Hi YXI friends,

This is Part 1 of a two-part essay on how I approach trading. In this article, we look at the fundamental drivers of a stock’s value and price. In Part 2, we will work through how to set up trades so we remain profitable in the long run.

What I write today is how I think about the market today. Please read everything with an open mind, but also a healthy dose of constructive questioning.

This is because as we grow together in markets, my thinking likely evolves. Furthermore, everyone is different, in terms of their trading style, approach, time horizon, and capital management.

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Macro x Fundamentals x Price Action

You may have wondered why I bother putting out long, tedious analysis of the macro, company fundamentals, and valuation metrics, if the price charts seem to command my trade setups.

To me, macro, company fundamentals, and valuation metrics are layers of context that helps me understand the business and the business environment we put our money in.

Price charts come in for 1) execution and 2) looking for future clues of what the market is seeing that has not yet shown up on paper.

The market is forward looking. Prices often lead the fundamentals. By understanding both the price action and the fundamentals, we can look out for catalysts for both upside and downside shifts. It also allows us to stay more level-headed and not become dangerously married to one side or the other.

It’s like getting to know a person, their background, and how (or why in a certain way) they think and behave, before deciding whether to be friends or to stay away. When we do become friends, we want to be ready for however they may act in different future scenarios, and not to be completely surprised when they choose not to follow the script in our head.

The analogy stops there, because we should be much more emotionally invested in our friends than with investment instruments. The market doesn’t know who you are or the price you paid. The market doesn’t owe you anything. No matter how much sweat and hard work you put in a trade.

2. How I think about stocks and valuation

For every stock I have covered so far, there is a striking similarity: over the course of multiple years, the stock’s price more or less follows the stock’s revenue or earnings growth.

Ultimately, the stock represents a piece of ownership of a real business. The company’s value derives from it ability to generate future free cash flows - how much real money that it will generate for its owners.

This is a blindingly obvious fact. Obvious, if one starts a real business, success means how much profit the business generates for them. Blindingly, because as traders, we sometimes get too consumed in fancy price charts and fibonacci levels, without thinking too deeply about what buying a share means.

The future free cash flows are discounted into a “Net Present Value” or “NPV”. This just means that $1 in 10 years time is worth less than $1 today - or that $1 today is worth more than $1 in 10 years. Why? Because you can park that $1 in a savings account, or better, in risk-free Treasuries, to generate interest every year. That interest compounds if you reinvest.

So here is the second part of the formula, the discount rate for that future cash flow, which is influenced by the risk free rate (e.g. 10-year Treasury yield), the company’s beta to stock market returns, and the company’s cost of servicing its debt.

A lower interest rate environment drives a lower discount rate, which makes the NVP of future cash flows larger. The company is therefore worth more to investors. (For non-income producing instruments, like Bitcoin, Gold and Silver, interest rates are opportunity costs of holding these assets. Lower interest rates mean lower opportunity costs.)

There is a second order effect. With looser monetary policies and financial conditions, it becomes easier for companies to borrow money, find investors, and fund growth. Banks have more excess reserves to participate in risky lending or investment activities, leading to higher market liquidity. There is simply more oxygen in the tank. This is why understanding the macro is important even for a stock picker. A rising tide floats all boats.

Thirdly, and this is a crucial point, execution is extremely important for real business. This is often overlooked by spreadsheet warriors, who play with assumption numbers to move their valuations up and down. There are infinite number of growth levers and pain points for any large businesses. High performing companies do well because they can absolutely execute. This means hiring the best talent, scaling their services or production, and winning in distribution. Surprisingly, coming up with a product / service idea itself is the easiest part. As an example, this is why so many EV companies fail. It’s much easier coming up with a prototype than mass produce the cars.

Famously, Warren Buffett hates corporate turnarounds - they rarely work. It is just so difficult to completely overhaul a company’s growth levers, talents, and culture, especially as it matures, to make it into a winner. This may be a hard lesson for many down-and-out growth stock owners (myself included).

3. What does a stock’s price mean?

Prices are what people are willing to pay in the market to own a financial instrument. Investors are willing to pay differently for companies in different sectors or different phases of growth. This is why looking at comparable valuations is extremely helpful at a specific moment in time.

I like to think about price volatility in terms of divergence or convergence of what people want to pay. Tesla is an excellent example of divergence - is it a car company? or an AI company? or a robot taxi / humanoid robot company?

When a stock is early in its public life, especially when its product distribution is uncertain, market participants likely have divergent views on what the company is worth. And this is often driven by the real, fundamental risks about the company’s ability to generate free cash flows in the future. Think about Zoom before, during, and after COVID.

As institutions come in, Big Money likely converges on what they think the company is worth. This is because 1) all the analysts and traders come from similar training and backgrounds, 2) it is much harder for divergent view points to move the markets due to the relatively smaller impact of its trade size among the Big Money volumes (aka higher market liquidity).

This is also why Cathie Woods splashes around in the growth stock market. Her media influence finds much better value-for-money in smaller stocks. And if she’s right, she looks like a genius. Do you know anyone who became a genius by saying Microsoft is a buy in 2024?

Then there is macro-driven volatility, for example, after a bad set of nonfarm payrolls report. Is it the time to get out? or is it actually the time to get in? This is divergence at best and where opportunities are created.

4. Objectivity in the market

Convergence does not mean objectivity. Objectivity in markets rarely exists. And that’s a good thing for us.

If everyone agrees something makes money, be it an indicator trading strategy or some momentum strategy, traders will spot it and start crowd into the trade. The slight edge of the strategy will quickly vanish. This problem is true even for algos.

Secondly, every price is relative. Is the SP500 P/E ratio too high? High compared to what? Its historical value? Other indices? Or 10Y Yield? There are of course loose statistical relationships, which I regularly present to our service here, but it is through these judgment calls that money is ultimately made.

You may say, Jim Simons used machines to beat the market! But if you read “The Man Who Solved the Market” (an excellent read on Jim Simons and Renaissance), you may identify multiple times that the Renaissance algo was on a heavy losing streak, and the management had to make the painful decision whether to cut risk, turn off the algo, or persist with the machine and get through the storm. And his fund cannot scale in size like Warren Buffett.

5. Technical Analysis Is Subjective

For those who don’t like technical analysis, there are often two arguments:

1) Technical analysis is a self-fulfilling prophecy - everyone sees a head-and-shoulder pattern, and therefore the stock collapses. Everyone sees a support and resistance, and therefore the price bounces between these levels; and

2) Technical analysis is too subjective - is this a bull flag or a double top? How can one retrospectively test the technical analysis?

These are contradictory arguments, because if technical analysis is subjective, then it cannot be agreed by everyone and become self-fulfilling.

Markets are fractal in nature - it means at various levels of timeframes, it can produce patterns. The larger the number of participants, the more the market behaves with crowd psychology. There are always support, resistance, trend lines, and volumes on a chart. Everyone knows RSI, MACD, and 200-Day Moving Averages.

These are just clues into how the market is behaving.

If we take away the price chart for a second and just trade via the phone as a market marker (which I did as an interbank trader). A large order comes in from a sharp hedge fund buying $1 billion of TSLA at $200 (they won’t ever do this, but we just use an example). As a market maker taking on the other side of the trade, now you are short $1 billion. Then an asset management firm comes in to sell $10 million TSLA at $199.50.

With no other information, which trade worries you more? Would you want to start buying TSLA to cover your short position against the hedge fund, even if the price now has now moved against you? Or do you say, oh I have a bearish view so I will stick to the short position that a hedge fund randomly handed me.

Take a way any sort of charts, and the answer becomes obvious. I would immediately hedge my position (e.g. buy buying a correlated asset or outright buy back at least some of the shorts), then study why the hedge fund made the move, and join the trade if it makes sense.

Technical analysis is just a study of how people constantly react to such scenarios but manifested on a chart.

6. Execution is what matters

Once we form a view, it is how we execute the trade that matters. The execution relies on our experience in understanding what the price action means at a particular point in time and how we leverage pattern recognition for that understanding. That is what lies at the heart of technical analysis.

There are no silver bullet setups and slam dunks. Each trade is a representation of our own thesis. The thesis can easily be wrong - or it can be right in the long run, but wrong in terms of timing, which is as good as being wrong.

And often its not that we are “wrong” per se. The trade may have worked a year ago, but the market has now evolved away from it. The trade is just a probabilistic bet based on the past market behaviour that we have observed, while the market simultaneously tries to moves on.

What we want to do is to understand the state of the market to nudge the odds of winning in our favour. We then put on trades that create higher returns than the money we put to risk. Ultimately, higher profit (or expected value) = higher odds x higher rewards.

Part 2: Stay Tuned

In Part 2, we will talk about how to exactly set up a trade with the right risk-reward and position sizing. Stay tuned!

Tools I find helpful:

Growth Investor Pro (GIP) on Seeking Alpha: I have been writing on Growth Investor Pro by Cestrian Capital Research for over 4 years. GIP is a tech-focused investing group which offers pro-grade research that finds opportunities to make money in any market. Sign up here to receive a 20% discount on the Growth Investor Pro membership.

Seeking Alpha: I am the dedicated FOMC Commentator on Seeking Alpha News. Seeking Alpha provides in-depth investment news, research, and analysis to 250k+ members. Sign up here to get $25 off your Premium Membership (7-day Free Trial).

TradingView: I use TradingView for all my chart analysis. It is very fast and simple to play with, including the mobile and desktop apps. Sign up here to get $15 off your new TradingView plan.

Koyfin: I use Koyfin for stock screening, comparative analysis, and fundamental analysis. It provides very comprehensive data and features at a reasonable price. Sign up here to get 15% discount off all Koyfin plans.

Fastgraphs: I find Fastgraphs very useful in gauging whether a stock is underpriced or overpriced versus the fundamentals. Sign up here to get 25% off using the coupon “AFFILIATE25” at the check out.

(Disclaimer: I am an affiliate of the above service providers and receive a commission from new signups.)

A quick “Thank You”

I really appreciate your support for this newsletter.

Please feel free to share any suggestions or comments, either directly through email or DM me on X

— Yimin