What We Can Learn from This Week’s Stock Rally

Stocks

If the stock market was really concerned about things like valuation, the coronavirus offered the bears a perfect opportunity to flee. The bulls are still carrying the day.

In the midst of what was a dramatic selloff in the markets that coincided with concerns that China’s response to the coronavirus threat that they are battling these days, several commentators believed that an even bigger threat was investors wanting to flee what they felt was an overvalued market.

There wasn’t any good reason to think that stocks are actually overvalued though, and this does not even make sense, but in order to know this, you have to know what value means with stocks and how it could be possible for stocks to actually be overvalued.

It is not even possible for stocks to be overvalued by the market, but only if you realize that it is the market that values stocks and that’s what we see when we see stock prices move. Tesla just keeps going up and it broke through $700 on Monday as well as $800 and even $900 for a time Tuesday, where the market has now valued this stock this much. The only way we could actually be overvalued is if the data was misreported, not because someone thinks that the market should value stocks differently.

As crazy of an idea that this might be, not only do people use it, it has infected investment thinking like a virus, to the point where very few fully understands what stock valuation even means.

We come up with all sorts of ideas and formulas to try to determine a truer value of stocks than the market has assigned, involving ridiculous assumptions, oversimplifications and inaccuracies. We don’t even need to go into that here although we do discuss some of these elsewhere, as all we need to say is that regardless of whether we agree with market valuations, this is what the market uses, this is what the truth is in other words, without question.

If we ignore the truth, we cannot expect to find it. If we think the proper valuation of Tesla is $360, like some analysts think, and we see its price at $900, they are wrong and wrong by a big margin. Even being wrong by this much doesn’t discourage these people though.

Whether or not someone believes Tesla will drop to $360 is another matter and a completely different one from what it may be worth today, as we know with absolute certainty that this stock has had its valuation last assessed at $892.52 at the close of trading Tuesday.

This is exactly what it is being valued at, not a penny more or less, and while we may wish to guess as to where it is going, whether that be down to $360 or to $2000, none of this has to do with how it is valued now, as we instead are predicting what we think how it may be valued at some point in the future.

This is a more important distinction than it may appear, as if we don’t understand it, we’ll be leaving the path of reality. These people really think that this stock has a value right now that is different from its trading price, and don’t understand how ridiculous this idea is. When our beliefs and the facts differ, we are mistaken, and when we place our mistakes right along the facts such as Tesla’s stock value being a lot less, and don’t even notice that this is not a mistake, we’re in real trouble.

We all want to achieve good insights to be able to predict future stock prices, future valuations in other words, and there are various methods that we can use to do this, but whatever we use is only as good as its predictive value. If we care at all about being right, we need to examine how whatever means we use measures up as far as reliability goes.

If we are using a crystal ball for this, we need to look at the predictions it provides to see how reliable it is, and this is needed with any method, because otherwise we’ll have no idea whether it even works. If we instead think that there is some sort of secret code that unlocks the true value of stocks, whatever it is, this must also be subject to scrutiny, or we’ll just remain lost.

Thinking that the value of stocks is determined in any way other than the prices that people trade them at over time leads us to some very false beliefs, but the worst of this is how people cling to their mistaken views regardless of how badly they perform.

If you think that your one of your kids who knows nothing about stocks can guide you every step of the way, because they are anointed, and the fact that the kid is wrong a lot this does not even discourage you or call you to question what you are doing, you have excluded even the possibility of ever figuring this out and being right enough.

Since the Market Decides Value, Arguing with It is Of No Use

People therefore can think that stocks in general are overvalued right now, and there are plenty of people right now that think this. This all gets decided in the free market, and we can indeed see enough people that vote to put stock prices down that the prices actually get put down, if the momentum from this exceeds the positive momentum.

Financial markets are completely democratic, and you can use your votes however you like, including moving all of your money out of stocks if you wish. It does not matter how bad your reasoning may be, because trading does not involve arguments or even analysis at the point of action, as all you have is the action.

We therefore always need to pay attention to these things, especially when things start to turn a little bearish. If there is something else that may scare investors such as the effects of this coronavirus, this can increase the fear level of those who are already afraid that the stock market is overvalued in their mind, presenting an additional threat.

As long as we realize that this is all a manifestation of changing confidence levels, we are able to perceive these risks for what they are and not imagine some outside force like their concept of valuation in of itself influencing stock prices to any degree at any time. If people are scared enough by this, that may be a different story, but in order to know what is going on, we need to look at the net confidence level, as it may be positive enough to offset these fears.

Knowing how easily a market becomes scared is something we can really use, and there is no better indicator to tell us what potential the bears may bring. If the bulls bend but not break, if they take some big concerns and have the power to turn the ship around in the right direction anyway, that’s a real good sign.

There’s a lot to be afraid of these days. There’s not only this fear of a market pullback due to overvaluation, there’s a coronavirus threat, the worry about Bernie Sanders or Elizabeth Warren winning the Democratic nomination for president, the progress with the trade deal stalling and reversing, the risk of a conflict in the Middle East, worries about our economy declining into a recession, and more, so this is a great time to see what this bull market is really made of.

We had become worried about the economic effects of China being locked down like it is now, but the real worry was about market resilience, whether the dips that this has caused will be seen on a net basis as a buying opportunity or a selling opportunity.

While we may not want to step away for any old reason, the risk here was high enough that this was wise while the bulls were getting knocked down, at least up until they picked themselves off the ground over these last two trading days and pointed their horns toward the bears in defiance.

This is not to suggest that the worst is over, but the fever caused by this virus has at least broken for now, where we can at least set the warning level from DEFCON 3 where we should take real precautions, to DEFCON 2 where things are stable but still require extra close monitoring.

If you were hedging against all this, as we suggested, the time to recognize the change in tone was during the overnight trading on Sunday night and early Monday morning, where we opened up after the weekend recess and just kept going.

This reveals an important use of a futures account even if you don’t trade them otherwise, where we opened up a little higher and those who trade futures or contracts for difference could have then got the jump on the regular market. For those who wanted to see more, Tuesday’s big up day actually started about 7PM eastern on Monday night. The regular trading hour move was actually neutral, and all of the day’s net gains happened between the close on Monday and the open on Tuesday.

It’s just as important to know when to pull a hedge as when to place it, and the action on Monday and Tuesday isn’t something we would want to avoid on purpose by deciding to sit on our hands. It’s not that we can relax yet, as we may want to put this back on depending on how things go, but we are clearly beating the effects of this virus and everything else back this week and that should not go unnoticed.

You get out so that you can get back in at a better time, but staying out during the better times is not the right way to do this at all.

The Return of the Bulls is Bullish Indeed

We ended up seeing Friday’s losses being gained back over the two days, and Friday’s trading was what really set the fire alarm off, suggesting that people may continue to flee. Even then, the move down was still pretty limited, and once the alarm got turned off this week, and we cleaned up the mess that this little stampede caused, this isn’t just good, it speaks big for how tough the bulls really are.

We took bigger hits than this last May and last August, and while we recovered, the potential of this one was bigger. Recovering so much more quickly this time reveals that the underlying confidence of the market is even stronger right now, and if our response is any indication, it would take a great deal indeed to keep it down for long.

President Sanders or President Warren could do it pretty easily, as this would be like sucking all the air out of whatever size balloon we can blow up, as they gleefully stick a pin in it. We need to not only watch this race run closely, we especially need to pay attention to how the market is taking it, because it is only what the market believes that matters, no matter what we may believe.

There does not seem to be anything else out there right now that can wrestle our current crop of bulls to the ground, and this is ultimately decided by how eager institutional investors are to buy whatever dips come our way. Seeing what happens in a dip is the best way by far to judge the strength of a bull market, as no matter how fast it runs, we also want to know what happens if it gets knocked down.

In a real sense, this week may be the most bullish yet, as we dusted ourselves off from a considerable fall and resumed charging. This is not the time to be hedging.

Some of this at least is due to the Iowa primary fiasco, and if you are an investor, seeing the Democrats look weak is indeed something to like, even though in the end something like this isn’t very meaningful. We’re pulling back now as the results are in, but not seeing Sanders #1 is seen as at least some consolation.

The threat to the market here doesn’t have anything to do with political ideals, unless you count bashing the economy and the stock market among them. This really about whether someone is for us or against us, and on that side, even Joe Biden is against us, although a lesser threat than the lefties.

The outcome of the primaries as well as changes in polling is already influencing us, and while some look back at previous races and may feel smug to wait until the election is at least closer at hand and things are clearer, we don’t want to superimpose this sort of belief on the market either, because we don’t get to decide how worried we should be at any step along the way, and we need to pay attention to what does decide this completely.

As for the coronavirus threat, if you believe that the market should pay a lot of attention to short-term economic pain, they sure haven’t done much yet, and they get to choose what path they want regardless of what you think their path should be in your own eyes. We should use our eyes to see and not just imagine, ensuring this sense is used to view the real world and not the way we imagine it is or will be in our minds, lest illusion displace reality.

We do not want to be basing our investment strategies upon fantasy, where we mistakenly believe that there is another force besides market sentiment that moves stock prices, and pay attention to these things and ignore what actually determines them. The inner eye can serve a purpose, but the outer eye must always be in charge because it looks upon the field where the game is played for real.

It is also very important to not try to be soothsayers when there is no reason to even try to be, where we make decisions based upon a belief of future value that will harm us if we are wrong.

Last week was terrible, and that means bearish. This week is much better, much more bullish. These two beasts will continue to fight it out this week and beyond, and we could guess that the bulls will have us higher at Friday’s close, but there is no good reason to want to guess here.

Each day tells its own story, adding to the history involved, and if we are thinking about buying or selling right now, we need to look at what is going on right now because that’s when we wish to act.

We always need to predict the future when we buy, sell, and even hold stocks, as each hour that we hold involves a decision not to exit. This is a time where it becomes even more important not to mess this up, in times of such uncertainty and volatility, but for now, the skies have cleared. Even if we knew for certain what the future will be at some point, there’s still the matter of the path there, and keeping our eyes on where we are treading and not just looking to the sky praying for guidance is the only real way not to trip and hit your head.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.