What’s Really Extreme in the Market?
In the End, it’s the Outliers that Count
A New Leader in the Oil Patch
Most investors who have been around the block for a couple of decades or more have had a few “ah-ha!” moments that pushed them toward whatever system or methodology they currently use.
I remember reading about one trader who was in a dry spell reading one of Bill O’Neil’s books and, about halfway through, started pacing around the room, thinking this was it—the system clicked with his brain. (I actually converse with this guy every now and then.)
I also remember a similar story with a value manager—he went through the usual ups and downs for many years, but after hearing a speech from a disciple of Ben Graham, the light bulb went off.
For me, one of my “ah-ha!” moments (there have been three or four) didn’t so much have to do with discovering the details of some new methodology—there are no Holy Grails in this business, no matter what anyone tells you—but by examining some numbers and reading an interview with William Eckhardt from the 1980s. Eckhardt was a mathematician at heart, and used math to develop some popular trend-following systems back then.
But this isn’t about the secrets of trend following; heck, we’ve been using some form of trend following in our market timing for nearly four decades. Instead, it was what Eckhardt said that changed my mind about what, in the market, really constitutes “extreme.”
Basically, he said that the market is not governed by the “laws” of distribution that govern everyday life. For instance, if you plotted people’s height, or weight, or even IQ, you’d get a bell curve—lots of people just above and just below the average, and fewer and fewer people the further you get away from the average. You’ll find a ton of male adults that are between 5’ 5” and 6’ 2”, for instance, but you don’t often come across 7-footers or 4-footers.
Because the bell curve is so well known, it’s often applied to the market. And that’s a big mistake! It turns out that big, so-called extreme moves happen frequently in the market.
I did a study recently that proves this out. Looking back to 1926, the S&P 500 has produced average annual returns in the 8% to 10% range, so according to the bell curve, you’d expect most years to come within, say, 0% and 20%, right?
But reality is much different. Since 1926 (88 full market years), just 31 years have brought returns between 0% and 20%—that’s only 35% of the time. Imagine! That means two out of every three years in the past century, the S&P rose more than 20%, or closed the year lower. Exactly the opposite of what you’d expect!
So how did all this bell curve-related stuff turn into an “ah-ha!” moment for me? Well, it taught me a couple of basic but powerful lessons that I’ve never forgotten.
First, it emphasized that returns in the market—whether you’re investing in mutual funds or individual stocks—are not linear at all. Sure, we’d all like to earn a steady 15% a year forever. But the only person I’ve heard who did that for more than a few years was Bernie Madoff! Seriously, it’s not impossible, but the fact is that the market isn’t wired to produce steady returns.
While that might sound like a bummer, it’s really a mental positive. After all, if you’re “supposed to” make a steady double-digit return (1% per month, etc.), then a few bad months will really put you behind the curve. But if you’re investing in growth stocks, you’ll realize that returns are streaky, so you know you can make up for a sluggish few months in no time. All it takes is one or two solid winners.
Second, I re-learned that, over many years, it’s your outliers that count. And there are many of them, both good and bad! Yes, yes, I understand it feels good to make 10% in a stock, or to see your mutual fund go up 8% during the first half of this year, etc.
But in my experience, most of those 5% or 10% winners will be offset by the inevitable 5% or 10% losses you’ll suffer along the way. Thus, your returns will be determined by your big winners and losers—all it takes is one or two years like 2008 to set people way behind, or, conversely, one or two First Solars, Baidus or XM Satellite Radios to significantly boost their wealth.
Thus, the whole idea behind the market is, when you lose, to lose small, and when you win, to win big (or at least try to win big a few times). That will guarantee that your outliers will be positive ones, which will, over time, lead to good results.
What’s critical is the ability to maintain an optimistic attitude about your trading. I don’t care who you are—novice, professional or somewhere in between—you are going to get kicked in the teeth every now and then by the market. The key is to make sure most of your teeth are still intact, and to come back swinging when the time is right.
While I wouldn’t say trend-following growth investors have had their teeth kicked in this year, it has been a tedious, up-and-down year to this point. (I can’t complain too much as last year was fantastic.) By my count, there have been just three short-lived rallies for growth stocks in 2014—the first two or three weeks in January (which led to a very sharp, short 8% market correction), the first three or four weeks in February (leading to the growth stock meltdown in the spring) and from about mid-May to mid-June. Since then, most growth stocks have been chopping around.
The good news about the last few weeks is that, unlike the prior two rallies (when stocks fell apart), few have broken down and a ton have either recently gapped out of basing structures on good volume, or look ready to do so. In other words, I’m not having trouble filling up my watch list.
One name that just grabbed the spotlight is Cameron (CAM), an oil service firm that recently powered ahead on earnings. Granted, oil service companies aren’t exactly considered growth stocks, but I’m noticing many of these firms have the numbers (including big earnings estimates for the next couple of years) that should keep buyers interested for a while.
As for the company, Cameron is a leading producer of wellhead equipment both on- and offshore. Here’s what I wrote about the company in Monday’s Cabot Top Ten Trader:
“Cameron is a leading provider of flow products to the oil, gas and processing industries, including things like sub-sea trees (which monitor and control the production of underwater wells) and blowout preventers (in big demand after the Macondo incident), which makes it a play on the growth in deepwater drilling, but it also does a fair business in surface wellheads and trees and unconventional wells. After a few years of lackluster performance, the stock is strong today because of a pickup in business, improved margins and a very aggressive share buyback program. The first quarter saw 20% sales and 30% earnings growth, a modest pickup in orders, a still-huge backlog (north of $11 billion!) and another 2% of the company bought back—in fact, shares outstanding in the second quarter were down 17% from a year ago! Moreover, on the conference call, management said that it expects orders for sub-sea products to accelerate again during the next 18 months and that it continues to look to return free cash flow to shareholders. Thus, there’s no one ruling reason Cameron is doing well, but a confluence of events (and a willingness to take a major chunk of its own shares off the market) that look poised to drive the stock higher.”
The stock gapped up nicely on its earnings report last week and I think it can do well going forward. But to get my exact advice of when to buy and when to sell, I encourage you to give my Cabot Top Ten Trader a shot—there’s a 60-day full money-back guarantee so there’s no risk on your part, and you’ll be able to read my advice on the strongest leading stocks in the market.
Working to make you a better investor,
Chief Analyst of Cabot Market Letter
And Cabot Top Ten Trader