You may remember that in mid-November – on November 13, to be exact – Bank of America (NYSE: BAC) revealed that it would have to write off $3 billion worth of bad mortgage debt and warned that its losses could grow.
That very day their stock opened with an upward gap and closed 5.2% higher.
Analysts rationalized the surprising rally this way: "Shares rose," they said, "as investors gained confidence that the bank and its rivals could withstand further turmoil" (Reuters).
Let's accept this reasoning for a second and fast-forward to last Friday, February 1. That's when Google, everyone's favorite search engine, reported that its "fourth-quarter revenue increased 51 percent and net income rose 17 percent, and top executives said they saw no effect of an economic slowdown" (Mercury News).
Think that was good news? Hard to argue with that, yet at the open Google stock promptly lost ground and closed Friday's trading down more than 8%. And then on Monday (Feb. 4), it lost some more.
If that's how "rational" markets behave, then what do irrational ones look like?
Even if we could come up with a good explanation for each of these cases, one question would still remain – the most important question, really. And that is – next time a company whose stock you own reports something good or something terrible, what do you – buy, sell or hold? … I wouldn't know, either.
So what do we, investors, do?
Let's look at the language analysts used to describe the news in each case. BAC's surprising November 13 rally took place because investors suddenly "gained confidence." As for GOOG, apparently "investors are wondering what to expect from Google tomorrow" (Mercury News).
Think about what each of these explanations really suggests. BAC investors "gained confidence," looked beyond the bad news – and bought shares. GOOG investors feared "what to expect tomorrow," looked beyond the good news – and sold. What drove prices in each case were not rational calculations. What drove prices were the two factors that are as old as the stock market itself: greed and fear.
This pre-existing investor bias is also known as sentiment. Ad if you're familiar with the Elliott Wave Principle, you know that investor sentiment plays a crucial role in shaping market trends.
In investing, there are very few blanket answers. As Bob Prechter once put it, investing is not physics: the "if, then" approach does not apply. More often than not, the emotional aspect of investing completely envelopes the rational one – and then we see stocks that should be crashing rally instead, and vice versa.
Going back to the earlier question – what do we do with these irrational markets – we at Elliott Wave International believe that irrational or not, markets still have structure. Incredibly, investors' seemingly chaotic collective emotions come together to paint patterns in market charts. Yes, patterns – we call them Elliott wave patterns. And it's those patterns that make the stock and other markets predictable.
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Editor's Note: Elliott Wave International's Prime Stocks Flash service featured shares of Bank of America (NYSE: BAC) and Google, Inc. (NASDAQ; GOOG) as potential trading opportunities during 2007.