Be Wary of This Market's Head Fakes

02/22/2011 11:24 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Getting into a stock early is good. Getting in too early can be painful. Getting it right requires that you not fool yourself before you jump in.

There's early, and then there's too early.

Early is buying Apple (Nasdaq: AAPL) on Oct. 6, 2008, at $98.14 and having to wait until March 2009—six months before the stock again starts moving up. And up. And up. On March 6, 2009, Apple closed at $85.30. A year later, on March 5, 2010, a share sold for $218.95.

Early is happy.

Too early is buying homebuilder DR Horton (NYSE: DHI) in July 2009. You thought long and hard before you moved. You didn't buy on the first bottom in summer 2008 or even in early July 2009. You wanted to see signs that the sector had bottomed and started to recover. The rally at the end of July seemed to promise that, and so you bought at $11.17 on July 29, 2009. Now it's February 2011 and the shares trade at $12.77. The 14% gain doesn't seem paltry until you remember that it's your gain over 18 months and that DH Horton shares still haven't taken off as you'd hoped.

Too early is disappointed.

And it can be even worse if you decide you can't wait any longer and just have to sell. If you've reached this point, there's a good chance you've spent months sitting on dead money before taking the loss.

It's clear why we buy early. We want to get a bargain price before everyone else piles on. And it's clear why we buy too early. We don't want to pass up a bargain and lose our chance, so we jump in too soon.

Are there any rules that might separate early from too early and let us maximize our investing happiness and minimize our investing disappointments? I think so, although the rules are more ad hoc than universal. And I think they tell us something about early and too-early opportunities.

Let's Look at Spain

I'd argue that Spain has been too early until very recently, for reasons that are typical of why we buy too early. I'll use the shares of the big Spanish and Latin American bank Banco Santander (NYSE: STD) as a simple stand-in for the Spanish market.

The stock traded at $21.84 in May 2008 and had plunged to $5.19 by March 2009. Who wouldn't at least consider snapping up some shares?

But you would have been too early if you were expecting a return to the $21.84 price of 2008. If you'd bought in March 2009, you would have enjoyed a great ride to $17.70, ending on Dec. 4, 2009, and then given half of that gain back. The stock traded at $12.61 on Feb. 18, 2011.

And I'll just bet that if you'd ridden from $17.70 even part of the way back down, you'd in all probability be out of the stock now and not thinking about getting back in. That would be too bad, as I think if you were to buy Banco Santander today, you would be early instead of too early and could look forward to a 25% gain in a year—and steady growth after that.

This example highlights a few reasons we buy too early:

  • First, the bigger the fall, the more likely we are to get overeager and buy too early—a drop by $21 to $5 is pretty tempting
  • Second, the better a stock did before it tumbled, the more likely we are to get in too early. Banco Santander was up 19.5% in 2007 and 44.6% in 2006
  • Third, the more we wish we'd owned it before the fall, the more likely we are to get in too early. The stock's price-to-book ratio, a measure of a value stock, had climbed to 1.9 in 2005 from 1.6 in 2004. It was clearly too late to get in by 2005, many investors would have legitimately concluded

There's nothing terribly surprising about any of this. It's only human nature to think that something—in this case, a stock—will revert to its former price or trend. And it's only human to hope that we might now be able to make up for the profits we missed out on earlier.

MORE: Dividends Help When You're Early

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Stocks Don't Move in a Straight Line

Banco Santander's stock illustrates another reason behind some of our too-early decisions. We tend to think in straight-line trends. Once Banco Santander had started to climb off the bottom in March 2009 and was just slightly above $5, many investors saw it as a sign that the trend was uninterruptedly uphill from there. They didn't think about setbacks, relapses, or false dawns. That's exactly what we got in Spain. The belief that the end of the global financial crisis meant the end of the Spanish banking crisis turned out to be very wrong, and the country proceeded to plunge into its own debt crisis.

This kind of interruption in a trend that seemed so promising, so certain to continue upward, happens to investors so often that we've developed names for it. One of my favorites is "head fake," as if the market intended to take a stutter step to the right before shifting the ball to the off-hand and driving to the hoop. The real "head fake," though, is inside our own heads, where we've convinced ourselves that a trend is in place before it really is.

I'm pretty sure there's nothing you can do to eliminate this tendency to talk yourself into seeing the trend you want to believe in. But you can temper the urge, I think, by testing your own ideas against trusted sources of strong opinions and by examining as much data as you can, and as honestly as you can. Put your opinions out there so friends and other investors can challenge them. Do all that, and sometimes you'll still persuade yourself to believe where doubt would be the wiser choice.

Dividends Help When You're Early

One more thing you can do, as is well illustrated by Banco Santander, is to find ways to avoid compounding any too-early mistakes you make by selling in reaction to those mistakes. For example, I bought Banco Santander for my Dividend Income Portfolio way back on May 28, 2010. Since then, there have been plenty of times when I've been tempted to throw up my hands, yell "You were too early," and sell. But I haven't, and the stock is up 24% through Feb. 18. And I can't credit myself with superior discipline. I've held on because the stock pays a 6.3% trailing 12-month yield. Amazing how a regular and juicy dividend can stiffen an investor's willingness to hold on.

So where am I looking now for opportunities that are early but not too early, with the conviction that I'll be wrong and be too early on some?

I think that Spain is now early. There's probably one more bump in its road—we haven't seen the last of the euro crisis—but Spain has shown a surprising willingness to make some hard financial choices and has made more progress on fixing its broken savings banks—the cajas—than I'd expected. You can also hedge the danger of being too early in Spain by buying banks with hefty dividends, such as Banco Santander and my recent Jubak's Picks selection, Banco Bilbao Vizcaya Argentaria (NYSE: BBVA), (see my Feb. 15 buy) which carries a trailing 12-month yield of 7.2%.

I think it's still too early for homebuilders and real estate developers. I don't think we'll get a real turn in this sector until the foreclosure rate peaks later in 2011. The market got a bit of a reprieve as the legal questions surrounding bank mortgage paperwork slowed foreclosures at the end of 2010. But banks have re-filed much of that paperwork, and the rate of foreclosures is picking up again.

Still, if I wanted to hedge my bets in this area, I might nibble at the timber companies with sizable real estate operations that pay a decent dividend. That group includes Rayonier (NYSE: RYN), with its 3.3% dividend, and Plum Creek Timber (NYSE: PCL), with its 3.95% yield.

I think it's too early in the economic cycle to switch to lower-risk stocks such as the big drug companies. When the current economic recovery gets long in the tooth, I think investors will want to own current laggards such as Abbott Laboratories (NYSE: ABT). I've repeatedly made the case for that stock on its fundamentals, but its performance—down 4.8% in 2011 as of Feb. 18 and down 8.1% in 2010—suggests investors just don't care right now. The stock pays a yield of 3.8%, but it's not clear to me that that's enough, given the market's indifference to the shares.

Emerging markets are also too early, I think. The danger there isn't sitting on the shares and having them go nowhere for years; I think you'll want to own the shares in the second half of 2011. The danger is that the first half of 2011 could contain a further 10% or 15% drop in markets such as China, India, and Brazil on interest rate and inflation fears.

China just raised interest rates and bank reserve requirements for the third and eighth time, respectively, since the start of 2010, and there's no sign that the medicine is working yet.

Brazil seems trapped between fears that the economy will slow—from 7% in 2010 to a projected 4.5% in 2011—and fears that the economy won't slow and inflation will pick up speed.

The Reserve Bank of India has been the most aggressive central bank in Asia at raising interest rates to fight inflation, which is one reason Indian stocks are down 18% from November 2010.

The last thing you want to do with volatile emerging markets is jump in too early, get burned, and then find yourself on the sidelines when those markets start to rally again. But then I guess you'd say that about any promising opportunity that might still be a little too early.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned in this post. The fund did own shares of Banco Santander as of the end of January. Find a full list of the stocks in the fund as of the end of December here.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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