Derek Hernquist on the Market as a Discounting Mechanism

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  • on July 12th, 2011

Consider a long uptrend, with quarter after quarter of good news and a reputation for delivering flawless results. Since good news begets more good news (and vice versa), we see a positive feedback loop that leaves prudent sellers behind and crushes anyone trying to short it. The stock appears indestructible, and gains a manic legion of devoted shareholders. Another great result comes out, and the stock gaps up again but it doesn’t stay up. In fact, it gives up its entire gain and goes negative. This is the point where news reaction has finally caught up with news flow. It does not mean that news flow has to turn bad from there, but if that news could not take the stock higher, what news could?

On the other hand, consider a long downtrend with multiple quarters of disastrous results. The stock has attracted early value buyers along the way, but the feedback loop crushes them quarter after quarter. It is on the trash heap, and pre-announces bad earnings again. After a brief sell-off, the stock closes higher. How could this be?

In these two cases, we are witnessing the great discounting mechanism that is the market. It doesn’t look in the rear view mirror, it looks 6-9 months out. This is why markets pull out of a bear market long before an economic recovery is apparent, and why stocks peak when they are most popular among retail market participants. So when can we move against the prevailing technical and fundamental trends instead of sticking with them?

Source: Chapter 20 – Identifying Trend Shifts by Derek Hernquist, @derekhernquist

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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