Over the last few nights, I have been watching the World Series of Poker on ESPN. I enjoy playing poker and have for a long time. My grandfather first taught me how to play when I was in kindergarten. He was visiting us from Virginia and when I got home around noon from morning kindergarten, it was just the two of us. He taught me the rules and what beat what in terms of hands and we used M&Ms as our currency. It is still one of my favorite memories of him.
While I certainly didn’t understand probabilities in kindergarten, I have come to appreciate how we use them in everyday life. When we are driving down the road most of us feel safe driving a few miles per hour over the posted speed limit. We figure the probability of getting pulled is small if we are less than five miles per hour over the limit. As we you increase your speed to 10 MPH over the limit, the probability of getting pulled over increases. We make these decisions daily and without giving much thought to the odds.
For me, I use probabilities almost every day in how I analyze investments. I look at the fundamental, sentiment, and technical analysis to determine whether the odds favor an investment moving higher or lower. And just like it is in poker, even if the odds are stacked in your favor, there are times when you will lose. Anyone that says they are always right with their investments is lying.
Let me give you some examples. In addition to writing for Bull Market Rodeo, I also contribute articles to Seeking Alpha. Over the last few weeks I have written four articles about different companies ahead of their earnings reports. I wrote one on Micron Technology (Nasdaq: MU) where I said I thought the sentiment was too bullish ahead of the report and that investors would be able to buy the stock at a lower price a week or two after the report. It turns out I was right with that assessment.
I wrote articles about McCormick (NYSE: MKC) and KB Home (NYSE: KBH) ahead of their earnings reports and both cases I predicted that the stocks would jump after their earnings reports. The fundamentals were good, the sentiment reflected indifference or bearishness, and the charts both looked good. Both stocks moved higher after their earnings reports.
I wrote one this week about the three big banks that reported earnings on Friday—Citigroup (NYSE: C), JPMorgan Chase (NYSE: JPM), and Wells Fargo (NYSE: WFC). I felt like the fundamentals were only slightly above average, the sentiment was either neutral or bullish (bearish from a contrarian viewpoint), and I only liked one of the charts. The one chart I liked was on JPMorgan Chase. After the earnings reports were released, Citi and Wells Fargo both dropped and JPMorgan experienced a slight gain.
In all of these cases, my predictions turned out to be right. Like I said before, no one is always right when it comes to investments. It just so happens that I have been right on the recent articles I have written.
I am pointing these stocks and my predictions out so that it might help readers evaluate investments better. I think too many investors just look at one aspect of analysis without looking at the other two styles. For instance, with Micron, I loved the fundamentals of the company. They have had great earnings and sales growth, the return on equity is really good and so are the profit margin and operating margin. The problem was with the sentiment. Investors were just too bullish in my estimation and I felt the probability of the stock jumping sharply was very low. The hurdle was just too high. No matter how great of an earnings report the company delivered… it was going to be very difficult for the stock to move higher.
I believe that the fundamental analysis tells us what stocks to buy, but the sentiment and the technical analysis tell us when to buy them. And for the sentiment analysis, I look at the short interest on the stock, the analysts’ ratings, and the option activity. If the short interest ratio is too low, the possibility of a short-covering rally is eliminated. If the short interest ratio is high (5.0 or higher), the possibility of a short-covering rally is a positive.
If there are 30 analysts covering a stock and 27 of them have the stock rated as a “buy”, the probability of an upgrade is very small and the probability of a downgrade is much higher. If there is twice as much call open interest as put open interest in the options, there is too much bullish sentiment from that area.
These are just some of the tools I use to measure how I think a stock will move. This approach has helped me choose investments for a number of years now. It hasn’t eliminated losing investments, but it has helped reduce the losing trades and increase the winning trades. Perhaps it will help you as well.