THE MARKET’S WEAKNESS over the last two years has been chalked up to everything from election jitters to energy prices, the economy to Enron (ENRNQ). Likewise, in the early 1970s, there was an equally daunting list of fundamental factors, from Vietnam to Watergate, Cambodia to communism that got blamed for dragging stocks down.
On May 21, 1973, U.S. News & World Report featured an enthusiastic cover story called “Brighter Days Ahead for Stock Market?”
“Conditions are shaping up for a sustained rise in stock-market prices,” the magazine suggested, citing analysis from a number of then well-known pundits, who almost universally expected better times ahead. “The market is ready to move up” predicted Ian Cramer of Kohnmeyer and Co. “We are buying stocks.” Pundits, it turns out, have been missing the boat for years.
The Dow, which at 900 had already been in a trading range for the better part of six years, went on to drop another 35%, hitting new bear-market lows and, for a period, trading at levels that hadn’t been seen since the late 1950s. The recently introduced Nasdaq went on to drop 50%.
The point of this history lesson? It shows the danger of investing in something because “it will come back.”
Yes, even among the lengthy list of fallen Nasdaq highfliers, many stocks will come back. The real question is whether you can afford to wait. While patience is a virtue when stocks are moving higher, it can too often become an excuse to sit on unprofitable investments that are going nowhere, slowly.
It’s a question we first broached a few months back, when we used historical rates of return to estimate how long the long haul might really be. And while the market has bounced significantly since then, many people are still underwater on positions they bought back in early 2000.
The buy-and-hold approach can be a very expensive proposition. The expense isn’t solely the time value of money, but the opportunity cost of not making other, potentially more profitable investments. Even in difficult economic times, there are always places to make money. As we’ve pointed out a few times over the past couple of months, despite sogginess in the major averages, there are certain sectors doing quite well.
This is the problem with “value” investing: You might see the value long before the rest of the market does. And while many individuals seem content to sit on dead money rather than take some losses and move on, the truth is that real wealth is created not through a steadfast devotion to particular stocks, but by consistent, absolute return. Personally, I don’t have the patience to sit through a two-minute commercial break, let alone a 20-year bear market in equities.
Weak stocks are weak for a reason. So although it’s always tempting to bottom fish, the majority of your trades should be in leading stocks, not the laggards you expect (read: hope) one day will turn around. Trading is like driving: The express lane will beat the bus lane virtually every time.
But we all like the idea of snapping up bargains. And — with the caveat that cheap stocks can often get much cheaper (or go nowhere for quite some time) — there are some basic bottom-fishing techniques that can make the shopping trip more profitable.
To start, we’ve often suggested that despite popular perception, trading is more about watching than actually trading. And although it’s tempting to buy recently battered stocks hitting 52-week lows, too often a low is just a temporary lull before the stock moves even lower. So whether it’s semiconductors or SBC Communications (SBC), at least wait for a recently battered name to stabilize for a few days before taking the plunge. This is why watch lists were created in the first place!
When a stock is falling, it isn’t your responsibility to stand in its way. A stock can’t be strong in the “long term” without first becoming strong in the short term.
Second, keep in mind that successful bottom-fishing, like most aspects of trading, comes down to appropriate position size. It’s perfectly acceptable to take positions in stocks trading at a fraction of their former highs, but putting too much of your portfolio into these can’t-lose losers is lunacy.
Weak stocks are, by definition, low probability and high risk. I wouldn’t suggest bottom-fishing in more than three or four names at a time — and then for no more than 3% of your overall portfolio in each initial position. It’s tempting to take a big swing on “oversold” names, but realize that it’s highly unlikely (read: impossible) that any of us will call every bottom. Declines of 10%, 20% or even 40% from initial entry points aren’t uncommon, reinforcing the notion that when it comes to overall allocation, less is more.
With any trade, risk management is key. And when it comes to small positions in beaten-down names, the biggest risk is often not losing money, but time. We live in a world of limitless opportunities but limited resources, and even with interest rates low and the broad market stagnant, you can’t afford to hold positions that continue to decline or go nowhere at all.
So instead of using a traditional stop-loss order based on price, when bottom-fishing I will often trade using what is known as a “time stop.”
In its most basic form, the market is made up of two key variables: price and time. When stocks are weak and probing new multimonth lows, traditional stop-loss orders are less effective because trends have a tendency to persist. Stocks that seem low often go even lower.
Rather than concentrating on price when bottom-fishing, focus on time. When you buy XYZ, do so with the understanding that while it might eventually come back, you aren’t willing to grow old in the process. Make a note that if the stock hasn’t moved higher in six months to a year, you’ll cut your losses and move on to the next trade.
This not only ensures you won’t be sitting on a portfolio of dead stocks, but forces you to bottom-fish only in stocks you expect to suffer a relatively short period of nonperformance. Stocks that you expect to eventually move higher, but not in the near term, should be relegated to your watch list, where you can monitor the price action until an appropriate technical buy signal suggests a good moment to pull the trigger. Time is indeed money, and you can’t afford to squander either.
– Originally on Feb 11, 2002 by Jonathan Hoenig
