Market myths and half-truths swirl around the stock market. The cockeyed seers of Wall Street daily inflict these supposed truisms on investors...
Market myths and half-truths swirl around the stock market.
The cockeyed seers of Wall Street daily inflict these supposed truisms on investors, but just because they are often repeated doesn’t make them true.
“So much of what people think they know about the market is flawed,” says William O’Neil, founder of Investor’s Business Daily, a financial newspaper.
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“People lose money in the stock market because they make too many mistakes based on these myths about the market.”
The granddaddy of market myths, and the one that has been most destructive, seems like sage advice on the surface: Buy low and sell high.
“A cheap or falling stock is no bargain, but rather just a weak one,” O’Neil says. “There’s a problem when a stock drops, and before you buy it you better be confident that the problem will be solved.”
Three steps and a stumble
Often there’s some truth in these aphorisms, but financial peril awaits those who blindly follow them.
It’s difficult to know how and why some of these ideas gained currency. The most cynical explanation is that some Wall Street sharpies make a fine living trading off misinformation.
Price-to- earnings ratio
“Sometimes they work; sometimes they don’t,” says James Stack, editor of InvesTech Research, a market newsletter. “And they inevitably seem to fail when you depend on them most.”
Buy and hold
Small investors should always be aware that buying stocks is risky business, and there is no Holy Grail that guarantees success.
The summer rally
Even the most successful investors make mistakes, but they try to learn from their miscues. Over time, they develop a winning strategy, which doesn’t come easy or fast.
The one thing almost all savvy investors have in common is that they often move counter to the so-called common wisdom. They know that these time-honored market myths do not lead down the path to riches.
BUY LOW, SELL HIGH: O’Neil advises investors to buy stocks that are moving higher — “breaking out,” as he calls it — rather than sinking lower. That’s because most stocks move in cycles.
Stocks that are dropping typically continue to drop, while those rising continue to rise. And just because a stock dropped from $20 to $10 doesn’t mean it will ever see $20 again.
The bargain hunters were swarming when shares of Pfizer began tumbling about a year ago. The stock price dropped from about $40 to $34 in three months — a 13 percent decline. Investors who liked Pfizer at $34 would have really liked it at $24, which it eventually hit.
“A lot of people will buy a stock simply because it’s falling,” Stack says. “Investors buying a stock because it has hit a three-month or six-month low are buying it for the wrong reason.”
Conversely, investors shouldn’t be overly timid about buying a rising stock.
Shares of Google may have looked expensive as they rose from $100 to $125 late last year. But Google shares hit $125, then $150, then $175 as they headed for $200. It’s now selling for more than $225 a share.
“You can’t buy a Mercedes for the price of Chevrolet,” O’Neil says.
BUY AND HOLD: The recommendation makes some sense, but carried to the extreme it can be disastrous.
It’s true that some excellent stocks drop and then recover a few months later. But others take five years or longer to get back — and some never do.
“Investors don’t need to put themselves into the position of waiting around for years for a stock to recover,” O’Neil says. “If you have made a mistake, don’t jeopardize the rest of your portfolio. Sell it and move on.”
He recommends that investors sell a stock that drops 7 to 8 percent from the purchase price. This strategy keeps losses from becoming too large to recover.
The idea is simply to limit losses, he says, a concept that millions of technology investors probably wish they had followed in 2000 when the sector buckled.
THREE STEPS AND A STUMBLE: Another Wall Street adage that has lost its magic — if it ever had any. This refers to the impact that short-term interest rate increases by the Federal Reserve has on the economy and the stock market.
According to this rule, three rate increases will kill a bull market. There’s some logic behind this because higher rates mean increased borrowing costs for companies and make investment alternatives to stocks more attractive. But the truth is the rule lacks historical credibility.
In 12 instances since the 1920s, the Federal Reserve has raised the discount rate three consecutive times. Under the three-steps-and-a-stumble rule, those increases should have been harbingers of a bear market.
But in eight of those cases, the Standard & Poor’s 500 index was higher six months later, and in three of those, the gains were double digit.
Sometimes it takes only one rate increase to kill a bull market. This has occurred four times since 1929. One rate increase in September 1987 triggered a 36 percent drop in the Dow Jones industrial average.
While rising rates typically are a bad omen for stocks, investors should realize that other factors can mitigate the impact.
Since June 2004, the Fed has increased short-term rates eight times. But this series began with short-term rates at 1 percent — their lowest level in 40 years.
And the market’s reaction? It had a strong rally in late 2004 but has since given up those gains.
“There is no absolute level of interest rates or number of rate hikes that will provide exact guidance in knowing when to exit the market,” Stack says.
PRICE-TO-EARNINGS RATIO: A favorite tool of analysts and market prognosticators involves a company’s price-to-earnings ratio.
The P/E ratio is a company’s share price divided by its earnings per share. A company with a $40 stock price and $2 in earnings per share would have a P/E ratio of 20.
Conventional wisdom has it that stocks with lower P/E ratios are better values than higher P/E stocks.
But O’Neil offers this bubble-bursting surprise: Many high-P/E stocks have been excellent long-term performers, while those with low P/E ratios have performed abysmally.
Companies such as Microsoft and Home Depot had their best performances when they sported relatively high P/E ratios of 25 to 50 times earnings.
Conversely, shares of Gillette and Coca-Cola looked like bargains when they had low P/E ratios, but they were cheap for a reason.
High-P/E stocks typically are more volatile than low P/E stocks, but O’Neil advises investors against “P/E bias.”
Fast-growing companies with new products and new ideas will have higher P/Es, but that’s no reason to avoid buying them, he says.
THE SUMMER RALLY: With the end of spring, investors are bound to be treated to another faulty prospect: the summer rally.
The idea of a summer rally probably sprang from the notion that the market sometimes hits its yearly low in May or June.
But there’s no evidence to suggest the market does any better in the summer months, and the pros know it.
“I have never made an investment decision based on the idea of a summer rally or a May decline,” says Tim Morris, chief investment strategist at Bessemer Trust in New York. “It’s just not meaningful for me, and I don’t understand why people think that way.”
A couple of years ago, Stack unleashed his computers on the problem and analyzed 30 years of data.
The result: The Dow has gained an average of 6.6 percent from its low point in May to three months out.
But the same could be said for any other month.
“Market gains from the lows of early summer will actually be weaker than those beginning during the other months of the year,” Stack says.