The Stock Market Teaches Bad Behavior

The Market Teaches Bad Behavior

The Math of Falling Stocks

A Stock for Your Watch List

(The first two sections of tonight’s Cabot Wealth Advisory were originally published on October 27, 2011 but I think the points are just as valid today.)

If you ask some professionals why it’s difficult to consistently make money in the market, you’ll get a variety of answers, ranging from complexity to emotions to the relatively recent advent of high frequency trading, which can push stocks around in the blink of an eye.

But I think one of the biggest reasons it’s tough to make (and keep!) money in stocks is because the market itself teaches bad behavior. The best explanation of this comes from William Eckhardt, who was interviewed two decades ago in the book New Market Wizards(written by Jack Schwager and available at any major online bookstore). Here’s how Mr. Eckhardt put it:
“The market does behave very much like a tutor who is trying to instill poor trading techniques. Most people learn this lesson only too well.

“Since most small to moderate profits tend to vanish, the market teaches you to cash them in before they get away. Since the market spends more time in consolidations than in trends, it teaches you to buy dips and sell rallies. Since the market trades through the same prices again and again and seems, if only you wait long enough, to return to prices it has visited before, it teaches you to hold on to bad trades. The market likes to lull you into the false sense of security of high success rate techniques (i.e., something that delivers a profit, any profit, most of the time), which often lose disastrously in the long run. The general idea is that what works most of the time is nearly the opposite of what works in the long run.”

Elsewhere in the interview (which is an outstanding read), Mr. Eckhardt has a similar thought: “While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader.”

Now, after chewing on those two paragraphs, you’ll have to admit it sounds a lot like the action we’ve seen since early 2011. In my experience, this period has been one of the toughest I’ve experienced or even read about; even though the indexes have made a little progress, the volatile, choppy, news-driven action has been difficult to handle. I know many investors have been chewed to pieces, buying and selling, buying and selling, as the market has whipped up and down for nearly two years.

With that in mind, what has the market taught investors? Clearly, buying after a couple of bad weeks and taking small profits has been a good strategy for the most part, with a few exceptions. So has selling stocks that are hitting new highs or have made big moves in short periods, and buying stocks that have fallen sharply but show signs of a turnaround.

In fact, I would go so far as to say that letting winners run and cutting all losses short–two of the main tenets of growth investing–have hurt investors since early 2011. So, naturally, what will most investors do in the months ahead? They’ll start doing more short-term trading, taking quick profits and being patient with their losers. And they’ll likely play things lightly with smaller positions.

Now, my point isn’t that such an adjustment is “bad;” heck, I wish I had more drastically adjusted my own actions a year ago. But you have to be careful not to learn too much from any one year or one period. Next year could bring further choppy action … or it could bring a new, smoother uptrend or downtrend. In other words, the market is always changing its tune, and thus, switching strategies can be like chasing your tail; soon after you switch, the market switches gears.

So what should you do? Try to be a master of one type of investing, and not a jack-of-all-trades. That doesn’t mean you can’t mix in some exchange-traded funds or value stocks with your growth stocks, but if you’re someone who aims for homeruns, don’t suddenly turn into a singles hitter, and vice versa. Instead, it’s best to generally practice patience until the overall environment is more conducive to your investing style.

Changing it up a bit, I wanted to write a little about the math of falling stocks. To many investors, if a stock is down 30% or 50% or whatever, it’s considered cheap. After all, if a stock is off a huge 50%, how much further can it fall? That is where the math comes in.

Ask most people how many 20% drops are in a 50% decline, and the answer is two and a half. Right? 50 divided by 20 equals 2.5. Simple … but also wrong.

In actuality, for a stock to fall 50%, it has to fall 20% three times and then fall another 2.3% after that. It’s true! And it’s because of reverse compounding; the first 20% drop takes a stock priced at 100 down to 80. But the second 20% drop takes the stock now priced at 80 down to 64. The third drop takes it down to 51.2. And then the final 2.3% drop takes you to 50.

My point here isn’t to bore you with tedious multiplication exercises, but to point out that, on the way down, a stock can dish out punishment for far longer than most investors believe possible.

Any of the fallen leaders in the market provide a good example. Chipotle Mexican Grill (CMG) fell from a peak of 442 in April of this year to a low near 235 in October … a 47% decline. Even investors who bought at, say, 300, after the stock’s earning blow-up in July (when the stock was 32% off its peak), had to sit through another 22% drop before the stock found support!

And CMG isn’t even the most extreme example; I didn’t talk about fallen angels like Acme Packet (APKT), Green Mountain Coffee (GMCR) or Netflix (NFLX), all of which tanked much more than CMG has (so far). The point is that buying on the way down, after a major break, might seem tempting, but can often lead to disastrous results.

As for the current market environment, it looks pretty rough, though it’s not a complete disaster out there. The rally that got underway the week of Thanksgiving is, technically, still in effect, but I have a couple of apprehensions. First, not many stocks have actually broken out to multi-month peaks and shown some power, and the few that have are generally not institutional quality.

And second, the overall trend hasn’t decisively turned up. In fact, our longer-term trend indicator (which is more of a background, red light/green light type of indicator) is still negative, while the market’s intermediate-term path is on the fence.
That said, if there’s one good thing I can say about the recent rally it’s that it has allowed us to separate the wheat from the chaff—the stocks that both held together during the market decline, and rallied smartly during the past three weeks, should be watched closely. Of course, until the market truly gets going, I wouldn’t be doing a ton of buying in these names, but as always, it’s vital to prepare now for sunny days ahead.

One stock that must be watched is Regeneron Pharmaceuticals (REGN), which, admittedly, has already had a huge run this year … something that makes it a riskier play. Still, if the stock wanted to fall apart, it could have done so during the past couple of months—instead, shares dipped reasonably and then exploded to new highs on huge volume as soon as the pressure came off the market in mid-November.

The big story here involves EYLEA, the firm’s treatment for age-related macular degeneration, a market that totals $1.5 billion in the U.S. alone, and up to $3 billion when looking at the entire world. On that note, EYLEA was just recently approved for use in Europe, which should boost sales through the company’s 50-50 overseas sales partnership with Bayer.

The treatment just hit the market earlier this year but it’s been one of the biggest launches ever—revenues have ramped from $123 million to $232, $304 and $403 million during the past four quarters. Earnings have exploded as well, totaling an incredible $1.89 per share in the third quarter, and analysts see $4.90 per share for 2013 … a figure we think could prove very conservative.

Now, as mentioned above, the stock has basically tripled this year, so it’s not in the first inning of its advance. But after dipping from 166 to 136 during the market downturn, it’s spiked to new highs above 180 before calming down in recent days. If you want to nibble, you can do so here or on a dip toward 175, but even if you don’t buy any, keep REGN near the top of your watch list.

All the best,

Mike Cintolo
Editor of Cabot Market Letter and Cabot Top Ten Trader

Related Article:

It’s All Psychology

Expectations vs. Reality

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