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The most enduring impact of life’s many lessons that we endure are those that reach deep into our souls. The ones that go straight to our core, the ones that sting. Who doesn’t have a vivid memory of love lost or the unexpected pink slip? It’s like being electrocuted. You’re stunned and shocked.

For long investors, the equities market offers another way to step on the third rail. Bad news. Who hasn’t seen a stock drop 40%, 50% or more in a matter of seconds? If you’re holding it, it’s scary, brutal and merciless. Experiencing just one of these will provide a wonderfully effective lesson for an individual investor. It’s the most common method the market employs to shine a bright light on your experience, skills and knowledge. In short, you’ll know quite clearly whether or not you honestly know what you’re doing.

I’ve been following Chinese stocks for some time now because of the heretofore enthusiastic demand for all shares Chinese. Whenever there is a bull market in full lather things get interesting. Why? The behavior of people, of course.

The first phase of a bull market is the fun phase. Everyone is making buckets of money. The initial big winners are the most financially sound and well-positioned firms. As their share prices rise 3x, 4x, 5x or higher everyone around the world wants to get a piece of the action. Investment banks work feverishly to satisfy the ravenous demand. There are only so many financially sound firms, though, so as the number of IPO’s increase the quality of companies decreases. Not to worry. Every new issue is going up so it doesn’t matter much. The party is in full swing. This was China ~3-4 years ago.

The second phase of a bull market is characterized by modest price appreciation and eventually price stalling or range-bound trading. The valuations are so rich that even the testosterone-fueled new masters of the universe can’t push them higher. This is the point where much of the "smart money" begins to take profits while many less-experienced investors continue to buy in. This is also the point where you start to see some downward pricing pressure caused by earnings disappointments, deteriorating fundamentals, etc. This is also the phase where you begin to see bearish reports from analysts. It’s during this phase where the bears endure the most criticism and vitriol. Why do you want to spoil the party? What perverse pleasure do you get by raining on the parade? It takes resolve to be the bad guy. This was China ~1-2 years ago.

The third phase is characterized by a large dose of reality. High growth companies have become low growth companies and, for those less-than-investment grade issues, "flame outs" become all too common. What’s made China so interesting is the degree of out-and-out fraud that has occurred. Shell companies, reverse mergers and phantom sales/earnings have been familiar themes for the past year or so. There is a long list of Chinese issues that, unfortunately, reside in this category. This is where we are today.

China MediaExpress Holdings, Inc. (OTCPK:CCME) has been a popular and vigorously debated stock on SeekingAlpha. The debate was stoked by a bearish report on the firm by Muddy Waters Research earlier this year. This is not what the bulls wanted to hear. The personal attacks and vitriol have been in full display in the "comments" section of CCME-related postings.

Psychologists call this type of behavior a confirmation bias. Negative responses, including personal attacks and insults, are characteristic of this bias. No one wants to hear that their well-thought-out investment stinks. How dare you question my decision? Are calling me an idiot? A rookie? You can deposit your analysis where the sun doesn’t shine, bucko! And so the story goes ...

The shorts have to be evil rumor-mongering trolls until, of course, they’re proven right. On March 14, the company announced the resignation of their CFO and their auditor, Deloitte Touche. Trading in CCME shares was halted as a result. Ouch! I’ll make a wager that there will be a slight down move when trading resumes.

Sadly, situations like CCME expose one’s lack of skill, expertise and experience. The market, in almost all cases, gives astute investors a number of signals that things are amiss. You ignore these signals at your financial peril. This is the reason that an emotional attachment to a stock is so dangerous. It blinds you to the implications of these valuable signals. This is also the reason you see this advice in every credible investment book.

So what were the signals re CCME? Let’s count ‘em:

  1. China’s stock market was down ~16% in 2010. It was one of the worst performing bourses in the world. ~75% of stocks follow the market’s direction so it was definitely not the time for a long position. Even though CCME started a bull run in October the market was still in bad shape. This is a huge headwind to battle so buying was ill-advised.

  2. The iShares FTSE/Xinhua China 25 Index Fund (NYSEARCA:FXI), one of the best, peaked in price (73.19) in October, 2007. After the 2008 bear market it has been range bound between 36 – 45 since May, 2009. There is long term resistance at 45 which is ~39% off the peak. This clearly tells you that the market has stalled. This isn’t a trade killer by itself, though, but ideally you want the market to be trending up when you buy.

  3. The NASDAQ Composite and S&P500 Indexes both gapped down on heavy volume on February 22. The next day was also a large down day on heavy volume. This is a clear message that the institutions were heading for the exits. Since all the stock markets are interconnected this did not bode well for global bourses. If our markets were selling off there was scant hope for China to buck the trend.

  4. Looking at CCME’s weekly chart, dark clouds began to form during the week of November 12. The price peaked at 22.30 but reversed on high volume to end the week at 18.22. This bearish reversal after a strong bull run (from a low of 7.72) signaled that many traders were bailing out. This should have at least put the longs on alert. The second attempt at a new high occurred during the week of January 28. The price peaked at 23.97 but finished in mid-range at 20.86. The new high didn’t hold. Ideally, the price should have finished near the top of the weekly range. The final exit signal occurred the next week after the Muddy Waters report. There was a huge down move on massive volume. This is a crystal clear message that the market viewed the report credibly and wanted out. It doesn’t matter if you agreed with MW or not. With this kind of stampede it’s best to exit and ask questions later.

  5. CCME’s market cap wasn’t reflecting the robust fundamentals had they been legitimate. They were reporting world-class sales and profit growth and an ROE of 101% for their last FY, yet it was still a small cap firm. The market has some short term inefficiencies but it’s not this inefficient. With the millions of investors from around the world scouring China for bargains they wouldn’t have missed CCME. This was a signal that some sort of dark cloud was hanging over the company’s financials.

There is no better way to internalize what you need to know and do than a gut shot like CCME. Several points to remember could be:

  1. Learn how to read a chart. This is essential since individual investors are at the bottom of the information food chain. You buy based on fundamentals and technicals but you sell based only on technicals. You have to respect the price action because there are always a lot of investors who know more than you do.
  2. Develop a healthy dose of skepticism. If something looks too good to be true it because it IS too good to be true. Do you really think you can uncover a true hidden gem that many of the keenest minds in the world have overlooked? The market prices these stocks for a reason(s). Best to find out the reasons before deploying your hard-earned capital. On occasion, hidden gems can be found. It takes a tremendous amount of research and grunt work to identify these. Reading an annual report or talking with your friends ain’t goin’ to get it done. It’s a full time endeavor.
  3. Become a student of the market. Read everything you can get your hands on pertaining to the financial markets and their history, trading, behavioral finance, cognitive psychology, etc. Try to read a book/week. You’ll amaze yourself at how smart you’ll become.

Tread carefully. There are a lot of potholes in the road to the pot of gold.

Recommended Reading:

  • "Devil Take the Hindmost: A History of Financial Speculation," by Edward Chancellor
  • "Manias, Panics and Crashes: A History of Financial Crises," by Charles Kindleberger
  • "The Panic of 1907: Lessons Learned From the Market’s Perfect Storm," by Robert F. Bruner and Sean D. Carr
  • "The Winner’s Curse: Paradoxes and Anomalies of Economic Life," by Richard Thaler
  • "Ponzi’s Scheme: The True Story of a Financial Legend," by Mitchell Zuckoff
  • "Extraordinary Popular Delusions and the Madness of Crowds," by Charles MacKay

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Missed Signals: The Hard Lesson of China MediaExpress Holdings