Sit Down Stock Market. You're Drunk

Jeff’s Random Words

This was a pretty wild week in the market. Over the last 5 trading days the S&P 500 is up 6%. Almost half of the 14% year-to-date return came from this week. I’m sure many people reading this saw even wilder movement with some of the individual stocks in their portfolios. Here is the weekly return for the top 3 and bottom 2 stocks I own sorted by weekly return.

I chose to use weekly returns for a few reasons, which are the point of this post.

1. It was easier, after all this is a free newsletter. You get what you pay for!

2. Some of these had more drastic initial responses and then a day or two of further change. For example:

   Lemonade had a one-day increase of 48% but went on from there to a weekly gain of 63% 

   Roku popped 31% the day after earnings and ended the week up 51%

   Procore dropped 17% but then recovered slightly to being down 14% for the week

The lesson here is not to panic or get too excited with an immediate post-earnings reaction. Buying or selling immediately after news often doesn’t work out like one would hope and it’s usually an emotional reaction rather than a rational decision. An emotional buy or sell of Lemonade the day after earnings would likely have resulted in regret by Friday’s close.

3. Even with these drastic movements, if you zoom out the view changes. Here are the same stocks along with their YTD return and their percentage off their 2021 high:

I realize this is a lot of numbers but the larger point is that as fun and or upsetting earnings reactions can be, they likely will have little impact on long-term results. Here’s one more example to close.

Fortinet’s drop after earnings was especially upsetting because the same thing happened after the last quarter was reported. The day after Q2 results were released, the stock fell more than 20%. As you can see from the chart above, the stock is only up 3% year to date.

But over the last 3 years, Fortinet is outpacing the market by 95 percentage points. Over 10 years it's beating the market by over 1,000 percentage points.

Time matters. Patience matters. Weekly gains aren’t worth much more than a free newsletter post.

Jeff

Jason’s Random Words

Since Jeff stole my idea for his words (Jeff did not, in fact, steal my idea) I want to talk a little bit more about Lemonade (LMND). 

Well. Really I want to talk about price anchoring and behavioral finance more broadly. 

My guess is that, for the most part, people who are interested in Lemonade as an investment view it as either:

• Time to sell after last week's crazy gains.

• Too late to buy after last week's crazy gains.

• Time to buy after last week's crazy gains.

• Huh. A lot is happening and I am doing nothing.

Who's right? Maybe all of them? 

There are professional traders who made a bet on an earnings pop, probably at least partly based on the nearly 25% of shares sold short just before earnings. That's a massive amount of shorts betting that Lemonade would continue to report high loss ratios that undermined its progress on getting AI to underwrite at profitable premiums. 

Well. That didn't happen. Lemonade reported its lowest gross loss ratio in about two years, and the rout was on as shorts joined actual buyers to bid the stock up almost 50% by market close after earnings. Shares kept going up the next day, too. 

So if I'm a trader who made the bet that this would happen, I'm probably taking my profits and happy to do it no matter what happens next. That's my game: looking for short-term opportunities that are favorable to make a profit. 

There's another group of people who see the big run up, and having anchored to the $11 price from November 1, have decided that the 60% gain in three days makes Lemonade too pricey to buy now. Sound crazy? Well, recent history is on their side. Lemonade's stock price has indeed fallen in the weeks and months after every single quarterly earnings release for two straight years. This time it's different? This group thinks not. 

Then we have the non-short-closing investors who are buying shares because they actually think Lemonade's stock will keep going up. What's wrong with these people? 

Well, a lot of them don't know about the shorts, and that once short sellers stop closing a lot of the buying action will slow, and they're just betting on continued momentum. Plenty of them also happen to believe in the business. And a scant few of that group  also know that, even after the better part of a double in three days, Lemonade's market cap of $1.2 billion is a drop in the insurance bucket. Giants like Allstate (ALL) and Progressive (PGR) are worth $34 billion and $91 billion, respectively. 

And there's good reason to think that they could all be right. Or at least for some measure of time. In addition to our short-term traders, there are some investors who bought Lemonade at some prior higher price on a belief in the business model. And they saw this quarter's results, with a modest improvement in underwriting – but also with significant slowing in growth – and are ready to move on. They see an exit point that they think will be the best they can get, and they're moving on. And even if Lemonade does continue to succeed and these sellers are wrong in the long-term, they could prove right in the short term. 

Next, We have our price anchorers, who are very much focused on the price movement and not thinking about the bigger picture. These are probably the largest group. I've been part of this group for a lot of my investing career. The myopic investors who view so much of investing – and life – as being zero-sum. There has to be a winner and a loser in every transaction. Take profits. Take your shot. House money. I think almost all of us have been there at some point. 

I think the odds are in their favor that this price will be "expensive" in the near term. This wasn't a great quarter. It was a good quarter. We saw modest improvement in the one thing that has to get better. But growth slowed, and I'd be this becomes the market's focus in the weeks ahead, and Lemonade steadily bleeds off some of its gains as expectations re-align. 

Lastly, we have our group of momentum traders and true believers, a temporary alliance betting that Lemonade's stock will keep going up. The momo folks could see some continued gains, but as I described above, I'm not particularly optimistic that will happen on the other side of the short squeeze. If shares start to fall, the momo-bull alliance will end, and the momentum trade will turn into a rout, possibly amplified by shorts regaining their courage and building out short positions once again. 

Where does that leave our optimists? The bulls who think this quarter is the first of a continued – maybe accelerated? – trend of better underwriting, and that growth will also re-accelerate. These are the ones looking at Lemonade as a potential 10-bagger, or even more. 

What's the point? It actually doesn't have anything to do with Lemonade specifically. I'm mostly in the camp of optimists that think they'll figure the underwriting thing out. But they also might not. And if they can't use AI to price insurance well, a lot of their competitive advantage won't materialize. But if it does, then it doesn't matter how much I make or lose on paper in the days around each earnings period. It won't matter how well shorts and traders do, or how poorly traders and shorts do. What will matter is what management does, and Lemonade's employees do, that leads to a disruptive, profitable business. The volatility around earnings – and the actions of the people who cause it – will. Not. Matter. 

The point is that we have to really understand why we own what we own, and why we think it will go up. I think a lot of the time, we default to believing it will go up because we own it, having lost the thread of why we bought it to start with, and not, to paraphrase Buffett, changing our opinions when the facts change. 

Play your game. Run your race. Know what you own. Know why. If the "why" is no longer valid, be prepared to move on, no matter what the stock did last week, or how much it's up or down in your portfolio.

Jason