Don't Catch a Falling Knife

We've all been there. Maybe while shopping or at an auction.
The item we want to buy is discounted deeply relative to where it was. In fact, it now looks like a big bargain.

In reality, our frames of reference are skewed. It happens in a lot of places. Sales people call it anchoring. Here’s an example of how it works.

You go to buy a car. There’s the listed price or MSRP (Manufacturer Suggested Retail Price) and there’s the dealer’s invoice (what they paid for the car). An example: MSRP is $40,000 and dealer’s invoice is $30,000. If the Sales person starts at $40,000 and then offers a $36,000 price, it looks like a nice 10% discount. But if you start at dealer’s invoice $30,000, that 10% discount actually looks like a 20% premium.

We anchor ourselves when we buy a stock simply because it looks cheaper than it was.

Another factor that comes into play is our blind belief that a stock can’t possibly fall any further. If a stock is down 30%, we tell ourselves, it must be close to a bottom. Which means that it is safe to buy. But we forget what happens in economic downturns.

In 2000, Cisco was $80 and 9 months later was $13. In 2000 AAPL was $35 and fell to $7 within 9 months. In 2002 IBM was $123 and in 9 months it fell to $57.

We are pre-disposed to bargain shop but our frame of reference is where we were and not where we are heading. Worse, we forget that stock prices drop deeply in economic downturns.

Applying this knowledge, consider Goldman Sachs. Is GS cheap at $167 or does buying it now look premature?

In 2005, GS revenue was ~$11B per quarter and the stock was ~$100. In November, Revenue was $23B per quarter and the stock was $247. In March, GS revenue fell to $18B, a 20% drop from 2 quarters prior.
Compared to 6 months ago, the stock looks cheap: revenues dropped 22% and the stock price dropped ~32%
Compared to 2005, the stock looks fairly valued: a 67% jump in revenue and a 67% jump in stock price.

But GS is not a bargain price. Sure it looks like a bargain because of the 35% price cut, but in fact it is just aligning with current business realities. The stock price is tracking revenue, and if you believe that business is improving, then GS stock price will grow. I think that business is continuing to deteriorate, and that GS will continue to drop. What is to prevent it from returning to $11B per quarter in business? And if it does, will the stock drop further to $100?

Buy now and catch a falling knife.

The same phenomenon is playingout in housing. With prices now ~20% lower than they were at peak, housing looks like a bargain. Many folks will buy and prices will appear to be stabilizing. A few months later, prices will drop again.

Because folks have bought based on price drops relative to where they were and not relative to where they are heading.