Stock Market for Beginners

Last week, we found that the market technicals looked bullish. This week, however, we had some indecision in the market. Investors have been hesitant about putting more money into the market at its all-time highs. This is a good sign as the hysteria that is so typical of the last leg of a bull run doesn’t seem to have hit us yet. See my crowd psychology series for more detail.

Stock Market Strategies for Beginners:

1. A new resistance level has formed at the 1560 level. This barrier was tested four times.
2. RSI is falling back to the 50 level. Look for a bounce off 50 and a healthy run up in the market. If not, we could be in for more losses.
3. We have support by both a trend line and the 50-day moving average at 1520.
4. Further support lies at the mid 1480s.

It seems as if we’re entering a critical junction in the market. The market showed it’s indecisiveness this week and could be ready for a big move in either direction. Here are a few insightful articles on the state of the stock market:

• Cracks in the Market Foundation - Brett takes a look at an increasing number of stocks with new lows being formed.
• Stock Market Trading Review Video - Brian narrates an excellent video on technical analysis and the current state of the stock market.
• Technical Market Report - Mike offers his short term and intermediate term technical analysis. He also goes into some Presidential Cycle analysis.
• The Bull Market Fights to Stay Alive - My own take on some reasons the bull market still has some fight left in it.

The common theme among these articles is that we need to be using proper risk management. While the market doesn’t seem to have reached its peak, we’ve entered a very volatile period where we could have a large sell off.

<< Previous Stock Market Overview - July 15th <<

>> Next Stock Market Overview - July 29th >>

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After the Dow first hit 14,000 a few days ago and Bear Stearns announced that their two sub-prime hedge funds are basically worthless, we were set up perfect this morning to open down and trade much lower. Intel (INTC) traded down the other day after good earnings and forecast was another sign that we were at a temporary top. Both Google (GOOG) and Caterpillar (CAT) had sub par earnings, which weighed down on the market today. In general though, this bull market has fought off any significant bearish movement. Let’s examine why:

1. A lot of earnings are still due to come out and they are expected to be good. Any company that is related to commodities and the global economy is on fire. The declining dollar has also helped multinational earnings.
2. There are a ton of shorts out that ironically support the market. Having a lot of shorts out there is like having a ton of cash on the sideline ready to buy any dip and buy any rally.
3. The subprime issue is slowly getting priced into the market. Bear Stearns ended unch on the day after delivering news that might make them liable for an unknown amount of debt and unpredictable amount of lawsuits. Also Wells Fargo and Washington Mutual expressed very little subprime exposure.
4. Global stock market rally is pulling us up. Even though we are the largest economy in the world, our stock market is taking a back seat to what happens in the rest of the world. We are no longer the lead horse pulling the wagon.
5. We are in the third year of a presidential cycle which has shown to be statically strong.
6. We are in the parabolic phase of the China and Commodity bubble. During this phase, the bubble will expand to irrational levels with many money managers, analysts and retail investors getting sucked in. As traders, ask yourself how much energy, material, industrial and international stock you own or trade. When you wake up one morning and your whole portfolio is made up of these types of investments, you should start to worry about a top.

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Insider buying data has shown to be a good indicator for future stock price appreciation but it is not a fool proof system. From reading the introduction to some of the online trading websites and trading tools that advocate insider buying, it would seem that if an insider is buying, you should follow along blindly. The fact is, not all insider buying is good insider buying and you need to know how to tell the difference.

Like Peter Lynch says, “insiders buy for only one reason: they think the price will rise.” The key word in that statement is “think,” because it means they strongly believe there stock will rise but they do not know. Here are some examples of insider buying that investors should be careful about:

• Biotech stocks. Insiders at a biotech companies are often confident about their prospects but they don’t know what the FDA will say when it comes to approving their drug.
• Penny stocks. These typically aren’t good investments because the overall dollar amount that insiders commit is not substantial despite the large number of shares. Furthermore, penny stocks are notorious for their high risk levels because they are small and illiquid.

As an investor, you need to understand why an insider is buying shares of their company. If they are consistently purchasing shares, this definitely instills confidence in the company for the long term. This does not, however, promise the short term gain that may follow from a large, single purchase that can be an indicator of pending news.

Insider buying reports will often show buying from groups with greater than 10% ownership. These are not actual insiders but are usually hedge funds, high-worth individuals, and institutional investors. These professional investors are also considered “smart money” because they usually have good research, advice, and connections. The way they invest, however, can throw an observer off because professional investors never make one single purchase at one price. They often cost average down and can afford to take huge losses for long periods of time in hopes of a long term gain.

A perfect example is when insider buying data is showing professional buying that has been consistent for months but the stock keeps falling. As you’ll often see, consistent insider buying does not necessarily make a great buy. These professional investors have deeper pockets than most of us, so they can keep buying for a long time, even if the stock keeps falling. This type of buying can be tracked for a decision in the future but it should be avoided for now.

Sometimes the insider buying information is not an actual purchase of the shares in the open market but actually an exercise of stock options. This can be determined by looking at the stock price and time the insider bought at. If the share price he bought at is much lower than the share price was trading at for that date, you now know that it was an exercise of options and not an actual buy. I have seen professional business reporters, analysts and insider buying websites misinterpret this information. This is a huge error because most insiders that exercise their stock options expect to sell their shares in the near future in order to lock in their profit.

<< Insider Buying (Part 1): Overview<<

<< Insider Buying (Part 2): Investing Strategies <<

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Evergreen Solar (ESLR) develops solar power products. Solar companies have definitely been volatile because of its dependence on government policy. If you’re environmentally-conscious, this might be a good play for you if you’re in it for the long haul.

Stock Market for Beginners:

• RSI has had steady increase and looks to test the 50 level.
• Price has entered a bullish channel and is close to testing support at the bottom of the channel.
• Further support by the MA(50) and MA(200) offer more assurance to hold ESLR afloat.

If ESLR bounces off support once more, that will be a solid indicator of a strong support line.  Look for long term growth in this stock as alternative energy plays gain more traction over time. In addition, when dealing with volatile stocks like Evergreen Solar, make sure you follow fundamental risk management techniques.

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In my position sizing article, I talked about the importance of setting a stop loss target every time you make a trade in order to manage your risk. In this article, I will talk about the importance of envisioning a stop profit target in order to determine your risk/reward ratio. Understanding this ratio is crucial to a solid trading strategy.

In order to calculate the risk/reward ratio for any trade you make, you’ll need three numbers:

1. Entry price
2. Stop loss target price
3. Stop profit target price

The entry price is the price at which you plan on purchasing the stock at. The stop loss target price is the predetermined price at which you will sell your stock for a loss if it falls to that price. The stop profit target price is the predetermined price at which you will sell your stock for a profit if it rises to that price.

For example, if you were to buy Intel (INTC) at $25, that’s your entry price. Let’s say that I don’t want to take more than a 10% loss on my investment, so my stop loss target price is $22.50. In addition, I believe that Intel has the potential to reach $30 – this is my stop profit target price. Determining these stop prices effectively is one of the most difficult things to do in investing. In the next article, I will discuss different methods of determining your stop prices.

Your risk is the amount of loss you are willing to take per share of the stock:

Risk = Entry price – Stop loss target price

Your reward is the amount of profit you want to take per share of the stock:

Reward = Stop profit target price – Entry price

Obviously, then:

Risk/Reward Ratio = Risk / Reward

Let’s go back to our Intel example. Your risk for the Intel trade is $25 - $22.50 = $2.50. Your reward for the Intel trade is $30 - $25 = $5. Therefore, your risk/reward ratio on this trade is 1:2. That is, for every $1 you risk on this trade, you have the potential to gain $2.

Clearly, it makes sense then to pick the trades that give you the most reward for every $1 you risk. Most traders will recommend a risk/reward ratio of at least 1:2 or 1:3. I will later discuss how you can manage your portfolio using risk/reward ratios to predict your expected rate of return based on your current performance.

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If you’re a beginner looking to truly understand the stock market or an experienced investor looking to expand your knowledge base, there are more than a few timeless investing classics. Here are a few investing reading lists with detailed comments on each book:

• About.com Top 10 Investing Books
• Amazon Best Investment Books
• Global Equity Strategy - Investing 101 Reading List
• Motley Fool Top Investing Books

The following books are the most commonly acknowledged as must-read investment classics:

• Manias, Panics and Crashes by Charles Kindleberger
• Reminiscences of a Stock Operator by Edwin Lefevr
• Security Analysis by Benjamin Graham
• The Essays of Warren Buffet: Lessons for Corporate America by Warren Buffet, Lawrence Cunningham
• The Intelligent Investor by Benjamin Graham

Thus far, I’ve read parts of The Intelligent Investor, and have just started reading Reminiscences of a Stock Operator. If you’ve read any of these books or think I left out a classic, please let everyone know by posting comments!

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The Wall Street Journal has a fascinating article on Christianity and supply-side economics on their weekend front page. A few groups attribute “God’s tentative return to Europe” to the laws of economics:

Some scholars and Christian activists, however, are pushing a more controversial explanation: the laws of economics. As centuries-old churches long favored by the state lose their monopoly grip, Europe’s highly regulated market for religion is opening up to leaner, more-aggressive religious “firms.” The result, they say, is a supply-side stimulus to faith.

“Monopoly churches get lazy,” says Eva Hamberg, a professor at Lund University’s Centre for Theology and Religious Studies and co-author of academic articles that, based on Swedish data, suggest a correlation between an increase in religious competition and a rise in church-going. Europeans are deserting established churches, she says, “but this does not mean they are not religious.”

While I’m not necessarily arguing the validity of the article’s hypothesis, I do appreciate the outside-the-box thinking exemplified by these scholars and activists. This sort of unique analysis is exactly the sort of mindset that can really help you strike it big in the stock market. By looking at different perspectives and finding interesting connections, you can find fundamental causes and effects and use them to your advantage. In fact, it is the truly controversial findings - if you can validate them - that do not get integrated within mainstream investing that are the richest gold mines.

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Well, as I anticipated in last week’s stock market overview, price has broken through resistance and had a massive move up in the same day. You can expect the markets to be very volatile in the upcoming weeks because many investors are hesitant to put money in the market since it’s at an all-time high. This attitude that many have is a strong sign that the bull market still has some legs behind it - see my crowd psychology series for more detail.

Stock Market Strategies for Beginners:

1. Price has broken upwards through resistance after it was stuck in a trading range for over a month. This means that the previous resistance level of 1540 has now become a support level.
2. RSI has maintained a healthy reading of around or above the 50 level. This is the sign of a solid bull market.
3. MACD crossover is a bullish indicator.

All of these technical signals are very bullish. General investor sentiment has not reached the feverish pitch that it so often does right before a crash. A dose of skepticism is definitely a healthy sign for the market.

<< Previous Stock Market Overview - July 8th <<

>> Next Stock Market Overview - July 22nd >>

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Hovnanian Enterprises (HOV) builds residential homes in the United States. They have taken a big hit, as has the rest of the real estate market. Keep in mind, though, that when most people hate it, you should start thinking about the tremendous discount you could be getting. If you take a look at the chart, you can see a massive fallout in HOV since the beginning of June. Looks like we may have hit rock bottom.

Stock Investing Basics:

• Price has broken upwards through resistance.
• RSI has broken upwards through the 30 levels after being consistently oversold. In fact, RSI has formed a double bottom.
• MACD crossover indicates potential bullish change in trend.

I would definitely consider this stock a risky play. I would risk less of my capital than I would normally if I were to enter this trade. Furthermore, make sure you follow solid risk management techniques when entering the market.

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Ever since I started trading, it’s been very useful to keep tabs on the news. The Wall Street Journal offers some interesting insight into the market.

‘Margin Debt’ Hits Record $353 Billion on NYSE:

Investors are borrowing record sums of money to finance trades on the New York Stock Exchange, according to data due out from the Big Board today.

NYSE officials attribute the trend to recent regulatory changes effectively allowing both small and big investors to take on more leverage, or borrowed money, from their brokers. So-called margin debt, a broad measure of leverage, jumped 11% to $353 billion at NYSE in May, up from nearly $318 billion in April.

Market Analysis

This news kind of scares me. It’s a sign that investor confidence is reaching new highs. You can bet that when investors are borrowing money to put into the market, we’re stretching ourselves thin. Winnings get magnified, but losses get magnified even more. That’s why when the entire market is trading off a lot of margin, losses can cause chain reactions that result in market crashes.

Whole Foods is Hot, Wild Oats a Dud — So Said ‘Rahodeb’

In January 2005, someone using the name “Rahodeb” went online to a Yahoo stock-market forum and posted this opinion: No company would want to buy Wild Oats Markets Inc., a natural-foods grocer, at its price then of about $8 a share.

“Would Whole Foods buy OATS?” Rahodeb asked, using Wild Oats’ stock symbol. “Almost surely not at current prices. What would they gain? OATS locations are too small.” Rahodeb speculated that Wild Oats eventually would be sold after sliding into bankruptcy or when its stock fell below $5. A month later, Rahodeb wrote that Wild Oats management “clearly doesn’t know what it is doing …. OATS has no value and no future.”

The comments were typical of banter on Internet message boards for stocks, but the writer’s identity was anything but. Rahodeb was an online pseudonym of John Mackey, co-founder and chief executive of Whole Foods Market Inc. Earlier this year, his company agreed to buy Wild Oats for $565 million, or $18.50 a share.

Stock Analysis

The things people do nowadays to get ahead just don’t cease to amaze me. You can expect Whole Foods (WFMI) to take a hit - it has already dropped 1.27% in after hours. While this single incident may not be devastating to the company, investors will lose faith in management at the slightest wrongdoing. If Mackey is willing to underhandedly attack his competition, what other shady things is he capable of doing?

This incident is also a good example of why you shouldn’t believe everything you see or hear. Online message boards are notorious for having posters with ulterior motives. When reading content online, make sure you always question the author’s credibility - what’s in it for him or her to provide this content? Make sure you think for yourself and ask yourself if what the author is saying makes sense.

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