If there’s one sure thing in investing, it’s that past performance doesn’t necessarily indicate future success. Yet experts and amateurs alike constantly make stock market predictions.
While there isn’t a surefire way to predict what the general market, an investment or a specific stock will do, there are many stock market predictors that forecast what behavior they might take.
Probably the best thing you can do before jumping into the world of market indicators is to assess what kind of investor you are or want to be.
Do you prefer a “set it and forget it” approach to you portfolio? Then you may want to invest in index funds and call it a day. “Study after study has shown that it is extremely hard for active managers to beat low-cost, broadly diversified index funds,” says Keith Lichtman, a founder with Maycomb Wealth Advisors who focuses on financial planning for lawyers in the U.S.
Or are you seduced by the allure of day trading or other shorter-term investing? If so, you’ll probably be more interested in indicators — but please understand that no one has a crystal ball.
“People have been searching for a foolproof indicator for as long as markets have existed, and there are brilliant minds constantly data-mining for clues,” says Steve Sosnick, chief strategist with Interactive Brokers and head trader with Timber Hill. “That this much brainpower, effort and money is spent on the search for solid predictors ought to be a clue that they are not easy to find.”
If you want to learn more about stock market predictors, here’s where to start:
— Economic indicators.
— Company fundamentals.
— Technical charts.
— Contrarian indicators.
When looking for indicators that can suggest how the whole market might move, one place to start studying economic indicators such as durable goods orders, manufacturing jobs, building permits, and the difference between the yield on short-term and long-term government debt.
Considerations about the economy and inflation affect interest rates, which determine how expensive it is for companies to borrow money to expand operations, acquire other companies, or free up cash for share buybacks or dividends.
Interest rates also affect how easy it is for regular folks to borrow money to buy a house or a car. That in turn can affect a host of companies from home builders and big-box home improvement retailers to companies that produce raw materials like copper or timber.
When thinking about individual stock indicators, investors try to figure out whether a stock’s current price reflects the company’s fundamental value, says George Calhoun, a finance professor at the Stevens Institute of Technology and author of “Price and Value: A Guide to Equity Market Valuation Metrics.”
There are many metrics that investors can use when trying to suss out whether a company is overvalued or undervalued. To start with a fairly simple valuation metric, an investor might examine the price-to-earnings ratio. Investors can then compare that ratio with the market’s overall average, the average for the company’s sector or industry, or with specific companies that compete against it.
At some point, this becomes a judgment call. A company with a forward P/E ratio twice that of its competitors could be overvalued, or it could be well valued because current fundamentals or future expectations are sound.
Metrics like P/E ratios can be considered as part of fundamental analysis of a company along with cash flow or debt load.
This type of fundamental analysis might be more appealing to longer-term investors who want to buy a stock and hold it for years in hopes that it grows in value, but short-term traders also use these metrics. When a company beats or fails to meet analysts’ earnings or revenue expectations, that can move a stock substantially in a short period of time.
There are a mind-boggling number of technical indicators that professional and amateur investors use to try to determine what a stock might do in the future.
“Generally speaking, the shorter the focus for an indicator, the more appropriate it is for trading and vice versa,” Sosnick says. “A trader might look at 5- and 10-day moving averages, or even 30 and 60 minutes, while an investor might look at the trends implied by 100- or 200-day moving averages.”
Let’s say an index has been declining and is nearing its 200-day moving average. Some would consider a sustained breakdown below that level to be a bearish stock market predictor, or a bounce off that level to be bullish.
Jake Wujastyk, chief market analyst at TrendSpider, says widely used indicators like moving averages become self-fulfilling prophesies. Those indicators don’t necessarily have much linkage to what is fundamentally going on with a stock, index or market. When a moving average breaks down, selling can beget selling.
There’s also the chance that, for the short term, a company could be a momentum play whose shares will keep falling or rising for a time regardless of its fundamentals.
Calhoun says stocks or a market that have trended one way for a period of time will probably continue in that direction — until they don’t. “At some point the music stops,” he adds. That’s part of a longer-term factor called reversion to the mean, a tendency for high-flying stocks to come back down and undervalued stocks to rise, according to Calhoun.
There is a strong correlation between negative sentiment and positive outcomes in the market, Calhoun says.
If most people are bearish on something, that probably means the market will be going up soon, he says. If most people are euphoric, “that’s a negative signal,” he adds.
“Whenever the market gets too excited on one side of the trade, the market generally does the opposite,” Wujastyk says.
The options market can provide an indicator for sentiment. A stock option contract is an agreement that gives the buyer the right to buy or sell shares of a stock at a given price on a given date in the future. Call options indicate optimism, while put options indicate negative sentiment.
When calls outnumber puts, that’s a generally reliable indicator that the market is going to fall, and vice versa, Calhoun says.
In addition to looking at puts and calls, Sosnick says a high CBOE Volatility Index may also be a sign of too much fear in the market and used as a buy signal. Because the VIX, as the index is commonly known, measures expected future volatility, it is often referred to as Wall Street’s fear gauge.
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