Despite all my analysis, it was very difficult for me to sell my GE stock options.
It is extremely difficult for anyone to sell a stock that has been going up in price for a number of years, no matter what the rationale. It is always tempting to extrapolate your potential future gains and hang on for “just one more year.”
That is why few investors actually benefited from the huge gain potentials of past time periods when the stock market climbed dramatically. In fact, John Bogle, founder of the very successful Vanguard Group, estimates that the aver- age return for equity funds from 1984 through 2001 was just slightly more than inflation! People just held onto their stocks through the spectacular stock rise of the 1990s and never cashed in! They just rode the stock prices back down.
Key Point
It is extremely difficult for anyone to sell a stock that has been going up in price for a number of years, no matter what the rationale. It is always tempting to extrapolate your potential future gains and hang on for “just one more year.”
Whenever a stock is doing well, it is important to periodically review the likelihood of this continuing. There is a bias to hang on to well-performing stocks too long and lose any accumulated gains. Investment analysis helps in that it removes some of the emotion. For example, for most of 2007, I owned stock in a small company called Altair Nanotech, Inc. This company’s main product was an innovative battery that had potential in electric cars and for massive power storage in electric utilities. The price of the stock was speculative because the promise of this technology had yet to be realized. The price had gone up substantially since I had purchased it, and I wanted to review whether I
should hold it or take my profits and come back another day. One of my con- cerns was that I thought the overall stock market was dramatically overpriced (as discussed later in the book), but my initial thought was that this stock, be- ing speculative and focused around a product that could help free us from for- eign oil, would not be overly affected by a drop in the general stock market.
However, I decided to test my “feel” with real data.
I first looked at a 2007 year-to-date graph of the S&P 500 and noted dates of relatively large drops in the S&P 500 value. I found five individual days and one series of several days. I then went into the specific S&P 500 clos- ing prices for those days and calculated the actual percentage price drops. I then went to the Altair Nanotech, Inc., stock price data and looked at Altair stock prices for those days. Table 2.2 shows what I found.
Not only did the Altair stock go down with the general market but also it often went down dramatically more than the market! With Excel, we can cal- culate probabilities, but this one we can do without Excel! If Altair stock going down was random and not correlated with the S&P 500, we would expect that the chance of the Altair stock price going down being coincident with the S&P 500 price going down would be random, or about half. For Altair to go down the same days as the S&P 500 six times in a row, the random chance would be
1⁄2 ⫻1⁄2⫻1⁄2⫻1⁄2⫻1⁄2⫻1⁄2⫽1⁄64, or 1.6 percent. So this correlation between Key Point
Whenever a stock is doing well, it is important to periodically review the likelihood of this continuing. There is a bias to hang on to well- performing stocks too long and lose any accumulated gains. Investment analysis helps in that it removes some of the emotion.
TABLE 2.2 Large Changes in the S&P 500 versus Altair
Date S&P 500 Change Altair Change
2/27/2007 ⫺3.4% ⫺6.6%
7/23–7/27/2007 ⫺5.3% ⫺12.8%
8/9/2007 ⫺2.9% ⫺7.8%
10/19/2007 ⫺2.6% ⫺4.3%
11/01/2007 ⫺2.6% ⫺7.8%
11/07/2007 ⫺2.9% ⫺0.9%
Source:Data from http://finance.yahoo.com
price drops is unlikely to be random, and it looks like a large drop in the S&P 500 is a KPIV for a drop in the Altair stock. Given the sometimes large per- centage drops in the Altair stock versus the drops in the S&P 500, a large mar- ket drop could be disastrous for shareholders of Altair stock. Because I felt that the whole market was at risk of dropping, I sold my Altair stock.
Did this mean that Altair would then definitely drop in price? Absolutely not! But using data and logic should increase the chance of a correct sell deci- sion rather than just using gut feel or the input of a financial advisor who is likely to be using his or her gut feel. Does this mean that there is a problem with Altair as a company? Again, no! The future for this company may be great.
But just like the pizza restaurant, a company can be good but overpriced. Just as the restaurant’s growth was in a temporary hold because area development was stymied, I felt that Altair’s stock price was at jeopardy because of the high- priced stock market. And if, as I expect, the stock market takes a dramatic drop, I hope to be able to repurchase Altair stock at half of what I sold it for.
When I was discussing my Altair sell decision with a friend, she asked me to see if two restaurant stocks she owned (Chipotle and Tim Horton) would also go down with severe drops in the market. She felt that these two stocks were growing rapidly and could be immune to what I had seen with Altair. So I compared these two stocks with the same market drop dates I had used for Altair. Table 2.3 shows the results.
So, Chipotle restaurant stock went down with the severe S&P 500 drops just as we had seen with Altair. However, the Tim Horton stock seemed to react more independently. When I tried to find out why the two stocks acted differ- ently, I found that the majority of Tim Horton restaurants are in Canada, as is the ownership of the chain, and that is probably the cause of the difference. After seeing this table, my friend asked me what she should do, since she also feared a drop in the U.S. stock market. We agreed that she might be wise to sell Chipotle and buy more Tim Horton, knowing, however, that there was a very real risk that any extended drop in the U.S. markets would eventually affect Canada.
TABLE 2.3 Large Changes in the S&P 500 versus Chipotle and Tim Horton
Date S&P 500 Chipotle Tim Horton
2/27/2007 ⫺3.4% ⫺5.3% ⫺3.3%
7/23–7/27/2007 ⫺5.3% ⫺4.9% ⫺4.4%
8/9/2007 ⫺2.9% ⫺3.3% 0.2%
10/19/2007 ⫺2.6% ⫺2.1% 0.7%
11/01/2007 ⫺2.6% ⫺3.4% ⫺0.6%
11/07/2007 ⫺2.9% ⫺0.5% 1.3%
There was one more bit of knowledge I wanted to squeeze out of this study. As mentioned, I feared that the U.S. stock market was about to experience a severe de- cline. I had been buying two exchange traded funds (ETFs), and I wanted to know how immune they were to the market drops. The first ETF bought Treasury in- flation protected securities (TIPS), and the other bought gold. Table 2.4 shows the results for the same S&P 500 drop days.
So, TIPS acted just as I had hoped, and they should be an effective hedge against a severe drop in the stock market. The results from the gold ETF were far more in- triguing. Early in the year, gold prices seemed to drop with the general stock market. But recently, gold started to act more independently, and the latest result shows it acting more like TIPS in that it countered the market drop. This is consistent with its general price over the year, where it was flat until September and then rose 30 percent in several months. Gold is a so-called “crisis” in- vestment. It is where investors go when they are worried and confused about the future of the economy and the stock market, which seems to be the current state of affairs. Just as with TIPS, these results on gold bolster my fears that the stock market is getting close to a large drop.
Also, it makes me feel comfortable with TIPS, and per- haps gold, as investments of choice for the current eco- nomic environment. Of course, readers of this book have the benefit of hindsight to see if this analysis was correct.
The lesson to be learned is that in a severe mar- ket drop, most companies’ stocks go down with the
Exchange Traded Funds (ETFs) Funds that track an index but can be traded like a stock
Treasury Inflation Protected Securities (TIPS) A low-risk, conservative investment that automati- cally adjusts for inflation, an investment choice that is especially good for anyone who is concerned about high inflation or a possible stock market crash
TABLE 2.4 Large Changes in the S&P 500 versus TIPS and Gold
Date S&P 500 TIPs ETF Gold ETF
2/27/2007 ⫺3.4% 0.9% ⫺3.9%
7/23–7/27/2007 ⫺5.3% 1.0% ⫺3.2%
8/9/2007 ⫺2.9% 0.3% ⫺1.9%
10/19/2007 ⫺2.6% 0.9% ⫺0.4%
11/01/2007 ⫺2.6% 0.6% ⫺0.9%
11/07/2007 ⫺2.9% 0.1% 1.0%
market, regardless of the company’s individual merits. That is why investors must understand the overall market and economy as well as any individual stock.