“How Do It Know?” is the punchline to an old joke. According to Urban Dictionary (with a little of my own copy editing!):
This expression is taken from a joke that describes a person’s failure to grasp the obvious or that demonstrates such intellectual ineptitude as to elicit a comment of “How Do It Know?”
The joke refers to a question posed to a scientist by a student (or in variations, a corporate executive and employee, a Congressman and voter, etc.) “Sir, in your opinion, what is the world’s greatest invention?” asked a student. The scientist replied “The thermos bottle!” “Why?” asked the student, obviously confused. ” Well” said the scientist, “it keeps cold drinks cold in the summer and hot drinks hot in the winter.” Holding up his thermos bottle in awe, he says “How do it know?”
Technical analysts make this joke all the time. The reason is that the stock market is a discounting mechanism and often reacts before the fundamentals become apparent.
Consider, for example, an article in the New York Times, dated March 21, 2013, entitled Sudden Rise in Home Demand Takes Builders by Surprise. Here are a few excerpts from the article, which has series of anecdotes about how the industry was caught off guard with the surprise housing demand.
The housing turnaround seems to have caught almost everyone in the business by surprise. As desirable as the long-awaited improvement may be, the unusually low level of homes for sale is creating widespread problems for buyers and sellers alike, leading to bidding wars and bubblelike price jumps in places that not long ago were suffering from major declines.
Monthly permits for single-family homes in the Sacramento area more than doubled from January 2012 to January 2013, though they are still only a quarter of the level they reached during the bubble. Nationally, the construction industry added 48,000 jobs in February, the biggest increase since 2007.
“You walk into the permit office, and it’s like a ghost town in there,” said Michael Haemmig, president of Haemmig Construction in Nevada City, Calif., about an hour north of Sacramento. He says local governments were caught off-guard by the suddenly renewed interest in building and do not have enough people in place to handle the paperwork.
Here’s what wasn’t caught by surprise: the price charts of housing stocks. Below is a chart of XHB, the ETF for the S&P Homebuilders Index, and Lennar (LEN), one of the larger homebuilders that happens to be in some of our managed accounts. XHB is up more than 100% from the trough in October 2011, while LEN is up around double that much.
Source: Yahoo! Finance (click on image to enlarge)
Although this is clearly a well-chosen example, this happens often enough that it is pretty clear that a lot of information is contained in prices. After all, prices simply reflect supply and demand—and often the buyers and sellers are very well informed.
Fundamentalists often deride technical analysis as some kind of voodoo, but supply and demand is pretty firmly rooted in economics. Informed buyers and sellers often catch on far sooner than economists or even most Wall Street analysts. For example, take a look a another chart of the same two items—with one twist. The only difference is the time frame. This chart runs from early 2006 to the end of 2007, a period when the economy was booming and few economists, fundamental analysts, or Fed officials were concerned about a housing bust.
Source: Yahoo! Finance (click on image to enlarge)
As you can see, before 2008 rolled around, the homebuilders had already been cut in half. In price, there is knowledge. That’s because prices contain investor’s expectations, not just what is currently visible. Of course, expectations can change—but prices will adjust to that too.
That’s the point of relative strength analysis. It allows an investor to scan the entire universe of securities and see where the strongest performances are. That’s usually where you want your portfolio to be too.
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