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Educational Article

Welcome To The Real World

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By David Popper

Machines hate me. One summer between my sophomore and junior years in college, I worked in the machine room at Florida Power and Light. My job was to assist in the running of the bill stuffing machine. The bill stuffing machine was a long machine that resembled an assembly line. The bills and any inserts were pulled down by suction cups, merged at the end and inserted into envelopes. Anyway, that was the plan. The suction cups had to be adjusted constantly. Something always went wrong. The supervisor was named Fred. Fred had been supervisor of the machine room for 20 years. He was not fond of summer interns.

On the day that I arrived he said "welcome to the real world college boy." He gave me a brief 5 minute orientation and then put me on the most complicated machine in the place explaining that college boys should be smart enough to figure it out. As I said, machines do not like me. Naturally, the machine broke down in every conceivable fashion--and often. Each time it broke, Fred would swoop down, fix the machine and say, "welcome to the real world, college boy." I followed procedures exactly and it still broke down. Here came Fred barreling down the hall to fix the machine and get another crack at me.

After I explained that I followed all procedures exactly, Fred unknowingly said something profound. He said, "sometimes even when you do everything right, the machine will still break down. Welcome to the real world." This bears repeating. Sometimes when you do everything right, things still do not work out. Welcome to the real world. Welcome to the stock market.

In the market, it is not a question of if things break down, it is a question of when and a question of what you are going to do about it when the breakdown occurs. The whole reason newsletters exist is to help predict the market as it exists today and make recommendations as to how to proceed. You can conduct some of analysis yourself.

First, understand that there are 3 types of risks to owning any stock. These risks are:

1. Market Risk
2. Sector Risk
3. Stock Risk

By analyzing the above, you can improve your odds of success. Below I will briefly discuss each risk.

1. Market Risk. It is generally known that most stocks follow the general trend of the market. There are many ways to discern the general market direction. Some talk about news driven events and technical charts of the general averages. Others discuss support and resistance levels of general averages, the volatility index, the positions of the commercial traders (who are usually correct), and other general items. These items are all important. Probably the most important item is market liquidity. The Fed controls market liquidity. The maxim "don't fight the Fed" is historically correct. Now the bond market is anticipating at least another 100 to 150 basis points in rate cuts this year. This causes the smart money to anticipate better earnings in the second half of this year. This is why stocks like Intel (NASDAQ: INTC) are rising in spite of being in the middle of a slowing business cycle. The prospect of rate cuts changes the sentiment in the market and will cause support for the market. Once this bottom is established, fund managers, who are underexposed to the tech sectors, will be compelled to enter the fray or risk falling behind their competition. This is how rallies are born. In short, the general market is looking good, even if short term profit taking emerges from time to time.

2. Sector Risk. Typically stocks perform similarly to other stocks in its sector. You will often hear people explaining that one stock may be up or down because it is trading in sympathy a related stock. This is normal. This is not to say that superior stocks in a sector will not outperform sector laggards. It simply means that momentum in a sector will affect a stock's performance. One way this information is helpful is to notice which sectors have performed the best after a serious market decline.

3. Stock Risk. As mentioned before, in each sector there will be stars and there will be laggards. In my opinion, it is safer to trade the most established stocks in the sector. Some people call these stocks the "gorillas" of the sector. Even gorillas can suffer a bad event and suffer a severe drop. Therefore, if you are to trade individual stocks, it is good to be aware of its quarterly reporting date, analyst meetings, participation in conferences, and dates of stock splits. These events can infuse momentum into a stock.

Understanding these concepts and trading accordingly can certainly increase your odds of success, but it doesn't guarantee success. Sometimes even when you do everything right it can still come out wrong. Welcome to the real world. Next time, let's talk about what to do when things go wrong.


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