It is said that Sir Isaac Newton, who was all but wiped out financially during the South Sea Bubble scandal of 1720, bitterly fumed that it was easier to calculate the motions of the planets than the movements of the stock market. While we generally shy away from short-term market predictions, this is the time of year when stocks that have been scathed often travel in a fairly predictable orbit.
Now that the heart of tax-loss season is near, many already-doggy stocks face double indemnity. The multitudes of investors who did not do their homework earlier in the year will jettison their duds. These latecomers to the dance create a supply-demand imbalance, knocking the price down without a corresponding change in corporate fundamentals. This creates an opportunity to scoop up out-of-favour assets at reduced prices.
On average, a gain of about half a percentage point is scored, although naturally, this does not happen with complete reliability.
Intrinsic to our decision to buy at this time of year is probability theory. An understanding the nature of risk-reward requires at least a rudimentary comprehension of this arena. The American Heritage Dictionary defines probability as “the branch of mathematics that studies the likelihood of occurrence of random events in order to predict the behaviour of defined systems.”
We prefer Aristotle’s more casual definition: “The probable is what usually happens.” Understanding what usually happens is partially based on the relative-frequency approach. This is garnered by looking at cumulative historical data. For example, odds dictate that the most battered sectors will return to favour within the next five years. Probably sooner.
Conditional probability is another factor. This dictates that if an event or certain events have occurred, it is more or less likely for a designated happening to transpire. Historically, the catalyst of tax-loss selling reduces stock prices, creating buying opportunities that augment probable returns.
Before the Contra Guys procure any new stock positions, we closely examine our current holdings. Any additional buys must not dangerously overweight the portfolio in any one sector. We also determine whether it is worthwhile for us to add to current positions by averaging down.
Many dismiss the idea of averaging down with the admonition that to do so is to throw good money after bad. This can be true, and when considering this technique, we must be certain that we have not fallen in love with a stock for misguided reasons. Some people average down in the belief that a stock trading at a huge discount to previous values is automatically a bargain. But a low price does not necessarily mean a stock is cheap. People constantly ask, when looking at former majors that have become penny plays, “Well, how low can it go?” The answer is, “Zero.”
When we look to significantly enhance a position, it is comforting to see that a stable bottom has formed, perhaps with a partial recovery. Some of our previous failures have clearly demonstrated just how difficult it is to catch a falling knife. Better to wait until the bulk of the negative turbulence is in the public domain before placing further bets.
Many are confused by the disparate signals being emitted on the business wires: Recession, recovery, titanic bankruptcies all vie for attention. A primary reason? Whereas two years ago greed drove the market, the current catalyst is fear. Is this a surprise? Absolutely not. As those who have studied even a smattering of history recognize, these events form an enduring pattern. It simply is not that discernible yet.