Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited. — George Soros
When someone has conviction, it is actually usually a sign of weakness. Failing to admit you are wrong can cost you big time. Eventually your emotional state will change and you will have to manage risk somehow or you may even need the money. So many fundamentals that you would think of as a positive are actually just traps. When a trade is too obvious it attracts weak hands and the market will transfer capital from the strong to weak hands even if it needs to move against common sense first to do it. Conviction is a bias of the ego in being unable to see the emotional components of the “id”, which ultimately governs behavior.
The vast majority of capital either has no choice but to try to outperform every single Quarter or they lack the discipline and patience to sit on their hands for a decade. So, most of the time, the best trade is to trap more and more people into bad fundamentals and squeeze every last short seller for as long as possible. Meanwhile they’re forced to neglect or even sell the best values and push them down to greater discounts.
Nearly every time there is a rally in an underperformer, the buying will be sold into. This will continue until the point when all that is left is deep value investors with maximum patience stepping in as everyone else sells. This may happen on bad news and concerns about future prospects so the maximum amount of people sell their shares. Then and only then when a stock has either capitulated or reached severe neglect is when fundamentals may actually matter.
The largest players are waiting for liquidity to accumulate. If they don’t, their demand will drive the stock higher before they can accumulate shares. They won’t create a floor in price until maximum selling allows them an in.
This need not be a conspiracy, but instead a mechanism. When everyone has sold, after selling pressure reaches its maximum, the position is so underowned that there are not enough people left who are willing to sell it to keep prices down. So selling pressure is over and it is not going to trade down. Then, it takes very little buying pressure to form a bottom. Conversely, when everyone has bought, there is no more buying pressure left and it takes maximum buying pressure just to maintain prices.
When a stock has a lot of short sellers because of legitimate reasons to sell while the stock is moving upwards, you are still far from the maximum buying pressure and short sellers must either successfully short a stock to exactly zero, or cover their shorts. Any buying at all can absolutely roast short sellers and that is where new sellers will emerge and either end up under positioned and have to chase, or end up shorting the stock and being vulnerable to placing market buy orders or margin clerks forcing them out later.
Valuation matters, but only at the extreme. When the dot com bubble stopped being able to pump easy money in and all the individual average Joes began to exit, THEN fundamentals mattered and everything overpriced without a sustainable business model adapted or went to zero all while one of the most neglected securities at the time (gold) bottomed around $200 / ounce. After selling pressure rinsed the market clean of any notion of buy and holding in 2002-2003, perhaps then some fundamentals mattered as that was the opportunity to get a stock at a good price until the market already gave you that fat pitch and then people begun being forced out into trash. Then in 2007 selling all the companies with CDO and CDS exposure and in 2009 buying the classic strong fundamentals for pennies on the dollar.
I recently analyzed a handful of different fundamental readings and I am convinced of these ideas now more than ever.
Methodology
I first wanted to know what percentage of stocks met certain performance threshold. Then I looked at the number of stocks that passed a particular fundamental threshold ane I looked at the percentage of all of those names that were superior performers.
If the fundamental was credible in the current environment, my hit rate should mostly continue to go up as the metric improves. It often didn’t. Even some of the best fundamental indicators reached their limit and the hit rate began declining.
Results
For example earnings growth Q/Q. The “if some is good, more is better” logic simply doesn’t occur. While the percentage of stocks moving up more than 20%, 30% and 50% this quarter seemed to improve when applying the criteria of earnings growth over 25%–it declined above 100% and declined further above 500%. The same was true for projected earnings and past 5yr earnings and earnings this year and past 5yrs sales growth. Higher was not better, it was the obvious and crowded trade that you should avoid and instead seek the moderate growth names as their are fewer amatures and more people passing those names up in favor of higher growth which makes them underowned.
Perhaps even more odd was what happened when I looked at profit margins.
As it turns out, adding criteria such as net profit margins above 0% or above 10% or 30% actually would have hurt your odds of getting a 20,30 and 50% mover in the last 3months vs randomly picking stocks. I actually found that out of all indicators, this was so reliably bad, that betting on stocks with negative net profit margins–or better yet profit margins under -50%– yielded major increases in hit rate. I thought this would be the exact opposite. After all, if a company can’t sell a product at a profit, what hope does it have as a business or as a stock? Perhaps none, but only after credit is inflated and it reaches maximum buying will that matter.
To give you some perspective, with no filter: 3.24% of all stocks this quarter are up more than 50%. 7.4% are up 30% or more. 14.9% are up 20% or more. Q/Q earnings showing more than 25% growth improves our quartler hitrate to 4.258% for >50% movers, 9.46% for >30% movers, and improves to 17.53% for stocks moving up 20% movers. Q/Q sales growth more than 50% saw 6.54% of stocks up 50% or more, 12.53% of stocks up 30% or more and 22.34% of stocks up 20% or more.
But a whopping 12.7% of all stocks that had -50% profit margins or worse were up 50% or more. You nearly quadruple your chance at finding a super performer up more than 50% on the quarter by looking for the worst fundamentals. 18.64% were up 30% or more and 25.42% were up 20% or more this quarter.
Think ROE is a good reason to own a stock? Only if you’re aiming for stocks with negative ROEs. Negative ROE was one of the best after negative margins.
But if sales growth is good, low price to sales should be? No. Over 25 P/S yielded more superperformers.
Conclusion
It is possible fundamentals matter, but apparently not at this stage of the market…. that is, unless you are using them to spot the likely underowned and/or to avoid those vulnerable to bullish conviction and/or to identify those neglected with bearish conviction. The fundamentals that did matter this last quarter are projected earnings growth and earnings growth revisions (provided they are not too high to attract weak hands), sales growth Q/Q and actual earnings growth. The ROE and profit margins were so reliably bad of an indicator that the worst numbers not only performed better, but also outperformed every other fundamental indicator I looked at.
Often times the worst stocks lead near the latter phases of a bull run, so perhaps this speaks to that idea. However, if there is one thing this study shows it is conviction is a liability and holding onto notions that ought to be true but the market says otherwise is a mechanism that will keep you on the wrong side of the trade.
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