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
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
Any of the fallen leaders in the market provide a good
example. Chipotle Mexican Grill (
) 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 (
), Green Mountain Coffee (
) or Netflix (
), 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
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 (
), 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
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
All the best,
Cabot Market Letter
Cabot Top Ten Trader