Play The Street, Don't Let It Play You

08/10/2012 11:00 am EST

Focus: MARKETS

It's easy to get sucked in to Wall Street's siren song of hot picks and fast money, but it's really a sucker's game, and smart investors need to stay disciplined, writes William Patalon III of Money Morning.

If you're like me, when you go out shopping, you look for deals. You watch for sales. And you search out bargains. Why pay full price when you can get the same item at a hefty markdown?

That's an economic concept known as "price elasticity." This "rule" essentially says (and I'm dramatically oversimplifying this) that when the price of a product rises, demand for it falls.

But here's the part of this "law" that I really find fascinating: When it comes to the "real-world" products and services that you and I purchase, there are no exceptions...except for the stock market.

Time and again during my 30-year career as a financial journalist, I've watched this play out. When stocks are cheap, nobody wants them (by "nobody," I'm referring to individual investors). But once stocks move, and the higher they go, the more individual investors want to buy them.

Need an example? Think back to the dot.com madness of 1999 and 2000; the higher they soared, the more investors had to have them.

Economists refer to this exception to the law of price elasticity of demand as the "bandwagon effect." But there's a better term: The "Greater Fool Theory," which demonstrates how Wall Street uses the retail investor.

That's right...uses. Those experts have labeled this as the Greater Fool Theory because there's always some other ("greater") fool to unload the stock on—at least until the retail investor decides not to play. You see, the retail investor is the designated loser—the ultimate "Greater Fool."

Think of it as a game of musical chairs—but one in which the outcome is predetermined: Wall Street investment banks set this game up so the retail investor gets left holding the bag. This happens because, with the benefit of superior (read that to mean borderline "inside") information, Wall Street knows which stocks the game I'm describing will work with.

Let's imagine there is a public company (that I'm totally making up) called NewFuel Inc. that's making the shift from household cleaning chemicals to biofuels. Thanks to the high-risk/high-return potential of this corporate makeover, let's say one or more investment banks anoint NewFuel as an ideal "Greater Fool" candidate.

After first positioning its best (institutional) customers in NewFuel at the "initial" low price (the market price of the stock when this gambit kicks off), the investment bank that "discovered" NewFuel gets the game going by letting in the next "tier" of customers (the slightly smaller institutions that are its second-best group of clients).

By now, the price action in NewFuel stock is getting interesting, so Wall Street fires up its propaganda system and starts to circulate "the story." You've seen these kind of reports...

  • "The stock is cheap compared with its potential earnings in the 'out' years."
  • "The company has turned the corner financially."
  • "This new management team really gets it."

The NewFuel analyst might "initiate coverage" with a somewhat tepid "outperform" rating. He or she chats up some of the more prominent pundits, cable commentators, and financial columnists. A "buzz" starts to build as the stock's surge accelerates.

Now the stock is getting noticed by the second- and third-tier brokerages and investment banks. These outfits aren't part of Wall Street's institutional inner circle, but can still move fast enough to benefit from this action in the stock.

Everyone takes the "game" up a notch...or two...or five. The NewFuel "story" takes on a life of its own—and the rally steepens.

Like the outward-moving ripples that form after you toss a big rock into a pond, an increasing number of analysts, traders, and money managers check in. Institutional types hit the talking-head circuit—appearing on the big cable financial programs and "pounding the table" on the stock.

The Street upgrades NewFuel, first to a "Buy" and then higher. We start to hear that "NewFuel has a new, paradigm-shifting technology," or "NewFuel can sell its fuel on the Web," or "NewFuel's cleaning detergent is a perfect core ingredient for its biofuel, giving it a three-year lead on its closest rival." Bloggers mount a charge of their own.

By now, NewFuel's shares are up 50%, and have hit new all-time highs. The mainstream financial press realizes it's missing the story—and opts to play catch-up.

Newspapers, Web sites, and magazines such as Money craft long-and-detailed "enterprise" stories to make like they'd been all over this story from the start. By working so hard to create a "new" angle, these meant-to-be objective analyses only hype the NewFuel story even more.

Then, one Saturday afternoon in July, you're in the supermarket checkout line, and see Money magazine on the rack. The Steelers (or Ravens, Giants, or Patriots) football season doesn't start for another month, and you're leaving on the family vacation that very night, so you need something to read. You buy the magazine.

Sunday night, after your happy-but-sunburned five-year-old conks out in your arms, you happen across the Money story: "Why NewFuel Will Still Triple From Here." You see that the investment bank that initially recommended the stock now has it on their "Single Best Idea" list.

Monday morning, you're on the phone to your broker—along with half of America's individual investors. You see, The Wall Street Journal and Investor's Business Daily have done their own NewFuel stories.

Four months have passed since this rally started, and the stock is up 167% off its lows, your broker tells you, but you don't hear the warning: Your portfolio has been pounded this year, and you can see making it all back on NewFuel. You buy 1,500 shares with money that was earmarked for your Roth IRA.

Unfortunately, you and all those other investors who bought that Monday morning are now the Greatest Fools—there's no "strong-hand" buyer left to sell the stock to.

Having cashed out, Wall Street's investment banks have moved onto their next "Best Ideas," meaning the NewFuel hype machine winds down. The void is filled by worry, and even some bad news, given that the mainstream news outlets now are writing stories that ask if the stock is overvalued. You gambled and lost: NewFuel gets crushed.

Why do I share this story? Simply put—it actually happens. I've seen it. And so have our experts. Indeed, the recent and badly flawed Facebook (FB) IPO contained some elements of the scenario I've sketched out for you here.

The lessons here are simple:

  • Beware Wall Street's hype.
  • Whenever possible, seek "first-mover" advantage: Make sure the crowd follows you, and not the other way around.
  • Look for undiscovered value.
  • And, finally, managing risk involves more than just using trailing stops.

If you do you'll avoid NewFuel-like mistakes and won't get played by Wall Street as a "fool."

Read more from Money Morning here...

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