Resisting Human Nature

 | Jan 18, 2013 | 10:00 AM EST  | Comments
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Investors are handicapped in that they are human, and human beings have numerous innate traits that interfere with being good traders and investors. Two of the most self-defeating traits we possess are to project the future based on the recent past and our need for instant gratification. Projecting the future based on what has just happened occurs in all aspects of society. It is akin to flipping a coin six times and having all six flips come up heads. Although the chances of the seventh flip being heads is still 50/50, a majority of people would bet against tails based on the first six flips. We use some of this faulty logic to try to predict the weather. In the late 1970s, three straight years of "once a century" snowstorms rocked the Northeast. The New York Times, Time, Newsweek and other publications were predicting we were heading into the next mini Ice Age. It didn't quite turn out that way. Several major hurricanes slammed into Florida in 2004 and 2005. Stories ran that this was the new normal. People stocked up on generators, building codes were changed and if you installed storm shutters, it was indeed the "salad days." Only one major hurricane has made landfall since.

This predilection shows up in the equity market, too. What was everyone's favorite stock in early September? Apple (AAPL). Why? Because it had nothing but one success after another for five years and its stock went up consistently throughout that period. Since then, Apple has been one of the poorest performers in the market as sentiment has changed on the stock.

The second big trait that works against us is our need for instant gratification. Not so long ago, one needed to wait for the nightly news to find out what was going on in the world. Now, the latest information is delivered instantly to your laptop, tablet or smartphone. In the markets, this has shown up in the amazing decrease in holding times for equities. The average investor's holding time on any one stock is down more than 75% over the past 25 years and that does not include high-frequency trading.

One of the ways I try to get away from both innate traits is to buy out-of-the-money long-term options or bull-call spreads on stocks or sectors that are currently out of favor. At the beginning of 2011 I bought two-year call options and spreads on a variety of homebuilders because the sector had the most negative sentiment. While I was buying long-term calls and spreads on Toll Brothers (TOL) and PulteGroup (PHM), most other investors were enthralled with fast-growing stocks that had been performing well, like Netflix (NFLX) and Green Mountain Coffee Roasters (GMCR). Those contrarian calls turned out to be amazingly lucrative.

Today, some of the most negative sentiment in the market is in mining and materials stocks. Two I like here are Cliffs Natural Resources (CLF) and Alcoa (AA), which is one of the most unloved equities in the Dow Jones Industrial Average. I have the Jan. 15 $10/$15 bull-call spreads on Alcoa for a net premium of $0.90, and I have the Jan. 15 $50/$60 bull-call spreads for $1.40 on CLF.

I don't know what factors could move these stocks upward over the next two years. Overcapacity in their respective industries could be addressed, or worldwide demand may accelerate at some point over the next 24 months. What do I know is both stocks are historically cheap, unloved and have traded at more than twice their current price levels within the past two years. I also know that I can reap 400% to 700% returns if sentiment reverses on these two equities. With those sorts of odds, I don't have to be right too often to make this contrarian strategy hugely profitable over time.

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