Over the years, I have found many people who are not in the investment business, find analogies like the title of this article much easier to understand than Wall Street gibberish like “head and shoulders patterns”.
“Trying to catch a falling knife” refers to a stock falling in price, giving a potential owner a chance to buy it cheaper, when some rudimentary technical analysis might suggest that the drop could be more than just temporary. Technical analysis, like anything in investing, is not an exact science and those claiming they have developed a way of knowing when to get in and out ARE FULL OF IT! But, I believe ignoring a discipline that has been around for over 100 years is akin to getting on the railroad tracks and waiting for the train to run you over.
A rudimentary familiarity with technical analysis can be a great tool for evaluating a potential buy and more importantly when to trim or sell.
Another question I like asking clients is what two forces determine the price of General Electric every single day? The answers I hear vary, but in truth the only two forces that determine price every day are Supply and Demand.
In the case of the stocks, it’s the number and size of the buyers vs. the number and size of the sellers. If there is more stock being bought then there is for sale, the price of that stock will move higher. Likewise, if there is more of that company’s stock for sale than there are buyers, the price of that stock will move lower—period.
What forms these basic forces are the many ways buyers and sellers evaluate stocks:
- The basic outlook for the company and what it sells
- Barriers of entry into the company’s industry
- Its balance sheet and cash flows
- What the chart of the company looks like (yes, the simple act of looking at and trying to evaluate supply and demand of a stock can feed on itself)
- Rumors regarding the company
And numerous other aspects, but the simple fact remains that all of the above are different ways of looking at a stock to determine whether we and every other participant in the market are either a buyer or seller.
The best way I can illustrate this is by telling a story. A number of years ago I heard an interview of a mutual fund manager on CNBC. He was discussing stocks he felt very bullish on; one he mentioned was Celera Genomics Group (symbol CRA). I had followed this stock in the Tech Boom of 1999-2000 and thought very highly of its potential prospects. Its founder, Dr. Craig Ventor won the Nobel Prize for being the first to successfully map the human genome. The possibility for developing genetic based drug therapies for diseases like cancer is simply astounding. However, in 2000 the mania surrounding tech and biotech stocks was such that I felt very nervous buying a stock that had risen to over $250 per share with no real sales.
Then the bear market hit and Celera’s stock, like many others’ fall from grace was breathtaking to say the least.
I had not looked at this company in years but the mention of the Celera name prompted me to listen to the interview. A couple of things stuck out from the manager’s comments:
- At the time of the interview the stock’s price was $19 per share—I thought “wow”
- The manager said the company had no long-term debt and a little over 1 billion dollars in cash.
- He went on to say that the cash on the balance sheet represented almost $10 per share, meaning you would be buying the rest of the company for about $9 per share—I thought “HOLY COW!”
I immediately pulled up the chart of the stock to just give myself a snapshot of what the supply and demand for the stock looked like. Here is what I saw:
The interview occurred right around the beginning of April; what I saw was a falling knife. I don’t know about you, but I usually don’t try to catch a falling knife. It took me all of 30 seconds (granted I am well versed in technical analysis) to determine the forces of supply were in firm control of this particular company’s stock. As you can see it fell from 19 to almost 6 dollars within the following six months! Utilizing technical analysis helped me avoid a potentially huge mistake! Although technical analysis will not guarantee you will always avoid mistakes, there is no denying that it will increase your odds of success if you go out and learn some of the basics and apply them to your portfolio process.
There are numerous sources an investor can search for education on technical analysis, from the internet and the bookstore to shows on CNBC. I specifically teach some of the basic tools I use to run stocks in my Investment Coaching program.