Category: Best Of

I am constantly watching the all-time high and the 52-week high lists to get a sense of emerging trends and gauge overall risk appetite. Both lists are extremely useful equity selection tools and they have been home for all big stock market winners at some point in their history. An all-time high is not an automatic buy signal for me. I have always considered the technical characteristics of the stock (is it just breaking out from a long base) in order to minimize risk of involvement. I also pay attention to the catalyst behind the breakout and the growth prospects of the underlying company. All those requirements have proven to be good filters over time, but with the price of numerous unwanted side effects.

Here’s how overthinking has robbed me from some great market opportunities:

February 2011 – tobacco stocks are clearing major multi-year highs on strong volume. I disregarded the signal, conceptualizing that smoking is dying and that tobacco companies will only see their revenues decline. $PM, $LO and $MO gained more than 50% from that point and are still hovering near major highs.

June 2011 – I noticed that more and more utilities show up on the all-time high list. I knew that it is never a good sign when defensive stocks are on the all-time high list, but I’ve never really considered owning them, because they are not real growth stocks. Many of those same utilities went to significantly outperform during the carnage of last summer as capital went to perceived safety.

September 2011 – a bunch of REITs and home improvement stores ($HD, $LOW) are breaking out to major multi-year highs. I ignored those moves, thinking that no one wants to own those slow moving, boring stocks and besides there is no way those moves will sustain with a housing prices still under pressure. Many of them went up 30%+ over the next six months as Home Depot reported solid earnings growth and rents reached all-time highs all over U.S. Even homebuilders like $LEN emerged to new highs in early 2012.

April 2012 – airline stocks are showing up on the 52-week high list and my eyes can’t believe. My brain quickly disregarded those moves as noise, recalling that airlines have historically been terrible investments. 3 moths later, stocks like $ALGT, $LCC are 20% higher, still hitting multi-year highs and many stocks from the industry are breaking out.

As the saying goes, it doesn’t hurt you what you know, but what you think you know, because it usually ain’t so.

I realize that in hindsight, everything seems so easy and clear and in real time it is never so. The point is that we have no idea how far a stock could go after it breaks out to all-time highs from a solid base. It might go up 15% and then fizzles or it might go up 50% or 200%. We don’t know that in advance and we have no control over it. Good risk/reward technical signals have to be taken. Focusing on price action alone helps to minimize my underlying biases.

How have your biases hurt you and what have you done to cope with them?

In the stock market, the real money is made by riding a trend long enough to make a difference, but having an exit strategy is of crucial importance. Sooner or later, all trends end. To protect gains, you have to exit at some point.

Trend change is a process and never an event. Market participants’ expectations change slowly and it takes some time for institutions to distribute their shares. Here are the typical four stages near the end of a momentum move:

1) Price goes parabolic and extends significantly above its relevant moving average (the average that has proven to be a level of support during the duration of the trend; in this example, this is 20dma for $AE and 50dma for $LQDT). Peeling a bit on strength makes sense in this situation, but keep in mind that you never know how long and how far a stock could go, especially in the late stage of its trend.

2) There is a major, high-volume move in the opposite direction of the trend – quick 5-20% drop that is unusual for the typical price range of the stock. It might last anywhere from a day to two weeks. This is a major tipping point. It changes the prevailing sentiment entirely. All of a sudden, people start to think about the risk involved in holding longer and might take a deeper look into the fundamentals of the company. Fear of giving back profits gradually overwhelms greed for more and fear of missing out.

3) This is not the end of the move. There is a group of market participants that has probably missed the entire move. They have been afraid to jump on the fast moving train and have been watching the stock climbs relentlessly, day after day, week after week, without giving a proper chance for entry. In this case, any major pullback will be considered a buying opportunity by this group of people and they will step up near the 20dma or 50dma. And in many occasions, they will be right. The bounce however will carry very little volume behind it or it will be less than the volume during the pullback.

4) The previous high will not be reached or if it is, it will be on low volume. That snapback bounce is wise to be used to liquidate your positions or at least lighten up substantially. Then there is usually a high-volume move lower.

Keep in mind that these stages are just a rule of thumb, not a bullet-proof rule.

Benjamin Graham doesn’t need an introduction. His sober look at the stock market has built an enormous following and for a good reason.

Here are some of his brilliant quotes and my comments on them:

1. “If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.”   –  It is true that perfumes come and go out of popularity, but no trend lasts forever. There are trends that last 3 months; there are trends that last 3 years.

2. “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.” – it depends on to what level has the expected growth been already discounted. The truth is that it is really hard to forecast growth in quickly developing businesses. The market always overdiscounts at some point, but in the meantime trend followers could make a killing. You never know how long or how fast a trend could go.

3. The only constants in the markets are change and uncertainty. Not only business environment changes, but also people’s perceptions of stocks change. Look at $GMCR for example. It went from making a new all-time high at $10 back in March 2009 to $115 in September 2011 to $25 today.

Most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time.

4. Different catalysts matter for the different time frames:

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

5. The difference between a trader and investor

The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.

6. How to think about risk

The risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.

7. There is nothing guaranteed. The market doesn’t owe you anything. There are no sure things. Equity selection process is important, but risk management discipline should always trump conviction:

Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible.

8. “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

9. “Wall Street people learn nothing and forget everything.”

10. “Most of the time stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble … to give way to hope, fear and greed.”