Hope and Fear in the Stock Market

Enemies from Within

Stay Interested!

An Old Favorite Regrouping

I’m going to start today’s Wealth Advisory with a rather long quote from “Reminiscences of a Stock Operator,” the famous fictional biography of Jesse Livermore.  This passage is rarely mentioned, but I think it’s one of most important in the book.  Here we go:

“I sometimes think that speculation must be an unnatural sort of business, because I find that the average speculator has arrayed against him his own nature.  The weaknesses that all men are prone to are fatal to success in speculation–usually those very weaknesses that make him likable to his fellows or that he himself particularly guards against in those other ventures where they are not nearly so dangerous as when he is trading in stocks or commodities.

“The speculator’s chief enemies are always boring from within.  It is inseparable from human nature to hope and to fear.  In speculation when the market goes against you, you hope that every day will be the last day–and you lose more than you should had you not listened to hope–to the same ally that is so potent a success-bringer to empire builders and pioneers, big and little.  And when the market goes your way you become fearful that the next day will take away your profit, and you get out–too soon.  Fear keeps you from making as much money as you ought to. 

“The successful trader has to fight these two deep-seated instincts.  He has to reverse what you might call his natural impulses.  Instead of hoping he must fear; instead of fearing he must hope.  He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.”

Now, much of this quote, when read at face value, simply refers to the old (and true) adage of letting winners run, while cutting losses short.  And that’s all well and good.

However, when you really study and think about this passage, you realize that Livermore is not just talking about a trading rule or two.  The meat of the message is what was mentioned at the very beginning–that speculation is an “unnatural sort of business” because each person “has arrayed against him his own nature.”  That, to me, is genius, yet it’s something I’ve seen few pundits ever talk about.

In the market, it seems like investors ask questions and spend hours every week studying everything going on in the world, from the oil spill to currency movements to economic indicators, and yes, even to charts, support levels and stocks building sound bases.  That’s just fine.  But few take a few hours every month or two and study themselves, even though that is usually more fruitful.  Everyone has investing weakness (including yours truly), and being aware of them (and minimizing them) can seriously improve your results.

The reason I’m writing about this today is because, during stressful market times like now, when the indexes are not only trending down but also extremely volatile, personal weaknesses tend to show themselves.  And I’m seeing that now in some of the emails I’m getting from our subscribers.

One very common weakness I’m seeing now is that everyone is allowing preconceived notions (mostly negative) to get in the way of their investing, and they’re also talking in sureties.  (Tim Lutts touched on this in Tuesday’s issue of Cabot Wealth Advisory.)  I’m getting a lot of emails like “Why are you even pretending that this market has a chance of going up with all the problems in the world?”  Or “It’s clear this is the second leg of the big bear market that began back in 2007, with the 2009 rally just being an interlude.”  

My response is usually that they could be right … but they could also be wrong!  The market is going to do what it’s going to do, and I didn’t hear these negative comments two months ago when stocks were flying high.  So just remember to confine your preconceived notions to political and economic debates, not to the stock market.

The major point to remember is that, sometimes, your own deep-seated instincts must be battled … and that’s especially true during tumultuous times like the present.  So always remember to take some time during these down markets to examine yourself, making rules and guidelines that will help you battle the speculator’s “chief enemies [that] are always boring from within,” as Jesse Livermore might say.

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Another thing most investors find difficult to do during down markets is simple:  Stay interested.  This is totally understandable–for me, this is my job and my passion, so following the stock market is something I do no matter where I am (though on vacation I’m obviously not checking stocks every 10 minutes).  The average investor, on the other hand, has a real job as well as other passions, so if the market isn’t doing anything grand, he has no reason to pay much attention to it on a day-to-day basis.

I am here to tell you, though, that such thinking is a big mistake.  While the term discipline is thrown around a lot when it comes to investing, I think the discipline of keeping up your research and, at the least, staying mentally prepared to buy when the market turn comes, is one of the most important things you can do.

Granted, I admit that, when we’re not close to getting a new buy signal, I dial back my research a bit; I don’t want to work hours uncovering a handful of good-looking stocks each day, only to watch them get lambasted and cross them off my Watch List a few hours later.  Thus I usually spend a couple days per week looking for generally strong stocks, and try to gather all the information I can on them.  (Especially helpful are recent online presentations from companies’ management.)  And I cast a wide net, knowing that a down market can make a lot of stock charts look sloppy.

But the main thing is that, whatever the method, you end up with a group of high relative strength stocks with sound chart patterns and good stories when the market begins a new uptrend.  Investors that have this information (an up-to-date and proper Watch List) on hand should prosper during the next upmove.  Investors don’t have the information will likely get on the train late, and be more likely to buy nothing-to-write-home-about stocks.

Thus, it’s easy to see that the work of keeping a Watch List is definitely worth it … and yet many don’t do it.  The instant rewards aren’t there, and in fact, there’s no telling when the rewards could come–you might work on your Watch List for a couple of weeks before getting a buy signal … or it might take six months!  So it’s tough to stick with it.  My only advice is to think long-term and realize that, over many market cycles, those who are prepared prosper, while those who aren’t do not.

On my own Watch List now are many familiar names that have been written about in these Wealth Advisories during the past few months.  But not all stocks on your Watch List during difficult times have to be within a few percent of their price highs.

Take Green Mountain Coffee (GMCR), for instance.  It was a big winner in 2009 and early 2010, breaking out of its initial base at a split-adjusted 9.6 in March 2009 and advancing as high as 33.2 (again, split-adjusted) this spring.  But the stock fell apart in early April, as the company’s story was simply too obvious–too many traders and investors were following the stock after its huge run.  And what’s obvious in the market rarely works.

GMCR then collapsed even further after its quarterly report “only” met expectations (even though sales were up 68% and earnings were up 82%).  Part of that disappointment was because the company had production issues; some of its Keurig brewers were returned due to malfunctions.  I’ll call that a management problem.

Looking ahead, however, the firm’s growth prospects still appear to be excellent–analysts see earnings rising 50% in the June quarter, 91% in the September quarter, and another 45% for fiscal year 2011 (ending next September).  Longer-term, Keurig continues to gain market share among all coffee brewers, and that’s leading to a great recurring revenue stream, as K-Cup sales are expected to be up 75% this year.

Back to the stock, GMCR’s total correction amounted to 35% … at least so far.  That’s not unreasonable given the market environment and the stock’s prior advance.  But what really caught my eye was that, after bouncing from 22 to 28 during the market’s brief June rally, GMCR held up in the 25 to 26 area (well above its prior low of 22), despite the market’s plunge to new lows.  Call it the first inkling of relative strength.

I would also note that, during this correction, the stock took out both its 200-day moving average, and the low of its prior base.  Such actions are often enough to scare and wear out most of the weak hands … “re-setting” the stock’s advance and giving it a new lease on life.

Now, to be fair, the stock is still nearly 20% off its high and is 13 weeks into a base-building process that, in my opinion, is going to take longer to complete, even if all goes well.  There’s an upcoming earnings report toward the end of this month, too, which adds risk.  So I’m not a big fan of buying GMCR here, even if the market suddenly turns healthy.

However, this razor/razor blade story remains one that I’m attracted to, and in my experience, if the company’s sales and earnings continue to grow rapidly during the next quarter or two, the stock should eventually emerge from this consolidation and begin a new advance.  Of course, if management is unable to correct its production problems, all bets are off!  Either way, GMCR is worth keeping on your Watch List, and it should be interesting to see how it reacts to the earnings report later this month.

All the best,

Mike Cintolo
For Cabot Wealth Advisory

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