Thursday, March 5, 2009

Searching for the Bottom

In this economic climate, in a similar thread to my post about the Hawk Dove model, everyone is waiting for the bottom so they can start to get in. I would, however, like to attempt to make the alternate case for those interested in getting in early by taking my most recent post about Daydreaming and Buyer's Remorse and extending it to explain why searching for 'absolute bottoms' is a bad strategy.

As have repeatedly mentioned, prices in the 52 week high or low category are at the extremes of stock prices. Consider this graph below:Today is represented by the leftmost point. In other words, this graph hasn't 'happened' yet. Assume that this is an optimistic view that this is the potential future of the stock you are analyzing. This assumption requires the belief that the stock will not stay down forever (a key point here, however, is that the time quantiles are not defined, that is to say we don't know how long it will take for this pattern to emerge). You can see some clear trends and spreads which emerge in the diagram below:The question I would like to propose is what is the best price to buy the stock? Instinctively, most of use would probably say at the very bottom of the through (at the very beginning of the second trend segment - the price stabilization point). However, I submit to you, that even if you could model the stock with extreme precision and pin point the bottom of the stock price valley, and even if you submitted an order to your broker who was exceptionally skilled, unless you yourself were sitting at a Bloomberg terminal with special trading hotkeys for one touch execution (such as those on the trading floors at major institutions) you would not stand a chance of getting in on the "ground floor"). Let's look again at the stock price, but using a more statistical analysis approach:Here we can see a more clear picture. The 52 week low occurs only once. Whereas purchasing a stock at any price below or near the lower trading band is common (almost two thirds of the total time window shown here). Also, the stock is entirely below the intrinsic value we modeled.

The challenge here is if you can have the foresight to correctly model the price of the stock using the appropriate valuation tools, you can maintain a relatively safe position while you wait to the stock to go up. The only problem with buying too early is that there is a bit of stomach turning as the price drops as well as the time elapsed between when you buy and when you start to see positive returns.

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