By Paul Goodwin, Editor of Cabot China & Emerging Markets Report
From Cabot Wealth Advisory 2/27/09 Sign up for free Cabot Wealth Advisory e-newsletter

Why do stocks go up? (I suppose I could as easily ask why they go down, but I'm trying to keep a positive attitude here.) Here are a few popular answers.

* The company's revenues and/or earnings have increased.

* A news story or economic forecast has brightened the outlook for the company's products or sector.

* The company has announced a new product or service that will kick business to a higher level.

* Its stock is trading at a deep discount to its intrinsic worth or has a low P/E ratio.

* Some analyst or TV investing guru has given the stock a positive mention.

* The stock's chart has formed a double bottom or a cup-with-handle or some other constructive chart pattern.

* A big institutional investor is accumulating shares.

This isn't an exhaustive list, but then it really can't be, because stock prices, like many complex phenomena, are subject to over causation.

Over causation is a favorite term of liability defense lawyers who invoke it to show that there were lots of factors besides their client's (alleged) negligence that might have led to a personal injury. If they can show that an employee's fall from a ladder was "caused" by that employee's poor choice in shoes or possible drug use or a bad ladder design, they can save their client a bundle.

For stock investors--people who try to anticipate what a stock's price might do in the future--the principle of over causation can be a vexing one. 

Fundamental investors track revenue and earnings (plus free cash flow, debt, return on equity and dozens of other metrics) in an attempt to find an investable trend. But sometimes they find an ideal setup that has every reason to rise in price (rising revenue and earnings trends) but just hasn't gotten around to it yet. 

Value investors diligently analyze a company's projected earnings, cash on hand, potential market share, etc., to assess the intrinsic value of a company and to identify those stocks that are trading at a discount to future earnings. And yet these stocks often refuse to act the way they should.

Technical investors focus on a stock's chart, looking at the direction and volume of price moves to identify patterns that have historically resulted in big price gains. Yet even the finest charts often zig when they should zag.

What all stock investing systems (including momentum investing, watching TV stock gurus and throwing darts) try to do is lower the risk of investing enough that we can actually pull the trigger on a new stock even after going through a crap-storm like the last year.

The lesson of the principle of over causation is that stock price movements are more complex than many people think. Nothing guarantees that a stock will go up, not increasing revenues, not earnings surprises, not new contracts, not a dive in price that drops the P/E into the basement.

The truth is that the only reason stocks go up is that someone believes they can make money by buying them. And people's reasons for that belief are all over the map. You can't reduce an over caused behavior to a simple set of rules.

I have two bottom line recommendations here.

The first is to encourage you to control your investing behavior by watching the action of the markets, not news about the economy. Reactions to economic news are certainly part of market movements, but they're not the whole pizza.

Second, the principle of over causation is an important reason for the use of loss limits in growth investing. Over-caused events always involve uncertainty, and an iron-clad loss limit--I use Cabot's recommended 20% below purchase price when the bulls are in control and 15% when the bear rules--can help to preserve your capital 

So analyze your Watch List using whatever system seems to make the most sense to you. Work to develop enough conviction to put your money to work. But remember that the ultimate goal of stock investing is making money, and that over causation makes absolute certainty impossible.

Click here for more information on Cabot China & Emerging Markets Report.

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