Go Against the Emotional Crowd
As a short seller, sharp rallies from oversold conditions can really cut into your returns. Since the panic low on Oct. 10, the market has rallied sharply, with the potential for further gains. This month’s oversold extremes were unprecedented. The pendulum swung much too far to the bearish camp. The current rally could last several more weeks, but how high it will swing is anyone’s guess. Dan Amoss explores…
Much of the recent stock market collapse can be explained by panicked forced selling, rather than fundamentals. Sure, we’re going to have a long, deep recession – especially in certain sectors of the economy. But you must also keep in mind that stocks are denominated in paper money. Central banks and governments are fighting this credit crunch with the greatest wave of inflation in history. I’m betting they’ll succeed, albeit with many consequences.
During the panic, I read many misleading statements about stock valuation. From day to day, stocks are, obviously, worth whatever the potential buyer is willing to pay. In panics, sellers overwhelm buyers.
But over time – in normally functioning markets – a stock’s price will reflect its ability to deliver free cash flow to shareholders. The next two or three years of earnings are only a small fraction of any stock’s value.
Yet many great companies, including National Oilwell Varco, quickly crashed by 70% or 80%, just because earnings might temporarily slow. NOV’s real value did not fall that much. This was an emotional overreaction, so we took advantage and picked up some cheap call options.
The value of any company depends on factors like future sales growth, profit margins, and capital investments necessary to sustain its business. In short, the value of companies, or stocks, doesn’t really change very quickly from week to week.
But the market can change its expectations very quickly, especially when fear overwhelms rationality.
Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, recently described how fear and stress can impact the stock market:
"The whole story of how humans deal with stress is really interesting, but there’s one facet worth emphasizing. When people get stressed, they tend to dramatically shorten their time horizons. If you’re a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard."
Most investors have clearly been acting under dramatically shortened time horizons. Redemption requests and margin calls have forced many fund managers to sell what they don’t want to sell at ridiculously low prices. But it finally seems we are heading back into a normally functioning market – where investors can make informed decisions without so much fear and stress.
A more orderly stock market will give us plenty of attractive short ideas. I’ll be looking for situations in which the market has already priced in a rosy scenario for a stock. We can all become better investors by honing our abilities to distinguish between the trading noise and the investing signal. In other words: What really matters to the value of this company, and what does not?
It’s amazing how often the market projects the fundamentals of the past year into the infinite future. Those who invested in bank stocks two years ago have discovered the hazard of investing on the assumption that the future will look just like the past. The same goes for traders that chase the latest hot stock up to the stratosphere, to the point where it must keep growing earnings at 30% per year for a decade to justify its valuation. Once there’s a hint that growth will fall short of expectations, formerly "hot" stocks can crash 30% or 40% in a day – especially if earnings were never sustainable to begin with.
In times of panic, the market tends to project the past year’s negative fundamentals into the future. For example, how much does the fact that U.S. gasoline demand is down 4% year over year matter to the value of oil stocks? It matters if gasoline demand keeps falling at a 4% annual rate over the next decade.
But you probably agree that this has little chance of happening, since oil consumption generally doesn’t fall quickly in response to higher prices. Yet most oil stocks now trade at valuations that anticipate an endless spiral in demand and prices.
I think the shortsighted fear about U.S. oil "demand destruction" is noise. It’s distracting investors from an important signal: sustainable worldwide demand and supply constraints that will determine the long-term price of oil. So you have the opportunity to take a contrarian stand, buy cheap oil stocks, and hold them as long as fundamentals stay intact and valuations stay reasonable.
Dan Amoss, CFA
for The Daily Reckoning
December 10, 2008
Dan Amoss, CFA runs Strategic Short Report, and is a contributing editor for Strategic Investment. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.
Dan brings with him the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for his readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.
It takes a while for the traveler to get used to Australia. He picks up the phone to call home and can’t quite figure out what time it is back in Kokomo or London; then he realizes that he can’t call anyone – they’re asleep. He reads the news and can’t figure out why the paper doesn’t report yesterday’s stock market close. Then he realizes that back in New York it still is yesterday.
We’re writing this on Wednesday morning. But it’s still Tuesday afternoon to most Dear Readers.
"I like reading the DR," said an Aussie investor last night, "but what I object to is that it is so long. Couldn’t you just save up your thoughts and put them in a simple message at the end of the week? Do you have to make us read so much to get the gist of it?"
Well, today we will keep it short. First, because less has happened – the day is still barely half over in North America. Second, because we have to rush to get on a plane to Los Angeles. And third, because we want to give long-suffering readers a break.
In that spirit, today we pass our own words through a kind of verbiage distillery and drip out the following moonshine:
Don’t think so…
Nope, one to go…
*** For those who like a little branch water with their hooch, we offer the following cogitation:
Poor Sam Zell! One of the smartest guys in real estate turned out to be one of the dumbest guys in the newspaper business.
Let’s face it, you don’t get much prestige grubbing for money in bricks and mortar. Everyone knows it’s a grimy trade, dominated by tough old birds with no heart. But newspapers! That’s a different story. A newspaper publisher is at the top of the social pecking order…because they can peck anyone they want on the editorial pages. And, heck, they don’t admit it…but they can peck on the news pages too. Editorial…news…sometimes you can’t tell the difference anyway.
So poor Sam Zell sold out his property empire at the very peak of the bull market…and used his cash to buy the Tribune – publishers of newspapers in Chicago and Los Angeles. He didn’t seem to realize that the newspapers were in trouble already – they were losing out to on-line news and opinion publishers. And now, with the falloff in advertising revenue, it looks hopes for a lot of newspapers. In small towns, for example, the local auto dealers took pages of advertising. And the local builders filled the rest of the rag.
But Sam Zell went ahead and bought the Tribune…and maybe he did some pecking…and maybe he didn’t get around to it. Because the papers have been in trouble financially since he bought them; that must have taken up his time and attention. And now they’ve gone broke.
But Zell has plenty of company. More firms are going broke every day. And others are desperately trying to stay in business by cutting payrolls. Sony, for example, announced 16,000 job losses yesterday.
We’ve done our part to help the airlines…but the industry is facing $5 billion in losses for 2008.
And Paulson has only $15 billion left of the $350 billion first draw for his deflation-fighting campaign. What happened to all that money? Well, it’s gone into the pockets of his friends and cronies on Wall Street. Bailouts…loans…nationalizations…that’s the way the new system works. The only big money being spent is money that doesn’t belong to the people spending it.
*** And the fix is in for Detroit too. At least, that’s what it says in the paper…that a "deal is close at hand."
Whew…what a relief. What would we do without GM?
We’d have to buy cars from one of the dozens of other car manufacturers in the world.
We’ve got more to say…specifically, about "balanced portfolios"…about the next big bubble…and other things. But we have no more time to say them…
So, we sign off for today…
The Daily Reckoning