“Stocks at all-time highs.” Wow, that phrase conjures up emotion, doesn’t it? Excitement, anxiety, greed, glee. It’s hard to make smart investment decisions when emotions are running rampant.
Our instincts warn us that stocks reaching all-time highs are invariably overdue to fall. Sometimes yes, sometimes no. Over the medium- and long-term, stock prices are driven by earnings. Consistent earnings growth leads to stock price growth. It wouldn’t make sense for a company with growing earnings to have a stagnant stock price, right? So don’t worry about stocks reaching new highs. Focus on valuation and price action.
Let’s examine two common scenarios involving stocks that are about to rise—or fall—from new high prices.
Scenario #1: A stock appears ready to launch upward from a steady trading range and begin reaching new highs.
This is a wildly bullish time to buy a stock. Think about it this way: if a magic genie were to let you buy one perfect stock, what would be your wish?
You, the Investor: “Magic Genie, I would like to buy stock in a great, famous company, famous enough that mutual funds would be attracted to the stock. A company with strong earnings growth and an undervalued stock price, so that it would have every reason in the world to go up. I want to buy that stock a day before it begins a run-up to new highs. There will be no sellers to drive the price back down, because every single shareholder will have a profitable position in the stock.”
Magic Genie: “Perfect. Would you like Adobe Systems (ADBE) or Kraft Heinz (KHC)?”
Scenario #2: A stock just rose a lot—possibly a ridiculous amount, consistently reaching new highs for several weeks or months.
This stock will eventually stop rising, it’s going to need to rest for a while. It could experience a big price pullback, or it could trade sideways near its high, for several weeks or months. How you proceed is going to depend upon your investment horizon, and whether the stock is over- or undervalued.
Long-term investors should simply hold the stock, as long as the company’s earnings growth prospects remain strong. Traders – people who want to make 10%-30% capital gains in a few weeks or months – should sell, because you just achieved your goal. Stick with your plan!
How do you know if the stock has maxed out its short-term run-up? Unfortunately, that can only be determined in hindsight. Therefore, traders should use stop-loss orders to protect capital gains, and raise the stop-losses as the stock price continues to rise. Eventually, you will be stopped out of the stock. Take your profits, pat yourself on the back and focus on your next stock market opportunity, which you’ve hopefully been scoping out in advance.
When my stock gets stopped out, I never look back. I never stare at the stock’s subsequent price movement. I am instead happy that I made a good profit, and excited about buying whichever new stock I’ve picked out for my portfolio. Following the price movement of a stock that you just sold is only going to cause you angst. You’re never going to sell at the exact highest price! Accept that, and move on.