can concisely put forth what the company is doing and then run the company at maximum efficiency. We don’t have to go in and run these companies, but we can sure look at them and analyze them.
Part of this is a fact that does not readily meet the eye: that is the float. The stock float is simply the number of shares issued and outstanding. In certain SEC guidelines, even outstanding options or warrants to buy the stock need to be included. Let me put this in perspective.
New investors often ask this question: “If this stock is $40 and that stock is $30, isn’t the $40 stock better?” This question just shows a lack of understanding. Yes, it may be a better company, but the price of the stock is irrelevant to the discussion. The $40 stock may be in a company with 10,000,000 outstanding shares on the float. The market capitalization of the whole company is four hundred million dollars. The $30 stock is in a company with 1,000,000,000 (one billion) shares outstanding. Its market cap is thirty billion dollars. The price of the stock, in-and-of itself, gives an incomplete picture. It can only be used in math formulas to determine other things, like the P/E ratio.
The float would signify not just the amount of stock that the insiders or founders own, but the complete public float. Even though there is a high demand for the stock, with so much supply (for example, in the billions of shares) the demand is overwhelmed by the huge amount of stock available. The stock hardly moves at all with good news or even bad news.
I would put in that category Microsoft and even Intel, and soon Google, Amazon, and the like. I would also include many Chinese stocks like Baidu, Alibaba and other internet and technology stocks. The point is this: with older, highly successful companies, if people want to own their stock, they already do so. Think what it would take to move the Microsoft stock up. As of late it’s showing some life, but it has been under $50 for over a decade. It's now moving up.
Many years ago Dell Computer (DELL) did multiple stock splits. Seemingly they were doing stock splits about every twelve months and it felt like they were going to continue to do so. Not only were stock splits becoming popular—I mean by that, the splits themselves were a specific reason for buying the stock—but DELL was very prominent in the industry with all types of advertising in many mediums and with a great business plan. They also had a charismatic leader and good management team and it seemed like it would never end. But as we all know “this too shall end.”
There was a five-year period of time when DELL did this series of 2:1 stock splits. DELL stock, after it did each split, would run back up to near its pre-split high. If there are 300 million shares of stock before a 2 for 1 stock split, there are 600 million shares after the split. After the next 2 for 1stock split there are 1.2 billion shares and after the next 2 for 1 stock split, 2.4 billion. Each time it did a split the highs would continue to be lower.
This is about the time when we determined that this game was over. I had made a lot of money on several of these stock splits but when we saw this huge supply and the stock not recovering to its previous highs, it told us there were too many shares on the float to be absorbed. See the write-up about Dell (now private), including a chart of this time period in my book, STOCK SPLITS.
I mentioned earlier that a stock price today is based on the anticipation of future earnings. Pause and consider this. The saying doesn’t say the stock price today is based on the past, though that set of facts has some relevancy. The statement doesn't even say the price is based on earnings. No, it’s all about the future.
One does not buy a stock for what it did, but what it will do for them going forward. The market news may be wrong, but something as simple as new management or as broad as the Federal Reserve raising or lowering interest rates, play into how companies will do.
The stock market is an open-air market place. There is constantly a herd mentality, and the herd is usually wrong. It’s nigh on impossible to anticipate the anticipation of others, and the news today—with several Financial TV shows and radio programs, numerous magazines and newspapers with financial sections, and now the ubiquitous internet— means people can be informed and stay uninformed, at their choosing.
I for one, trade and invest with all of this in mind. Fear and Greed. Supply and Demand. Let me end this with a plug for Writing Covered Calls. We like movement, say a stock going up and down $1 or so every few days, and with this strategy, one can make money constantly.
It’s what I call No.R.M. This stands for No Required Movement. Writing Covered Calls and certain Spreads let you make money with virtually no movement in the stock. I like Covered Calls because this cash-flow strategy lets us incorporate virtually everything in the section, and put market forces to work for us, not against us. And we need all of the help we can get.
© 2016 Wade B. Cook. All Rights Reserved. This article was excerpted and edited from
Cash Flow the Stock Market. This book and others are marketed by wealthinformationnetworkinc.com. (wininc.biz)