Treat everything with skepticism

Happy Friday! It was another choppy week in the market with plenty of interesting moves.

My topic today is all about signal versus noise after a conversation we had in the Theta Gang Discord earlier in the week. The Market Wizards book series had several interviews where traders mentioned how much confusing news is dumped on traders each week. These books are amazing and they really helped me improve my trading psychology:

Sifting through the mountain of news and data coming from the market each day is a Herculean task. 🥵

But I have a simple solution for you: treat every single thing you see with skepticism.

Okay, are we talking about "trust but verify"?

No, we're not. This may have worked for US-Soviet relations when Suzanne Massie explained the concept to Ronald Reagan, but it doesn't work here.

Controversial news generates clicks. Clicks bring eyeballs to websites. That sells ads.

How many times have you gone to Twitter/X, a financial news site, or seen a link in a Discord that reads something like this?

FAMOUS WALL STREET HEDGE FUND MANAGER PREDICTS S&P 500 CORRECTION OF 50-70% BEFORE END OF THE YEAR

Imagine how many clicks that article gets. A ton.

How do I read news then?

Sometimes, it's better off if you don't. I make some exceptions in areas where I don't have much knowledge or experience.

For example, macroeconomics is a weak spot for me. I enjoy reading certain articles about macroeconomic factors that could have longer term impacts on my trading, but I'm looking more for the warnings signs than anything else. I push the opinions and predictions aside and look for the tools I can use to watch for problems.

So I should stick to analyst reports?

Absolutely not! Analysts have access to the same information that the rest of us have and they offer predictions and price targets that seem to be pulled from thin air. Companies often influence analysts in various ways so that they write favorable (or less favorable) analysis for other companies in the market.

Take an example from The Smartest Guys in the Room, a book about the rise and fall of Enron. Even as Enron was collapsing, analysts were writing favorable analysis with high price targets. Analysts who wrote anything negative found themselves excluded from future events. Here's one of my favorite quotes:

Wall Street was dazzled. “We rely heavily on Enron’s risk-management ability,” Todd Shipman, an analyst with the Standard & Poor’s credit-rating agency, told Fortune. “You can’t overemphasize how important that is. It’s the underpinning to everything. . . . It gives you a nice, warm, fuzzy feeling. . . . Even though they’re taking more risk, their market presence and risk-management skills allow them to get away with it. . . . Enron has such extraordinary risk-management capabilities that we look at them differently.” Rick Walker, managing director in the Houston office of Chase Manhattan Bank, added: “Rick has figured out how to profit from risk. Consequently, Enron has become a company defined by the way in which it handles risk.

Enron and "warm and fuzzy" don't seem to go together for me.

Analyst reports can be useful at highlighting blind spots for a particular company. For example, there may be something on the balance sheet that you missed or there could be a different company in the market that is encroaching on another company's turf. These reports can give you an idea of further reading or investigation that you need to do prior to adjusting your trades. Just skip over any mentions of price targets or future predictions. 😉

We can trust company earnings reports filed with the SEC, right?

Companies can hide a lot of problems on their balance sheet, but only for so long. I tend to put the most faith into the actual numbers they file with the SEC after they've been audited. However, Enron (and other companies that imploded, like MCI Worldcom) were able to hide some of the problems they were having within their numbers.

If you are going to analyze earnings reports, there are some important numbers to check. Here's my list in order of importance:

Free cash flow: Healthy companies should have a steady or increasing cash flow and it highlights how efficiently they can raise cash. This opens the door for them to quickly invest into a new area or pivot into a new product offering.
Operating margin: This one is tricky because every industry has different operating margins. Software companies have huge operating margins while a grocery store might have much tighter margin. I usually look to see how margins are improving for the same company over time and relative to other very closely related companies.
Price to book ratio: This ratio can help you find undervalued stocks or predict those which have a greater chance of improved cash flow later. This measurement isn't helpful for most software or high-tech companies since they usually have fewer assets on the books, but it can be helpful for industrial, energy, and retail stocks.

Koyfin has a great free plan for reviewing this information on the largest companies in the market. Their paid plans are quite pricey, but it's the closest thing I've found to a Bloomberg terminal.

I don't trust the comments made by CEOs and other executives in their filings and earnings calls. It incredibly easy to talk about a loss as "investment in the future", especially with the AI hype that is pervasive in today's market. As an example, a chip maker isn't posting a loss, they're "doubling down on their AI investment".

So what can we trust?

Fortunately for the retail investor, there are two bits of information that are always trustworthy and they appear on every stock chart for free: price and volume.

You just need to use caution about reading too far into the messages they send. Every indicator on every chart eventually falls back onto price, volume, or both. I use these tools to quantify my risk on trades, not to predict the future. Predicting the future is a fool's errand and it will leave you frustrated.

Remember that you don't have to look at price and volume in isolation! Relative charts, such as comparing a stock to its index, has tons of value. You can also take two stocks in the same sector and do a ratio chart of both. This can highlight which stocks have the greatest strength relative to each other or to their index.

Have a great weekend and good luck to you next week. The US markets are closed for Independence Day on July 4th, so plan accordingly! 🇺🇸