A company said one word on a conference call and the stock dropped 25%.
The word was delay. Not a miss, not a guidance cut, just a warning that things were going to take longer than planned…
And the chart gave you nothing beforehand. No topping pattern, no divergence, no signal…
If you were trading that name off the chart, you were long into it.
I want to explain what set the size of that drop, because it was sitting in plain sight and it was not on any chart you own.
The chart tells you when. It cannot tell you how far.
I have been doing this 40 years and I will put it plainly. Your chart is a timing tool. It is not a risk tool, and most traders size their positions off it anyway.
What determines how far a stock can fall is the multiple, meaning the price to earnings ratio. That is what you pay for a dollar of the company’s profit.
Pay 25 for that dollar and you are making a large assumption about the future, while paying 12 means you are barely assuming anything at all.
Here is the number nobody hands you. When tech stocks bottom out, their multiples tend to settle somewhere between 12 and 15.
So take a name trading at 25 that gets hit and drops to 19. People look at that and think they are buying a bargain. They are buying the middle of the decline, because the mechanism has not finished working.
Multiple compression is what destroys a position
They took the multiple on Lululemon from 70 down to 9.
Read that again, because it is not the share price I am describing. It is what the market was willing to pay for a dollar of that company’s earnings, and it got cut by roughly 87%.
That is what kills you. Not the bad quarter and not the downgrade. The market reprices what it will pay, and the higher your multiple started, the further it has to travel before it stops.
It only takes one hiccup to expose you. If a company is trading at a stretched multiple and somebody on that call says the word delay, that stock is in the crossfire and it is not coming back quickly.
Why a low multiple protects you
Take a name trading at a stupid multiple. When the tech complex gets slapped around, it goes almost nowhere.
The reason is that there is nothing there to compress. The market already refuses to pay up for those earnings, so the usual mechanism of destruction has nothing to work with.
That is a reason to own something. Not a pattern, not a signal, not a chart.
You have to know what you are paying for or you will get blindsided in this business.
The stocks I will not short regardless of the chart
This cuts both ways, and it is where most people get it wrong on the other side.
Sometimes I will short something based on what is happening on the chart. And there are names where the chart does not matter to me at all, because I will not touch them.
Goldman Sachs is one. That is a Bierman no-no and I will never short it.
The reason is the same reason. Brokers sustain multiples between roughly 12 and 18, and Goldman’s valuation never gets stretched. It gets pushed, but pushed is not stretched, so the fuel that makes a short work is not there.
Compare that to the shorts that worked for me, like Jefferies at 60 times earnings and Brookfield. Those were stretched well past 50, and stretched is what gives you room to be right.
Apple is on the same list for a different reason. People do not buy it on fundamentals, they buy it because it is Apple, and you are not going to win that argument with a chart.
The horizon problem
Now I want to be straight with you about something, because I teach this and I am not going to hand you half of it.
Valuation is close to useless for telling you what happens next week. The research on this is not ambiguous. Price to earnings ratios explain almost nothing about short-horizon returns and a great deal about multi-year ones, somewhere near half the variation in ten-year returns.
So if you are trading a two-day move, the multiple is not your signal. Your chart is a better tool for that and I use one.
But the multiple is still the thing telling you what you are exposed to while you hold. That exposure does not care what timeframe you thought you were trading, and it shows up all at once on a day like the one I opened with.
What to do with this tomorrow
Before you take any position, long or short, go pull up the multiple first.
If you are buying, ask what the stock is worth if that multiple compresses to 12. That number is your real downside and it has nothing to do with a support level.
If you are shorting, ask whether the multiple is stretched. If it is not, you are betting on a chart while the valuation sits there waiting to expand right through you.
Fundamentals matter. They do not matter much in the middle of a momentum market, which is exactly when they will expose you.
Professor Jeffrey Bierman
Creator of the Genesis COG System
