Chowder:
There are 4 stages of price movement.
- Stage 1 … The basing area is where buyers and sellers (supply vs demand) are in equilibrium but sellers still are in command because Stage 1 comes at the end of a correction. This is often called the bottoming out phase. (I’m keeping this short!)
- Stage 2 … The advancing stage is when the selling has died out, more buyers (demand) are starting to come to market and this is the ideal time to build a portfolio. This is the stage that only comes in a raging bull market. It is the ultimate breakout phase and often lasts for years. Miss this stage and it takes decades to make up for the lost opportunity. It is this phase where you saw me POUNDING the table on buying 52 week breakouts. As a former trader I knew this was as close to a gimme as you can get.
- Stage 3 … The top area is where you start to see huge volume but it isn’t supported with a confirming price move. This indicates a lot of churning of business. The market tends to trade sideways or in a narrow range, sort of like we’ve seen the last 5 weeks.
- Stage 4 … The declining phase is when there is no catalyst to drive prices higher and volume will often start to dry up. When the buying dries up, traders and short term folks will start to lock in profits and the market starts to decline.
Now this is important, Stage 4 does not always follow Stage 3. We can get another Stage 2 price move after a Stage 3 depending on the condition of the market.
Earnings season starts in a couple of weeks and I think that will determine which stage the market moves in for the next quarter.
I will add this critical point, you DO NOT use historical PE’s in your valuation process during Stage 2 price moves. Doing so would have had you sitting on the sidelines since 2012 or 2013 at the latest.
A follow up response about PE’s and why those of you following PE’s have made a huge mistake the last 4 or 5 years. Look at the companies you own that aren’t as large as you wanted them because you held off on buying more because you were looking at the PE. You were looking at current PE to historical PE and determining your company was too expensive to add more and the price kept going higher and higher and higher. I’ve made this mistake myself. … Rookie mistake!
Short term traders rely on PE’s. The talking heads on TV rely on PE’s because they are traders, not investors, and it takes a different mindset to be an investor.
How many of you have identified a good company that you let go because you thought it was overvalued and you allowed the PE to help confirm your non-action? I’d bet odds everyone here has.
Pull up a 5 year chart of your best performing companies that you are underweight on. Look at that price move over the last 5 years. Your company was overvalued based on PE analysis in most cases and that Stage 2 price move that will be staring you in the face was missed because you focused on a short term technical indicator for a long term investment.
Yes, I know Peter Lynch talked about PE’s, I’ve got his book, I’ve read his book, I followed that advice until I finally made the connection. He had to give a “generic” analysis because he couldn’t take the “condition of the market” into consideration because he had no idea what the market conditions would be in the future. PE analysis is a great “generic” indicator, but it also forces you to miss Stage 2 price moves, moves where the greatest returns come from, and once the Stage 2 move is done, it may take years for another one to develop and then PE analysis can come back into play, the way Chuck presents it in his articles.
Cash flow analysis is better suited for long term investments. Earnings can be manipulated and that in and of itself manipulates the PE. You can not manipulate cash flows, and that’s why most firms who present fair value numbers use discounted cash flow models and not some other source of criteria.
Following their discounted cash flow models has made my job of investing a lot easier. I’m not trying to out-think myself, out-guess the market, or suffer from some of the most hated words I ever want to hear … I wish I owned more of it.
You had it, you blew it, and you blew it because you bought into the rhetoric of others and it was right there in front of us all this time. It took me years to figure it out, but I got this now. I hope you do as well.
