Choosing the Right Price

Markets go up, and they go down. Or to be more precise, individual stocks, commodities, other financial instruments and collections thereof (indices, ETFs, mutual funds) go up and down. Rarely do prices sit at one level for any length of time, whether the duration is measured in minutes or years. This raises the all-important question when one is looking at a real-time quote: is this the right price? What we mean by this is, is there some rational, evidence-based justification for this price, or is the market simply wrong?

That's a great question, and probably the best possible question. Is there an answer? More importantly, if there is an answer, is it knowable? Having that knowledge is a near certain path to untold wealth; all you need to do is determine what the right price is and place your money where the price correction -- which you are sure must occur, sooner or later -- will yield profits. Of course it isn't that easy, and even the very best get into heated arguments over what is the right price.

Here we have Rogers and Roubini arguing, among other things, about whether the current price of oil is right or wrong? We have Rogers saying that the most recent dip in the price was the market getting the price wrong, therefore the 47% rise off the bottom is not only not unexpected, but may yet indicate that the market is still undervaluing the commodity. On the other side, Roubini says that since the economy is still in distress, the previous low price is closer to being right, therefore the recent 47% rise is unsustainable and we should expect a correction.

Who is right? Is the price of oil too high, too low, or just about right? I certainly don't claim to know. If you really care about the fundamental arguments about pricing, these sorts of discussions are very pertinent: you need to know which of these guys is right. Since (as is commonly understood) the market is a future discounting mechanism, the current price is an indication of the future returns of the current economic trends, typically about 6 months out. If you believe that, and since oil is in an uptrend, you must believe that the market is saying we are gradually pulling out of the recession. Of course if you think the economy really stinks, you should believe the market is being stupid, so you should go short on the commodity or the producers and you'll be that much richer in 2010.

If you ignore the fundamentals and only look at the chart for guidance -- this is called technical analysis -- it is enough to know that there is an uptrend. Yes, it has to end sooner or later, but what you should do is go long now, then cash out when the trend turns against you. You too, if you get it right, will be richer in several months.

The one nice thing I do like about technical analysis is that you don't need to know if the price is right. It's enough to know that other market participants believe that the price is too low -- which is what is driving buying and the trend to higher prices -- and go along for ride while that belief dominates. It is however crucial that, once taking this approach, you do not subsequently become a believer. When the market turns, sell. With that discipline you are most likely to profit, and you can do it without knowing whether the price is right or wrong. Leave that for the pundits.