Why does the stock market go up one day then fall flat on its face the next? The media always has an explanation. One day the economy is on a road to recovery and the next is doomed to fail. If we were to make investment decisions based on the medias interpretation, we would be buying at the highs and selling at the lows.
If it is already raining outside, how does a forecast for rain help us? What we really need to know is when the sun is coming out. What we need is a barometer. When a barometer’s pressure is rising we can expect good weather is on the way. When the barometer’s pressure is falling, we should prepare for bad weather. So what is the barometer for the stock market?
The simple and most logical answer is, expectations. When expectations are falling as with a barometer, we can expect the market to start deteriorating. When expectations are rising like a barometer, we should expect the market to start improving. Probably the most important point to understand is when the pressure can’t get any lower or higher.
Stock market direction is our reaction to expectations improving or deteriorating. An example of how expectations influence our behavior is best expressed by the following.
Imagine twin siblings attending the same school and enrolled in the same classes. One of the twins typically gets straight “A’s” while the other regularly gets “B’s”. On report card day both twins come home with straight “A’s”. Which twin will have the biggest reaction from their parents? The obvious answer is the “B” student, but is it warranted?
The straight “A” student works hard all of the time, while the “B” student is capable of getting straight “A’s”, but chooses to only get them when he or she wants a big reaction from their parents. This example shows us that the parents’ larger reaction with one twin over the other was determined by expectations.
This example also shows us that once we reach a peak in high expectation there is no other direction to go but down. It’s impossible for a straight “A” student to exceed expectations at this level. The higher we move in expectations the smaller is our margin for error.
The above example plays out in the markets regularly. How many times do we see a company report earnings and beat estimates by a large margin, yet the stock sells off because it just was not enough? On the other hand, how many times have we seen a company miss earnings, but one little data point beats expectations and the stock takes off? The difference between these two companies is the level of expectations the market has for them.
If we just look at the daily market action, we are just looking out the window. If we really want to forecast future market conditions, we need to know which way expectations are going and at what point it can’t get any worse or better.
To learn how to create an indicator that tracks the stock market expectations and identify its limits, read “The Art of Expectations”.