Alpha Stocks: Stock Market Logic

Tuesday, March 25, 2008

Stock Market Logic

If you have been trading or investing for any length of time, you should have come to the stark realization by now that there are times when the market defies reason and conventional logic.

Success in this business depends on the ability to be forward thinking. Trading based on old information is a recipe for mediocrity at best.

We all know about the bad news. The market sucks, we have a terrible housing market, conspiracy theories are on the rise, and who knows what will happen with the Presidential election? In short, we are on the brink of Armageddon. Everybody and your old third grade teacher knows that.

With a goodly number of traders and investors, including “Joey-bag-of-donuts”, focused on the news (viz. “noise”) from the asshats at CNBC, market recoveries usually begin when a group of market participants know something that the rest of the market doesn’t.

Unless you have the advantage of a time machine, the news you and I get is probably known by insiders at least a day or two before it gets released. However, the one aspect that tends to level the playing field for those of us who are “unimportant, third-tier bloggers” is technical analysis. (Btw, I have to put in a plug for Woodshedder. He is definitely a student of the market and his craft.)

With that said, I simply want to point out that the market is working on a recovery that might surprise the bearish camp. Supply and demand, the most basic of economic principles, is flashing at least a short term buy signal via the P&F charts:

The Dow’s chart pattern has formed a triple top breakout.

S&P 500, a double top breakout:

Naz 100, double top breakout:

Russell 2000, double top breakout:

Check out oil breaking down:

…and gold...

Follow through this week will be key. Right now, I intend to focus on technical analysis, not so much the news and the fundamentals. The bear market, the credit crisis, the banking crisis, a recession—all old news. In addition, everyone is expecting Q1:2008 earnings to be “bad”, especially for the banks and financials. All this is already priced in. Pundits are predicting how long all this is going to last. I like it when they start doing that. The market is ripe. Keep in mind that “the market” and the economy are not the same thing. All it takes is one or two major upside suprises, and potentially, off we go.

Stock market logic.

Trade accordingly.

Disclaimer: Conduct your due diligence concerning matters related to your money. You can lose your entire stake in the market. Should that happen, expect a conciliatory Asshat Award to arrive in the mail shortly thereafter.

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About Alpha Stocks

Alpha is a risk-adjusted measure of the so-called "excess return" on an investment. It is a common measure of assessing an active manager's performance as it is the return in excess of a benchmark index.

The difference between the fair and actually expected rates of return on a stock is called the stock's alpha.

The alpha coefficient (αi) is a parameter in the capital asset pricing model. In fact it is the intercept of the Security Characteristic Line (SCL). One can prove that in an efficient market, the expected value of the alpha coefficient equals the return of the risk free asset: E(αi) = rf.

Therefore the alpha coefficient can be used to determine whether an investment manager or firm has created economic value:

αi < rf: the manager or firm has destroyed value
αi = rf: the manager or firm has neither created nor destroyed value
αi > rf: the manager or firm has created value

The concept and focus on Alpha comes from an observation increasingly made during the middle of the twentieth century, that around 75 percent of stock investment managers did not make as much money picking investments as someone who simply invested in every stock in proportion to the weight it occupied in the overall market in terms of market capitalization, or indexing.

Many academics felt that this was due to the stock market being "efficient" which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only luck made it possible for one manager to achieve better results than another, before fees or taxes were considered.

A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples are the S&P 500 and the Wilshire 5000 which approximately represent the 500 largest equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.

In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager).The name for the additional return above the expected return of the beta adjusted return of the market is called "Alpha".

The Alpha Stocks blog is my way of documenting and focusing on picking stocks that have capital appreciation potential on a risk-adjusted basis, either on a short term basis or for the long term. From time to time I will also add my thoughts and observations on the market and economy in general. Thanks for reading. You are free to comment.

No guarantees are made here. Investing involves risk and you may lose money. This is not meant to be a thorough and complete analysis of a company's stock. My intention is to merely point you in the right direction so you can perform your own due diligence.

Alpha Stocks

Tuesday, March 25, 2008

Stock Market Logic

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