Momentum Trading Cuts Both Directions

Back on Monday October 19, 1987, the Dow fell 508 points, which was a decline of more than 22% in a single day. Today that same decline equates to roughly 2%. With the Dow trading at such high levels, in absolute point terms, a large decline might seem scary if not presented in percentage terms. The same is true when the financial media likes to focus on every 1,000 Dow points, as if a move from 25,000 to 26,000 is anything more than a simple 4% gain that historically takes less than 6 months, on average.

So rather than care about “a 1,000 point Dow decline!” let’s look at a one-year chart of the S&P 500 for some perspective:

As you can see, all we have done over the last two days, when the Dow has dropped 1,600 points, is give back the gains booked in January! When I look at this chart, I don’t see the mother load of all buying opportunities yet. I probably would not get even a little bit giddy about buying U.S. stocks unless we got back down to 2,400 or 2,500. That does not mean it will get there, or that I think it might (I — like anybody else — have no clue).

Momentum markets work in both directions, and when computerized algorithms conduct much of the daily trading in the stock market, moves like we see today can happen with ease, and most importantly, without tangible “reasons” behind them.

Most of the time I wish we could go back to the days when stocks were less volatile, a 10% correction occurred about once a year, on average, and the media did not over-hype days like today. It will make for good, scary headlines, but that’s about it.

Noodles & Company Falls Back To Earth, Still Not A Bargain

About 14 months ago fast casual restaurant chain Noodles and Company (NDLS) had one of the most successful initial public offerings of the year, more than doubling on its first day of trading from an offer price of $18 per share. That very day I warned how overvalued the stock was at its then-$36 price. Investors trampled over each other to buy the shares for a few more days (the stock peaked at $51.97 on its third day of trading) and then reality slowly began to set in. Paying more than 40 times cash flow for NDLS, or any stock for that matter, is a very dangerous proposition.

After several quarters in the public spotlight, many recent high-flying IPOs have crashed and burned. Most are in the retail space, such as The Container Store (TCS) or Zulily (ZU). Amazingly, even after huge drops, most of these stocks are not yet bargains. Circling back to Noodles & Company, which is trading below $20 per share today after reporting lackluster earnings last night, the stock still trades at about 15 times cash flow (enterprise value of more than $600 million for a company that booked EBITDA of about $20 million during the first half of 2014). That price is still on the high side of fair, even if you believe in the growth story and think NDLS will succeed in continuing to grow its unit base by double digits annually for many years to come. I’m not a huge fan of the company to begin with, so a 15 multiple is not even in the ballpark for me to consider it as an investment, despite the fact that I have favored growth stories in the restaurant area for a very long time.

For bargain hunters, it certainly makes sense to watch these recent IPOs as they crater back to earth. However, be careful not to jump at something just because it is down 50% or more from its peak. NDLS is a perfect example of a stock that is down a ton (62% in the past year) but is still not cheap. You really need the valuation to be favorable to justify bottom fishing in recent IPOs. Some of them went so far above a reasonable price right out of the gate that a price drop alone puts them in the “less expensive” category, as opposed to “undervalued.”

Full Disclosure: No positions in NDLSTCS, or ZU at the time of writing, but positions may change at any time

The Average Investor Can (And Should) Ignore the 60 Minutes Story About “Rigged” Markets

The piece on 60 Minutes this past Sunday has ignited a discussion about high-frequency electronic trading systems and undoubtedly has spiked sales of the new Michael Lewis book entitled “Flash Boys: A Wall Street Revolt” which digs deep into the topic. Since I have yet to read the book, I am not going to get into many details here, but the big issue is that technology has become so advanced these days that certain people are now able to get insights into what orders are coming in for a particular security, and jump in front of those orders to make a few pennies per share on the backs of smaller investors. It’s gotten so bad (read: unfair) that a company called Virtu Financial Inc, which recently filed documents to go public, disclosed that it has only lost money on one day out of the first 1,238 trading days it has been operating.

Since I work with regular retail investors, the most salient question my readers might want to ask is “Does this affect me?” I would say “No, it doesn’t.” There are definitely counter-arguments to be made, but for the typical investor (who is investing in the stock market and planning on holding a stock for months or years) the existence of high-frequency trading firms should not even be a blip on their radar. The market is not “rigged” against the types of investments they are making. If you want to invest in Company A, you have done your research, and you feel as though paying $20 per share for that stock is an attractive price, then all you have to do is enter a limit order to buy Company A at $20 per share. In that scenario, you know what you are getting, you know what price you are paying, and you feel good about your odds of success. Over time if your investment thesis proves accurate then you will make money, and vice versa. Nothing else really should matter to you.

Now, it is hard to argue that we should embrace or even accept a system where certain groups of people with more money and better technology should be in a position to game the system and earn a profit 1,237 out of every 1,238 days the market is open. Hopefully regulators will do everything they can to close these loopholes in the system. That said, the discussion around whether regular investors should change how they save and invest based on this new book or the 60 Minutes segment are focusing their coverage and attention on the wrong headlines, in my view. Carry on.

Trading in Dendreon Stock Shows Why Short Term Trading Is Such A Gamble

You may have heard about Dendreon (DNDN), a small money losing biotechnology company that is in the process of getting its cancer vaccine, Provenge, approved by the FDA. Full results from a crucial phase three study were released yesterday afternoon in Chicago, but about half an hour prior to their release, shares of Dendreon fell off a cliff for a couple of minutes and trading was halted for “news pending.” Between 1:25pm and 1:27pm ET Dendreon stock fell from above $24 to as low as $7.50, and were halted at $11.81 per share.

Immediately investors were baffled. The most plausible explanation was that the full study results somehow were leaked early, someone learned they were bad and sold their stock, which in turn caused others to panic and sell too. That would have been an odd turn of events, however, because the company had indicated recently that the study results were clearly favorable.

When the news was finally released to the public there were no surprises, which makes those trades just before 1:30pm very strange. The NASDAQ exchange quickly investigated the trades to see if any were made erroneously, but they found nothing wrong and the trades will stand. Today the stock reopened and is currently fetching about $24 per share.

This story only serves to further my personal belief that short term trading in the stock market is so speculative that it is really nothing more than gambling. Evidently somebody somewhere thought they saw or heard something that was negative for Dendreon, others followed suit and sold their shares like lemmings jumping off a cliff, but in reality there was no news at all.

Undoubtedly some investors quickly hit the sell button during those few short minutes yesterday afternoon, fearing that if they didn’t their stock would fall even further (Dendreon stock sold for $2 in March, so many people had huge gains). They lost between 50% and 75% of their money for no reason. Other investors surely had large paper gains in Dendreon and had stop loss orders in place to limit any future losses. Many of those stops were triggered as the stock collapsed from $24 to $7 and rebounded to $12 and those investors also lost big time.

As you can see the market is very complex and sometimes things happen that are not rational and should never have happened. Speculating on near term movements of stocks (especially small biotech companies) is a very risky endeavor. All the market needs is a willing buyer and a willing seller to agree on a price in one split second. Reality need not apply in such a case, but millions of dollars can be lost in a matter of minutes, as was the case with Dendreon yesterday.

Traders beware. In some cases Wall Street can look very much like a casino.

Full Disclosure: No position in Dendreon at the time of writing, but positions may change at any time

After a Brief Break, Here’s A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I’ve posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday’s closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck’s dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

So Far, Technical Support Levels Holding Up Well

During crazy market times like this I can talk my head off about fundamental issues that show the market is undervalued, but fundamentals don’t matter right now. Stock prices are claims on future corporate profits forever? Who cares, earnings are going to be terrible in 2008, 2009, and maybe even 2010. Rather than trying to convince people (correctly) that earnings this year or next really don’t have a material impact on a company’s long term equity value, let’s focus on what does seem to be working right now… technical analysis!

Long time readers of this blog know I don’t use technical analysis because for a long term investor, charts don’t tell us what stocks will do, earnings and valuations will. Still, technicals do work quite often in the short term because thousands of people are looking at the same thing and acting in the same way. Today was no exception, as the 10-yer S&P 500 chart below shows.

The 2002 closing low for the index was 776. Today we sank at the open, hit 776 and bounced significantly (818 as I write this). The long-term 2002 support level has held, which is crucial for the short term market environment. I might not care where the market trades today, next week, or next month, but a lot of people do.

Market Action Shows How Much Negativity Is Priced Into Stock Prices

One of the most important things to know about investing is that the stock market is a discounting mechanism. That does that mean? It means that expectations for future events are reflected in stock prices ahead of time, before the events actually occur. People who try to guess what the headlines next week are going to be, and invest accordingly, might not make any money in the market. Remember, stock prices go up or down not based on how well the underlying companies do, but rather how well the companies do relative to the market’s expectations.

I bring this up because today’s market action shows us that a lot of bad news has already been priced into equities. UBS (UBS) reported astonishing writedowns of $19 billion and Lehman Brothers (LEH) raised $4 billion of capital even though they claim they don’t really need it. Pretty bad headlines, but the Dow is up 260 points as I write this. Last month when Bear Stearns (BSC) nearly went belly-up the market reacted by dropping 1%, and has risen ever since. Many might have expected a far worse reaction to such startling news.

Now, this is not to say we are completely out of the woods and the market will soar from here. In fact, I think we will be range-bound for the foreseeable future. That said, it appears that things would have to get significantly worse for the market to take a huge hit from current levels. Hopefully first quarter earnings reports won’t have any big negative surprises. If that is the case, those who are claiming we are in a bottoming process might be right, in the short term anyway.

Full Disclosure: No positions in the companies mentioned at the time of writing

Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between “trading” and “investing”? I’m always curious to hear what people think is the difference.

Thanks for the question, John. I don’t think there is too much of a debate over the difference, and my views likely aren’t much different than most, but I’m happy to give my personal thoughts on the topic.

The main difference between “trading” and “investing” is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company’s stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one’s cost basis in order to maximize profits over time. Temporary drops in share price aren’t likely to change an investor’s opinion of a stock’s long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won’t own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren’t willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don’t have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren’t at a statistical disadvantage, so the comparison isn’t perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders’ odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader’s stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don’t incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

Traders Bracing for Retest of January Lows

Regular readers of this blog know that I am a fundamental-based investor. As a result, over the long term the two key determinants of future stock price performance that I focus on are earnings and valuation. Although I strongly believe that technical analysis only works over short periods of time, in the absence of new material information, enough people read charts (especially traders, as opposed to investors) that they can predict near term market movements due to thousands of people acting on them in the same manner simultaneously.

I bring this up because when we got the huge leg down in January, which served as a short term bottom after the Fed temporarily rescued us with an emergency rate cut, traders were adamant that we did not see capitulation (Bernanke didn’t let that happen) and would have to retest the lows after an oversold bounce. Sure enough, we got a bounce up toward 1,400 on the S&P 500, moved along in a narrow 1300-1400 band for a little while, and now are moving back down to the lows, as the chart below indicates.

Let’s give the chartists credit for their call. Market bottoms often look like the letter “W” on a chart, a pattern I have noticed since I started following the markets. The next step is to see if we in fact retest the lows (we are a few points on the S&P away from the closing low of 1310 as I write this, but still a few percentage points away from the intra-day lows of 1270).

If we get a retest, followed by buying interest sparked by all those chartists salivating at a potential double bottom formation, we could certainly have another bounce in coming months. Depending on the economic and earnings picture at that point, it could very well give investors a chance to take some chips off the table. That is only one possible scenario, but it is the one bulls should be hoping for.

The S&P 500’s closing low was 1310.50 on January 22nd. Today the index hit an intra-day low of 1310.49 and has since bounced about 4 points.