Falling Knife Realization
I had a wonderful realization lately about the market that I'd like to share. Many of you have probably already realized this, but I have finally got there.
The market doesn't care that a stock has dropped 80%.
Doesn't seem like that bold of a statement, until you put human emotions into play.
As a value investor, I'm constantly on the lookout for cheap stocks. Many of us contrarians start by learning a simple rule - buy low, sell high. So when we see stocks getting beaten up by the market, its hard to ignore. Let's look at the airlines - absolutely punished in the last 3 months. Many are down by more than 50%. The worst part about it is that many contrarians start trying to find the bottom - bad news folks - the bottom is a myth and really a pure luck play in situations like the airlines, housing and financials right now.
"But HistoricalPEGuy, aren't you all about finding stocks that are at their lowest point according to P/E ratio?"
Of course, but you must understand the 'E' part of the equation. If the earnings are so uncertain that its tough to make heads or tails of the situation - the strategy doesn't apply. In these cases, there might as well be no 'E', so that metric is out the window
The market only knows about today and where it thinks the stock is going.
This is such an important point that I never really understood. I've hated the "efficient market hypothesis" since the day I heard it. It really doesn't apply to real markets - just ask Warren Buffett. However, the basic statement does apply in a very general sense. If you are looking at a stock and see it down over 50% -- THAT DOESN'T MEAN ANYTHING. Stocks aren't cheap because they get sold - its the market attempting to correct for potential future earnings. The market doesn't care how far it falls, it is just trying to attempt (sometimes not very good) to estimate its value.
Interestingly enough, this "epiphany" came to me while deciding to short LCC and then trying to decide when to close the position. After thinking a bit about it, I remembered a fellow fool's comments:
"I can generate more points on CAPS if I short a stock, close it quickly and then short it again" -- dwot.
That statement had me thinking.... And now it makes perfect sense. dwot has done well by shorting, closing, shorting, closing, shorting, closing, etc. because the market doesn't care how many times dwot has shorted the stock, or how far its fallen - it is only trying to find a way to estimate the real value of the company -- and sometimes that means a huge fall from grace. Other times, its a minor correction (plus it gives her more points instead of just keeping a red thumb).
So before you call a stock oversold -- ask yourself -- is it really cheap, or am I just telling myself "its dropped over 50% in the last 3 months and it can't go down more than that".