Don’t Let Bull Market Convince You That You Are Smart
February 24th, 2007
By Vitaliy Katsenelson, CFA
February 24, 2007
Lately I’ve been getting this powerful feeling that everything I touch turns to gold. Every time I buy a stock, it goes up. Did I finally figure out the stock market game? Did I find a secret to Will Rogers’ advice? Buy stocks that go up, and if they don’t go up, don’t buy them.
No, I didn’t get much smarter, and my stock picking skills haven’t improved that much over the past year. I was simply a willing participant in the latest (cyclical) bull market. A bull market makes you feel smarter than you are the same way a bear market makes you feel dumber than you are. Feeling smart makes you do the opposite of what you should be doing. The euphoria of the golden touch is a dangerous thing because it can make you (and me) careless. We forget about risk since we haven’t seen it in a while and focus only on our rewards. You have to actively make yourself aware of the four-letter word R-I-S-K!
How do you do that? My favorite way is to remind myself how “dumb” I am. I pull out an annual return report of a company on which I lost a boatload of money and masochistically try to read it from cover to cover, reliving my “dumbness.”
We all have these stocks, the ones we lost a lot of money in because we were overconfident. We tend to forget about them during the bull market phase. But I suggest you remember them now, so you’ll have fewer of those names to remember in the future. Risk is still there; it is just hiding under the joyful sentiment of the bull market. Believe me, it will show its ugly face. It is just a matter of time.
In the bull market, it is easy to forget about selling discipline and then turn into a “buy and forget to sell” investor. Every time you sell a stock you look dumb because it usually goes up afterward. I recently sold Becton Dickinson (BDX) at about $72-$73, and then it hit $78! I don’t feel smart about that decision. However, when I bought Becton Dickinson, I set a sell P/E, and when it approached I quickly reviewed the stock’s fundamentals - they had not changed much, so I sold the stock.
You cannot worry about marking the “top” in every sell. My objective is not to buy at the “bottom” and sell at the “top.” No, my objective is to buy a great company when it is cheap and to sell it when it is fairly valued! I suggest you do the same.
Vitaliy Katsenelson, CFA, is a portfolio manager with Investment Management Associates Inc. and an adjunct professor at the University of Colorado. His blog is ContrarianEdge.com
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4 Comments Add your own
1. Hank Riehl | February 24th, 2007 at 6:54 pm
I read your article in Saturday’s RMN Business Section. And I must admit, I too had those “feel stupid” moments myself. Too many of them.
But take it from a guy who managed very large corporate pension funds of Fortune 500 companies, we are in more than just a “cyclical” bull market as you suggest. A lot of smart guys I know think that this market is a continuation of “secular” bull market that began in the mid-1970s or early-1980. So if you feel bad about your BDX hitting the high-70s after you sold it in the low-70s, then you are going to feel a lot worse when it breaks 100.
As you know, BDX enjoys positive price momentum with a rising price above a rising 50-day moving average which, in turn, sits above a rising 200-day moving average. But that’s only a small part of it. The relative yield on the 10- year Treasury note comapred to the earnings yield on the foreward projected earnings of the S&P 500 suggests stocks are undervalued by some 25% compared to bonds–severe undervaluation last seen over 25 years ago. This model (which accurately suggested 65% overvaluation in 1999-2000) may not tell you “when,” but it accurately tells you for “how much” you are playing the game. That translates into a DJIA solidly north of 15000. For investors, the upside clearly outweighs the downside.
So may I suggest that you put those backward-looking annual reports down. Althoug interesting to read, that information has been dicsounted by a foreward looking market some 6-9 months prior to their publication dates. So, the next time that BDX kisses its 50-day moving average (and it will), buy it!
And by the way, the “E” in P/E is worth a lot more under conditions of low inflation expectations versus periods of high inflation expectations. A historical average (or mean) is an apples-to oranges-comparison that includes both periods of low AND high inflation. You can’t have both at the same time. Per the historically low yield (some 70% determined by inflation expectations) on the 10-year Treasury, we are in a low inflationary environment. The only comparable P/E was accompanied by a low inflationary environment. Bottom line: we have room for some P/E expansion per the low 4.7% yield on the 10-year T.
And just because earnings growth may be slowing, it doesn’t mean that those still rising earnings are worth less. Historically, they can be worth more if accompanied by lower inflation. All things equal, a 5% earnings gain gets you 5% more P. And if those earnings are worth (valued) more because of lower inflation, you can get an even higher P, say 10 or 15% higher.
2/24/2007 10:17:00 AM
2. David | February 25th, 2007 at 3:30 pm
The decision to staying true to ones “discipline” is key to long term investment success. I often refer to the comparison of discipline versus conviction. I can’t tell you how many investors in 1999 had a “conviction” that tech stocks were going to grow to the sky. Many investors threw “discipline” out the window and paid dearly for the mistake.
3. Vitaliy | February 25th, 2007 at 3:49 pm
Hank,
Thank you for a very thoughtful response. I strongly disagree with your “cyclical” comment, I disagree so much that I am finishing a book on the subject (see book tab on the blog).
Regarding P/Es. If interest rates stay at these low levels than it will be an indication that economy is slipping into a recession. If economy is going to continue keep humming along than interest rates will likely rise. Neither scenario is good for P/Es.
David,
I agree, take a look a look at the article I wrote on the subject “It Is Not the Cards You are Dealt; But is How You Play Them” on December 2nd, 2006.
Best,
Vitaliy
4. DavidDT | February 28th, 2007 at 3:47 am
Vitaly,
market is deceitful just like Devil who’s greatest trick was to convince everyone the Devil does not exist, market’s greatest trick is convince everyone that “one” is smarter than a market. Right before the very end of 1999 the doorman of my New York’s building stopped me and shared his excitement of how he “just made a killing on the stock market - easy”. That is really great when everyone is making money, that is strange that it is easy, so I went short on Software.com and KANA and after quite a bumpy ride up for a while rode those stocks all the way down to under a $1 ( from well above $1000 I think). Market is a hard work, the moment one disrespect Mr. Market - is the beginning of the end
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