Whether it is good news or bad news, stock markets and investors tend to overreact on the upside and the downside. If we focus on the upside, an overbought position will eventually fall back into line but it can for some time become a self-fulfilling prophecy attracting more and more investors. There is a skill in stripping out the froth of a share price, the overbought position compared to the potential for the long term, and there are many ways in which you can benefit financially.
Short selling
If you have monitored the stock market over the years you will no doubt have seen many situations where share prices are pushed to levels which are unsustainable in the short term. There may be some kind of feelgood factor, short-term news expectations or simply misplaced hopes for the future. You will see “professional investors” taking advantage of these short-term spikes to sell stock they don’t hold and then buy back at a lower level. This is your stereotypical short selling position and done correctly it can create some significant gains.
Letting the share price settle
There will be occasions where share prices are pushed to levels which stretch the valuation in the short term but in the medium to long term they still have good potential. Time and time again we see investors sucked into these situations and even though the prospects for the company may be encouraging in the longer term, when they consolidate at lower levels you can be left with “dead money” until the next rally.
One option is to monitor the share price of companies which have announced game changing situations which the market has very quickly jumped aboard. Even though short-term speculators often get a bad press, they offer much-needed liquidity to small and medium-size companies. Sometime you will see bouts of profit-taking, perhaps a few bad days for the share price which will bring it down to more “sensible” levels.
Target entry price
In the above situation, where a share price rallies and then consolidates after a bout of profit-taking, if you are interested in buying the shares you should have an entry price in your mind. What potential earnings multiple do you believe is sensible at the moment? Where does the risk/reward ratio start to tip against you?
While it is always good to have a target entry price in mind you can be a little flexible give or take a few pence. Do not miss out on a potentially good return for the sake of a couple of pence and sticking rigidly to your target entry price. At the end of the day, if you believe the company has significant potential then a few pence here or there were not make a big difference in the long term. Use your target entry price as a broad measure of the level at which you feel comfortable buying into the company but do not deviate too much from this.
Information exchanges
If you see stock markets as simple information exchanges, different views are entered into the system and a share price is calculated accordingly. As a consequence, whether a share is overbought or oversold, if the fundamentals remains constant the share price will return to a more “sensible” level in the end. Markets do eventually “get it right” but in some situations it can take longer than expected!