There is an entire school of investing that would have you screening for stocks that are making new lows in price on the assumption that the best values can be found in that group. I recently wrote about the strange psychological wiring of value investors who believe that they can outsmart Mr. Market and find investment ideas that are mispriced by the crowd. They are supported in their belief by the study of momentum and crowd psychology which shows that investors often over react to bad news and sell securities at prices well below their intrinsic value. With steely nerves and an ability to see value that the rest of the market doesn’t see, value investors are the heroes of the professional investment universe (foremost among them, of course, is Warren Buffett).
On the other hand, there is a huge school of investors who search the universe of stocks looking for stock prices that have just made a new high. Making a new high in price is a magical moment for these investors because it means that everyone who had previously purchased the stock at the old high and wants to get out of the position to cover their losses has now already done so. In other words, if you bought a stock at $100 per share and it declines in value to $75 per share, you might be anxiously waiting for the stock to recover to $100 per share so you can sell it and escape your position without a loss. Identifying the highest price at which the ‘suckers’ purchased the stock in the past allows us to draw a line called price “resistance.” Until the stock (or the stock market) makes a new high, there are still sellers out there selling the stock as it moves higher in price. But once the stock makes a new high, then all of the resistance is gone, all of the prior buyers have sold, and now the price is free to soar without the baggage of selling by previous buyers. Wonderful!
In addition, by buying when a stock (or the stock market) reaches a new high, you can claim that you are free to participate in a longer-term secular bull market move, which implies that huge gains are just ahead. While the market may have rallied 100% (in our case it has rallied over 130% from the market lows in March of 2009 to the new high of 1569 last week), excited investors would gleefully and correctly point out that you can’t gain 1000% in the stock market without first gaining 100%, and then 200%, and then 300%, and so on. When the market makes a new high, it is a signal that the optimism of investors who had the nerve to buy at the lows was correct, and there’s still time for everyone else to get in on the action. It’s a great feeling for investors who completely missed the bull market cycle from the previous trough to a new high to know that the market can move higher still.
Those investors who screen for new highs are the complete opposite of investors who buy at new lows. Bottom fishers revel in the notion that they are being contrarian investors who are buying when there is “blood in the streets.” After all, you don’t buy umbrellas in a rain storm if you want the best price. But investors who screen for new highs revel in the notion that they are in sync with the crowd of investors. They believe that the market has all of the information it needs to make a good decision about stock prices, in aggregate; so if the market reaches a new high, it is signaling good times ahead. When the crowd of investors feels the same way about this very positive turn of events, then positive momentum in prices takes over and the thundering herd of bullish investors is free to take prices even higher.
Today’s financial news is filled with pundits taking one side or the other of the Value Versus Momentum debate. To my mind, both camps have a point. Pinnacle tends to view new market highs in the context of the current market cycle. In this case, the investment team has concluded that the cycle has more room to go… though the risks are increasing. We are now four years into the current bull market cycle that began in March 2009. It is worth noting that the last bull market in the current secular bear lasted five years, from 2002 to 2007. Needless to say, that bull market didn’t end well for investors. We continue to monitor the weight of the evidence in deciding whether risk taking is still warranted at this new peak in market prices. So far the answer is yes, but only at neutral or benchmark levels.
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