Analysis of earnngs and news about a company can give some insight into the quality of earnings.
If management has increased earnings by firing half the company's personnel, or the increase is derived from closing several facilities, the quality of the increase is not as valuable as it would be if it reflected improved sales and other revenues.
Slash-and-burn strategies can lead to a further decline in productivity, resulting in additional weakness in earnings and eventually lower prices for the stock.
On the positive side, drastic cuts can force companies to become more efficient, thereby increasing the quality of earnings, which may lead to higher stock prices.
The investor must analyse the company's growth and observe the stock price in action. From the analysis, the investor can determine whether the value of a stock is more likely to:
- increase,
- remain flat, or
- begin to decline.
The analysis can be difficult at times because a winner can temporarily take on the appearance of a loser.
Three situations:
- daily price fluctuations,
- market declines, and
- price advances followed by weaknesses
can make a winner appear to look weak, but they are not necessarily a signal to begin selling. These are usually temporary situations and are therefore exceptions to the sell-the-losers rule.
Exception 1: Daily Price Fluctuations
Stock prices fluctuate up or down in day-to-day trading. A glance at any daily price chart will show what may be considered normal daily fluctuations for any individual stock. Stock prices also move from one trading range to another.
For example, a stock price could have a daily fluctuation of $30 to $35 but could occasionally move to $40 and then drop back to the $30 to $35 range. The trading range would be considered $30 to $40. When the stock moves up and begins fluctuating between $40 and $55, it is trading in a new, higher range.
The trading ranges and daily fluctuations can be readily observed on a price pattern cahrt. The investor should take the time to become familiar with these trading ranges and fluctuations from the preceding few months.
Familiarity with price movements will help the investor differentiate between a normal fluctuation and a breakout to a new trading range.
If a lower stock price is within the normal range, it may still be a winner, even if the investor is experiencing a small loss - assuming that the initial analysis showed the stock to be a winner in earnings and growth. Therefore, the kind of weakness seen in a normal fluctuation does not indicate that the time to sell out and take a loss has arrived.
Exception 2: Market Decline
A significant drop in the overall stock market can force the price of a winner to lower levels. All stocks can eventually look like losers, and some will become losers.
Most often these severe market corrections are a time for concern, but not panic.
As we have seen in recent years, the stock market can drop 100, 200, or more than 500 points and recover quickly. Stocks that were winners before the correction will likely be winners agains when the market recovers.
In October 1987, the Dow Industrials dropped more than 508 points (22.6%). Looking back in 2004, that is still the largest percentage drop in one day. Merck & Company had already been showing some weakness, but on the sharp correction on October 19, it dropped from $11.00 to $8.50, a significant $1.50. This correction was an overall market reaction. For Merck, the weakness of the market in late 1987 was an excellent buying opportunity. It began a quick recovery, and by April 1988, after prices were adjusted for a stock split, Merck was trading above $9.00 a share.
In a Continuing Decline
If the market correction is sudden and appears to stabilize in just a few days, it may be best to hold a position and even consider buying more shares of the same stock. Many investors recognized the severe correction in 1987, for example, as a buying opportunity. Although the Dow remained volatile, it reached new highs in early 1989.
Unless they are severe and extend over a few weeks and months, market corrections do not necessarily turn winners into losers.
If a market decline continues, however, the investor should consider selling and moving the funds to the sideline. Extended market corrections are bear markets where stock prices decline and interest rates rise.
Exception 3: Price Advance Followed by a Weakness
A significant upward move to a new trading range, followed by some price weakness, is a fairly normal occurrence. As a stock price makes a major upward movement, many investors will begin to take profits.
Although there is nothing wrong with taking profits, the upward price movement might have only just started. Even so, it is inevitable that some profit taking will occur, and the stock price that has risen to new highs will show some downward price correction.
A signal is given if a stock begins to fall lower than its daily trading range and the overall market is unchanged or advancing.
If a stock price that normally trades between $45 and $50 a share drops to $43 and then to $40, it is time to be concerned. The signal is even stronger if the stocks of comparable companies are not showing a similar weakness.
It is a signal to either sell the stock or find out the reason for the price decline.
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