Luck and Randomness in the Market
A Liquid Leader that’s Tightened Up
Staking your professional life to the ways of the stock market is a funny thing. I’ve worked my whole post-college life in a job that’s tied directly to the stock market, writing about it, recommending stocks, decoding the market’s message and so on. And that means there’s been a great deal of randomness to my day-to-day activity—it’s depended on how the market and my stocks were acting.
I’ve thought a lot recently about what it would be like to have a “regular job,” where most people feel that every day (or every week) they’ve made some progress. Don’t get me wrong—I know that every job has its down days, but usually, if you’re working on a project of some sort, you likely feel that you’ve earned your keep and made some progress each week.
In the stock market, that’s not necessarily the case. It’s similar to being a football coach—you put in all sorts of effort, but whether it’s because of mistakes or just a bad bounce of the ball, there’s nothing that says you can’t come out on the losing end of the scoreboard that week. There’s just a random aspect to it.
Jim Cramer loosely alluded to this in his first book, Confessions of a Street Addict. (It was written back in the early 2000s, well before his recent popularity. I know he’s written a couple of newer books, but his first was one of my all-time favorites; I highly recommend it.) He has a passage about how, despite all the brash talk and overconfidence of many fund salesmen, those in the know realize there’s a healthy dose of luck and randomness involved:
“Managers pitch themselves as having strict stops on the downside, hard and fast rules about selling “overvalued” stocks—whatever the heck those are—or ironclad strictures about stocks with high price-to-earnings multiples. The more certain and insistent and self-assured a manager comes across, the more warning lights should flash in the client’s head. The humbling nature of stocks and bonds is the only true precept, and those who have no humility are the first to get their bells rung. The great ones never admit that their principle attribute is luck, but they know it and confide it to others when they are in the hedge fund clubhouse, safe from clients’ ears.”
Later, Cramer wrote about the fallacies of Long-Term Capital Management, a giant hedge fund that blew up back in 1998 and took the whole market down with it for a bit:
“In retrospect these experts [from Long-Term Capital] were simply a group of gambler salesmen who hired academics to gloss up the joint and give it a look of certainty. We accepted the markets for what they were, totally unpredictable, chaotic, and incapable of being gamed by large amounts of money without distorting the process.”
There are three chapters of this stuff, where Cramer goes into detail about how he almost blew up during this period, partly because of LTCM’s failure. Again, it’s a terrific read.
At this point, you might be wondering if you should conclude that Wall Street is one big roulette wheel and you might as well hit the casino instead. But don’t fret—in the long run, sound rules and tools do make a difference. I believe Cramer himself, before retiring from the hedge fund world, made north of 20% annually for more than a decade. And here at Cabot, we haven’t been able to stay in business since 1970 simply because of luck!
Instead, the real question is how can you make the market’s randomness and luck work for you, instead of against you? To me, there are two basic ways, one mental, one tactical.
Mentally, knowing that your short-term, week-to-week results involve a great deal of luck, it’s easier to shrug off down days and keep an even keel when your stocks shoot higher. I find this to be one of the biggest differences between experienced, successful investors and beginning investors who are struggling to make money.
Now, don’t get me wrong—I can get as moody as anyone when one or two of my stocks collapses on earnings or gets nailed on a random rumor. I’m human! But it’s important not to personalize your results, either on the upside (“I’m a stock-picking god!”) or the downside (“I’ll never make money again!”). Instead, it’s better to think of each trade as just one of 500 more you’re going to make over the next many years.
Second, I think you can use the element of “luck” to your advantage when managing your portfolio. How? By letting the market make more decisions for you; or, said another way, by using the action of the market and your stocks as a feedback mechanism.
By that, I mean you should plan your trade ahead of time—not just what stock to buy and where to buy it, but where your loss limit will be, how you’ll trail your stop, at what level you might buy more, etc.—and then stick to that plan. If you do this with a handful of new buys, you’ll let the stocks themselves tell you which ones are going to be the big winners, and which ones won’t.
Too many investors do just the opposite—they actually trade themselves out of “good luck” by selling too early, or being shaken out on a normal pullback or by not having the patience to sit through a three- or four-week quiet period. This was actually one of my biggest lessons from 2010; I got shaken out of winners like Acme Packet and Netflix too early, and then watched in agony as those stocks doubled and more in the months after. The Model Portfolio was up 27% that year but we could have easily been up more than 40%; it’s a mistake that I’ve learned from!
The upshot of all this is that luck really does play a big part in the market. But it’s not as random as you think, and the good news is that practicing sound rules and giving your top stocks a chance to keep growing can put luck on your side.
The market has been acting about as expected during the past couple of weeks—the major indexes have paused to digest their huge gains from the late-June low (though today might mark the end of that pause), while individual stocks have been all over the place in reaction to earnings reports.
Overall, the tenor is bullish, and while there are a couple of yellow flags—the number of stocks hitting new lows stubbornly refuses to dry up for more than a few days—the onus is definitely on the bears to show they want to take charge.
Thus, I’m still in a buying mode, though holding a little cash on the sideline isn’t the worst idea as earnings season progresses.
In terms of stocks, well, there are a lot of good-looking ones. As a rally progresses, the temptation is to start looking for more and more leading stocks ... and indeed, you always want to keep your eyes open for emerging leadership. However, most investors take that lesson too far—you really only need a few great stocks every year to make good money. Thus, while staying flexible is key, it’s imperative to remain focused on the liquid leaders.
One of those is Cree Inc. (CREE), which is leading the LED lighting revolution. The big idea here is that, after years of promise, LED technology has advanced (and the prices have fallen) enough to cause mass adoption—for many commercial customers, payback of more expensive LED lights and lamps is less than a year, and even for the average Joe, buying a Cree bulb at Home Depot will pay you back in about two years. And all of Cree’s lights have 10-year warranties, and a rated life of 22 years!
Some of the numbers and possibilities being thrown around are truly mind-boggling—McKinsey, the global consulting and research behemoth, estimates that the share of LEDs in all lighting solutions (residential, commercial, industrial, etc.) is about 8% today ... but that should rise to 50% by 2015. Imagine! Helping that along will various restrictions on the sale of incandescent light bulbs—in the U.S., 75-watt bulbs can no longer be made, and 40-watt and 60-watt bulbs will be gone next year.
Yes, there are still CFL bulbs (the swirly-looking ones), but those have mercury, are a pain to dispose of, and aren’t quite as efficient or long-lasting as LEDs.
Of course, there are other players in the field (including Philips), and Cree’s stock has had a huge run this year, so I certainly won’t say there’s no risk here. But after being one of the first stocks to push to new highs following the market’s June 24 low, CREE has paused in a very, very tight range (basically between 68 and 70.5) for three weeks.
Earnings are due out on August 13, and that will be the key event. But if you’re game, I think you could buy a small position here, maybe one-third to one-half of what you would normally buy, dollar-wise. That way, if the stock falls apart after earnings for whatever reason, you won’t be too hurt. But if it surges higher, you can look to buy more as this story unfolds.
All the best,
Analyst, Cabot Market Letter
and Cabot Top Ten Trader