The markets seem broken. Stocks aren’t reacting how you might expect to key economic data and company earnings.
Moves fade out and reverse sharply. Promising setups evaporate in a heartbeat.
In particular, the disjunction between price and fundamentals makes it challenging to trade.
So to make sense of this market, you need to pay close attention to subtle market dynamics that may not be as obvious.
Today, I’ll run through some of those factors you need to consider…
The relationship between price and fundamentals is straightforward on the surface…
People will try to judge a company’s valuation based on its free cash flow, revenue, and earnings. They’ll evaluate its market share and position within its sector (leadership, moat, management, etc.), its product lineup, and its prospects for growth.
Investors can then use metrics like the price-to-earnings (P/E) ratio to determine if that stock is over- or undervalued.
But what do we do when these fundamentals don’t line up with the price action? For example, we may see a stock burst higher on an earnings beat before sharply reversing and ending the day in the red.
That’s because other factors can drive action in stocks, with no immediate relationship with fundamentals. It’s why the moves don’t make any sense on the surface…
Nowadays, there are news-driven algorithms that process data and make trades before a human has even had time to read a headline. If these algos hit with sufficient volume, they can generate substantial moves.
Another factor is that some funds must adhere to strict volatility guidelines. They must reduce their exposure to stocks if volatility reaches a specified level. This can set off an unexpected wave of selling that’s very hard to predict.
Plus, of course, option market makers constantly adjust their exposures to avoid potential losses. That can greatly distort the market in the short term.
Each of these participants is trying to use very different strategies or follow specific guidelines that may not be obvious.
Put simply, their actions are driven by factors other than fundamentals.
That can lead to erratic price action… and confusion for anyone trying to figure out the market’s next move.
So what can we do?
Even though the markets can be confusing, we don’t have to sit things out.
As we discussed earlier this week, we can trade the reaction to the reaction. We wait to see how the market initially reacts… and then trade off the back of that reaction.
Yet sometimes a stock will bounce around after an announcement.
One way to counter that is to focus on key price levels. The more a price tests support (or resistance) and holds that level, the stronger that level becomes. So you can focus on how the price reacts to that price level.
If the level continues to hold amid the mayhem, it can become a potential entry for a trade. That’s more manageable than trying to guess which way a fast-moving stock is going to swing next.
Another technique is to watch how far a stock has swung away from a key moving average (MA), like the 50-day MA, for example. The greater it has stretched, the more likely it is to snap back the other way, setting up a potential mean reversion trade.
Likewise, momentum indicators can point to a potential change in direction. We’ve talked about the Relative Strength Index frequently as one of my favorite signals.
The key is to stay patient… and ready to pounce. You control when you trade – and you get to determine your strategy.
When the price and fundamentals don’t match up, simply adjust your strategy accordingly.
And as always, look for strong setups, be nimble, and take your profits off the table quickly.
Happy Trading,
Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
