The cyclical nature of stocks.
The life story of a stock
As a trader, it is immensely helpful to know the life cycle of a stock.
Each stock goes through a cycle that starts with a lull in the stock price, travels through excessive enthusiasm, and ends with a precipitated decline or a long-time correction when the stock doesn’t go anywhere and stays in a prolonged range.
A typical cycle of stock looks like this:
The stock is said to be a value stock when it is completely ignored by the market. The ignorance is mostly because of a lack of fundamental positives. The stock may remain a value stock for times ranging from a year to decades altogether. Some stocks remain in the value stock zone for life and never come up.
I speak of opportunity cost a lot on my channel, imagine being invested in a stock for decades without a return.....
If you are a momentum trader, stock in this phase will never attract you. Value stocks are mostly picked by long-term investors who do a deep dive into the company’s business to track the changes happening in the company. They are much ahead of the rest of the crowd in identifying opportunities in value stocks.
As mentioned, some value stocks tend to have a fundamental backing that is figured out by value investors. Ultimately those fundamental factors lead to a positive surprise in the earnings, which brings the stock to the radar of other opportunistic investors and traders.
As the earnings surprise comes, these investors figure out the reason behind the surprise, and based on the sustainability of higher earnings, investors choose to invest or traders decide to trade the stock.
Sometimes it’s not clear from the start how far the earnings will grow. Therefore, investors take the leap of faith based on the upside of the story, while still digging into the story to find more about the stock.
The analyst community also takes note of the earnings surprise and apprises its earnings forecast of the company, building in the new factors that are leading to better earnings.
The analysts only make incremental changes, in the beginning, being conservative and leaving a lot of room for error in forecasts.
Whatever forecasts the analysts put out become a comparison benchmark for successive quarter earnings.
The company comes out with another strong quarter, beating analysts' estimates.
More people take notice as good quarters pile up. The stock goes onto the institutional investors' radar, who start researching the stock to buy in big numbers.
This is where the institutional demand comes in, often classed as Smart Money.
Institution after institution get interested in the stock and start piling up the stock, building the momentum in stock price. As these institutions are big buyers, they have the firepower to move the stock price significantly.
As the momentum in stock price builds in, more momentum traders take notice and look for entry while the party is still on.
The stock is now halfway through in the journey.
EPS momentum (Growth Stock)
The company continues to post significant earnings growth, beating analysts’ estimates quarter after quarter and now every person on the street knows about the stock.
It has become an institutional darling and now the entire street thinks that nothing can go wrong with the story. Every potential buyer has now filled a truckload.
Loss of growth momentum
Growth hits a roadblock. The triple-digit growth gets down to double digits, but the story still remains intact, at least for the hopeful crowd. People take confidence in the fact that the company is still growing better than the other slow-growing businesses in the market.
The return ratios are decent and balance sheet is looking good.
This is the start of the decline, where smart investors look to exit regardless of the stories floating around. Swing traders might still be interested in squeezing the last move from the stock while following tight stop losses. New investors stay invested thinking that the company is the next Google or Apple.
The analysts that were conservative at the beginning are now aggressive with their estimates. Some of them are more confident than the company’s management about the growth trajectory of the company.
A lot is now expected from the company and unless the company does some financial jugglery, it will be difficult to deliver the expected growth.
The high analyst estimates eventually become too high to beat and the company misses those estimates due to lower growth or other challenges. Hell breaks loose when this happens.
The price adjustment for the disappointment is severe and quick. Months of the up move in the price goes into thin air in days. The investors who did not sell earlier when the signs of crack started appearing in the precious phase are now trapped, often referred to as dumb money.
Another big mistake is made in this phase. Looking at the price collapse, some investors compare the new price to the stock’s recent high and think of it as a bargain and lap the stocks up, averaging down, thinking the overall cost of acquisition is lower now.
This approach is ok for a well diversified fund or Index, but for a singular stock this can lead to disaster.
Jeremy Lefebvre (Financial education) is a fine example -
The analysts now become more reasonable with their estimates and revise them downwards in the wake of new information.
The price continues to slide or keeps consolidating at this point. The hope traders are now depressed seeing the lower crashed stock price and their dead investment. They still keep on, reading up positive stories on the company and completely ignoring the contrary information. (AKA cognitive bias).
The stock has now been languishing for months and is now back in the phase in which it started. It will spend months and years in this phase and will either go dormant at some point or get a new lease of life if fundamentals improve in the future..
The investors who did not exit earlier are now married to the stock. They will either exit at a deep loss, keep the stock forever or get out at breakeven when the stock moves again, missing the rally that ensues after they sell their holdings.
Investors and traders who know the typical life story of a stock get in and get out on time and never get married to the stock. It won’t be obvious to you as a beginner but will build as you mature.
The key is to always follow the price and never blindly believe in stories. Price somehow alerts the investor in advance before the actual turnaround or tragedy happens.
You must be smart enough to catch those signals. Reading this article or learning my strategy below could be the first step towards that.
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