The Rules of the Game

Rule No. 1: There’s a market for everything – oil stocks, newly public stocks, small-cap value stocks – so pay attention to how it works. You should even think of the stock market in general as a market, meaning it’s governed by supply and demand as much as anything else.

The importance of supply and demand in trading is especially true for hyped up, trendy stocks. Just look at ethanol in 2005 and 2006. At the end of 2005, when every major media outlet was running stories about how ethanol was the next great energy source, stocks like Archer Daniels Midland, which makes ethanol, and Andersons, a grain elevator company, were great picks because they were some of the few companies with ethanol exposure. Ethanol didn’t necessarily make sense as a fuel, but the demand for the stocks was intense because the supply was limited.

But by the summer of 2006, when VeraSun, Hawkeye and Aventine were on the scene, the oversupply of ethanol stocks had killed the run in that sector. If you’d just been paying attention to the fundamentals, or to the hype about ethanol in the media, you would have been caught totally off guard by downturn in ethanol. A lot of people got caught up in the hype and ignored the simple but important rule of supply and demand.

The oversupply doesn’t just have to be in a sector, either. Cramer once got burned on the Sealy initial public offering, and not because there was a sudden glut in the supply in mattress stocks – it was the record rate of IPOs. The quarter the mattress professionals came public saw the most IPOs since the dot-com bubble. Anybody who was after a newly public stock, who wanted to play the IPO game, had already gotten a piece of the action somewhere else. He ignored the market for IPOs, and he paid the price.

Bottom Line: New rule from the new book – Pay attention to specific markets for specific kinds of stocks. The supply and demand of a certain kind of stock is just as important as a company’s earnings.

Questions? Comments? [e-mail]