Sometimes this kind of thinking works perfectly, as when European equity markets took an uppercut to the chin on May 13 when the French bank Credit Agricole issued about $9 billion worth of rights to raise funds to cover its subprime losses. That's the kind of news that makes the ordinary investor head for the bomb shelter, vowing to keep his nest egg safely stashed under the Beautyrest. Bad news is bad.
But equity investors, especially those who follow the lure of growth stocks, know that bad news can be good news. That's because bear markets persist until investors give up and sell their stocks. When the last, stubborn holdout finally succumbs to despair and types in that sell order, markets can start to turn up. That's not an attempt at cheap irony or an oversimplification, that's the literal truth.
The moment of maximum hopelessness marks the start of the next bull market.
That's fine for those of us who have actual market timing indicators that we trust and use. Markets are always going up and down, and if you have a way to distinguish a real market move from random motion, you can be back in the market before most investors know that the bull is back in town.
When Bad Is Good
Right now, for instance, while most investors are still cowering under the covers, the market timing indicators for the Cabot Market Letter and the Cabot China & Emerging Markets Report are positive. The people who read and follow the advice that we write in those letters are making money. And the bottom line is the bottom line.
Ultimately, what chills markets the fastest is the bad news from news sources. Try to get a picture in your mind of the global investing community when the CountryWide Financial/Bear Stearns crisis first hit. Lots of people hit the sell button at that point, and they kept on hitting it every time more bad news confirmed how bad the situation really was.
But there was also a small army of green-eyeshade types who immediately went to work trying to get some solid numbers on the scope and danger of the problem. While the general public was getting pummeled for weeks and months by news of write-offs, bankruptcies and deteriorating liquidity, the gnomes continued calculating until, finally, they felt they understood the scope of the problem. With knowledge comes opportunity, because a company that can calculate damage can also project value. As the public continued to sell, the gnomes were telling their masters that it was time to do a little bottom fishing, a little shopping at the fire sale, a little stocking up at discount prices.
Soon after news of the devastating earthquake in China began running on U.S. TV screens, we began to receive questions from our subscribers asking whether it was prudent to sell shares of Chinese companies. Basically we said no.
Today I started seeing reports that investment professionals were bidding up steel companies because the earthquake damage would have to be repaired. And this time, there was going to be a lot more earthquake resistant steel involved in the building process.
As a general rule, by the time the individual investor hears about a story, it's too late to use it for investment purposes.
Back when the Wall Street Journal was the king of the investment media (before the Internet, before cable, even before cell phones), one Wall Street tycoon made a great living by getting ahead of the crowd. He had his limo driver pick him up every day at 3 in the morning. Then they'd drive by the building where the WSJ was printed and pick up one of the first copies to come off the presses. This guy would read the paper on his way to work, and would put in his buy and sell orders based on what he read. By the time the rest of the investment world was thumbing through the Journal over their coffee, his work for the day was done. It's not my idea of an ideal life, but it worked.
You don't have to actually be glad when you hear bad news. (People will think you're weird.) But you should always be on the lookout for the moment of maximum despair, because that's when things start to get better. And those who have the vision to get back into the market ahead of the herd can do very well indeed.
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Scholars of the stock market like to argue about the Efficient Market Hypothesis. The Hypothesis states that all available information is already reflected in the price of stocks and bonds, which means that it's just about impossible to beat the market. Since you're on the same level with everyone else, the price of stocks moves in response to long cycles of economic boom and bust and short cycles of news-driven trading. (If you'd like to read more about the EMH, here's a link to Wikipedia http://en.wikipedia.org/wiki/Efficient_market_hypothesis .)
If you subscribe to the EMH, the only reasonable thing for you to do is to slam your money into an index fund and wait for time to hand you your efficient-market payoff.
What a load!
The money made by growth investors is made by using commonly available information. There's nothing secret about information that appears on Yahoo! Finance.
There's also nothing arcane about the few simple rules that growth investors (at least Cabot's growth investors) live by. Buy stocks that have strong fundamental numbers, excellent products and that are increasing in price. Sell them if they hand you a sizable loss from your buy price. Hold them until they weaken or begin to fall. When the markets themselves begin to decline, get out and keep your money in cash.
With a little information and a little discipline, an individual investor can beat the market. Despite the confidence of Daniel Kahneman, the 2002 Nobel laureate in economics, who said: "They're just not going to do it. It's just not going to happen," about investors beating the market, he's just wrong. Not only do we know it can be done, we can help you do it!
For my investing idea in this issue, I'm going to stick closer to home than usual. I've been noticing a company called Lumber Liquidators (NYSE: LL) advertising on NPR and elsewhere. The company began in Boston in 1993 when a man named Tom Sullivan began buying wood that other companies didn't need and then reselling it. He dug out a niche market in hardwood flooring and opened its first store in 1996.
The company now has more than 120 locations nationwide, and an enormous inventory of prefinished and unfinished hardwood flooring, plus laminates, bamboo, cork and butcher-block products.
Profits come from buying in enormous bulk (sometimes buying a mill's entire year's production) and passing the savings along to customers.
I like it for two reasons. First, the story reminds me of the early days of Home Depot and Lowe's, when an ambitious company starts using bulk buying and aggressive construction of new locations to consolidate a fragmented market. Lumber Liquidators looks to be the category king of whatever markets it enters.
Second, I like the chart of this November 2007 IPO. It came public just in time to be mauled by the winter bear, but since bottoming out at 6 in January, the stock has soared to 17 before pulling back slightly. Earnings trends are positive and just enough institutional investors have signed on to give the stock a sheen of respectability. It's worth checking out.
Editor's Note: As is usual with these investment ideas, we won't necessarily mention Lumber Liquidators again. But the stocks that we recommend in our paid publications are followed rigorously, giving you the kind of edge that might just drive an efficient market hypothesizer to distraction. If the idea of getting ideas and information from the top investment newsletter of 2006, 2007 and the trailing 12 months ended April 30 appeals to you, then you should try a no-risk trial subscription to the Cabot China & Emerging Markets Report. Click the link below to find out more.
For Cabot Wealth Advisory