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A business can’t live on love-only money

September 18th, 2014

Let’s imagine this scenario. As someone who watches the news and reads about investing, you recently have been looking into JP Morgan.  You’ve heard about them in the news, so you know that there will be interest in the stock–which means price movement.

 

Let’s also imagine that you believe in “technical analysis”– the practice of only looking at a company’s chart for valuation instead of its financials. The thought process is that a stock will be worth what people are demanding for it, normally represented in a chart. In short, the value is based on how much people like the stock.  After looking at stock charts from early March onward you see the price has been increasing as such on the chart on the upper right.

 

Upon running a technical analysis, you see a new “price floor.”  A “price floor” is just a technical analysis term for a price that the stock does not fall below for too long.  As you see above, the price does not dip below a line unless it enters a new price range, with the old price ceiling becoming the new floor. Seeing the price dip below the floor with a curve upward makes you certain that the price will increase, so you buy. But the next couple of weeks bring some major surprises, with the chart looking like the one on the lower right at the end of that period.

 

As you can see, the stock plummeted past numerous standard deviations and price floors.  The reason is twofold.  The huge drop on Sept. 10 is due to a huge trading loss of two billion.  The loss near Sept. 24 is because of disappointing earnings reports.  In short, it was fundamental financial data that corrected the market.

 

The problem with only looking at technical analysis is that it is short-term and based off of fickle demand.  Look at almost any earnings report and compare it with the stock price and see how they relate to each other.  Remember, in the long run, a business exists and thrives on making money.  It does not matter if everyone loves a company and invests in it. If financials keep shrinking, then the core business will catch up with the market price, and investors will start selling.  It is by understanding the company’s financials, the industry and the economy as a whole, and then looking at market support like technical analysis, that you can eliminate most surprises.

 

In short, it does not matter how much people love a stock in the short run. The value of a company will follow how the company actually performs.  Stock prices change based off of financial reports all the time, but a group of people have never, for no reason, suddenly invested in a company solely based off of demand.

 

Technical analysis is a great thing to look at, but just one of many aspects to consider when valuing a company.  Although it may seem like common sense, many people forget that firms can’t live on popular demand, only money.