In essence, a speculator buys the stocks that have the most institutional support, in a strong uptrend.
But it’s not only about finding a stock that is in an uptrend, that stock also to have the highest possible chance of continuing that uptrend with the least interruption.
Think about what “least interruption” could mean for a stock. As we discussed, a strong trend is determined by buying demand outpacing selling pressure, that means there is more money interested in buying than in selling. When a stock runs up to a price level where it has traded before in the last few months, years or even longer, an effect comes into play that is known as “Overhead Supply”. Overhead supply has nothing to do with the business and accounting metric of ‘overhead costs’. Stock overhead supply is a concept that you have to write on the inside of your skull, and burn indelibly into your memory. It’s that important.
What overhead supply is
Let’s take a brief step back. The stock market is a large machine driven up and down by crowd psychology. However, most market participants are not savvy about how the markets truly work. Amateurs, and many professionals that manage larger amounts of money alike, are human and a large part of them do the wrong thing at the wrong time, listening to impulses and succumbing to emotional or logical pitfalls. They are part of what’s generally referred to as the “dumb” money.
Looking at the below schematics. In a stock, many speculators buy unsystematically and ignorant of previous price history or a chart, for example at points A and B. Many private small speculators, larger pro traders and even institutional money managers often buy stocks at the wrong time, only to see their price keep dropping right thereafter over weeks, months or years. Should they continue to hold onto their shares, then they will be sitting through large and accelerating losses. And many do really continue to hold, as most people in the markets do not manage risk properly and succumb to ‘hope’. These long periods of sitting on large losses cause a lot of negative emotions such as regret, frustration, fear, anger, panic, and pleading in the holders. This also happens to the less-savvy professionals or institutional fund managers – they are just as human as everyone else.
New or the same people again will at points C, D & E buy into the falling stock, often arguing with undervaluation or buying into a small rally they ‘hope’ will be the continuation of the up-trend, or a new one all-together – and immediately sit on a loss. Again, many will continue to hold their shares through a growing loss, ‘hoping’. Once price has dropped, more buyers will flock in at F & G to buy more of the stock, seeing it low-priced, or hoping it starts a new rally. At some point, the drop finds support and ceases, because a lot of capital/people start buying here.
This of course shall not be a justification to buy down-trending stocks – C, D & E thought the exact same thing and now have a loss, and it only so happens that F & G are not sitting on one, but price could have declined another 90% from there – in the market there’s no sure thing, and it’s all about probabilities.
Now, should the price return many weeks, months or years later to about the price area where people bought in the past, a surprisingly large amount of the “dumb” money sees that their losses have mitigated to a point of break-even.
Since most market participants act impulsively & unsystematically without a strategy, most will at such a point sell their shares out of emotional relief, to recover their funds and to “avoid a loss” – so at least they argue in their head, eager to get out unscathed financially and emotionally. Speculators who bought at points A, B, C, D, E will sell to recover their funds once their losses are minimal or null and they are at break-even. “Got away with this one, Phew!” they’ll think, ignoring the reality that their account balance and money had drawn down largely in the meantime. “I won’t do that again anytime soon!”. Buyers in group A can reach back months or years.
Added to this is selling from people who bought at lower prices and want to take their profits of the table. Speculators and traders from F & G will start taking profits, causing even more selling. Both sellers from A-E and from F & G can be amateurs or professionals, large buyers or small – human nature and its weaknesses are the same, whether for a professional fund manager, or a small private stock buyer.
To visualize, better, here are the two forces of overhead selling supply at work – namely selling to recover funds (by previous buyers at A-E), and selling to take profits (by previous buyers at F-G):
This selling can become very intense and even overwhelming to an advance, as many millions of dollars of selling can come almost simultaneously to the market, depending on the stock and its history. Since selling pushes prices down, all these speculators selling around the same price area biases the balance of supply and demand so that a price advance will be slowed substantially, brought to completely to a halt, and/or strong volatility ensues (J, K). Often a trend may here even be reversed (L) by such selling. This is crowd psychology at work, and epitomizes the hazards of overhead supply.
Exceptionally, should the stock be able to come back through the overhead supply to it’s old high prices and “digest” constructively (we’ll discuss later), it’s a sign of strength – and the stock might become again interesting to a speculator.
No overhead supply = no resistance for a trend
Going back, the ability of a stock to continue its trend with “least interruption” means that there will be a minimum amount of people inclined to sell when prices advance. That means, stocks with the least or no amount of overhead supply will not be unnecessarily slowed or halted in their advance, thus they will be the ones that have the highest probability of moving the most in the shortest amount of time.
That is so because none of the holders of the stock are at a loss, and there are no natural sellers into a price advance. Everybody is happy and making money with a rising trend. The only reason people would sell would be to take profits (which will lead to short-term pullbacks, “digestions”, and tops, which we’ll discuss later), or those erroneously believing that a stock is overvalued and shorting it, just to be forced to cover their short position soon after and giving more fuel to the rally. We will later understand the crowd psychology behind why an uptrend tends to stay in motion in more detail.
So, when the market turns and the meaty part of an uptrend starts, you want to be in the best stocks that can magnify that trend the most. That means these stocks have to be in strong trends, near their recent high prices. The lack of overhead selling supply when the stock advances into New High prices, enables it to march on initially relatively unencumbered, to enter a full process of price discovery to the upside.
As a summary, it is paramount to understand that when a stock makes a new price high, it enters a price level at which it has never been trading before. The necessary result of this is that nobody has ever paid a price that was higher than this current price high. Thus, by definition, there can be no sellers trying to recover their funds at any point M-Q in the below chart. It is because of this dynamic, that against consensus opinion, the act of considering to buy a stock actually actually has the lowest risk associated with it when it is near its historical high price, as only limited selling (profit-taking from buyers at lower prices) can temporarily depress the price. However, we will neither just indiscriminately buy stocks at new high prices.
From this perspective, it’s crucial to really grasp the value of stocks trading at prices that are considered “high” to their historical price range. Ideally not just high, but near the highest it’s ever been.
This is of course only the case in an early trend, and not in a later mature trend in a stock or market that is about to top out and progress into heavy selling and dropping prices. As you’ll see later, joining a young trend is one of the main criteria for stock selection.
Does this sound counter-intuitive?
Now, this may appear completely wrong to those that have learned run-of-the-mill “investment” tips, commonly what’s known as value investing – “Buy Low, Sell High”. In value investing, you calculate an intrinsic value of company, and buy the stock when it trades at a price below that intrinsic value, which is, not always, but very frequently, after a stock price has dropped precipitously. I’ve warned about the problems with value investing before.
Buying stocks at historically Low prices is problematic because of the extreme overhead supply that such stocks have to fight through, slowing any upward move massively down or halting or reversing any moves frequently for years. Money can be made, of course – but if you risk you hard-earned money at all, you might as well do it where the highest rewards loom for the same amount of risk.
Worse, stocks that are bought for “value” often trend down, and are doing so for a reason. Remember that selling causes price drops, and consistent and large-volume selling over a long time, indicating institutional buyers leaving a stock, leads to downtrends. Selling begets more selling, as on every small rally, the “investors” who bought even just a little higher will sell eager to recover their funds at break.-even, leading to renewed downward selling pressure.
“Value” or collapsed once-expensive stocks lock up your money for long times
There’s no guarantee that buying stocks at low prices with overhead supply will work, but even if it does, it will often take a rather long time to make profits – because the stock has to work through that same selling supply. This can take years or decades, and show slow and meandering price advances with much lower profit potential.
The other, and even more problematic way of value investing is to buy past leading growth stocks that have collapsed in price. There, amateurs became interested near the end of their previous strong run. They were afraid to buy at high prices and had been waiting to buy at lower prices, now expecting these stocks to repeat their strong up-trends over and over. But this uptrend was once so engineered by the “smart” money institutional holders to make a buzz around these stocks to create a liquid market to sell their large holdings into. There is no guarantee a stock will ever repeat its old performance once it has collapsed – and many don’t, as countless examples from the dot-com bubble, the 1960s, 1920s, 1980s or any other bull markets show.
You needs stocks in an uptrend, close to new high price. But you can’t just buy them at any time you wish!
Summarizing, the smart small speculator buys stocks that trade near their highest historical price ranges, even if that may ‘feel’ risky to the amateur. The negative effects of overhead supply slowing/reversing trends and causing whipsawing volatility with regard to performance and risk management cannot be understated.
Of course, there will always be multiple stocks in somewhat of an uptrend and somewhat close to new highs. These stocks will have better or worse quality and will perform better or worse for you. At a later time in this course we will of course cover how to select the specific stocks out of the bunch that truly are worth your time … but before learning how to select the right stocks, it’s crucial to first learn how to handle the situation when we select a stock that later turns out to be a bad idea.
Let’s suppose that we have some selection criteria in place. Once we have pinpointed a stock that we consider interesting, the succeeding step will be to think about when to buy … because nothing could be more wrong than just jumping into an interesting stock the moment you spot it.
The next guide will take a quick detour into basic risk management before we head into finding low-risk entry points … because the process of how to handle stocks that turn out to be a fluke is heavily intertwined with determining the ideal timing of a stock purchase.
Confused? You’ll understand it soon.