"Over Reaction" and How It Hurts Us Traders
The market has been called a perfect entity, where buyers and sellers even things out. Well to a certain extent that is actually true. But, before it "evens things out" it often overshoots the marks on both sides of the ledger. For instance let's say XYZ makes some big noise about an upcoming deal they are getting. Soon the market is going crazy buying it up and XYZ is flying. Was the news really hot enough for XYZ to gain 10 points in two days, or was it simply a big momentum wave that got built up and everyone wanted "in" before they missed the boat? We suggest it was the latter. On the other suppose you see a stock taken down over $5 a share simply because they stated their revenues wouldn't be "up to par". Is that valid? We don't think so. Both of these examples are "over reactions" and once the hype and rush is over, THEN the market equalizes things out. For example, suppose the second stock did not show less sales or revenues, but simply had to deliver them at a time where they couldn't be accounted for during this quarter. So, for a "timing" issue a stock loses 5 dollars in a day. That is nuts. So why do we bring this up? Well naturally we think that in specific issues a stock might make for a great longer term buying opportunity. (Not all smackdowns are buying opportunities, if the stock had really blown it on losing sales or something, that is a different story.) And in the case of XYZ, there was a short sale made in Heaven, once the initial hysteria was over. But maybe more importantly we need to know when WE should be in a frenzy over something. Suppose a Friday is the day before a holiday weekend and we do very well. Then Monday when everyone is at the beach we still have a pretty good day. Yet when the selling hits on Wed. we get "talking heads" screaming about how the market is unsteady and it may be headed down. They are the same guys screaming we should be buying up everything just two days earlier! See the point? Too much upside Friday and Monday, followed by too much downside Wednesday. So, what we need to do is get excited about big up days AND big down days for trading, but not get caught up in the hype from overreactions. We need to profit from them. That means not buying XYZ after it has gained 10 points in two days and not thinking the world is ending when the averages take a hit for the day (of course several weeks at a time is a different story!) Look at over reaction down days as a possible buying opportunity. How do you know if it is just over reaction or a real panic sell? Let's take a look at say a chip sector downgrade, say on a Wednesday, by perhaps a firm like Salomon's. The market needed to take a breather after a few good days (not recently), and traders got a bit nervous over a few tech companies warning about earnings. Then comes Salomon's downgrade. So they sell off the chips hard. An over reaction? Well the downgrade was because they were "too expensive" and valuation downgrades are generally short lived creatures. So what you need to do when something like that happens is watch the action over the next couple days. If they are heading back up, the downgrade was a gift and even if you missed the first few dollars of the move up again, you are still getting in cheaper than they would have been before the downgrade. The bottom line is this: the market overshoots just about everything. If you base some of your trades on those extremes by shorting the frenzies and buying the smackdowns, you will find that very often you have made a good trade. Just don't get caught up in the frenzy yourself!
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