I have been in this market since the middle of the 1990s, Stock Traders Daily has flourished during the debacle that followed the Internet bubble, the bullish market conditions between 2002 and 2007, the credit crisis, and we actually have the best performing strategy on the market since December 2007, but over all of these cycles one thing has been abundantly clear. When the market makes a longer-term top and then begins to turn smaller investors play a significant role, and usually make significant mistakes.
About 2.5 weeks ago I issued an important alert to clients identifying what seemed to be arrogance on the part of smaller investors. They seemed to be so overly confident that it was off putting, and immediately we shorted the Russell 2000. That trade paid off and is paying off, and the catalyst for that decision is part of this discussion.
When smaller investors jumped in with both feet, like they have in recent months, it should be a red flag to everyone else because almost always smaller investors buy at the top and sell at the bottom.
Because we are nowhere near a market bottom at current levels, our discussion here is about the mistakes that smaller investors make when the market turns down from a longer term top.
The first mistake is that they fail to differentiate the company from the stock price. A great historical example over time has been Apple (NASDAQ:AAPL), because investors love the product and thought the stock would go up forever until it fell on its face last year. They fell in love with the stock because they liked the company, but they do not necessarily go hand in hand.
The better immediate example in today's market is Twitter (NYSE:TWTR). I would argue that Twitter has an excellent product, they have excellent growth rates from a subscriber bases, but the company simply is not making any money, they are not even generating substantial revenue, and the stock price, from a valuation perspective, is out of this world. Still, smaller investors seemed to fall in love with the stock because they love the product, but these do not go hand in hand.
When these mistakes are made after longer-term tops in the market are established the result often is substantial loss for investors that fail to manage their risk. Using Twitter as an example, after the company reported earnings, in the after-hours session, we also send an email alert because Twitter, during that after our session, was trading at our stated resistance level, but since then the stock has pulled back by 20%. It seems to be on its way back down again, towards our longer term support level, and we are not in love with the stock as a result. Still, some smaller investors remain in love with the stock because they love the product, but that's a big mistake because they do not go hand in hand.
The second mistake smaller investors make after market tops is a rationale that they indeed will plan to go to cash after they get back to where they were before the declines began; instead of just selling they decide to wait for a bounce, and after market tops bounces never come. This is the error that caused wealth destruction for so many in 2008.
A great example of this is General Electric (NYSE:GE). I'm using a widely owned stock in this example because people tend to think that even large cap, blue chip companies would not fall if the market falls. They realize the quality of the company, and GE is a high quality company in my opinion, and they determine that they could hold on to the stock no matter what happens to the market.
Surely, General Electric will probably survive any market setback, it has a history of doing that, and I do believe that the company can survive even the most aggressive of market pullbacks, but the stock price is a completely different story. Investors who allow their golden handcuffs to prevent them from selling when longer-term peaks in the market are established often find themselves significantly under water in companies that are otherwise considered to be high quality. Golden Handcuffs cause investors to hold on even when the market is set up to fall on its face, and those decisions are often supported by large brokerage firms who get paid to keep you invested at all times (that's how they generate fees).
In the specific case of General Electric, this high quality company has a peg ratio well over 4, with a yearly EPS growth rate of 3.87%. When the multiple is compared to the growth rate, the stock looks rich, valuations are extended, yet some investors surely will let those Golden Handcuffs influence their decision to hold or sell.
In summary, smaller investors not only help us identify longer-term peaks in the market, they also make mistakes around those longer term peaks that could end up being devastating to them. Based on my macro economic analysis, the Investment Rate, and my evaluation of Net Real Stimulus (NRS), we may have seen a longer term peak and I am advising all investors who might fall prey to these mistakes to approach their decisions in a mechanical fashion, businesslike, and without emotion, because over the past 20 years I have learned that those investors who get hit hardest are the ones who fail to approach the business of investing as a business.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: By Thomas H. Kee Jr. for Stock Traders Daily and neither receives compensation from the publicly traded companies listed herein for writing this article.