5 Fundamental Reasons Stock Prices Might Not Be Totally Random

Fundamental and value investors use corporate earnings analysis  as one of the driving factors to select investment with the highest potential. However, another class of investors is not particularly concerned with either intrinsic value or earnings, but instead is focused purely on the stock price and which direction it is heading.

Momentum-driven investors frequently are looked down on by fundamental analysts, who see them as “dumb” money. But as we saw in  a  , there is pretty strong evidence that buying past winners and selling past losers is a profitable strategy over the long term. There are a few fundamental reasons stock prices might not be totally random, but instead tend to “trend” at important times:

1. It can take a long time for large institutional investors like mutual funds and pension funds to enter into positions in a stock. This is because they are managing so much money that they need to space out the time period in which they buy a new stock in order not to flood the market with “buy” orders and make the price go up.

2. Professional investors tend to “herd” together for various reasons (either they are directly sharing ideas, or it is just the professionally safe path to take because if the stock you buy goes down, at least you can claim that plenty of other people made the same mistake). Once one big fund accumulates a position, pushing the price up in the process, others are likely to follow.

3. New information may not be instantaneously incorporated into the stock price. If, for instance, a company’s new products are selling far better than anyone expected, different analysts may figure this out at different times. This can create sustained buying pressure on a stock.

4. Somebody may have non-public information. The first buyers in a trend may be analysts with inside information, or company insiders who know something is up. These first buyers cause the stock price to go up initially. Once the news travels, the price continues to go up until the information is completely reflected.

5. Once a stock has gone up a lot (for any reason), momentum investors will flood in and purchase its shares, pushing it up even more. In this sense, momentum can be a self-fulfilling phenomenon (the mere fact that a lot of people think it exists reinforces that view).

It is important to note that these factors fall into two categories. Some are fundamental factors related to the transmission of information. Others are technical factors related only to the short-term supply and demand for shares of a company’s stock. Often, both of these factors are involved. A stock’s momentum run can start on the back of fundamental factors, such as a pick-up in the company’s business that the market does not instantaneously recognize, but then continue after favorable news has already been fully priced in because of technical factors.

Be careful when ’fighting the tape’.

Long-time stock traders like to say that it is never a good idea to “fight the tape.” In other words, if the market seems intent on sending the price of a company’s shares down, it is not a good idea to go against the grain and buy them. This generally may be sage advice, but it is confusing to many, as it goes against the “buy low, sell high” value investing ethos favored by famous investors such as Warren Buffett.

A more nuanced view would be “don’t fight the tape unless you have a good reason.” There is usually a reason why stock prices react the way they do. If you believe that reason has become obvious and that the market has moved past the “fundamental” momentum stage and into the “technical” one, then buying a stock that has gotten beaten down to below its fair value can be a very profitable strategy. But make sure that you really understand the business and have a good reason for thinking that it will be worth more in the long term than it is today. This is why Buffett only owns a small and concentrated portfolio of companies with relatively simple businesses that he can understand.

“Fighting the tape” can be really dangerous because there is always a strong chance that somebody who is selling knows something that you do not. They might even be aware of non-public information. For most individual investors who do not have the time to really understand a business in as much detail as professional investors such as Warren Buffett, it is probably better to wait for a stock price to stabilize for a couple of months before rushing in and buying (e.g., look for a chart that has flattened out and is no longer falling).

On the other hand, buying stocks that have already gone up in price can be difficult because it feels like you may have already “missed out on the party.” But this can actually be a profitable strategy over the long term. A key to investing in these kinds of momentum stocks is to get out (sell) once it seems like the positive business news has been more than priced in and the only buyers remaining are momentum chasers. Evidence of this might be when the price-to-earnings (P/E) ratio of the stock has reached unjustifiable levels and the stock is frequently mentioned in the financial news. Stocks that are relying on technical momentum factors can fall sharply for little reason, since even a small fall will cause the momentum crowd to bail out of their positions en masse. Netflix (NFLX) is a great example of this situation in recent times.

Private investors must keep in mind that, with expert analysts on staff and advanced analytical technology, institutional investors have a considerable advantage when it comes to identifying and exploiting short-term trends of stock price movement. However, private investors can use knowledge and concepts to assemble and manage a profitable investment portfolio over the long term.

Another important concept that private investors must consider is the time value of money, which will be discussed in a different article.

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Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.