Heed Trickle of Market Warning Signals

 | May 23, 2014 | 11:30 AM EDT  | Comments
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stri

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crvp

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VIX

If there is one thing no investor has -- not even Warren Buffet -- it's the ability to accurately time market tops and bottoms. What the really good investors do is show up early and leave early.

While perfect market timing may be impossible, the market is a creature of habit, always flashing warning signals when extremities are occurring. Those warning signals are being flashed today.

In The Wall Street Journal alone, two headlines from today's paper caught my attention. The first was "Investors Show Little Fear." As you can surmise, investor confidence continues to climb. A measure of market fear, the Volatility Index or VIX, is trading at a 14-month low. One has to go back to 2007 to find similar VIX levels.

The second headline was more dramatic: "Penny Stocks Fuel Big-Dollar Dreams." A headline like this is the quintessential warning signal. Individuals from all walks of life are chasing the fast buck by piling into penny stocks.

A particular quote grabbed my attention. A day trader remarked, "I like things below three cents, because of the upside potential and it limits the downside." I went back and double-checked my math but I do believe that if you buy something at 3 cents and the price falls to zero, the downside is 100%. I'm not sure how that has limited downside.

The reality is that this trader -- and the thousands of others like him -- are succumbing to a terrible cognitive bias. They see a stock going up from 3 cents to 6 cents as a 100% gain but are failing to see other side of the coin -- the downside. A loss is loss in my book.

Trading penny stocks, for the majority of the time, is basically a spin of the roulette wheel. In roulette if you hit the number or color once you will make multiples on your bet. But odds are that your next string of bets will lose, so in the end if you are lucky you break even. Often, the thrill of hitting the next jackpot keeps you betting until you are wiped out, or have suffered losses.

I do think there are fantastic microcap "penny" stocks trading on the OTC. Insignia Systems (ISIG), STR Holdings (STRI), and Crystal Rock Holdings (CRVP) are some examples. Many good businesses have to start out very small. But what is starting to happen now is the return of pure speculation and I think we all know how that usually ends up for 95% of those who try.

Make no mistake -- market optimism continues to expand. At some point the optimism will run out. That could be next month or next year. But the warning trickles are coming in one by one as they always do and it's up to investors to pay attention.

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