Tuesday, April 20, 2010

"What if 6 Dow stocks went to zero?"


What if they didn't? What if instead Citigroup rallied 460%?

This was the title of a Bloomberg Television segment on March 6, 2009, the exact day of the 6,470 low in the Dow Jones Industrial Average. The video shows how little impact 6 stocks, including, GM, Citigroup,and Bank of America, falling to zero would have on the dow, which is price-weighted. This means the lower the price of the stock, the less of an impact that stocks has on the Dow. These 6 Dow Stocks falling to zero would have taken just 47 points off the Dow. This video was talking about how these stocks falling to zero would indicate much larger problems in the economy and how it would suggest the rest of the stock market would fall along with it. Yet, the day of this gloomy outlook for 6 Dow stocks, the market bottomed and geared up for a 70%+ rally. Citigroup has rallied, low to high, over 460% since its bottom on March 6. Since its low on February 20, 2009, Bank of America has rallied an amazing 685%! Now that the market has rallied over 70% since the low, you don't exactly see this type of gloomy outlook from analysts and reporters on the financial media. Everybody is ready to buy stocks again at these over-inflated prices, but they hated them at the March 2009 low. This process is a natural human psychology cycle in financial markets. Financial market participants herd with the crowd, blow up a speculative bubble, only to see it pop. Yet, when investors get out at the bottom, saying "I give up!" They won't want to get back in until a top is close, and they will naturally try to rationalize it, saying "oh well, its lower than the last time I bought it anyway." This suggests that the traditional laws of supply and demand in an economy do not apply to financial markets. Rather, it suggests that markets "herd" in a series of Elliott Waves, as discovered by Ralph Nelson Elliott in the 1930's (for more on Elliott Wave Theory, see my first post). In the market for milk and other economic markets, consumers receive a certain amount of utility that they believe is more than the oppportunity cost they incur when they trade their currency for goods. They will wait until the price comes down if it is too high to buy it. But in the market for stocks, people don't want to wait for the price to come down, but rather they want to jump on board to ride the stock market higher. Soon everybody is buying into the market until it is up 400%, with no signs of heading down. But all of a sudden, the market reverses. Then it drops lower, and lower, and lower, until the same consumer who waited for the price of milk to come down before buying it didn't do that with his stock portfolio, and lost most of the money he invested in the stock market. at the bottom, he says, " I've had enough!" and sells it, only to watch it double in price off of its extreme price low. It is quite interesting how different financial markets are from economic markets, even though if they were treated the same way people would be much better off. This does not mean, however, that if an investment starts to go against an investor he should wait until the price bottoms and starts uptrending again. He should define his objectives and risk tolerances and set a stop loss, or have a money management plan in place BEFORE investing in the first place. This, I believe, is a key element to financial success.

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