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Whenever Wall Street ends up getting overly exuberant about an excessively valued bubble stock, those who have the gall to point out that something is very wrong here are usually the ones getting eggs in the face. One of my favorite authors, Paulo Santos, very often acts as such a voice of reason - only to get proverbial eggs tossed in his face in the comments sections of his articles.

Now, here's the thing about bubble stocks - there's two types of buyers. The first type of buyer is what I like to call the "wide eyed retail investor". This person legitimately believes that the stock is "going to the moon" and that <insert company here> will dominate <insert hyped up new industry here> and make <whatever EPS value required to justify crazy share price>. Every so often, such investors actually get it right - look at those lucky folks that held Apple (AAPL) when it was a $10 stock.

However, the vast majority of these stories tend to rise quickly and - once the party's over - fall quite hard. The people smart enough to buy low but not get too greedy (and I'll talk about them in a minute) typically make a mint. See, opposite the "wide eyed retail investor" you get the guys and gals who understand what this is - a game of musical chairs. You want to get in reasonably early when it's clear that this is going to be a "story stock" and you want to get out when it's clear that the story is "breaking down" (when the "wide eyed retail investor" is buying the 25% "dip" and claiming that it's all market manipulation).

Does This All Sound Familiar?

Obviously there are a bunch of these types of stocks out there, but probably the craziest one is Tesla (TSLA). Some might argue that Netflix (NFLX) deserves this title, but at the very least Netflix makes money (GAAP money, not non-GAAP nonsense) and provides a service that's inexpensive and continues to be widely adopted by the masses. I would argue that Netflix is expensive but it has a massive TAM and a major brand moat - there are no guarantees, but Netflix has a pretty reasonable shot at actually justifying its current valuation.

The problem is that Tesla makes niche, high end electric vehicles. Of course, you can see how it's easy to spin a story around that:

  • "Electric vehicles are the future!"
  • "Teslas are the best! Nobody else can make cars this great, because Tesla has super duper battery technology that nobody else could ever have!"
  • "Elon Musk is the next Steve Jobs!"

While these all may eventually turn out to be the case, the current price seems to assume that all of this is *bound* to happen. Are the bulls sure that none of the larger car players will come in and leverage economies of scale to muscle Tesla out of its business by providing functionally equivalent vehicles for cheaper? Also, another thing that I see is that the bulls assume some pretty serious operating leverage in the model that I'm not convinced would actually materialize.

Now, the problem for the short sellers here is that Tesla lacked a catalyst to drive it downward. Shorting a stock just because the widely held long thesis seems wildly optimistic isn't a smart idea - it's equivalent to claiming that shorting a high P/E stock since it has a high P/E is a good idea (it's a really bad idea - don't do it). Shorts needed a catalyst/sentiment reversal, and now they finally have one.

Why Is Tesla Stock Cratering?

The poor souls who enthusiastically paid $194 for shares of Tesla are now down 36% on their investments. In order for those folks - that is, if they're still holding - to break even, the stock needs to appreciate to the tune of 55%.

Now, while the "wide eyed retail investor" may actually be holding a bag this large, most traders/more sophisticated investors probably had stop losses in place. In fact, that's one reason that the stock is losing steam: lack of buyers. Once everybody who is going to buy has bought, the stock starts to come down. As the stock comes down, stop losses for many investors/traders begin to trigger. For a stock like this, particularly if traders/investors are levered to the hilt, this leads to a cascading effect: as stops trigger, selling ensues, which leads to more stops being triggered and so on. This is the exact reverse of what happens with a short squeeze (which is, in my view, what drove the shares so high in the first place).

When the stock price starts to go down, and when the company doesn't blow away estimates (or when something as simple as a few of these magic cars catching fire), the "story" that people loved suddenly becomes dull and people even start finally looking at what could actually go wrong. This is typically very sobering for investors, and all of a sudden what those people who were whispering words of caution on the way up is widely accepted and even viewed as common sense. Weird, right? But this also contributes to lack of buying and more confidence for the short sellers. Also, don't forget those stop losses.

Conclusion

When it comes to these bubble/story stocks, if you're going to hop on board, try to get on early-ish. If the stock is up 300%+ year to date, then you probably missed the boat - let it go. However, if you do, be very careful to set reasonably tight stops. You do not buy these kinds of stocks because you actually believe the story (whether it's true or not), but you buy it because you believe that people will continue to believe it for a while and therefore you can make money.

Source: Tesla: Learn From The Mess