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Predicting the Future, Twitter-Style

A new hedge fund will trade based on the frequency of opinion tweets on stocks and the markets.

Predicting the Future, Twitter-Style

Valuable Information the CIA, Google and Hedge Funds Overlook

One Useful Hint on When to Buy or Sell

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I’ve often thought if I were to operate a storefront as a psychic (and don’t ask me why I’d end up in business as one), the first thing I would say to everyone who walked through the door would be “I was expecting you.” It certainly would make a favorable impression, especially to those inclined to use a psychic’s services.

But can anyone tell the future? Foreknowledge of events has been the subject of intense speculation from the Oracle of Delphi through the science fiction movies of today. So it is in the stock market too.

One recent sign of how much information about future moves is valued is the emerging insider trading scandal in which hedge funds paid $1,000 an hour to speak with industry “consultants,” essentially people selling their knowledge of a former employer’s aims and future moves to investors.

Even advance knowledge of what another investor will do is useful information, as anyone who watched the movie Wall Street knows. When “Blue Horseshoe loves Anacott Steel,” you buy Anacott shares for yourself too.

Traders also spend a lot of time and effort in legal ways divining where the market or a stock is heading, in sometimes-curious ways. London-based Derwent Capital Markets is launching a new hedge fund next month that will trade based on the frequency of opinion tweets on stocks and the markets.

A paper by researchers at Indiana University saw a statistical connection between stock and market-related tweets using one or more 7,000 emotional words and the movement of stocks and the market in the following two to six days. According to their system, which they didn’t provide a lot of detail on for obvious reasons, they are accurate 88% of the time.

Basing a new fund on the paper, Derwent had already raised $39 million for it as of the end of December, according to Bloomberg. Presumably, if a few thousand people start tweeting “I luv #anacott steel!” Derwent will buy it. The company boasted to Bloomberg that it expects to make between 15% and 20% annual return using the system.

A different company, Recorded Future, is doing much the same thing, sifting with computers through tweets, blog posts and Facebook data to “predict the future,” with backing from Google and the CIA (as if the duo don’t already know enough!). Earlier this decade, the Pentagon, inspired by unusual airline stock options activity ahead of 9/11, examined whether futures markets could indicate pending terrorist attacks. The idea, to be called the Policy Analysis Market, was spiked by the Senate as distasteful.

I don’t dismiss the value of information in forming opinions and I appreciate the predictive value of disparate bits of information. But I have my doubts about Twitter and Internet-based investing strategies. For one, exactly how valuable are certain tweets?

Last week rapper 50 Cent tweeted to his 13,000 Twitter followers that “BIG MONEY” is to be had in the stock of a company he owns a chunk of, H&H Imports (HNHI.OB). Certainly, his tweet was retweeted many times—and the stock did leap from 10 cents to 35 cents in one day before slipping back to 26 cents lately. The company made $726,000 in the past 12 months.

How much of your investment dollars do you want relying on the tweets of thousands of rap star fans or the Yahoo! Finance bulletin board musings of pump-and-dumpers?

I know this: The institutional traders and mutual funds that buy stocks in great volumes and truly drive shares higher or lower aren’t tweeting their feelings about a stock or musing on Facebook about their favorite industry. Or, on the off chance they are, they’re lying half the time.

The promise of algorithms that sift through Internet musings to predict the future sure is appealing to the superrich who invest in hedge funds. Wealthy hedge fund clients are in many cases eager to believe their wealth buys them access to information no one else has.

Hedge funds play on that desire too—as well they have to—the number of hedge funds competing for investors ballooned more than 150% in the past decade to over 12,000 (with another 6,000 or so hedge funds that invest only in other hedge funds). And each of them charges healthy fees of 2% or more of your assets annually and 20% or more of your profits.

I’m here to say that you and I have access to a wealth of highly predictive data that beats Recorded Future and Derwent Capital hands down for quality and reliability. If I were arrogant enough, I’d even say I can predict the future too.

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What is this valuable information? The stock chart and trading volume data. Using a stock chart and volume data you can reliably predict the future of a stock. It’s not 100% reliable of course—nothing yet truly predicts the future—but I’ll argue it is more useful than tweets any day. But it doesn’t get Google to invest or billionaires to hand over their money because the information is accessible to anyone: It’s widely available for free on finance websites and your broker undoubtedly offers you charting functionality with your online account.

Why is a stock’s chart so valuable? Because the action of a stock reflects everything that is known about it, both fundamentals such as its revenues and balance sheet items and less tangible psychological and emotional factors too.

Another reason is that markets and stocks trend—they move up or down or sideways—and trends tend to continue. When signs indicate the trend is reversing or speeding up or slowing down, that is very valuable information.

Lastly, trading volume trends tell you if buying interest is increasing, selling pressures are waning, and, with some degree of confidence, if institutional investors are buying shares or selling. We also can be fairly confident when selling pressure will fall on a stock and when buying support should materialize to buoy a sliding share.

The interpretation of charts is called technical analysis, and since there are many statistical approaches and theories to weighing what price and volume are telling us, being good at it is both an art and a science. I don’t have the space to explain the many pieces of data and trends I watch that helped make my Cabot Green Investor return 24% in 2010, but I can recommend one piece of technical data I pay a lot of attention to: The 200-day moving average.

The 200-day moving average is simply the running average price of the stock over the past 200 trading sessions. History shows that it acts as a stiff level of resistance to stocks that are trading beneath it and as good support to stocks trading above it. But if a stock can convincingly break above its 200-day moving average (that is, not just an intraday blip) it’s usually a great long-term buy signal. And if a stock breaks below its 200-day moving average it’s usually a great long-term sell signal.

Some traders rely only on technical analysis to trade, while others rely solely on classic fundamentals—the valuation of a company or a sense of its market and products—to make trading decisions. In Cabot Green Investor, I combine both, using technical analysis to determine with a high degree of confidence good times to buy and sell, and fundamental research to identify companies where good news will be generated that should boost the share price.

Saying I am predicting the future makes it sound more mystical than it is. I call it smart, hard work that has profitably outperformed Green mutual funds, green newsletters, the broad market and the alternative energy segment last year and since we launched Cabot Green Investor three years ago.

What do I see for the market ahead? Green stocks are in the midst of a bullish move that, while already five months along, shows signs of still being very young. Trading charts indicate rising investor sentiment to own Green stocks and some impressive momentum in many alternative energy and Green lifestyle companies. My fundamental take on the market is that rising energy prices will power interest in energy efficient and new forms of clean energy through 2011. Markets can change direction (and ultimately they always do), but now is a good time to be a buyer.

All the best,
Brendan Coffey
For Cabot Wealth Advisory

P.S. Brendan Coffey is the editor of Cabot Green Investor, which returned 26% in 2010! Compare that to the S&P 500, which rose 9%, the Nasdaq Composite gain of 15% and the WilderHill Clean Energy Index, which fell 7%. Our secret: A superior knowledge of the industries we cover, a sense for where the market is headed confirmed by informed market watching, and timely advice to subscribers on when to sell to lock in profits and minimize losses. Don’t miss another issue, get started today!

Cabot Editor