Death, Taxes and Overreaction by Investors…and Two Trade Ideas

“…..in this world nothing can be said to be certain, except death and taxes.”

– Benjamin Franklin, 1789

If Benjamin Franklin had been aware of the Dutch Tulip Mania that occurred in March of 1637, a mere 150 years earlier, he may well have added “overreaction by investors” to the end of his now famous quote.  As described in a book by British journalist Charles Mackay in the mid 1800’s, the price of Tulip bulbs in Holland shot up by 20 times their normal value in one month’s time due to speculation and were being traded in exchange for acres of land and even full estates.  The prices of course eventually crashed, investors were devastated, government intervention was fruitless and a depression followed.  For tulip bulbs?

Most recounts of this story are in the context of investor speculation and the creation of asset bubbles.  However, there’s a another lesson that is not as often discussed, but is just as reflective of human psychology and as powerful in its impact on the markets.  What happens when the bubble bursts?  Negative news hits the market, or in the case of the tulip bulb mania buyers didn’t show up at an auction for fear of contracting bubonic plague, and that’s all it takes.  When fear sets in, investors react the same way today as they did 400 years ago…they overreact.  Just as tulip bulb prices crashed and eventually fell well below the normal trading range, we’ve seen this happen over and over throughout history with some recent examples in the stock market alone being in 1987, 2000, 2001 and 2008.  Bad news or events turn to fear, and fear sets off a rush for the exits with the same momentum and enthusiasm as the impact of euphoria on the way up.

This phenomenon of overreaction to news and events does not just happen in the extreme, but rather is impacting security prices on a daily basis in the markets.  Securities of all sorts go on a nice run, news or information hits the market that’s negative, and it starts a chain reaction.  Buyers pull back, the fear of loss encourages profit taking, the selling accelerates and the behavior and pattern repeats with greater momentum leading to the sell-off being overdone.  The fear of loss, and overreaction to news, is a powerful and predictable behavior that can be modeled to great benefit by all investors regardless of approach or time horizons.  How?

The simple answer is EidoSearch (product placement!), but specifically by having an objective input for understanding how investors will once again react, or in this case overreact, to current trends as they have been doing for centuries.  A great and more recent example is with Tesla Motors.  Last year, investors shot Tesla all the way up from $40 in the beginning of April to $193 by the end of September.  Then came the reports of a few car battery fires in a short span in early October.  Although this is statistically insignificant based on the number of cars they have in the market that have had no issues, investors became fearful and the trickle-down effect (or in this case the dam breaking) ensued.  Investors proceeded to trade Tesla all the way back down to $121 by the end of November.  An almost 40% drop in only two months.  Just as the fundamentals of the stock didn’t justify an almost 400% increase in 5 months, the three battery fires didn’t justify a drop of $70 in two months.  This was not about fundamentals.

This is a repeating behavior, reaction and pattern in the markets, and the stock price for Tesla was going to rebound.  But when?  That’s where the modeling comes in.  We took the one year price pattern for Tesla (chart below) through to the low point of the sell-off when it had dropped down to $121, to find the most similar occurrences of this price trend historically and to see how investors typically reacted in the next 3 months.

The chart below highlights the forward returns of the most similar historical occurrences of this pattern in Consumer Cyclical stocks.  The average return in the next 3 months was 20%.

Are we suggesting a long term fundamental investor take positions based on this information alone?  Of course not, but what we are highlighting is the impact of price trends, driven by investor behavior, in the markets.  Ignoring these inputs is leaving money on the table in many areas of the decision making process including overweight/underweight decisions, trade timing for adding to or trimming positions, risk management, etc.

Another benefit in understanding price patterns is with idea generation.  We took the same one year price pattern for Tesla after the sell-off to $121 in late September.  Per the above, we already know how investors have reacted historically to this pattern, so we decided to look for similar instances of this one year pattern occurring RIGHT NOW to see what other Consumer Cyclical stocks look poised for a rebound.  We found a bunch with high similarity to the pattern in Tesla, and have highlighted a couple of them below:

• Tractor Supply (TSCO):      Average return of this pattern in the next 3 months historically is 9.99%
• Polaris (PII):                        Average return of this pattern in the next 3 months historically is 9.58%

These are powerful indicators, and combined with an investors experience and the primary factors (fundamentals, etc.) in their tool kit, can lead to tremendous opportunities.

Current one year chart for Polaris Industries (PII)      

Current one year chart for Tractor Supply (TSCO)