BUYING HIGH; SELLING LOW: NO NO NO!!

Time To Buy Stock – A Typical Pattern

A stock you have been watching has seemingly gone straight up with no end in sight.  It caught your attention, as it did many other investors’, after the second full week of its parabolic run.  You keep watching as it goes up for another week, while telling yourself, as the “smart” investor you are, “I will wait for a pullback and then buy in for the next parabolic run that will surely be coming.” 

At the end of the 3rd week, you see the stock weakening, and starting to pullback.  The pullback lasts approximately a week long, and then you think “now is my chance.”  You jump into the stock on the pullback.  The stock then goes up for another week, but, not quite as strongly as you had initially expected.  But, you are so proud of your investment prowess in that you are now making money.

However, you wake up one morning, and the stock has dropped 10% in price.  You convince yourself that it is just a small set back, and the parabolic rally, which you watched so carefully, will surely continue at any time now. 

However, the stock continues to only meander over the next few days.  But, you maintain your position, waiting for the parabolic rally to continue.  However, the following week, the stock gaps down another 10%.  The stock has now moved below the point at which you bought the stock. But, now, your ego or your fear of “losing” money will not allow you to sell the stock.  “It will come back,” you think to yourself.

It then has a “rally” of approximately 5% over the next week, and you breathe a sigh of relief.  However, when you wake up the following Monday morning, the stock has now gapped down another 8%.  The following day, another 5%.  You begin to panic.  Finally, after two more days of losses, you can’t take it anymore, and you sell the stock after losing 20% from your entry price.

A month later, you decide to validate how smart you were to get out of the stock, thinking about all the other poor investors that held on, only to find out, to your utter dismay, that the stock has now moved back up over your purchase price.

What’s Wrong With This Picture?

While this may not be exactly what has occurred to you in the past, I can guarantee that something like this scenario has occurred to just about every single investor at one point or another in their career. Yet, many still continue down this path, and make the same mistakes over and over again.

Not sure to whom I should appropriately attribute credit (either Ben Franklin or Albert Einstein), but I will simply provide the following quote anyway, as it is quite instructive:  Insanity is doing the same thing over and over again while expecting a different result.   This gives us insight as to why the majority of investors are indeed “insane,” and, consequently, almost always lose money.

In most all aspects of our purchasing lives, we are in search of “The Deal.”  We look for the best price in just about anything we acquire.  We will spend days comparing prices on our car purchases to get the best possible price.  We will spend hours and hours to find the best possible price on that HD 50’ television that we so desire.  Yet, we do not bridge that same mentality over to the stock market.  What is even worse is that we actually apply just the opposite thinking.   When we see prices significantly rise, we then feel compelled to buy.  But, what is it about the stock market that seemingly makes us put our wise buying perspective on the sideline?

If we take a step back, and try to understand what motivates an investor to notice a movement in the stock market or a particular stock, it provides some insight as to why the mistake we just outlined above is commonly made.

First, it takes a large and strong move in a stock or a market until most investors will really take notice.  Once that larger move finally exhibits a pullback, they automatically assume that the move will simply continue forward now that they have had the opportunity to get on board.  However, this simply applies linear analysis to a non-linear market, and the results simply cannot be positive. 

As an Elliottician, I believe that the markets are fractal in nature, or, patterned, if you will.  In theory, Elliott Wave theory postulates that public sentiment and mass psychology moves markets in 5 waves within a primary trend, and 3 waves in a counter-trend. Once a 5 wave move in public sentiment has completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply a natural cause of events in the human psyche, and not the operative effect from some form of “news.”

Sentiment Within The 5 Waves

Within the 5 wave move, each wave has its own “personality,” and indicates a different level of public sentiment and psychology.  Understanding this psychology is the key to understanding when to invest, which is often much more important than the actual investment vehicle chosen.   

The first wave in a bullish market represents the point at which the prior bearish decline has ended.  The first wave is usually begun at the point when the worst news for that specific wave degree is hitting the wires. It begins on a nice move up from the lows.  The initial move off the low is not believed by the masses, and is only looked upon as another rise to potentially short.

As a recent example, while the market was declining into the Thanksgiving holiday of 2011, the news seemed to be getting worse and worse regarding the precarious nature of the European banking/liquidity crisis.  In fact, the market was in what we classified as the final stages of a larger corrective downside move during this period of time, which often provides us with the environment for a wave one to begin.  In fact, right after the CNBC analyst, Steve Leisman, reported that the financial markets are within hours of worldwide collapse, the market turned up into a wave one from the lows of the prior corrective downside move.

The second wave engenders thoughts of the prior bearish decline, and the public is thoroughly convinced that the worst of the bear market is yet to come.  This is why second waves often retrace so deeply into the price advances of wave one.  However, second waves will retrace in a corrective looking manner, and the underlying technical indications of the move, along with the price pattern, will usually provide evidence that this is a second wave retracement.

This second wave sets up the strong price action that is viewed in the third wave powerful thrust to the upside.  As Frost & Prechter, in their “Elliott Wave Principle,” state:

Third waves are wonders to behold.  They are strong and broad, and the trend at this point is unmistakable. Increasingly favorable fundamentals enter the picture as confidence returns . . . third waves produce the most valuable clues to the wave count as it unfolds.

It is this third wave that makes the public take notice.  It provides a strong move up that makes everyone wish they were in the market.  It is often late in the third wave rise when they are looking for that “pullback” so they can ride the market, as it will seemingly continue in its parabolic rise.

However, the pullback they usually buy into is the fourth wave consolidation.  Often, fourth waves trend more sideways than down, as they pause to build the base for the final rally in this five wave move.  This is often where we see a lot of distribution within this corrective wave, and many of those that wanted to be in the market now buy from those who are happy to take their profits.   The “new” investors are now eagerly awaiting the continuation of the parabolic rise.

However, the fifth wave is almost never as dynamic as the third wave.  The fifth wave is usually accompanied by less volume as compared to the third wave. It is during this fifth wave that the fundamental picture is at its best, and optimism is running at its highest level.  For these reasons, many are strongly convinced that the rally will simply continue unabated, despite the fact that the fifth wave rise occurs on lesser volume and narrowing market breadth. 

Nevertheless, this is the point in time when discussions of the market heading to all-time highs are prevalent among almost all analysts.  During this time, even newscasters provide market analysis, since it is so “obvious” to them about the direction of the market.  It is during this period of time that you see many of the financial newsletters and websites provide headline articles representing the overall strong bullish sentiment.  Bullishness is riding at its highest levels at this time.  It is during this period of time that your cabdriver is talking to you about how you should be invested in the stock market.

But, as Elliotticians know very well, this is clearly the time to be reducing risk, especially after the third wave subdivision within the larger fifth wave.  But, unfortunately, the prior larger degree third wave has done its job, and has baited the masses that missed its strong rally to rush into the market to join the expected continuation of the prior parabolic move.  The prior parabolic rally will generally not continue in the same fashion.  The market is now moving nearer to a major topping point, rather than the continuation of any parabolic rally.  The ensuing reversal after the top of the lackluster 5th wave often leaves most investors battered, and wondering what they did wrong.  Yet, history evidences that the great majority of investors will do this time and time again, not having learned any important lessons along the way.

Professional Analysts

Many individual investors feel that they are alone in this whipsaw-world. But, I can assure you that the analyst world falls right into the exact same trap.  In fact, they are, most often, the worst culprits within this cycle since they are at the front lines and are caught up in the frenzy of the herd, expecting further parabolic rises in stocks and markets. 

For example, in noting how professional economists are always wrong about the prevailing trend, Professior Hernan Cortes Douglas, former Luksic Scholar at Harvard University, former Deputy Research Administrator at the World Bank, and former Senior Economist at the IMF, stated “[b]efore contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons.”

A mass form of progression and regression seems to be hard wired deep within the psyche of all living creatures, and that is what we have come to know today as the “herding principle.” Humans are hard wired for herding within their basal ganglia and limbic system within their brain, which is a biological response they share with all animals.

Finance professor Robert Olson published an article in 1996 in the Financial Analysts Journal in which he presented the conclusions of his study of 4000 corporate earnings estimates by company analysts:

Experts’ earnings predictions exhibit positive bias and disappointing accuracy.  These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.  This article suggests that the human desire for consensus leads to herding behavior among earnings forecasters. 

Moreover, it seems that this herding principle is pervasive among professional traders, who adhere to the Elliott Wave pattern quite ubiquitously.  In fact, when reviewing the levels of cash held at money manager institutions, they are always at historically low levels at each of the historical market peaks.  But, with the low levels of cash available at market peaks, what is going to be left to drive markets yet higher in the expected parabolic fashion?

Conclusion

I sincerely hope that you are now able to obtain a clearer picture as to why most investors buy at or near the highs.  Ultimately, these same investors sell at the lows for the exact opposite reasons, as you simply have to inverse the analysis during a bear market.

Unfortunately, if one does not understand this market dynamic and psychology, then one will be continually caught within this investor cycle that seems to constantly bait individuals and professionals to buy high and sell low.