How Accurate Can They Be?

I have always been split 50/50 on the Market Efficiency Theory. What this theory suggests, is that all information is already baked into the share price. This is the premise behind technical analysis.

If a stock is trading at $100 per share, market efficiency tells us that the share price is absolute (more or less) and has already factored in all available information. The theory suggests that the share price is reflecting company financials, company direction, company head-winds, and any other company info that might be important to know. No work is needed on your part, says the market efficiency guru.

So, I did a little study to see how accurate consensus estimates are. After all, if market efficiency is true, then you would think estimates would be somewhat accurate. Wouldn’t you? If a share price is absolute, and “is what it is,” then the market makers who set these prices have to base them off of something. Company financials are certainly a big part of the theory.

First, here were the rules for my study:

  1. I couldn’t pick the companies. I asked my Facebook group to pick random companies. Those companies had to be legit, and could not be garbage OTC companies. However, I did have to switch 4 companies on my own, as the previous 4 did not have enough financial data on the website I used. The companies I picked were ROKU, AMZN, AMD, and Macy’s. I used 10 random companies total.
  2. I used the same financial website for all data. I used Markets Insider. I also used the same 3 quarters of information for all companies.
  3. I used earnings per share (EPS) and revenue (Rev), as those two are the “big” ones that are looked at closely.
  4. I simply took the difference between estimate and actual, and then found the percentage in which it was off from the actual. From there, I subtracted the percentage it was off from 100%, and used that as my study’s accuracy level.

So what did I find out? Let’s see…

The first 5 companies: Disney, Tesla, Apple, Shopify and Amazon.

The second set of 5: Goldman Sachs, Kinder Morgan, Advanced Micro Devices, Macy’s and Roku.

The overall accuracy for EPS was 73.36%, and the overall accuracy for revenue was 95.87%. That’s pretty impressive if you ask me. The only companies that brought the overall accuracy down were the “wild card” companies: Tesla, Shopify, and Roku. I call them wild cards because they’re technology based. Except Tesla. Tesla is a wild card because it’s a new space in the auto sector, and their CEO is a little bit of a loose cannon.

You can take what you want from this little study of mine. But for me, it brings me a little bit closer to believing the efficiency theory. Am I all in on it? Nope. But I’m closer than I was before.

However, there is still the unforeseen to contend with… Elon Musk tweeting that he may de-list his company and go private, for instance. Or the sex scandal at CBS, or shady accounting practices at Enron. The list goes on. There is much in the market that makes things not efficient.

As I always say, there is absolutely no way to predict the market with 100% accuracy. There never has been, and there never will be. But, I’d take 73.36% or, even better, 95.87% accuracy ANY day of the week!

The Put/Call Ratio Charts

In the Dumb Money Trader Facebook Group today, I posted this pic with the comment “I look at put/call ratios from time to time. In specific, $PCSP and $PCALL. Noticed that both bottomed today. Bottomed where they’ve been hitting bottom for quite some time. These charts sometimes coincide with what the market does – the same seesaw effect. Meaning, if PC hit bottom, the market may pullback soon.

Somebody replied to it basically asking what I meant, and what is the PC ratio telling me. And his question was my inspiration for this blog post. So here we go!

First, the only 2 PC charts I use are 1) $PCSP (put/call ratio for the S&P 500) and 2) $PCALL (put/call ratio for the entire market). There are others, but I will not get in to them right now.

The P/C ratio chart (I call them PC’s) is the ratio between puts and calls. Remember from options 101 that puts are bearish, and calls are bullish. To know what the ratio is you simply divide all the puts by all the calls.

Let’s say there are 1000 puts and 500 calls. The put/call ratio would be 2 (1000 puts divided by 500 calls). Now let’s say there are 500 puts and 1000 calls. The put/call ratio would now be .5 (500 puts divided by 1000 calls). Lastly, let’s say there are 1000 puts, and 1000 calls. The put/call ratio would be 1 (1000 puts divided by 1000 calls).

So now that you know the basic math involved, let’s discuss the basic theory behind this ratio.

According to Investopedia, a ratio above .7 is considered bearish, and below .7 is considered bullish. That is, above .7 means there are more people buying puts than buying calls. Which can be a bearish sign. Why .7? Simple. Since people typically buy more calls than puts, using a ratio of 1 would not be “accurate” to determine market direction because that would imply a 1 to 1 split between puts and calls. So, the investing gods decided .7 was a good “middle” point. Honestly, past what I just told you, I don’t know any other reason for .7 being “neutral.”

Now, what can this ratio tell us? I use these charts from time to time, to help me determine which direction I think the market is going. If I open this chart and see a rising PC, I may go easy on my bullish bets. But if I open this chart and see a falling PC, I may increase my bullish bets. I have noticed that this ratio sometimes coincides well with market moves. Meaning, I have noticed that some very bearish days in the market was preceded by a rise in the PC ratio.

If people are getting bearish, they’re not going to buy calls, and vice versa if people are getting bullish. So, if the PC is rising, that can be a sign that people may be getting more bearish because they are buying more puts. If the PC is falling, that can be a sign that people are getting more bullish because they are buying more calls. As always, does this mean it’s guaranteed bearish or bullish sign? Absolutely NOT! But the more tools you utilize to make investing decisions, the better off you might be. No one particular “indicator” is going to be 100 % accurate.

Investing is like a puzzle – You have to put all the pieces together to see the bigger picture.

To Short… What Does That Mean?

The concept of shorting really tripped me up when I first started investing. Before that, I always assumed the only way to make money investing, was to buy. You know – “buy low, sell high.”

But, what I soon learned was that “sell high, buy low” was also a very valid concept. In fact, once I figured this out, I knew that I was going to be able to make money regardless if the market was bullish or bearish. Of course, you still need to know what you’re doing… but in theory, money can be made in a bull or bear market; recession or crazy hot economy. Makes no difference.

But what is shorting? Short selling is the borrowing of shares from ones broker to sell in the open market, and buying those same shares back at a cheaper price and profiting on the difference. Let me explain:

Let’s assume I am bearish on company ABC (hypothetical company). I think they suck, and I think they will drop 5% in price within a week. Currently, ABC is selling for $100 per share. I want to short them, so I open a short position via my trading platform for 10 shares. When I “Sell to Open” via my broker, my broker then lends me the 10 shares I requested, and they are automatically sold on the open market for $1,000 (not including fees).

So, to recap: I borrowed 10 shares from my broker and sold them for $100 per share netting me $1,000 that is deposited into my trading account.

A week goes by and ABC stock did exactly what I thought they would – they tanked 5%. WOO HOO! What a great analyst I am! So ABC is now selling for $95 per share – $100 minus $5 (5% of $100) equals $95. I decide to close my position by placing a “Buy to Close” order.

Now I am buying back the shares that I borrowed, so I can return the borrowed shares to my broker. But, I am buying the shares back at a cheaper price than they were when they were loaned to me… so I get to keep the difference. I sold ABC for $1,000 (10 shares at $100 per share), and bought them back at $950 (10 shares at $95 per share) to give the 10 shares back to my broker. I get to keep the difference – $1,000 minus $950 equals $50. I just made $50, or 5% on my return. FANTASTIC!

The example I gave was for short selling stocks. However, there are other ways to short like buying put options. A put option… simply put (LOL LOL)… is an option contract that you purchase when you think the underlying is going to fall in price. But put options are for another article. Just know that with a put option you are not borrowing anything, rather, you are buying with your money a security that will allow you to profit when the underlying falls in price.

Understanding short selling broadened my horizon in terms of investing. With a good understanding of short selling, it is entirely possible to profit in a bear market, the exact same as you can in a bull market. But, like any other investment type, short selling carries certain risks that other strategies do not. As always, it is absolutely necessary for you to educate yourself on whatever you do BEFORE you do it when it comes to investing or finance.