7 things you need to know about the stock market

By Stephen Sutherland, author of Liquid Millionaire.
Posted in the Category of ISAS, SIPPS, Investing, Stock Market on 27th November, 2011.
Tags: bull market, institutional investors, isaco, liquid millionaire, market health, market indexes, nasdaq composite, russell indexes, s & p 600, stock market, stock market summary.

7 things you need to know about the stock market

Some financial advisers will make out that the market is very complex – however, the way it works is probably simpler than you think.

Today I’m going to share seven lessons explaining the fundamentals about how the stock market works, and how the stock market is tied to investing using Stocks and Shares ISAs.

1 – Markets keep going higher.

Most Britons have heard of the FTSE 100 but fewer have heard of the S&P 500.

The FTSE 100 is an index in the UK that has the top 100 companies trading in it. The S&P 500 is the United States equivalent and you guessed it, this one has 500 companies trading in it

Data Supplied by Yahoo.

What long-term trend has this index formed? Is it up, down or sideways? Yes, that’s right, it’s in an uptrend.

Can you see the grey vertical shaded areas on the chart?

These grey shaded areas are representing the down periods in the market. They are known as bear markets. And the white areas on this chart are the times when the market rose. These periods are called bull markets.

What do you see happening after each bear or down market?

That’s right. The market goes up. Would you agree that after every bear market, the index always eventually moves into new high ground?

Good.

2 – The market works in cycles.
Did you know that historically, bull markets or up markets have lasted between two and four years?

Bear or down markets tend not to last as long. Bear markets tend to last between nine and eighteen months and therefore are much shorter than bull markets. Because bull markets last longer, the stock market forms an uptrend. It’s like a staircase effect where you have three stairs up and then one stair down.

3 – Three out of every four stocks (and funds) move in the same direction as the market.

Because three out of four stocks move in the same direction as the market, the performance of the funds you choose to be protected by your Stocks and Shares ISA will be directly linked to the market’s direction. That’s because investment funds own a large portfolio of stocks. And so if the market is trending up, three out of four funds will move up.

But if the market is trending down, three out of four funds are going to move down. And if the market is trending sideways three out of four funds are going to move in which direction?

Yes, you are correct – sideways.

When the market takes a heavy fall, investors who do not know how the market works will probably blame either the fund manager or their advisers for their losses.

But what they really should be doing is noticing and understanding the link between their fund value dropping and the market heading downwards.

You see, most investors do not know that three out of four stocks will always move in the same direction as the market.

That means even if you own a fund that is managed by one of the best fund managers in the world, if the market takes a dive, that fund you are invested in will also be likely to take a dive.

4 – The stock market can be timed.

Opinions are divided on whether the stock market can be timed. I strongly believe that markets can be timed – although it is never easy to time markets accurately.

So where do you start?

First of all you need to understand how to read and analyse the stock market’s health. To do this, you have to observe and study the major indexes carefully.

Here they are:

• The Nasdaq Composite.
• The S&P 600.
• The S&P 500.
• The Dow Jones Industrial Average.

As well as watching these four indexes, it’s crucial to watch the behaviour of leading stocks and leading sectors.

By studying these four indexes plus the action of leading stocks and leading sectors – each and every day, you can come to realise meaningful changes in the daily behaviour at key turning points like market tops and bottoms and learn how to capitalise on them.

5 – 75% of the market’s movement comes from institutional investors.

Institutional investors have the largest influence on the market’s future direction. Institutional investors can be fund managers, banks, building societies or insurance companies. And if these 800 pound gorilla investors are buying, you can jump onto their coat-tails. And if they are selling, you can quickly switch out on to the sidelines. Here is how it works.

Picture the market as a big tree. Let’s imagine institutional investors being woodcutters. If institutional investors are selling heavily it is like them taking a cut out of a tree and this of course makes the tree or market weaker. If they take too many swipes at the tree in a short space of time, what is going to happen?

That’s right, the tree will fall over. So when the tree or market gets weak because of excessive selling it sends a red flag to say it’s probably the time to get out of the market. On the other hand, when institutional investors are buying heavily and in a short period of time, this makes the market healthy and extremely strong – and this is the time when you do want to be invested.

6 – Watch the price and volume action.

One of the best ways of reading the market is to look at charts. A stock chart is a graph that displays the price and volume history of a given security or index over a period of days, months or years.

Price and volume charts help you to see what the professional investors are doing so that you can follow in their footsteps. Whether they are buying or selling, through a chart you can see what they are doing by simply looking at the price and volume action. Price action is how a stock or index changes in price. Volume action tells you the number of shares that have been traded.

For example, if volume is far above its average and the price action is up, institutional investors are buying. On the other hand, if the volume is far above average and the price action is down, it means institutional investors are selling. Lack of volume combined with prices moving up indicates little demand from institutional investors. This is viewed as unhealthy action.

Lack of volume combined with prices moving down means institutional investors are reluctant to sell. This type of action is viewed as healthy action. By watching the market every day, and keeping a close eye on price and volume action, you can determine exactly what institutional investors are doing with their money so that you can do the same.

Next we have four images. They show the difference between healthy price and volume action and unhealthy price and volume action.

Healthy Price and Volume Action

Unhealthy Price and Volume Action

It is also important for you to understand that it takes a lot of buying or selling to confirm that the trend of the market has changed.

For example, if the trend of the stock market is up, it takes a lot of selling to change the trend from up to down.

By measuring how much selling is going on over certain time periods, you can determine when the trend is about to change or has changed and you can then act accordingly.

Having the ability to read the market’s health well can assist you with predicting future market direction. After your analysis, if you believe the market is healthy, it means invest. However if you believe the market’s health has become sickly, it tells you not to invest as it carries too much risk.

It is helpful to be aware that it’s impossible to time getting out at the very top of the market or getting in right at the very bottom. If we use an elevator analogy, when a bear market (down market) ends and new bull market (up market) begins, it’s impossible to get into the elevator at the ground or first floor. Instead, you get in at floor two. This is because you have to see clear evidence of institutional investor involvement before committing. By adopting this approach you take out the guesswork and lower the risk of getting your timing wrong.

This principle works for the end of a bull market (up market) cycle too. When a bull market has run its course which is generally two to four years, a new bear market (down market) starts. Trying to catch the top of the market is also impossible. Sticking with the elevator principle, we don’t get out on the top floor, and in this case we’ll call it the tenth floor, we get out on floor eight or nine.

Let me give you a real life example. The 2003-2007 bull market started March 2003 and ended Oct 2007. We decided that the bull market had ended March 2007 which proved to be six months early. That means after we came out the market, it dropped for a while but then continued to climb. During that six month period, some people who were Shadow Investing doubted the decision to exit into cash made by me however eventually it all made sense because in late October 2007, the market peaked and headed into a horrible 55.7% correction.

7 – In bear markets, you switch from your investment fund into a cash based fund.

When you notice that the market trend has changed from up to down, you bank your profits by switching out of your investment fund and into a cash based fund such as Fidelity’s ISA Cash Park. This helps to protect against future losses because of the trend change. This is when you then simply sit, wait and be patient.

Bear markets don’t last as long as bull markets and so you should be parked in a cash-based fund for no longer than 9-18 months. Why do you do this? The reason is simple. Because you learned earlier that three out of four stocks move in the same direction as the market, and because you’ve learned markets work in cycles it means that ideally in bear markets you want to move out of equities and into the safety of cash.

Many UK investors don’t realize that it is possible to do this. Some mistakenly think that once you are invested in a fund, you have to stay in that fund.

Some wrongly think that to switch into a cash-based fund would adversely affect their ISA allowance. To do this correctly, you have to remember that when you are dealing on your ISA account, it’s not about selling – it’s about switching.

You see, if you sell, then you lose all your annual ISA allowances that you’ve built up over the years. But when you switch, your ISA allowances remain intact. Fidelity offers a way of temporarily parking your ISA investments into a cash fund.

This can be extremely useful if you believe that the market trend is downwards, and is going to continue to head lower in the future. By parking your money in cash on a temporary basis, it means that even if the market crashes, your money will be safe. In fact, even though equity (stocks and shares) ISAs could be dropping like stones, a cash park will actually be rising in value.

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