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HistoricalPEGuy (63.68)

Falling Knife Realization

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May 31, 2008 – Comments (7) | RELATED TICKERS: LCC

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".

Fool on!

-- HPEGuy

 

7 Comments – Post Your Own

#1) On May 31, 2008 at 5:03 AM, PDTBiotech (92.31) wrote:

"Stocks aren't cheap because they get sold - its the market attempting to correct for potential future earnings."

Doesn't this statement imply that forward PE's are more useful than historical PE's?  I've always been confused by why people get so excited about low ttm PE's when it would seem the market wouldn't care about the ttm E nearly as much as the forward E.

I'm actually testing this theory in a very clumsy way right now, basically I set up two ghost ports that trade the same group of stocks (pharma's Big 12) based on TTM PE or forward PE.  Only been running it for a few months - so far they're about even, but both have thrashed the control port, which was just to buy and hold all 12 stocks.

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#2) On May 31, 2008 at 1:29 PM, HistoricalPEGuy (63.68) wrote:

I think you may be mistaking "Historical PE" -- at least the way I look at it. 

TTM or Future P/E - take your pick.  Now once you've decided on the right metric, look back historically and determine at what point was that metric (TTM or Future PE) at its lowest.  That gives a reference point as to when the stock was "cheap".  Now, what is its current metric value (TTM or Future PE)?  If its hovering near its all time low, then to me, its a buy (given that the company has shown the "E" part of the equation is stable).

-- HPEGuy

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#3) On May 31, 2008 at 1:37 PM, mandrake66 (93.24) wrote:

I don't know what dwot's theory was regarding shorting/closing many times in succession, but I recently came to this realization myself. It's just arithmetic.

Just say you know a stock is going to fall from a price of $16 to $2. If you just red-thumb it once and ride it the whole way, you have a gain of 87.5 points (assuming the SP500 stays the same throughout). But if you red-thumb it every time it drops by half (from 16 to 8, from 8 to 4, from 4  to 2) you get a gain of 150 points. Of course this is now spread across three separate picks, so your accuracy goes up (three correct picks instead of one), your total point value goes up, but your avg score per pck is only 50 as opposed to 87.5.

I still haven't figured out the CAPS rating rules enough to determine the optimal approach, but dwot's strategy seems to be a pretty good one. Moves in the SP500, the 7 day delay in closing a pick, and a bunch of other unknowns make following a set strategy pretty difficult though. There certainly does seem to be a high reward for having many closed, positive picks though, no matter how low a score they are.

One practical problem I have right now is a stock like First Marblehead. This stock dropped roughly 75% on me, from about 12 to 3. I think it will eventually rebound, and would like to sit it out. Perversely, though, if I closed it out now for a 75 point loss and then green-thumbed it, and it did return to 12, I'd have about a 400 pt gain (again, factoring out the SP500) for the second pick. In the real world it would make no difference if I closed it out now and then immediately rebought it, but in CAPS it makes a huge difference. The percentage based reward system here creates incentives that don't exist in the real world.

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#4) On May 31, 2008 at 7:48 PM, ctojeira (37.94) wrote:

All of this is nice, but the bottom line is, I'm no richer for closing and re-opening my position.  I guess if your goal is to get a high CAPS score, so be it.  But who really cares... isn't it the goal of everyone here to simply make money?

I appreciate your point, HPEGuy that the market doesn't care about how far down a stock has come, and this realization can save you a lot of money in the future.  I'm guessing that this is your primary point here and that you could really care less what your CAPS score is.

 

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#5) On May 31, 2008 at 7:51 PM, ctojeira (37.94) wrote:

All of this is nice, but the bottom line is, I'm no richer for closing and re-opening my position.  I guess if your goal is to get a high CAPS score, so be it.  But who really cares... isn't it the goal of everyone here to simply make money?

I appreciate your point, HPEGuy that the market doesn't care about how far down a stock has come, and this realization can save you a lot of money in the future.  I'm guessing that this is your primary point here and that you could really care less what your CAPS score is.

 

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#6) On May 31, 2008 at 8:14 PM, ctojeira (37.94) wrote:

All of this is nice, but the bottom line is, I'm no richer for closing and re-opening my position.  I guess if your goal is to get a high CAPS score, so be it.  But who really cares... isn't it the goal of everyone here to simply make money?

I appreciate your point, HPEGuy that the market doesn't care about how far down a stock has come, and this realization can save you a lot of money in the future.  I'm guessing that this is your primary point here and that you could really care less what your CAPS score is.

 

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#7) On May 31, 2008 at 9:48 PM, HistoricalPEGuy (63.68) wrote:

ctojeira - bingo....  Who cares about the caps score, in the end I want to make money and to know the difference between a truly beaten up stock that doesn't deserve it vs. those stocks that totally have it coming to them and more...

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