Expectations vs. Reality

Expectations versus Reality

Expectations in the Basement

Hard Disk Stocks Come Back to Life

I’m going to start my Wealth Advisory today with a passage from the excellent book Hedgehogging (by the recently passed Barton Biggs), which gives an account of the problem most investors have historically faced—excessive expectations.  (FYI, this passage is a bit naughty, but it also actually happened, so here it is):

“In the 1930s, out of power and financially strapped, (Winston) Churchill taught a lecture course at Cambridge on human sociology. One afternoon standing at the lectern and, always prone to the dramatic, he turned to the large class and demanded, ‘What part of the human body expands to 12 times its normal size when subjected to external stimulation?’

“The class gasped. Churchill, obviously relishing the moment, pointed at a young woman in the tenth row.  ‘What’s the answer? he demanded.

“The woman flushed and replied, ‘Well, obviously, it’s the male sexual organ.’

“’Wrong!’ said Churchill. ‘Who knows the correct answer?’ Another woman raised her hand. ‘The right answer is that it’s the pupil of the human eye, which expands to twelve times its normal size when exposed to darkness.’

“’Of course!’ exclaimed Churchill, and he turned back to the unfortunate first woman. ‘Young lady,’ he said, ‘I have three things to say to you. First, you didn’t do the homework. Second, you have a dirty mind, and third … you are doomed a life of excessive expectations.’

Excessive expectations have been burying investors since the beginning of time; I can’t tell you how many emails and phone calls I have received over the years from investors who, with a starting stake of, say, $10,000, simply want to grow that to “only” $30,000 or $40,000 within a year or two. Dollar-wise, such a desire doesn’t seem outrageous—but that equates to an 80% to 100% compounded annual return! Of course, that’s very unlikely unless you’re willing to take huge risks and go belly-up.

Historically, part of my job has been to get new subscribers to buy into and trust our system of stock selection and market timing. I’ve always emphasized that learning to do the right things in the market (identify true leaders, let winners run, cut losses short, watch your risk, etc.) will yield excellent results over time—but if you try to force things, the market will punish you. It’s like the baseball player who swings for the fences every at-bat; it rarely works. Usually homeruns come from having proper preparation and simply trying to make good contact.

In fact, one of my tricks of the trade I’ve used to spot high-risk points in the market is when subscribers as a whole begin to confuse lost opportunity (i.e., they didn’t buy a stock that ended up rising 20% or more) with lost money (i.e., they bought a stock that actually fell 20%). Those are two very different things, but when lost opportunity “feels” like lost money, expectations are usually too high.

Today, however, the problem among investors isn’t excessive expectations—it’s expectations that are too low! I’ve never seen anything like the current environment. Instead of investors yearning for the next big winner, most simply want to keep the money they have. Instead of reaching for a 100% gain, most are comfortable in income securities yielding 2% or 3% per year. And instead of worrying about missing out on the next upmove, the vast majority want most of all to be sure of a return of their capital. Safety is paramount.

Notice that I am not talking about level-headed thinking—I am all for that every day of the week. But most investors today, in my opinion, have ratcheted their outlooks down far too low.  

For instance, I’ll share a long-term study I performed a few weeks back; it looked at the “average” value of the Dow Industrials every year going back to 1920. Then it looked for times (like now) when the Dow Industrials had returned a total of between 0% and 20% over a 12-year period—that is, it looked for times when there was 12 years of basically zero gains.

Going forward from those years, the returns were solid—the Dow averaged 8% to 9% annual gains for the next 10 years (averaging a total return of 130% during the following decade)!  That’s not 1990s type of returns, but after what we’ve seen during the past decade, I think many investors would be thrilled with those numbers.  

Now, to be clear, I’m not advising you to run out and take any action because of such a long-term study; you should base your actions on what’s happening in the market right now. (More on that below.) I’m still advising subscribers to be about 50% invested in resilient growth stocks and 50% in cash. My point is that the time to have a major negative frame of mind was after the bubble burst in 2000. Today, after 12-plus years of nothing, it’s time to begin thinking that this multi-year bearish/choppy period is likely to end and give way to a new, durable uptrend.

On a more general note, changing your expectations based on how you feel or what the headlines say is going to have you out of sync with the market. Instead, keep a level head and, most important, have a market timing system and follow it!

As for the current market environment, it’s not any breaking news that trading has been volatile and news-driven; whenever a European or central bank leaders says boo, the market reacts viciously in one direction or the other. We’ve seen this for months now—really, the last multi-week trend we saw out of the market was in May … and that was a sharp downtrend.

Nevertheless, the action of the market last Thursday and (especially) Friday marked a minor change in character. Yes, we’ve seen the major indexes rally for a few days before, so there’s nothing special there. But volume during those two up days was very big, a sign big investors were taking action. And, most important, many potential leading stocks broke out to new highs … and most held those gains, even continuing to advance in some cases.

That is a marked change from what we’ve seen since mid-June, when just about any and every stock that tried to poke its head up was immediately met with selling. (I call that a “whack-a-mole” market.)  Considering the bulk of my system is buying stocks at or near new-high ground, such action told me to play lightly and nimbly, if at all. But now there’s some evidence that the sky is brightening a bit—the sun isn’t out, but the cloud cover is thinning. Time to get ready.

With that mind, I’m re-, re-, re-working my Watch List (so many stocks have failed with others coming to life it’s a full-time job just keeping up on what’s working). One name I’m optimistic will see higher prices is Western Digital (WDC), a seemingly mundane maker of hard disk drives. However, the combination of the Thai floods last year, which seem to have permanently affected the industry’s supply chain, and industry consolidation (Seagate and Western Digital make up about 85% to 90% of the global hard disk market) have elevated prices and created a situation where both firms are making unheard-of profits. Here’s what I wrote about the company in this week’s issue of Cabot Top Ten Trader:

“The devastating Thai floods of late 2011 continue to have a major impact on the hard disk drive industry; while capacity is back up near pre-flood levels, average selling prices are miles above where they used to be and the supply chain is still recovering. That’s leading to unbelievable earnings for the two top players in the industry, Seagate Technology and Western Digital, the latter of which just reported June quarter results. As you can see in the table below, Western Digital’s results bordered on ridiculous—earnings quadrupled to a whopping $3.35 per share as margins and unit sales both beat expectations. But far more impressive was that management went on record as expecting about $2.50 in earnings in the current quarter and an amazing $10 in earnings per share during the next 12 months. Ten bucks!! Of course, that means not only is the stock dirt cheap (four times earnings), but investors can expect the company to use its hoard of cash to help the stock—in the last quarter, the firm used $604 million to repurchase 16.4 million shares, and it expects to buy back another 14 million or so in the current quarter (of a total share count of 260 million). Investors keep wondering when prices for hard disks will fall, but with industry consolidation and the shock of the Thai floods, that day appears to be a ways off. If management’s prediction of $10 of earnings comes true, the stock should see higher prices.”

WDC shot ahead 21% following its earnings report, but that only brought shares back up to resistance in the low 40s (the stock took a 38% haircut during the market correction). Interestingly, peer Seagate (symbol STX) reported a so-so quarter this week and initially fell hard … but has found major support in recent days. I take that as a positive for WDC, as it’s better if both stocks are faring well.

Given the monstrous earnings and the fact that Western Digital is finally beginning to use that capital on share buybacks, I think WDC has a shot at staging a great rally … if the market gets going. For now, you could either nibble with a stop around 36 to 37, or just look for a powerful upmove from the market and a push by WDC above 41.

All the best,

Mike Cintolo

P.S. While the financial media may be preaching caution, we see another powerful trend developing in the marketplace and has recast our trading strategy to take advantage of it. That “trend” of course is the run-up to the November presidential election.

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