The Market Teaches Bad Behavior
The Math of Falling Stocks
A Stock for Your Watch List
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If you ask some professionals why it’s difficult to consistently make money in the market, you’ll find they point to a variety of culprits, ranging from complexity to emotional factors to the relatively recent advent of high frequency trading, which can move 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 the spring of this year. In my experience, this period has been one of the toughest I’ve experienced or even read about; even though the big-cap indexes have made some progress, trends have been fleeting, small-cap indexes are in the dumps and most growth stocks have chopped around wildly. I know many investors have been chewed up pretty badly, buying and selling, buying and selling, as the market has gyrated up and down for most of the summer and fall.
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 can confidently say that letting winners run and cutting all losses short-two of the main tenets of growth investing-has led to sub-par results for most investors this year, especially if they’ve been concentrating on growth stocks. 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. 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, or vice versa. Instead, it’s best to generally practice patience until the overall environment is more conducive to your investing style.
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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.
The oil stocks provide a good example these days. The group has imploded due to lower oil and gas prices, and those investors who thought they were entering at bargain levels a month ago are sitting on huge losses. There are any number of examples, but let’s look at Concho Resources (CXO), which was a leader in the group earlier this year before topping out in June around 149. It skidded below 125 in mid-September, to 105 in early October, and as low as 93 during the mid-October market plunge. After a good bounce, the stock actually kissed lower lows this week (to 91) as investors bailed out of all things energy-related. All told, it’s been a 39% top-to-bottom drop so far.
Given the overall bull market, it was reasonable to think CXO was a good buy after it dipped 25% (to 112 or so) from its peak, but buying then led to another 19% drop to this week’s lows, and odds are that the pain isn’t done yet.
Of course, crashes like the one we’ve seen in the energy sector don’t happen every month, but that’s the point-in the market, it’s the outliers that do the most good or bad to your portfolio, so you have to work extra hard to avoid the bad outliers while developing a few big winners. Buying on the way down, after a major break, might seem tempting, but can often lead to disastrous results.
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As for the current market environment, things were looking great following the mid-October shakeout, as the market’s unusually strong push higher was a good sign that all the sellers were wiped out. And, from a top-down perspective, I still think that’s the case for the major, big-cap indexes like the S&P 500 and Nasdaq-there’s been little in the way of sustained selling there.
Looking at the broad market, though, there are some things to worry about. Small-cap indexes have begun to lag again and haven’t hit decisive new peaks since the spring. Growth stocks as a whole have bounced, but they’ve also lagged the market, and most (all?) of the money was made in the first three to four weeks off the market low. And, just looking at a broad array of stocks on my own watch list, the action has been choppy and sloppy since early November.
Now, this doesn’t spell doom for the overall market-my trend-following indicators are still bullish and few stocks (growth or otherwise) have done anything “wrong” on their charts. Because of that, I’m remaining bullish ... but I’m also keeping my eyes open in case the 2014 chop fest isn’t over and the market sinks into another deep pullback.
In terms of new buying, stock selection and timing your purchase are paramount. One name I’m watching closely is Tableau Software (DATA), a rapidly growing company that’s cracked the code on making business intelligence software useful for the masses, not just the top brass. Here’s what I wrote about the company in Monday’s issue of Cabot Top Ten Trader:
“Tableau Software is at the intersection of Big Data and Business Intelligence-the firm has made waves by developing software that easily and graphically depicts a firm’s data so that most employees (not just the few at the top) can get the most out of it. (It was spun out of Stanford a decade ago with VizQL, a technology that allows users to produce sophisticated graphs with just drag and drop functions.) Despite its average initial sale being in the $10,000 range (Tableau is trying to democratize data analytics), the company has been growing like mad; it serves 70% of the Fortune 500 and is even used to better understand the reams of data produced by other high-quality products like Splunk. While sales growth has been slowing some, it’s projected to grow in the 40% to 50% range for many quarters to come thanks to larger deals (more than 200 deals of more than $100,000 in the latest quarter alone); earnings should remain positive but fail to grow much because of heavy investments going forward (employee headcount in the third quarter was up 65% from the year before!). The main worries here are competition-IBM and Salesforce are jumping into the graphics analysis field-and the investment spree will keep the valuation at nosebleed levels. But Tableau looks to have a special product and rarely found growth that should keep big investors interested.”
“As for the stock, it’s in the midst of a huge, deep base that began when glamour stocks imploded in March-DATA fell from a peak of 102 down to 52 in May. Since then, it’s been slowly working its way back; usually when you have a base that deep (49% in this case), the stock (a) needs many months to repair the damage, and (b) will build a shallower, tighter base near its old highs-a “base-within-a-base” is the parlance.”
That’s what DATA looks to be doing now-it’s four weeks into an 11% consolidation. It could go on for a bit longer, but I think nibbling around here (maybe a half-sized position) could work with a stop in the mid-70s. Then look for the stock to stage a powerful breakout above 87 or so in the weeks ahead; assuming the market is still positive, that would be the signal to add some more shares as DATA would likely be starting its first sustained upmove since February.
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All the best,
Michael Cintolo
Chief Analyst, Cabot Market Letter and Cabot Top Ten Trader
