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How to Be Profitable: Signal vs Noise


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    One of the inherent characteristics of youth is curiosity. For example, when little kids ask their parents, “Why is the sky blue?”, they are curious about the world and seek a simple, satisfying answer. However, the actual scientific explanation, involving complex concepts like Rayleigh scattering, might disappoint them due to the intricacy.

    The blue-sky question relates to investing because investors often ask, “Why is the equity market going up or down?” expecting straightforward answers. They may seek reasons like global macroeconomic data points, political events or complex valuation markets. However, financial markets are influenced by a composite of complex factors, making it challenging to pinpoint a single cause.

    Nonetheless, amateur market participants often excessively concentrate on the “Why?” behind markets, hoping for a clear explanation. Unfortunately, known and unknown factors, along with current and future possibilities, are akin to the scientific complexities behind the sky’s color.

    Don’t focus on the “Why” for market direction, but instead focus on the “What.” In other words, what drives market direction?

    Savvy Investors Focus on “First Principles”

    Overemphasis on finding a single, definitive reason, or reasons, can lead to frustration and disappointment, much like a child’s reaction to the complex scientific explanation of the sky.

    Instead, investors should turn to a favorite concept of billionaire genius Elon Musk – first principles. First principles thinking is a problem-solving approach that breaks down complex problems into their most basic, fundamental components. For example, rather than following a traditional pizza recipe, a first principle approach would involve breaking down the pizza into its fundamental components: dough, sauce, cheese and toppings. By understanding these basic elements, you can create a pizza tailored to your unique preferences and dietary needs.

    Back to the market. Like the pizza example, the first principles approach allows you to find the simple components that drive markets and take advantage of those components.

    However, unlike the pizza example, investors using this method must understand that they cannot control the market. Even so, you can find the simplest, easy-to-understand market components that drive stocks.

    Don’t worry about finding complex reasons for why the market is moving. In the heat of battle, simple signals supersede complex ones.

    The Concept of “Signal Versus Noise”

    The concept of “signal vs. noise” is used in various fields, including data analysis, communication and decision-making. Imagine you are listening to a radio station that is disseminating information you want to hear. The clear sound of the station you want to hear represents the “signal.” In contrast, any interference, static or other random sounds represent the “noise” – the irrelevant or random, chaotic data that obscures the signal.

    In Wall Street terms, the signal refers to anything meaningful, relevant and valuable in helping you make money. When analyzing data to extract useful information, the goal is to identify and focus on the signal while filtering out the noise. The goal is to exert all your energy to identify and hone in on the signal.

    In summary, signal vs. noise is all about separating valuable insights from irrelevant, distracting data, allowing for more accurate analysis and effective decision-making.

    Ask yourself this, “Do you want to sound smart, or do you want to make money?”

    Continued . . .

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    Signals & Lessons from Two Decades of Investing...

    What Direction is Price Moving in?

    Successful investing, broken down to its most straightforward building block, means buying a market at one price and selling it later at a higher price. So, what is the best way to accomplish this? Buy stocks that are already moving higher. For investing, the saying, “A body in motion tends to stay in motion,” is relevant because, as the old Wall Street saying goes, “The trend is your friend.”

    You are immediately giving yourself an edge by simply buying stocks that are trending above their moving averages. Don’t fear buying uptrends. Legendary investor Peter Lynch says, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in all the corrections themselves.”

    Reward-to-Risk

    Amateur investors spend most of their time searching for the next hot stock pick when they should focus on risk mitigation and money management. For example, the best and brightest investors in the world are often wrong on many of their stock selections. Nevertheless, savvy investors understand that perfection is not a prerequisite for profitability in the stock market.

    To flourish in the imperfect world that is investing, you do not need to be a mathematical genius. By contrast, you only need to understand and implement basic, grade school math.

    Let’s say you implement my preferred reward-to-risk ratio target of 5-to-1 (you risk $1 to make $5 on any given trade)…You can be wrong 80% of the time and still break even! Conversely, if you can muster a win rate of just 30%, you can flourish.

    You may be wondering, if it is so easy, why don’t more investors achieve profitability? The fact of the matter is that most retail investors obsess with stock selection and completely overlook these straightforward money management techniques.

    To achieve profitability in the long run, focus more of your time on easy-to-understand money management principles.

    Buy When Fear Hits a Fever Pitch

    Time and time again, when fear hits a fever pitch, stocks find a bottom. This phenomenon lends credence to the saying, “If everyone’s thinking the same, then someone isn’t thinking.” Often, price alone changes sentiment.

    The CNN Fear & Greed Index is a prime example. As the name implies, the Fear & Greed Index combines seven indicators to gauge market sentiment and scores the market from a range of “extreme greed” to “extreme fear.” In the past year, the index flashed an “extreme greed” reading twice; and each time, the signal marked the intermediate bottom in equities.

    Investors don’t need to solely rely on the Fear & Greed Index, however. The VIX, also known as the volatility index, measures market expectations for future volatility based on S&P 500 index options. Investors can interpret VIX spikes over $20 as excessive market fear. VIX spiked over $20 twice thus far in 2023 – once when the market bottomed in March and earlier this month, right before the multi-week rally stocks are enjoying currently.

    Instead of making investment decisions based on your gut during pullbacks, leverage sentiment indicators to gain market insights from the crowd at extremes, and zig when they zag.

    Seasonality

    A farmer tracks seasonality to observe recurring patterns and trends in crop growth, weather conditions and market demand over specific periods. Investing is no different, and 2023 proves that markets follow historical market data and trends during specific times of the year. For instance, the pre-election seasonality roadmap correctly predicted that the beginning of 2023 would be strong and August and September would lead to a correction in equities.

    Though it is unclear why markets follow seasonal trends, the fact is that they do. As investors, our job is not to figure out why the market is doing what it is doing. Instead, we should determine the course the market will likely follow and exploit it for profits.

    Price Action Versus News

    For market participants, the reaction to big news items is far more telling than the news itself. Three examples include:

    Late 2022 Inflation Numbers: Last October, inflation numbers shocked the street by hitting 40-year highs. Though stocks opened lower, they reversed violently and finished the day higher, marking the 2022 bear market bottom.

    FTX Debacle: Crypto exchange giant FTX faced fraud accusations and went bankrupt weeks later. Instead of plunging, the FTX bankruptcy marked the bottom in Bitcoin. Since then, Bitcoin is up more than 60%.

    Fast forward to last week. Investors grew concerned as Hamas invaded Israel and war broke out in the Middle East. To the surprise of many, the S&P 500 brushed off the bad news and rallied more than 1% for the week. Is history set to repeat itself?

    Successful investors program themselves to focus on the market’s reaction to news, not the news itself. Without the context of price action, news means nothing to sharp investors.

    Tying It All Together

    In the investing realm, newcomers’ curiosity often mirrors a child’s innocence questioning why the sky is blue. Investors frequently seek simple explanations for market movements, akin to a child’s desire for straightforward answers. However, much like the complexities behind the sky’s color, financial markets are influenced by a multitude of intricate factors.

    Seasoned investors recognize the importance of focusing on “first principles,” breaking down complex problems into fundamental components, just as one deconstructs a pizza into its basic ingredients. By understanding these essential elements of the market and concentrating on meaningful signals rather than distracting noise, investors can navigate the complexities of the financial world successfully.

    Emphasizing basic money management, recognizing extreme market sentiments, leveraging seasonality patterns, and paying attention to market reactions rather than news headlines are key strategies for investors to thrive amidst the market’s uncertainties.

    Cutting Through the Noise

    It’s hard to ignore the headlines about rising tensions around the world. But here’s the key: from the markets standpoint, it hasn’t had an impact on business earnings or the larger economy, and that’s why stocks have been largely unaffected.

    Still, when volatility persists, it’s important for investors to find trends – one being that many of the biggest gains have been in tech, which looks to continue thanks in part to the Artificial Intelligence (AI) Revolution.

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    All the Best,

    Andrew Rocco

    Andrew is Zacks' technology stock strategist. His passion is education, where he aims to provide valuable insights from both a fundamental and technical perspective, which he shares in his Technology Innovators portfolio.

    ¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.

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