Stock markets around the world plummeted Friday, and oil prices dropped to their lowest level in more than a year. Even safe havens such as gold fell sharply. The main culprit was a growing fear that governments, central banks and finance ministers seem powerless to stop the deepening of a global recession that looks set to crush corporate earnings and lead to deep job losses. The question on most investors' minds is how to navigate these unprecedented times. To do so, it's necessary to understand the psychology of crowds and how they react in time of panic. Professionals know that they have to grasp herd mentality and be able to respond to fear, greed and hope. Many investors describe themselves as contrarian investors, meaning they do the opposite of what most market participants are doing. And contrarian investing can be very profitable, if you know what you are doing. However, just being contrarian to go against the market will get you slaughtered. Trying to go against a major trend in the market or a stock can cost you a tremendous amount of money. This happened in the late 1990's when stocks were becoming very overvalued. Many fundamental and value investors started shorting the market, expecting it to drop. The problem with an overvalued or undervalued view is that markets and stocks can move to the extreme before a change actually comes. The investors who shorted too soon lost big because stocks were overvalued for years before the bear market arrived.
The opposite has happened this year, as value players jumped into financials and any other company that appeared undervalued. In too many cases, these value plays become worthless. Had these investors used price and volume movements on the charts to confirm their analysis, they would have waited and perhaps been spared major losses. Another advantage of charts is the insight they provide into institutional buying and selling. Because the trading is usually done in large chunks, it shows up on a chart in the volume and price movement. Institutions are like elephants -- when they do something, they leave huge footprints. That doesn't mean they are always right, but it does reveal their activity. Many investors rely solely on the fundamentals, and I do watch them closely. However, the fundamentals only give you an idea of what should be happening in a stock. The charts reveal what is actually going on. An individual investor simply cannot compete with the research abilities of institutions because of the money, manpower and connections that they may have with the companies, suppliers and competitors. Because of this institutional insight, a stock could drop well before news comes out. This is where the charts can give an investor a major advantage. Charts clearly show major distribution (selling) or accumulation (buying) because of the volume surges and the change in character of the price movement. Charts can also help you to identify when a trend may be changing from up to down or down to up. Many times, prices on charts will start to move well before the fundamental picture is altered. A clue to this is when a stock starts to go up on bad news. That suggests the negatives are priced in and better times are probably ahead.
In my column earlier this week, Market X-Rays: All the Symptoms of Nearing a Bottom I said that: "My indicators on the major indices have given off a solid short-term buy signal. My intermediate indicators are still negative, but current conditions continue to signal a high probability of further upside. The key now will be for the market to confirm that our indicators are correct. This is often the mistake that many market analysts make -- they trade strictly off of fundamentals, or economic conditions, or technical indicators, and they leave out the confirmation of market action. Until that happens, nothing is confirmed." If you read that column, you will see from the charts that the breakout never occurred. Even if you decided to jump the gun, like I did, you would have been stopped out when prices broke the lower trendline on Thursday with just a small loss. Going forward, we will have to see how this capitulation plays out. Until then, capital preservation remains crucial.