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The financial news in the past week or so has been full of stories about GameStop, AMC Entertainment Holdings (AMC), Blackberry, Reddit, r/WallStreetBets, hedge funds, short squeezes, margin calls and Robinhood, among other things. Many of these stories explain parts of what is happening. However, they often use terminology that may be unfamiliar. My goal with this post is to help you better understand what is happening and what you are reading.
I’ll start with a brief overview of the news, in case you’ve seen only bits and pieces of it. I’ll then explain and provide examples of the important aspects of the story.
GameStop, AMC, Blackberry and a handful of other companies have not been doing well financially for various reasons. Many investors expect the prices of these companies’ stock to go down.
Some hedge funds, most notably Melvin Capital, have been betting that the stock prices will go down by using various tools that make them money if the price goes down.
A large number of individual investors have been buying stock in these companies. Many of these investors “connected” with each other on social media, primarily in the Reddit group, WallStreetBets. When there are more buyers than sellers, the stock price goes up.
These increases cause problems for investors who have bet that the stock price will go down. In fact, due to certain rules, some of these investors are forced to buy the stock to make whole on their bets which pushes the stock price up even further.
Brokers have to have cash to cover the value of any trades that haven’t been settled. Behind the scenes, it takes two business days for each trade to settle. The high volumes of trading over the past several days have increased brokers’ cash requirements.
Robinhood is a relatively new online-only trading platform that is attributed with being the first to offer free trades. Because of its relatively small size and business model, it didn’t have a lot of cash available relative to the volume of trades.
As such, Robinhood and some other brokers had trouble meeting their cash requirements. Some of them therefore halted trading in the high volume stocks. In a few cases, brokers sold the stock of some of their clients without asking.
The Wall Street Journal has a summary of what has happened in the past week with some great analogies, if you have a few minutes for a different perspective.
The companies targeted by WallStreetBets, including GameStop, have two common characteristics. First, they are all facing financial difficulties. Second, there have been a lot of transactions, measured by something called “short interest,” that take the bet that the price of these stocks will go down.
GameStop primarily sells video games from its stores. In recent years, people increasingly buy video games online or play in games that are hosted online. In addition, many of its stores are in malls that have been shut down or forced to limit traffic due to COVID-19 restrictions. As such, GameStop’s business model has become outdated. Unless the business model is updated, GameStop is unlikely to return to being a successful company.
AMC’s primary business is ownership of AMC movie theaters. Even before COVID-19, streaming services were significantly cutting into audiences at movie theaters in general. In the past year, attendance has decreased dramatically at most movie theaters if they are allowed to even open.
Blackberry
Blackberry was an innovator in smart phones, but has transitioned its business to focus on security software and services. It hasn’t made a profit in the past seven quarters and its revenues have been substantially flat.
Bed, Bath and Beyond is a retailer of home goods. As with AMC, it wasn’t doing well prior to COVID-19 due to competition from stores like IKEA and target. With the advent of COVID-19, Bed, Bath and Beyond started closing a significant portion of its stores.
As you read these stories, you’ll see the common theme that the companies aren’t doing well financially, especially in the current environment. As such, many investors have bet that the stock prices will go down.
On the other hand, these companies are making changes that could turn around their financial situations. Certain other investors, in part prompted by the r/WallStreetBets forum on Reddit, recently started investing in these companies. Their purchases of stock in these companies have driven their prices up substantially.
A true hedge fund is a pool of money (like a mutual fund) that hedges its investment risk. A hedge is an action that is expected to reduce the risk of your primary activity.
About a year ago, a friend of mine began to think that the valuation differential between Home Depot and Lowe’s was too great. He thought Home Depot was overpriced and Lowe’s was underpriced. He sold his position in Home Depot and replaced it with Lowe’s. By comparison, a hedge fund might have bought Lowe’s and entered transactions that allow it to profit it Home Depot stock went down.
The hedge or offset does not necessarily have to be a stock. For instance, you might like gold mining stocks but are concerned they might decline if the price of gold falls. To hedge this risk, you offset your stock position using one of the techniques discussed below that wins when the price of gold goes down.
The term “hedge fund” has morphed into a term that describes fat cats that viciously undercut the market with false rumors in an attempt to drive share prices down. There are a few of them. In reality, though, a hedge fund is simply a mutual or other type of fund that uses hedging as an investment strategy.
it is important to remember that, while hedge funds are businesses, they are ultimately owned by individuals. Some of the owners might be considered “fat cats.” However, there are many “ordinary” people who have investments in hedge funds. Some are direct owners, while others are participants in pension plans or own stocks in companies that, in turn, own the hedge funds.
Hedge funds, and many other investors, use tools that allow them to bet that the price of a stock will decrease. When you buy a stock, you are said to take a “long” position in it. You buy it because you think the price will go up. You want the value of your investment to increase along with it.
There are two tools that are commonly used when you want to profit from your expectation that the price of a stock will go down – short sales and put options.
In a short sale, the investor borrows shares from someone else and sells them. Retail investors, like you and me, borrow the shares through their broker from another of the broker’s clients who owns the stock of interest. For larger investors, there are other mechanisms that allow them to borrow shares. The investor pays interest to the lender to borrow the shares. At any point in the future, the investor can then buy the same number of shares. The purchase allows the investor to return the borrowed shares.
Here’s an example. An investor thinks that the GameStop stock price is going to go down from $20 a share to $10 a share some time in the future. The investor borrows the shares and sells them at $20 apiece. This transaction is the short sale. Let’s say the broker charges 2.5% a year in interest to borrow the stock. If the investor holds the short position for two years, the broker will get $1 a share (2 x 2.5% x $20) in interest over the two years.
If the GameStop stock price goes down to $10 at the end of the two years, the investor buys the shares. At that time, the investor returns the borrowed shares to their owner. The investor has made a $9 gain per share equal to the $20 it received for selling the shares minus the $1 in interest minus the $10 it paid for the shares. The only money the investor has paid out of pocket is the $1 in interest. In the interim, it has had the $20 per share in cash it received from selling the shares.
If, instead, the GameStop stock price went up and showed no sign of coming back down, the investor might have to buy the stock at $30. In this situation, the investor will lose $11 per share equal to the $30 it paid to buy the stock plus the $1 interest minus the $20 it received for selling the stock.
As illustrated, there is always the risk that the price of the stock will go up in a short sale which causes the investor to lose money. The broker who loans the shares doesn’t want to face the risk that the investor won’t be able to afford to buy the shares if the stock price goes up. To protect against this risk, the broker requires investors to hold money in their account at the time the short sale is made. This money, called a “margin,” acts as collateral for the broker and the person who loaned their shares to the investor. A common amount for the initial margin is 150% of the value of the stock being shorted.
I’ll continue the example from above. When the investor borrows the shares, the value of the position is equal to $20 times the number of shares. I’ll use 1,000 shares for this example, making the value of the position $20,000. The total value of the assets in the account must be at least 150% of $20,000 or $30,000, using the typical margin amount I mentioned above. Remember, though, that the investor has the $20,000 it received when it sold the shares.
When the stock price rises, the margin requirement rises accordingly. If the stock price went from $20 to $30 in our example, the investor would then have to have at least $45,000 of assets in its account. At that point and the broker required the same 150% margin, the investor has two choices if it doesn’t have that much money in the account. The investor can buy enough of the stock at $30 (an $11 loss in our example) to lower the margin requirement. Otherwise, the investor can move money from another account into this account so it meets the margin requirement. The broker’s requirement to either increase the total assets in the account (i.e., the margin) or reduce the short position is call a “margin call.”
I note that brokers have the ability to be flexible on the margin when the stock price changes, so the total amount of margin required in this example might not be as high as $45,000.
In a short squeeze, an investor is subject to a margin call. That investor can buy stocks to cover its short sales. When it buys those stocks, the stock price has always increased from the price at which the investor bought the stock. This difference causes the investor to lose money. The loss on that money further reduces the value of the assets in the investors account making it even harder for the investor to meet the margin requirements.
To be clear, there is nothing inherently wrong, illegal or immoral with short-selling stocks. Short sales are a valid strategy for limiting risk. Short-selling stocks is also a valid trading tool, no less moral than talking long positions in stocks.
Where it can go bad is when the short-sellers spread rumors and gossip, sometimes outright fabrications, in order to advance their positions. The same is true for people who fabricate stories to increase the price of a stock so they can profit from taking a long position. Using rumors, gossip or lies to manipulate the price of a stock in either direction is wrong and it is against the law.
Another strategy that investors use when they believe the price of a stock will go down is to buy put options. When you buy an option, you have the choice to buy or sell something, but aren’t required to do it. By comparison, when you short-sell a stock, you are required to buy it at a later date.
A put option gives the buyer the option to sell a stock at a pre-determined price, known as the strike price, by a fixed date. That is, unlike short-sales which have no deadlines, options have deadlines that limit the time frame during which the buyer can exercise the option.
If the stock price goes down before the deadline, the buyer can buy the stock at the then-current price and exercise the option to sell it to the person who bought the put option. When the stock price doesn’t fall below the strike price before the deadline, the option expires and nothing else happens.
As I write this post, the price of Boeing stock is $194.19 per share. The price or premium of a put option to sell 100 shares of Boeing stock at $195 on or before a week from today is $5.72. My broker may charge me a fee for buying the option in addition to the premium. For this example, I’ll ignore those fees.
Let’s say I buy that put and the stock price goes down to $190 at some point in the next week. I can exercise my option to sell my 100 shares stock at $195 per share or a total of $19,500. Just before I exercise my option, I will buy 100 shares at $190 per share or $19,000. My gain on this transaction is $494.28 which is equal to the $19,500 I get from selling my shares minus the $19,000 I pay for my shares minus the $5.72 I paid for the option.
If the price jumps up above $195 very early on the next trading day and never falls below $195, the transaction costs me only the $5.72 I paid in premium.
I don’t believe there are margin requirements to buy puts. I couldn’t find anything that confirms that there are no such requirements. It makes sense to me, though, because the investor can’t experience a loss once the put has been purchased.
At first, it might have seemed counterintuitive that hedge funds could get in financial trouble when these stock prices went up. It turns out they had significant short positions in many of these stocks.
I’ll use GameStop as an example. On January 12, the stock price was about $20 per share. By January 26, the stock price closed at just under $150 per share. There are approximately 70 million shares of GameStop outstanding. Let’s say a hedge fund short-sold 10,000,000 shares of GameStop at $20 on January 12. On that date and using the typical 150% margin requirement, it needed $300 million (= $20 per share times 10,000,000 shares times 150%) in its account as margin. When the stock price went up to $150 per share, the margin requirement went up to $2.25 billion (or a lower amount if its broker was willing to lower the margin requirement)!
If the same hedge fund had only $1.125 billion in its account in total, it would need to buy enough GameStop stock to reduce its margin to $1.125 billion. Initially, it could buy 5 million shares to reduce its short position. However, two things happen when it buys those shares. First, when someone buys shares totaling more than 7% of those outstanding (5 million / 70 million total is about 7%), the price of the stock goes up even further. Second, the company has to pay $750 million to buy the 5 million shares which will likely reduce the value of the money in its account. Remember that the hedge fund has to return the shares it bought to the lender. It doesn’t get to keep them in its account. You can see what’s coming next! With less value in the account, it needs to sell more shares . . . .
The hedge funds short-sold more shares of GameStop than are outstanding. It took me a while and some help from a friend who is a retired stock analyst to figure this out. Essentially, the hedge fund borrows the same shares more than once.
Here’s an example. Mary buys 500 shares of GameStop. She allows her broker to loan them out for short sales. Hedge Fund A borrows Mary’s shares and sells them to Joe who then sell them to John. John, in turn, allows his broker to loan his shares. Hedge Fund B borrows shares from John, but it turns out they are the same shares it borrowed from Mary! If this pattern happens often enough, investors can short-sell more shares than a company has outstanding.
I’ve read that the shares are supposed to be tagged once they have been loaned. The tags ensure that no shares are loaned more than once. I don’t know why these tags didn’t work the way they were intended.
Some brokers, Robinhood most notably, restricted their clients’ ability to trade in some stocks and, in some cases, sold clients’ shares without their knowledge or agreement. Initially, I saw rumors that these restrictions were to protect the clients from too much risk or to help bail out the hedge funds. The reality is that some brokers were having their own version of a short squeeze, though it wasn’t a short squeeze and isn’t called one either.
Most individual investors are unaware of the process of settling stock trades. From our perspective, it appears that we can instantaneously buy or sell a stock. What actually happens is that the order goes to a clearinghouse. It takes two days from the time you place your order until the clearinghouse settles the trade. In the meantime, brokers are required to have cash as collateral until the trade settles. I have not found exactly how much cash is needed, but it bears some relationship to the market value of the trades that have not settled and the clearinghouse’s perception of the volatility of the stocks being traded.
As investors made more and more trades at higher and higher prices, the dollar value of unsettled trades skyrocketed. Some brokerage firms didn’t have enough cash to meet the collateral requirements, with Robinhood being one of them. When that happened, Robinhood couldn’t accept more trade orders until one or both of its cash requirements were lowered as trades started settling or it acquired more cash.
The information in this post is based on my understanding of what happened. I have no first-hand knowledge. I have done my best to provide a fair and balanced explanation. It is not clear that everything that has happened is completely legal. I will leave it to the Securities and Exchange Commission, among other, to sort out those details.
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Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab. In the past, I haven’t been one to re-balance my portfolio, so I spent some time thinking about why I haven’t followed this common advice. Up until recently, almost all of my invested assets have been equities, equity-based mutual funds or exchange-traded funds (ETFs). As such, I didn’t need to do any re-balancing across asset classes.
In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks. I’ll also explain my strategy (which may or may not be right for you).
Re-balancing is the process of buying and selling securities in your portfolio to meet certain targets. In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.
Some people have targets that define their desired allocation across asset classes. One common rule of thumb is that the portion of your portfolio that should be in bonds is equal to your age with the rest in stocks. In my case, that would mean roughly 60% of my portfolio in bonds and 40% in stocks. The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets in retirement.
The process of re-balancing is fairly simple. Periodically, such as once or twice a year, you compare the market value of your investments with your targets. If there is a significant difference between how much you own in an asset class and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.
Let’s say your target is 75% stocks and 25% bonds. You start the year with $10,000 of investments – $7,500 in stocks and $2,500 in bonds. If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875. Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds. To put your portfolio back in balance, you would need to sell $94 (= $8,250 – $8,156) of stocks and buy $94 of bonds.
You can avoid selling any assets if you have money to add to your investments at the end of the year. Continuing the example, let’s say you have another $500 available to invest at the end of the year. That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash). Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds. In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assets.
The chart below compares the average annual returns and risk profiles of several sample portfolios with different mixes between stocks and bonds. In the middle four portfolios, the first number is the percentage of the portfolio invested in stocks and the second number is the percentage in bonds.
In this chart, the average annual return is represented by the blue dash. When the blue dash is higher on the chart, it means that the returns on the portfolio were higher, on average, over the historical time period.
The green boxes correspond to the ranges between the 25th percentile and the 75th percentile. The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile. When the box is tall and/or the whiskers are long, there is a lot of volatility. In this case, it means that the annual return on the portfolio varied a lot from one year to the next. At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.
I have arranged the portfolios so that the one with the most volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right. You can see how adding bonds to the S&P 500 reduces volatility as the height of the boxes and whiskers gets smaller as you move from left to right. At the same time, the average annual returns decrease as bonds are added to the portfolio. Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond Fund had an average annual return of 7.2%. By comparison, returns on investment grade bonds are currently generally less than 4%.
Because stocks and bonds are not 100% correlated, the volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility of owning just the riskier asset – stocks. As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolio goes lower than the bottom whisker for the 80% bonds portfolio.
Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolio with 80% bonds and 20% stocks. The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time! As more bonds are added to each portfolio, the blue bar/average moves down. This downward shift actually moves the whole box and the whiskers down.
This relationship can be seen in the chart below.
The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios. The horizontal or x-axis on this chart represents the average annual return. Values to the right correspond to higher average annual returns (which is good). The vertical or y-axis represents the percentage of years with a negative return. Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).
“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns). Any time a point is further to the right and at the same level or lower than another one, that portfolio better meets your objectives if probability of having a negative return is your risk metric.
I have circled two pairs of dots. The ones in the lower left corner are the two I’ve mentioned above. The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point. As you’ll recall, the average return on the 20% stocks portfolio is higher than the average return on the all-bond portfolio so the dot is to the right (better). The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolio so the dot is lower (also better).
There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right). The 80% stocks point is at the same level and to the right of the 60% stocks point. As such, if average annual return and probability of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same risk.
Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a risk/reward mix that meets with your financial goals. As I indicated, the purpose of re-balancing is to ensure that your portfolio is consistent with your goals. However, it is important that you considering the then-current economic environment when re-balancing.
For example, interest rates are lower than they were at any point in the historical period used in the analysis above. Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase. If interest rates stay flat, the returns on bond funds will tend to approach the average coupon rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held. This range is much lower than the average annual return of 7.2% in the illustrations above.
If interest rates go up, the market price of bonds will go down, lowering returns even further. As such, the risk-reward characteristics of bonds change over time. I would characterize them as having lower returns and higher risk (the one-sided risk that prices will go down as interest rates go up) now than over the past 40 years.
Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty. While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.
If you re-balance your portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest. With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.
Another consideration when you are deciding whether and how often to re-balance your portfolio is income taxes. Every time you sell a security in a taxable account, you pay income taxes on any capital gains. If you lose money on a security, the loss can offset other capital gains. On the other hand, if you own the securities in a tax-free (Roth or TFSA) or tax-deferred (traditional or RRSP) account, re-balancing has no impact on your taxes.
Let’s look at an example of the taxable account situation. If you targeted a portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.
In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year. A bar that goes above zero indicates that you would have bought stocks in that year. A bar that goes below zero indicates that you would have sold stocks in the year. The proceeds from every sale would have been used to purchase the bond fund. Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.
In every year, you either sell some of the stock index fund or the bond fund. The difference between the price at which you sell a security and the price at which you buy it is called a capital gain. You pay income taxes on the amount of capital gains when they are positive. In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes. The Canadian tax rate on capital gains is of about the same order of magnitude.
Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period. Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes. By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.
As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.
You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classes, such as stocks and bonds. My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes. By keeping my invested assets in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.
The chart below helps to illustrate this perspective.
It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio of 60% stocks and 40% bonds over one year.
The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return. Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.
Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classes. The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio. That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio. However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.
The comparison on which I focused in selecting my investment strategy is the one between the second and third bars. That is, I compared the volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year. As can be seen, there has been less volatility in annual stock returns when considered in five-year time periods. Yet, the average return on stocks is higher than the average return on the blended portfolio. Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.
Your time horizon until you might need the money in your investment portfolio and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolio is a better fit for you.
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Before we talk about the specific indicators that would signify stock market sell signals, we must understand why we bought each stock in the first place. The simple theory of ‘buy low, sell high’ seems practically very easy, but the reality of the situation is much more complex. When investors look to spend their hard earned cash on stock market investments, it is absolutely necessary that they buy stocks when they are relatively undervalued in comparison to the company or market as a whole. What investors need to assume is the fact that you make money at the price you buy at, not the price you sell. It is imperative as an investor that you understand both sides of the coin when it comes to buying and selling stocks. A breadth of knowledge in technical, fundamental, and psychological factors that affect stock prices will give you an edge.
Many factors can be used to help look for and find buying opportunities. When buying stocks, look for low price-to-earnings or P/E ratios relative to the industry average or a P/E ratio that is near the low of its five-year range. Find companies with strong earnings and ones that have an economic moat that will protect said earnings. Use short-, medium-, and long-term charts to identify if the stock has a history of growth. You’ll be surprised how many companies don’t make money or make less than before, and the stock chart usually reflects that. Finally look at the business you are interested in from afar. Is it growing? Does it change the world we live in positively? How does its competition look? Utilize everything you can when looking to buy stocks. Trades should be based on calculated risk. Without that, you are gambling.
Now that we’ve discussed why we would buy a stock, let’s dive into why you should sell a stock. As the market moves, it’s important to keep an eye on how your company looks from a financial standpoint. Below we will discuss in detail some key fundamental metrics that could be used to signal that a stock is overvalued, also known as stock market sell signals.
The P/E ratio is used to show how expensive a stock is relative to the money it earns. The first check you can perform on any stock is to compare the stock in question’s P/E with the sector average. If the stock’s P/E is higher than the sector average, then the stock is relatively more expensive than the sector’s average and can be considered a sell signal. Some companies (typically tech companies) carry a high P/E due to the public pricing of future earnings. This is why the next step would be to compare the stocks P/E within a five-year range of its own P/E. If the stock is near the top of the five-year range, then it’s more overvalued than it has been in the last five years, which could be an indication to sell.
Next, with a word of caution we can look at the Forward P/E. I say with a word of caution because this is based on analysts’ expectations and guidance set by the company. Don’t forget these are educated guesses – they can be spot on or miss the mark completely. Typically, when the Forward P/E is higher next year than the current P/E, there is a projection of lower earnings. Most, if not all, investors should invest in companies projected to make more money quarter over quarter and year over year. This too could be used as a signal for when it’s time to sell a stock. With some simple yet advanced tactics, you can even project the stock price in a range for the next year. Want
The price-to-book (P/B) ratio is a comparison between the market valuation and the book value of the company. A good buy point for any stock is a P/B under 1. But, when a stock’s P/B is higher than the sector average, then it’s relatively expensive. This comparison could be used to signal when to buy or sell depending on what the P/B is at, as well as how to compares to the industry average. Another word of caution – use this as a checkpoint and not a definitive buy/sell signal. Sometimes companies can window dress book value causing the P/B to appear lower than it really is, so again be cautious.
Earnings per share (EPS) growth uses projected earnings to give us a glimpse into what may happen next year. This can also be used to understand trends. Is the company constantly growing its earnings? Is it stable, consistent growth? If the answer differs from its history, it could be one of our stock market sell signals. The importance of earnings growth is that the stock price inevitably follows earnings. Some newer companies could have growth based on expected future earnings, but the stock price generally reverts to the mean at some point – all based on the company’s actual earnings.
If a stock has a debt load, it is important to assess how management is handling it. Is management letting debt grow or paying it down faster than expected? The answer is important because a building debt load increases the interest expenses the company will have and therefore affect the bottom line.
We want to focus on year-over-year changes in the debt/equity ratio as well as the long-term debt/equity ratio. We want these ratios to either be a low stable number relative to the industry average or we want to see that management is actively paying it down. In doing so, shareholders equity or the value of the shares you currently own will increase. When the opposite is happening, such as erratic or increasing debt loads, we should be concerned and possibly ready to sell. If you want to look at a year-over-year trend of these statistics, Charles Schwab has some great tools that come with its account. Below we can see the five-year trend in graphical form to the left, a definition of the ratio in the middle area, and the current value of the ratio to the right for a sample company.
Do you want to open a Charles Schwab account to access these awesome features? Click this link to sign up, it only takes minutes! http://www.schwab.com/public/schwab/nn/refer-prospect.html?refrid={REFID}
Sometimes the best way to tell if it is time to sell a stock is to see if the story has changed.
Before you ever invest in a company, it is imperative that you look at the business from every angle. It is necessary as an investor to know what you are buying and why you are buying it. You would not buy a car without test driving it, would you? Typically, you look at Consumer Reports, talk to people who have owned that car model, and look at safety ratings and mechanical flaws or misnomers. The same can be said for stocks – look for changes in the income statement, balance sheet, and statement of cashflows. When these things begin to change from your initial thesis, it may be a stock market sell signal.
When management changes, it may be time to sell. Typically, stock prices fall when new management is announced because a different mindset is at the helm of the company. People may have the same goal, but different paths to reach said goal. The story can change on a multitude of levels. Even if the financials are still intact, if the story about who it is as a company or what it does has changed, it may be one of our stock market sell signals.
An example of this is the Chinese company, Lukin Coffee, which, from its financials, was poised to be the next Starbucks. It was later realized that the earnings were not as they seemed and they were forging financial documents. The stock tanked and has since been delisted from the NASDAQ. Sometimes you can see the smoke before the fire and get out of a stock, and sometimes you will have to get out while down to prevent a total loss. As a caution, though, a decrease in a stock price isn’t always a sell indicator. In fact, in some cases it may be a chance to buy more of the company’s stock. So, you’ll want to be sure to understand why the stock price has decreased.
The stock market moves in and out of sectors like the tides in the ocean based on the current point of the economic cycle. Understanding where money is moving in and out of could be used as a signal for when to sell a stock. The best way to grasp this concept is to take a step back and look at the overall economy. During times of fear, the best investments tend to be non-cyclical defensive positions like grocery stores and household goods. In a depression or economic contraction, you may not buy a new iPhone, but you will still buy bread and toothpaste for your family.
Many graphics can be found by googling ‘sector rotation’ to give you a better idea as to what are the best sectors to invest in based on the economic picture at hand. Trying to time the market tends to not be a successful strategy. The old saying goes, ‘time in the market is better than trying to time the market. Use sector rotation to either sell at right time or buy on the dips when the sectors rotate.
As you build your portfolio, if you invest in great companies, then eventually the underlying stock prices should rise. As those stock prices rise, the overall percentage that it takes up of your portfolio rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolio to avoid company specific risk.
Now you have some stock market sell signals! Remember that you should only invest in what you know. When things start to change, do whatever you have to in order to protect your money and continue to grow your wealth. Good luck investing!
The All Seasons Portfolio reports amazing statistics about its returns. I’d never heard of the All Seasons Portfolio, so had to check it out. As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to …