The Four Evolutions of Investing

At the end of the day, everyone is in the market for the same reason – to make money.

But making money doesn’t have to mean sifting through reports, keeping an eye trained on the financial news 24/7, or staring at stock charts from opening to closing bell.

Making money in the market doesn’t have to be boring.

It can – and should – be fun. That’s a mantra I live by.

I start my day whenever I want – no more 4 a.m. alarms to get up and track futures. I get things buttoned down and finished by 1 p.m., 2 p.m., or 3 p.m., and then go about the rest of my day without giving the markets another thought.

Now, it wasn’t always this way. I used to get up early in the morning and sit behind my computer screen all day long. But since then, I’ve gone through my own personal evolution of investing. And I’ve developed an approach that makes making money easy.

Today, I want to show you that approach. I call it the “Strikepoint Formula.” But first, I’m going to reveal the Four Evolutions of Investing that led me there.

These reveal my methodology in a way that I’ve never shared publicly before. They’ll put you miles ahead of ordinary investors who are still only doing the basics. They’ll drop you right in front of the perfect, most lucrative stock. And they’ll show you the best ways to make money today.

The First Evolution: Fundamental Analysis

When most people dive into the stock market, the first approach they take is fundamental analysis.

Basically, fundamental analysis is a way of determining a stock’s value based on its financial health. Analysts will study everything under the sun that could affect the stock’s value – earnings, dividends, the economy, you name it.

In the end, they take all that qualitative data and turn it into a number at which they believe the stock should be priced.

But here’s the thing – it’s next to impossible to match a company’s qualitative worth to its actual value. There is no consensus on what these qualitative factors actually mean. I’m a numbers guy, and you just can’t turn subjective opinions into a number.

The truth is, fundamentals don’t matter. These days, watching fundamentals is like watching a calendar when you should be watching a clock. I should know – I’ve made the mistake before.

When I worked in investment management at Prudential Securities, the first stock that hit my radar was Motorola.

Every time I got on the phone, I was telling clients to take positions on the telecommunications company. It was about to announce earnings, and man, they were going to be big.

Three days later, Motorola’s earnings were released. And I was right – they exceeded expectations. The stock immediately rallied! But then, after the close just one day later, the rally stopped. The stock sold off by 5%. In one week, it lost 12% of its value.

When I close my eyes, sometimes I can still hear my phone ringing. People wouldn’t stop calling – they lost money, and they were mad. Back then, I didn’t know what went wrong. But now, I do.

The problem was that everyone was buying Motorola ahead of earnings based on the fundamentals. The good report was already priced into the stock, and the trade was overcrowded.

When earnings came out, the stock rallied initially – and all of a sudden, everybody was selling to cash in on those gains.

Basically, a good earnings report doesn’t mean the stock will rise. Not always. I’ve been reliving my Motorola nightmare over and over again the last couple of quarters, especially among financial companies.

On average, the financials tend to beat their earnings number by 3%. So they rallied over the first couple of days – but then, more than 78% of companies lost that gain. They ended up trading lower in the following two weeks, even on good earnings.

You’ll never ever catch this in time if you’re just using fundamental analysis. You have to watch the clock, not the calendar. I learned that the hard way.

Now, you can’t just throw fundamental analysis out the window. It’s still necessary, but it isn’t enough on its own. I’ve learned a different way to analyze the market, and now my Motorola nightmare isn’t a nightmare anymore. And I have my second evolution of investing to thank for that…

The Second Evolution: Technical Analysis

When I was introduced to technical analysis, it completely changed the way I looked at the stock market. Technical analysts look at statistical trends, like price movement, volume, and signals. In essence, it’s a study of aligning numbers.

Those numbers come from all different factors, including moving average, price, price patterns, relative strength index, and more.

For years, technical analysis was considered voodoo science. But today, this kind of analysis happens on a daily basis. If you want to squeeze real cash out of stocks, technical analysis is absolutely vital.

Technical analysis is where I fell in love with research. The 50-day moving average, the 200-day moving average, you name it. These were all metrics that gave me the tools and frameworks I needed to study stock trends.

My mentor at Prudential Securities used to sit me down every day with nothing but chart paper and a pencil. He’d have me plot the price of a stock, writing my analysis down in a worn three-ring binder, day in and day out.

I would use two months’ worth of price plotting on stocks in order to calculate moving averages. Then I could tell if there was a trend in place – and follow that trend all the way to profits.

Now, technical analysis has been around for a long time. But over the past decade, it’s become much more accessible and popular because of technology. When I first started, I had to look up things like price-to-earnings ratio at the library on a Saturday afternoon in order to determine if a stock was overvalued or undervalued.

But today, you don’t have to suffer through hand cramps from writing on chart paper for hours. You don’t have to spend your weekends at the library trying to find the right data. You’ve entered the world of technical analysis at just the right time.

Now, you can access every data point you want on your laptop. I have a database that brings in billions of records a year for the models that I’m running on a daily basis.

It’s a far cry from where I started. And as much as I hate to admit it, it’s still not a perfect process.

See, when I first started working with databases, I was testing a ton of different technical analysis ideas. I was trying to figure out which was the best length of a moving average to watch – and I uncovered the 86-day.

When I reverse-engineered it, looking back through a historical perspective at all these statistical features, based on the standard deviation and the robustness of those returns, the 86-day moving average was the best.

But then I started using it to look forward… and the results were terrible. As it turned out, the 86-day was one of the worst moving averages to look at. Why? Because nobody else was watching it.

I love data and technical analysis, so it’s hard for me to admit this, but in order for a technical analysis to work, everyone has to be watching it. That’s because people’s reactions are what move the market.

But there’s one moving average that everyone is talking about, making it one of the best indicators to watch. And that’s a stock’s 50-day moving average. It’s as simple as checking to see if it’s moving higher or lower, and it’s at the center of my Strikepoint Formula.

When you apply the 50-day moving average to any of the stocks in the S&P 500, there’s a 2:1 chance it’s going to close higher or lower the next day, depending on which direction it’s moving. So if you want to know where the stocks in your portfolio are going, look at their 50-day and ask, “is it moving higher or lower?”

This is one of my favorite indicators. It’s in every single one of my 20 different models right now!

The bottom line is that technical analysis is great. It’s absolutely necessary to your success – but it’s still not enough. As I said, reactions move the market. Which brings me to my third evolution of investing…

The Third Evolution: Behavioral Finance

The next stage of the evolutionary process is behavioral finance. Unlike fundamental and technical analysis, behavioral finance doesn’t focus on earnings reports or technical indicators – it focuses on psychology.

Basically, behavioral finance seeks to understand why people make certain financial decisions. It is assumed that investors’ characteristics determine their investment decisions, which in turn influences market outcomes.

Let me remind you of the Motorola story…

I told all my clients that they needed to buy Motorola so that they’d be ready when the stock’s earnings came out three days later. Then, once earnings came out, reality hit – everyone was selling.

It’s because of how people set and manage their expectations. Everyone expected a stock gain, and the earnings were good. But the stock still dropped 12%. Why? Because people decided to sell.

Rationally, Motorola’s stock should have gone up because of good earnings. Instead, it sold off 12%. That right there is behavioral finance. It’s human psychology at play.

And if that’s not enough, here’s another story for you…

When I was in school, I hit that phase where I really hated doing homework. Like most kids, I wanted to go outside and play with my friends, not sit at the kitchen table and study fractions.

But I was a smart kid. So I started setting my parents’ expectations about my grades before my report card came out.

This science class is really tough,”I’d tell them. “I don’t think I can pass.”

Basically, I was making sure my parents expected me to fail. Usually, a C on a test would have gotten me grounded. But when I came out of that science class with a C, we were off celebrating with pizza.

Right now, the market is just like my parents. It’s being driven more than ever by expectations, all coming from human psychology and behavioral finance.

And this leads me to my fourth and final evolution. With this, we can combine all my models into an unstoppable force for making money – the Strikepoint Formula.

The Fourth Evolution: Best in Breed Behavioral Valuation

I call the fourth evolution “best in breed” behavioral valuation. It harnesses all the expectations from fundamental analysis, technical analysis, and behavioral finance, creating a whole new way to predict success with stock picks.

You can summarize it all with one phrase: counterintuitive contrarian.

The counterintuitive contrarian is the person at the top of Wall Street’s food chain.

Let me explain…

Take any stock that is doing well technically. When you look at a stock chart, you see that the fundamentals are good too. But Wall Street’s expectations don’t match up. For some reason, the crowd is just not interested in that stock. Instead, they’re staying away from it – for now. But there are still a ton of potential buyers out there waiting to drive the stock up.

That right there is a perfect buy: strong technicals + low expectations + good fundamentals.

Now, what about the perfect short?

Let’s say that Wall Street is pouring into a specific stock. Expectations are high, but its technicals don’t look good. And when you look at the chart, neither do its fundamentals.

Weak technicals + high expectations + poor fundamentals = the perfect short.

The Fourth Evolution: Best in Breed Behavioral Valuation
Fundamental Analysis + Technical Analysis + Behavioral Finance
=
Trading Success

Perfect Buy:
Strong Technicals + Low Expectations + Good Fundamentals

Now, let’s put these explanations into action with two of the biggest stocks on the market: Apple and Microsoft.

In the early 2000s, Microsoft was absolutely killing it. But Apple, basing its business in education, had some issues. The company wanted to put its computers in schools, and they owned the graphic design market. But what really broke them out was this: “You can put all your music on it and listen wherever you want.”That’s right – the iPod.

Microsoft had their own version of the iPod called the Zune. Now it’s 19 years later. Everyone’s heard of the iPod – but could anyone tell you what a Zune is?

Back then, 98% of analysts were telling you to buy Microsoft. Only about 14% were talking about Apple.

But then, the technicals and the fundamentals started to improve for Apple. The stock got out in front of the curve and started innovating when everybody else was pulling back and holding on.

It was right at the end of the dot-com bubble. I went to a breakfast roundtable meeting and Steve Forbes, editor and chief of Forbes magazine, was there, giving a speech.

He said one of the things that worried him most about the dot-coms was that the control of these companies wasn’t in the hands of the CEOs any longer. It had been put in the hands of the CFOs instead.

One of those companies was Microsoft. But Apple still had its CEO, Steve Jobs, in charge. He was a visionary who laid out a plan for the future, not caring how much money they were going to burn through, as long as they stayed on track.

Everybody loved Microsoft, and everybody hated Apple. But Microsoft turned a corner and started heading down. It didn’t take long for people to jump off the bandwagon, pushing it even lower. Eventually, Microsoft intersected with Apple – which was on its way up.

Apple was making technical innovations no one had seen before, and the company’s earnings started to show it.

So let’s put it all together. Strong technicals, low expectations, good fundamentals. Back then, Apple was trading around $1 a pop. Now, it’s over $300. Clearly, Apple was a perfect buy.

Microsoft, on the other end of the stick, had weak technicals, high expectations, and poor fundamentals – what I like to call a perfect short.

If you had known then what to look for, you would’ve gotten ahead of the curve for both companies. You would’ve been the counterintuitive contrarian.

If you follow this simple approach and remember that prices do not reflect expectations, then you’re set in this market.

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