A New Car! or a Chicken

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Let’s take a quick look at what happened last week. Fairly uneventful when you consider the huge moves we have had the prior few weeks. There was some negative macro data as the Empire Manufacturing Survey data released Monday was a little light. There were wild swings in the energy pit as multi-dollar moves were taking place in minutes in the crude pit. There were rumors of the strategic petroleum reserve being tapped. It was a bunch of nonsense really, but it provided some fireworks in the pits. The S&P 500 closed down 0.30%. 

Tuesday was rather slow also. Transports came under pressure because FedEx lowered forward earnings guidance. The S&P 500 was down slightly on the day and the Dow closed higher. 

The Bank of Japan got into the central banker sweepstakes last Wednesday as they announced QE8 in order to boost liquidity in their market. The S&P 500 closed down again by roughly 0.1%.

Some weak earnings guidance and disappointing economic data hit the tape Thursday.  Norfolk Southern lowered its earnings outlook. This news put the transports under pressure. It is important to note that NSC has heavy exposure to coal, with less exposure to the thriving Bakken. 

Friday saw a spark at the beginning of the day on rumors that Spain was working on a plan to calm things down in their markets. There was also another strong move higher in the housing sector. Homebuilders again moved higher. Some homebuilders reported last week and they gave better than expected outlooks. 

So, as I suggested in last week’s piece, based on the strength in the recent advance, pullbacks should be controlled. That has been the case so far. Last week we had a negative divergence. Friday the NASDAQ moved out to new highs and the other averages did not confirm. There are definitely some signs of short term churning in the market. Support levels for the S&P 500/Dow/NASDAQ/Russell 2000 are: 1449/13,500/3155/846.  If we have a close below all four of those levels we will see our first decent retreat in a while. 

The technical picture of the market remains positive. 74% of the stocks in the S&P 500 are either in basing or advancing patterns, down 4% for the week. 72% of the names in the secondary markets are sound technically. For several weeks now there have been more attractive than unattractive sectors in the market. These two points underscore improving breadth.

There has been a great deal of commentary regarding the market volume. Actually the talk has been about the lack of volume. Now regardless of what we are attempting to do, common sense should be a part of our arsenal. Let us try to use some common sense in an attempt to wrestle with the volume dilemma. Let’s just use one stock in our example.  Apple moved above $700 dollars a share last week. Eight or nine years ago Apple was barely in the double digits. When evaluating volume you have to consider both share count and dollar volume. Certainly, you wouldn’t compare the volume figures of a $700 dollar stock and a $10 stock and not consider the cost of buying 100 shares of either one. As the years fly by we should be able to conquer this seemingly unsolvable riddle. Many are claiming volume isn’t high enough to support this advance. There is no way for the markets to go up for several months in a row without sufficient volume! Those that are pointing to a lack of volume are not looking at the situation properly. If you were a real estate broker would you want to sell one multi-million dollar house or two $100,000 houses? The answer is pretty clear. But, the wizards on TV haven’t been able to figure this one out. When you look at dollar weighted volume there is ample evidence to support the recent advance in the market. There are several triple digit stocks trading on the NYSE and NASDAQ. When you look at the total dollars invested in the market, and not just share count, volumes are simply not an issue. 

Now, let’s move on to this week’s common sense brain teaser. We are going to enter the world of game shows for this week’s offering. Good old Monty Hall used to whip the crowd into frenzy on Let’s Make A Deal. He wasn’t stupid; he knew if he gave contestants choices they would more likely than not make a poor decision. Here’s the scenario. Monty presents you with three doors. Behind one door is a brand new car!, and there’s a chicken behind the other two doors. You have to choose a door. You pick door number one. Monty says before we show you what is behind door number one let’s show you what is behind door number three, and a chicken is behind door number three. He then offers you another choice. You can stick with door number one or switch to door number two. What should you do? Remember this was a TV show. There is math and probability involved but it was also a TV show. They obviously were going to do things to make your decision tough. So, stay or switch and why?

We are close to the start of the fourth quarter of the year. Earnings pre-announcement season was milder than most predicted. The central bankers took over and now our attention moves toward the fiscal cliff and the upcoming elections. Let’s try not to put too much credence in the headlines and TV yakkers. The technical shape of the market is strong right now. We are entering a period where the economic releases should improve. 

Now let’s return to our game show situation. Remember brianiacs, this isn’t a lab, this was a TV show one step removed from a carnival. They don’t want you to win the car. So, stay with your first choice or switch.  I’ll give you a minute………

You should switch! Switching actually doubles your chances of winning from 1/3 to 2/3’s. Remember it isn’t a pure math problem, kind of like the markets. Monty is going to play tricks on you. When you make your first choice you have a 33% chance of winning. You have no idea where the car is. Then the math gets pushed to the side. They are always going to reveal a door that has a chicken behind it. They aren’t going to just say hey you missed it the car is behind door number two you lose. They put in the twist of always revealing a door that has the clunker behind it. Before you start cursing me and telling me I am wrong just think about it for a minute. I’ll wait…… When you first made your choice you had a 1/3 chance of winning. You had no idea where the car was. This leaves you with a 2/3’s chance of losing. The house only loses if you were lucky and happened to pick the winner. The house is taking the other side of the trade; they have a 2/3’s chance of winning. Wouldn’t it be great if we could have those odds? By switching you move over to the other side of the trade and will win 2/3’s of the time.

So, let’s go through what would happen if you switch:

-You picked door number one and it was the winning door. You switch and you lose! Sorry thanks for playing.

-Now remember when you made your first choice you had a 2/3’s chance of being WRONG. So, I want to have the house odds of 2/3’s chance of winning. If I switch I only lose if I was right in the first place. I win if I was wron`g in the first place, a 2/3 chance. I double my odds of winning to 2 out of 3 from 1 out of 3. If the prize is behind either 2 or 3 I win. He revealed one of the losers—he always will. When I made my first decision I had a 2 out of 3 chance of being wrong. The house had a 2 out of 3 chance of winning.  Mid game I become the house and double my odds of winning. 

Get out a piece of paper and work through it. Switching doubles your chances of winning.  We’ll have a few more of these each week and then tie them into the things we do to trip ourselves up in investing.

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About Thomas J Smith CFA