Stop Losses for Whom?

By on May 16, 2006

Originally published on:

December 1, 1996

The market continues to inspire awe. At 6521, the Dow has surpassed the most optimistic forecasts for this year. A pause is long overdue, but I’ve spent a lot of time cruising the investment forums and there continues to be a preponderance of bearish statements. This indicates more upside potential. It is indeed getting scary up here with the average PE over 20 and a dividend yield around 2 percent. There are many things that could send this market reeling….and the biggest threat I see on the horizon is higher oil prices. As the economies around the world start to grow at a faster rate (especially European countries), the demand for oil will pick up. However, OPEC has shown no backbone with regards to quotas which is our “ace in the hole.” So I’ll go out on a limb and predict stock prices will continue to climb the wall of worry. The Dow should surpass 7,000 by late January 1997. Also, look for the lagging small caps to start making up lost ground on the popular big cap stocks.

Stop Losses For Whom?

Every now and then, market seers exhort the virtues of stop loss orders. Stop loss orders, also known as stop sell/buy orders, are designed so that investors can sell a stock at a predetermined price to prevent further erosion of the position. “Stops” can also be used in short positions. This is known as the “stop buy order.” An investor can choose any price they want to place the stop order. For example, an investor may buy a stock at $10 per share and thankfully watch it rise to, say, $30. The investor then figures it best to “protect” his profit and asks his broker to place a stop loss order at 15% below the current price ($25.50). When the stock reaches that price, it will automatically be sold. On the surface, this doesn’t sound like a bad idea, but let’s examine it further.

The stock market rarely corrects more than 15%, however, individual stocks often dip this much. A stop loss order of 15% below the current price of a stock has a high chance of being executed. A closer stop, say at 10% below the current price, has an even higher probability of being filled. Over the last 6 years, stop loss orders have generally been a very detrimental strategy. Stocks, during this rising tide, have experienced many small setbacks along the way. Investors who have used stops, most likely have lost ownership in some very lucrative investments. Of course, stop loss orders used on most technology stocks at the top of the tech stock boom of ’95 would have been very fortuitous. However, knowing when to place an appropriate stop loss order is similar to knowing when the peak in stock prices is occurring.

I sense some manipulation is occurring in the markets. It is uncanny how smaller stocks will drop for no apparent reason. Ten to twenty percent drops occur with regularity. I suspect some big money individuals/institutions are driving smaller stocks down on light volume and then able to pick them up again at lower prices by triggering unsuspecting investor’s stop loss orders. This is a very plausible strategy and one that certainly could be employed with sufficient capital. Wouldn’t it be nice if we could all buy our stocks at a 10-15% discount on demand? It is very difficult to prove the market is being blatantly manipulated through the use of this strategy. However, it is my opinion that stop loss orders provide a convenient way to part unsuspecting investors from their capital.

Portfolio Holdings Update

NVR, Inc.(home builder) is one of the worst investments I ever made. I originally purchased it in 1990 at $5 a share and watched it slowly deteriorate to 37.5 cents (a stop loss would have saved me some grief…Ha!). Worsening the pain was that I bought it in my IRA, so I couldn’t even write the loss off my tax return. About three years ago the company did a reverse split and seems to be making a slow turnaround. Thanks to its plunge, NVR represents a miniscule percentage (less than 1%) of the conservative portfolio. But all hope is not lost. NVRs Board of Directors has authorized the repurchase of up to 2,000,000 shares of outstanding common stock from time to time in the open market and/or in privately negotiated transactions as market conditions permit. In addition, the Company announced that its Employee Stock Ownership Plan intends to purchase approximately 200,000 shares of NVR common stock in the open market over the next several months. NVR currently has about 15 million shares of common stock outstanding, so this is a pretty good size buyback program. In all likelihood I won’t recoup my loss, but it is nice to hear a positive development on this dog.

Shares of Novellus Systems (NVLS) sprinted ahead about 25% a week ago, giving the aggressive portfolio a good shot in the arm. The buying spree followed comments by chip manufacturing sector flagship, Applied Materials, that even at the low-point in the current cycle, the company expects its profit margins to remain higher than in previous market cycles. These are encouraging comments, but the chip sector is not yet out of the woods. Nevertheless, I expect NVLS to trade at a much higher price within a year.

Recommended Allocations

The aggressive portfolio is invested in 90% stocks, 10% cash. The conservative portfolio currently is 70% stocks, 30% cash.

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