Dispelling Investment Myths
By Michael Cintolo, Editor of Cabot Market Letter and Cabot Top Ten Report
From Cabot Wealth Advisory 10/15/09 Sign up for free Cabot Wealth Advisory e-newsletter
Today, because of some of the questions I'm getting from newer subscribers, and from some subscribers who attended my online seminars, I want to dispel a handful of investment myths.
How do investment myths get started, and why are they widely believed? Mainly it's because the market is a contrary animalwhat seems like it would work in the stock market often does not (or, at least, not over the long run). Thus, most ordinary investors (and even some professionals) tout these beliefs, even though there's no evidence backing them up. In fact, there's plenty of evidence against them!
Myth #1: One of the most discussed themes in market history has to do with October--specifically, that October is the month of market crashes.
Truth: Unlike a simple myth, there's a lot of truth to the "October crash" crowd. The 1929 and 1987 implosions remain forefront in investors' minds, but there have also been numerous other October wipeouts, including the 550-point Dow drop in 1997, the 1998 Russian Ruble/Long-Term Capital Management debacle, and, of course, last year's acceleration of financial panic from late September.
But as we know, the market is a contrary animal, and it's succeeding in that respect once again. As it turns out, October's history is nearly the exact opposite of what most investors believe!
Since 1958, October is actually the sixth-best month, right in the middle of the pack, with a 0.9% average gain for the S&P 500. (For the record, September and February are the two worst months of the year, on average.) Sixty percent of all Octobers have finished on the positive side of the ledger.
Moreover, instead of a month that ushers in crashes, October is actually a month that ends them. According to Stock Trader's Almanac 2009, October has marked the end of the 1946, 1957, 1960, 1962, 1966, 1974, 1987 (the decline actually started in August of '87), 1990, 1998 and 2002 bear markets. In my opinion, it also marked the end of the 2008 collapse, as the broad market bottomed in October (when 88% of the NYSE hit new 52-week lows).
Also, looking ahead, the months of November, December and January are three of the four best months of the year (April is the other). Thus, far more often than not, October is a month to buy, not sell!
Myth #2: It's no use buying higher-priced stocks because I can't afford to buy many shares of them.
Truth: This is one of the most popular wrong-headed beliefs out there, and it's one reason so many investors are attracted to lower-priced stocks. In the world of growth stocks, however, you almost always get what you pay for.
Remember this: Institutional investors, who control billions of dollars, are the ones who move markets. And they could care less about the price of the stock--they're trying to find the best merchandise available, meaning the companies with excellent sales and earnings growth, revolutionary products or services, and bright prospects for continued growth.
Do you think they ignore a stock like Baidu (BIDU) just because it's priced above 400? No! In fact, you know they're not ignoring it, because the stock is acting exceptionally well, and the dollar volume traded each day is north of $700 million. Clearly the institutions are involved!
These big investors really view a $400 stock just like a $40 stock--except that the price swings will be 10 times as large. Of course, not every stock you buy will be 400, but the point is that you shouldn't worry about how many shares you own; it's meaningless. What counts is the dollar amount of stock you own--a higher-priced stock will move more points, but percentage-wise, it will move similarly to a lower-priced name. Your goal should be to own the best companies under the strongest accumulation, not stocks priced in your comfort range.
Myth #3: Stocks that have already had a major run-up from their lows are bad investments—they can't continue to go up after such a big advance.
Truth: We've all been taught our entire lives that a bargain is a good thing, while only suckers pay top dollar for something. Indeed, many people are chastised for "splurging" on clothes or other goodies from a young age.
But as I wrote above, the market is a contrary animal, and as it turns out, buying strong stocks is the way to make big money. Why? Again, it's because the institutional investors are trying to buy positions in the best stocks they can. That causes them to go up! And these big investors aren't going to sell all their shares just because a competitor with a not-as-good-product is cheaper.
Now, you must buy strong stocks during periods of weakness; you shouldn't buy after a stock has rallied 15% in just two weeks. You should try to buy after the stock has consolidated or pulled back 5% to 15% over a couple of weeks. But that's different than betting on a stock that hasn't budged during the past six months.
Also, you must consider the overall market. This year, the major indexes have rallied a huge amount from the oversold lows of March. Thus, if you're searching for stocks that haven't rallied much in recent months, you should be asking "Why haven't they taken part during this super-strong rally?" If they haven't, there's probably something amiss.
In total, you're better off identifying leading stocks and buying them during normal bouts of weakness. At some point, those leaders will break down, which is the time to sell most of your shares. But in a bull market, ignoring these leaders and focusing on laggards is a sure way to lose money.
Myth #4: The S&P 500 is trading at 50 times earnings, and thus this rally is a nothing more than a giant fake-out.
Truth: Market-wide valuation measures have rarely been useful in forecasting future market movements. What's more important is investor perception of the future; if investors believe the future will be much better (economically and earnings-wise) than the past, then they'll bid up stock prices.
Also, you must remember that many of the widely cited valuation measures are, first, based on trailing earnings (fairly meaningless since the market discounts the future, not the past), and second, often include one-time write-offs and other special expenses (not how most investors judge a stock).
Overall, market-wide valuation measures are almost always descriptive, not predictive.
Myth #5: If a stock heads up (or down) into its earnings report, it means it will report good (or bad) earnings. And that will be good (or bad) for the stock.
Truth: Trust me, I've studied earnings reactions five ways from Sunday and I haven't found any consistent link between a stock's performance heading into its report, and the stock's performance immediately after the report.
The real key to earnings season is to have a game plan, something I write about frequently. Maybe you decide to sell some of all your growth stocks ahead of their reports. Maybe you decide to sell none, holding through earnings (as we do in our newsletters). Maybe you decide to sell some of those stocks that you don't have a profit cushion on, while holding the stocks in which you do have a nice profit.
Whatever your decision, just make it and stick with it. Earnings season is more about portfolio management than divining a particular stocks' reaction to its report.
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