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Focus on Probabilities, Not Possibilities

The Great Disconnect: Wall Street vs. Main Street

The S&P 500 hit a new all-time high this week and topped the psychologically important 2,000 level for the first time ever. The S&P 500 is up approximately 8% for the year, after rallying a very impressive +29% in 2013! If you lived on another planet and were told the S&P 500 is at an all-time high, one would expect to hear that the US economy (Main Street) is surging. Unfortunately, the US economy has been barely growing. In the first quarter of 2014, the US economy actually contracted. So how can the market be at a new all-time high if the US economy is barely growing?

Wall Street Moves Before Main Street:

The economy is improving and Wall Street looks forward, while fundamental data looks backward (tells you what already happened). Here is a real-life example to illustrate this point. On Tuesday, we saw durable goods surge +22.6%, easily beating the +5.1% forecast. This illustrates how Wall Street moves BEFORE Main Street. Stocks are already up nicely for the year and Main Street is just now catching up. As long as stocks continue to rally, Wall Street believes that Main Street will continue to improve for the foreseeable future.

This Is Normal & It Happens All The Time:

Throughout history, we have seen this phenomenon occur over and over again. After studying countless market and economic cycles, I have found that Wall Street tends to move 3-9 months before Main Street. It is important to note that just like most every other rule, there are exceptions.  The primary exception is that Wall Street does not always move before Main Street but it does the vast majority of the time.

Who is the Smartest Guy In The Room:

In life, and in the stock market, success is about stacking the odds of success in your favor. In Las Vegas, there is an old adage that says- you want to always know who the smartest guy in the room is. Most people look around the room and try to size up their competition. However, the real answer in this scenario is that the smartest guy in the room is the person who owns the room! Why? Because the person who owns the room knows that, in the long-term, the odds of success are clearly stacked in their favor.

Focus on Probabilities, Not Possibilities:

The same rule applies to Wall Street and most other endeavors in life. Before making a decision (where the outcome is uncertain), ask yourself: Are the odds of success stacked in my favor? If not, you might want to think twice before making that decision. Remember, anything is possible in life, but success comes from measuring what is probable. The same is true for buying and selling stocks on Wall Street. Define and measure your downside before you enter the trade, this way you know exactly where you will exit if wrong and how much you will lose. If you are comfortable with that risk, and see a favorable reward, then you should take the trade. Otherwise, if the risk/reward ratio is not favorable, move on to the next idea.

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