As I watched the market move lower Tuesday on yet another round of confusion out of Europe, I felt a lot more confident about my "react do not predict" approach to the markets.
Less than a week ago, everyone was super bullish and predicting a bright future now that Europe had solved some of its sovereign debt issues. Who could have possibly guessed that the Greeks would decide to vote on allowing the rest of the continent to bail them out? If nothing else, we have learned that expecting rational behavior out of Europe is too much to ask. There appear to be too many self-interested parties at the bargaining table to reach a mutual and workable conclusion.
I also felt a lot more comfortable with my strategy of looking at the new-low list of stock ideas as opposed to the new-high list. While I get the whole "a stock has to make a new high in order to double in price" approach popularized by William O'Neil in the 1990s, I also get that many of the stocks on the new-high list are vulnerable. As Warren Buffett once observed, "You pay a very high price in the stock market for a cheery consensus." If a popular company makes a mistake or misses earnings, the fall can be sudden and brutal. Since the stock does not trade at a discount to assets or earnings value, there is often a real and permanent loss of capital. My value stocks may go down, but they tend to have assets such as property, building, equipment and even deferred tax benefits far in excess of the market quote, so a permanent loss seems less likely to me.
Looking at the current list of stocks flirting with new highs, I see two that are potentially dangerous. Starbucks (SBUX) hit a new 52-week high last week and has already slipped more than 5%. I am not necessarily a fan of the high-priced coffee shop, but my wife and daughter love the place. In the interest of total disclosure, I wrote this column at a Starbucks because I'm still waiting for the Internet to be connected at our new home. But just because Starbucks has saved me a few times during Internet outages does not mean I am willing to pay 27x earnings for its stock. I admit that Howard Schultz is a marketing genius and a great CEO; however, that does not entice me to pay for a stock that has quadrupled in the past three years and is up 44% in the past year. One corporate mistake or a continued decline in consumer confidence that makes a $5 cup of coffee less attractive and new-high buyers could be looking for something to spike their lattes. I am not ready to short Starbucks, but I f I owned it I would be looking to sell or hedge some of my shares.
AvalonBay Communities (AVB) is another great example of the dangers of the new-high list. I made the bear case for this stock a little more than year ago and bought some put spreads on the apartment real estate investment trust. The trade was a loser as the shares continued higher after the briefest of dips. Last week, they missed earnings by a penny and the stock dropped 10 points in a day. Currently, AvalonBay shares are a little more than 6% below 52-week highs, and I am ready to try this one again. The multiples of cash flow, earnings and asset values are ridiculously high. Investors playing the housing theme have pushed them way beyond any rationale estimate of valuation. I am shopping for put spreads to bet on the downside in this stock over the next six to 12 months.
Rather than looking for names on the new-high list, I use it as a source for candidates to sell or short. I prefer to bet against a cheery consensus staying in place amid today's cynical financial markets.