The Market Teaches Bad Behavior
The Math of Falling Stocks
A Beautiful Set-Up?
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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 first 10 months of 2011. In my experience, this has been one of the toughest years; even though the indexes haven’t moved much net-net, the volatile, choppy, news-driven action this year has been difficult to handle. I know many investors that have been chewed to pieces, buying and selling, buying and selling, as the market has whipped up and down this year.
With that in mind, what has the market taught investors this year? Clearly, buying after a couple of bad weeks and taking small profits has been a good strategy this year (except for the August crash, most of which has been recouped). 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 cost investors plenty of money during 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 adjusted my own actions starting a few months 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 problems, but to point out that, on the way down, a stock can dish out punishment for far longer than most investors believe possible.
Netflix (NFLX), which has been an unmitigated disaster in recent months, is a good example; its trip down from 300 in July to 75 earlier this week (a 75% drop in total) included six drops of 20% topped off by another 5% drop! Even investors who bought the stock when it was down a whopping 60% from its peak still lost 37% after this week’s earnings disaster!
NFLX is certainly an extreme example, but the moral of the story still applies--the distance a stock falls from its old peaks doesn’t tell you whether a stock is a bargain. Even something down 40%, 50% or 60% from its highs can still do a lot of damage to your portfolio.
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As for the current market environment, it’s still not quite there yet. Of course, the major indexes have bounced nicely, but most of the action has been in the off-the-bottom crowd ... the stocks that fell 40% to 50% during the past three to six months like the financials, the transports, the oils, the commodities, the industrials and the semiconductors.
Please don’t get me wrong--there is nothing wrong with the rally’s strength initially being led by these off-the bottom stocks and sectors. But, in my experience, these names almost always slow down as all the unhappy shareholders who own the stocks at higher prices sell out.
For a real prolonged bull move to develop, we need to see some leadership--stocks with good stories and sponsorship--hit new 52-week highs and, just as importantly, hold those highs and push even higher. As I wrote above, that sort of action has been lacking for much of 2011, and I’m still not seeing much of it yet.
That said, it’s still early; so much damage was done so quickly during the July-October meltdown that you can’t expect new leaders to just surge out of the gate right away. But I would expect new leadership to form within another two or three weeks if this rally is the real McCoy. Today’s Europe-inspired surge is a great start, as a few more breakouts emerged.
One name to keep an eye on is Ulta Salon (ULTA). The stock has admittedly had a huge, huge run during the past couple of years, but it held very well during the market crash and has some of the best price-volume characteristics of any stock.
The company aims to be a national beauty chain of sorts; its 400-plus stores stock a huge array of beauty products, and some of its newer, larger stores also offer hair styling and similar services. The firm has cranked out solid growth for many quarters--sales have risen 20%, 21% and 23% during the past three quarters, while earnings have jumped 41%, 61% and 52% during the same time frame. Long-term, the firm is looking to get to 1,000 stores by expanding about 15% to 20% per year--an aggressive growth plan.
As for the stock, it caught my eye after leaping 14.5% on September 9 following a blowout earnings report; volume on the move was more than five times average! Then, after a dip to its 50-day line during the market plunge earlier this month, the stock found two days of big-volume buying that pushed shares from 59 to 67.
Now ULTA is meandering on low-ish volume; I think it’s worth a stab around here, though a move above 73 would be more telling. On the downside, a stop could be placed around 62, so your risk is in check.
All the best,
Mike Cintolo
Editor of Cabot Market Letter
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