Market Truisms with Powerful Meanings

 

Market Truisms with Powerful Meanings

Applying the Truisms to Today’s Market

The Next Salesforce.com?

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I’ve been at Cabot for 16 years now (almost exactly), and I can’t tell you how many words I’ve pounded into my computer during that time. It’s got to be in the millions! But despite all those words, and all the deep thinking I’ve done on the market during those 5,840 days, I’m not very good at coming up with truisms—i.e., short, spiffy sayings that really capture an unappreciated truth about the stock market.

Maybe because of that, I’m a sucker for these truisms … especially during challenging times. I keep a mess of sticky notes on my desk with favorite sayings that I’ve come across in books, periodicals and online. I like to add one every now and then, though the handful I have are hard to displace.

So I thought I’d keep this week’s Wealth Advisory brief and educational by reviewing my favorite market truisms … and how they apply to the current environment.

Only egotists and fools try to pick tops and bottoms. Which one are you?

This one is from the book Hedgehogging by the late Barton Biggs, one of my favorite books. And the message is clearly simple—a trend, once in effect, can often last far longer than most investors expect. Yet most investors feel the call of the countertrend, i.e., they’re eager to get out of stocks that are still in uptrends, and conversely, eager to pick bottoms, buying “cheap” stocks that must be “oversold.” In the long run, these methods lead to plenty of pain and missed opportunities.

Applying this to today, I have a slightly different interpretation: the current “trend” of the market is sideways, and it has been for the better part of six months. So investors who have tried to predict every breakout and breakdown from the indexes or individual stocks and sectors have been wrong. The sideways trend is in effect, and until there’s clear evidence of that changing, it pays to hold some cash, be very selective on the buy side and take some partial profits on the way up when you get them.

It’s hardest to keep things simplest (or simplicity is the ultimate sophistication).

This one came from a book called The Perfect Speculator, which is a fictional account of a teaching episode from a market master to an average investor.

During my first couple of years at Cabot, I tested at least two dozen different market-timing systems, some based on price, some on moving averages, some on sentiment. And as I progressed, I started to get into the arcane (one system, which actually worked decently, measured the rate of change of sentiment, if you can believe it).

I was searching for some sort of Holy Grail, but while I got some good tidbits, nothing I developed was really as effective as trend-following—and in fact, in 2002, I helped hone our Cabot Tides, which uses a couple of simple moving averages (25-day and 50-day) to tell us the intermediate-term trend of the market. And the Tides remains one of Cabot Growth Investor’s key indicators to this day.

It’s the same for stock selection and finding entry and exit points. In the market, it’s almost always better to keep it simple with some basic, rubber-meets-the-road criteria, instead of delving into the complicated and arcane.

Moreover, you might have a simple, precise plan (say, to hold the stock as long as it trades above its 50-day moving average), but it’s all too easy to be tempted out of that stock because it gets temporarily extended to the upside, or because it has a bad day, or suffers from a bad earnings report, etc.

In today’s market, it’s a similar story: it’s too easy to get overly bullish or bearish depending on the market’s action of the past few days, and it’s very easy to get scared out (or tempted to buy) a stock that really hasn’t done anything noteworthy. In a sideways tape, it’s best to put in some buy/sell levels for individual stocks … and then follow the plan!

In theory, theory and practice are the same … but in practice, they are not.

This is actually a quote that applies to nearly everything (not just the stock market) and has been attributed to many people (including Albert Einstein). But in terms of stocks, it applies in a couple of different ways.

The first way is when an investor (often a beginner) figures out that paper trading and actual trading are two different things. It sounds pretty easy to say, “OK Mike, we’re going to buy $10,000 of this stock if it pulls back to 55, place a stop at 50, and then be patient if it goes higher.” It’s another thing to buy it at 55, see it sink to 52 the next day after a downgrade, and see your other stocks sink at the same time because the market is down 250 points … and still hold on because it hasn’t tripped your stop.

The second way I’ve seen this truism apply to investing (especially in recent months) is that many investors will observe a method working a few times, develop a theory and then put it into practice. For example, an investor holds his three stocks through earnings, and they fall 10% each. So the theory, of course, becomes that you should sell ahead of earnings! But then what happens in practice? The next two stocks gap up 15% and the investor is wondering what’s going on.

Forming theories based on insufficient evidence is one of the most common missteps of investors, in fact, just because something worked two or three times doesn’t mean it will work again. The moral of the story is that forming a system based only on theories, and not experience, can often lead you astray in the market.

The human mind emphasizes being right, not maximizing profits.

This came from the interview with Richard Dennis in The New Market Wizard, one of the best interviews I’ve ever read. In it, Dennis talks about how, as a matter of business, the market “seems” to teach investors to do all the wrong things by tempting us with high-percentage trading strategies.

For instance, a great percentage of the time, a stock that rallies a few days in a row will tend to pull back afterwards (that’s been especially true this year). And the opposite is also true; a stock that falls sharply is usually temporarily oversold, leading to a bounce. On a “batting average” basis, then, you’d be better off buying dips and selling rallies.

However, the market is a bad teacher in that sense. If you consistently buy oversold and sell overbought stocks, you might do well for a while, but eventually, you’ll get your head handed to you, because the market is all about outliers, the big gains or big losses in your account. And by constantly betting against the trend, you’ll eventually (and frequently) be caught on the wrong side of some mega-trends. In the long run, betting against a stock’s (or market’s) trend will at the very least leave you disappointed, if not lead to outright losses.

Instead of focusing on being right (a high batting average), a growth investor should focus on the size of his average winner compared to the size of his average loser (which I call the trader’s slugging percentage). Just one or two big winners (i.e., outliers) can make up for a slew of small, almost-meaningless losses, and if you capture a few tigers by the tail, your portfolio’s returns will amaze you!

Losers average losers.

Made famous by legendary trader Paul Tudor Jones, my last truism is a bit of a corollary to the previous one. For a growth investor, the number one, never-break rule is to cut all losses short. Instead, most investors love to average down, buying more of their losers to lower their average cost.

In the book, How to Trade in Stocks, Jesse Livermore gave a great example of a stock trader buying more shares every three points on the way down, detailing how the averaging-down investor thinks. After describing buying more and more from 50 down to 29, the last line was prescient: “Of course abnormal moves such as the one indicated do not happen often. But it is just such abnormal moves against which the speculator must guard to avoid disaster.” (Emphasis mine.)

In other words, it’s similar to what I wrote above: averaging down here and there might allow you to “get out even.” Heck, I’ve talked to more than a few people of late who are doing just that, buying more on the way down because these stocks always bounce back. I hope it works for them … but it takes just one severe break in a stock in which you’ve been averaging down to put your portfolio behind the 8 ball.

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As for the current market, we remain in an intermediate-term sideways trend, so I’m still sticking with a relatively neutral stance—I’m not opposed to buying a low-risk set-up in a great growth stock, but I’m also holding some cash and being choosy on the buy side.

That said, I’m growing a bit more optimistic for a few reasons. First and foremost, the longer-term trend remains up.

Second, I’m seeing as many set-ups among growth stocks as I have for many months. (For my purposes, a set-up is a relatively tight consolidation, or controlled pullback, following a multi-week or huge one-day earnings-induced surge.)

Third, sentiment has cooled off—not many investors are bearish, but the number of bullish individual investors is at a level that generally precedes positive performance.

And fourth, the Nasdaq has held up better than the Dow and S&P during the latest rejection from new-high ground.

None of that is making me more bullish, but I am making sure my watch list is up to date. One stock that has set up nicely is Tableau Software (DATA), which I believe has a chance to follow in the footsteps of other huge software pioneers like Seibel Systems, SAP, PeopleSoft and Salesforce.com by leading a new industry niche and growing rapidly for many years.

Here’s what I wrote about Tableau in Cabot Top Ten Trader last month:

“Software stocks are always a tricky bunch because there always seems to be a competitor right around the corner that can take business away. Tableau certainly has plenty of competition, but it’s so far ahead of the game we think the firm could grow rapidly for many years. Tableau’s visual data analytics software allows workers of all levels (not just IT guys, and not just the top brass) to get the most from a company’s data—it’s basically taking Big Data and making it accessible and understandable to people across an enterprise. As last week’s quarterly report shows, demand for Tableau’s solution remains red hot—sales grew 75%, earnings topped estimates and the firm inked another 2,600 customers (now more than 29,000 worldwide). And all of the sub-metrics looked great, too; the number of $100,000-or-more deals grew 108% from a year ago, international revenues soared 89% and management guided Q2 above expectations. The company latest release (version 9 of their software) has been a hit so far. Long-term, Tableau could even start eating away at the use of spreadsheets to create business graphs! The potential is enormous, and the wind is clearly at the company’s back today.”

Moreover, after popping on earnings last month, DATA has now traded tightly for the past four weeks, just a bit above where it closed following the earnings gap. I think a position around here, with a stop down near 102 or 103, has a good shot at working.

For more updates on DATA and additional momentum stocks, click here.

Sincerely,

Michael Cintolo
Chief Analyst, Cabot Growth Investor and Cabot Top Ten Trader


Michael Cintolo can be found on Google Plus.

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