Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC
If we are going to invest successfully in this new, more treacherous environment, we are going to have to recognize that bizarre stock movements have become a staple, if not the hallmark, of this era. Before we even get to the buying and selling of individual stocks in order to create wealth, we have to understand how stocks are impacted by both understandable events and what seem to be random gyrations that baffle and frighten us. We need to fathom these moves because when we become scared and confused investors we become emotional and reckless investors. Ignorance is the opposite of bliss in the stock market.
Let's take the most glaring example of a pernicious quarter-hour event that turned off more people to the stock market than just about anything since the Great Recession: the Flash Crash of May 6, 2010. I happened to be on television when this horrific 1,000-point decline occurred, and I have to tell you that it was one of the most mystifying moments in my career. Virtually nothing of any real import was happening; we were all chatting about riots in Greece at the moment the crash was triggered, explaining why riots aren't a reason to sell off investments. But the market proceeded to decline so precipitously that a giant stock like Procter & Gamble traded at $60 one minute and then at $50 and then sliced right through $40, all within the confines of a commercial break. Fortunately, I was in a position to say there was nothing fundamentally wrong with P&G or a host of other stocks that were also plummeting, but I was at a loss to explain how it could happen.
It was only after the event and the subsequent run right back up that we realized it was just an example of the power of the S&P 500 stock futures running roughshod over all stocks, as the market couldn't absorb a couple of huge sell orders that came into the futures pits in Chicago all at once. The pummeling in the stock futures cascaded over to individual stocks, and the avalanche took down almost everything in its path as stocks broke down, triggering various sell strategies. Buyers were fleeing the market in fear that something larger and more terrible was occurring that no one knew about. When we found out there was nothing fundamentally wrong, nothing that spooked the markets, just a series of overzealous traders selling all at once, it turned out to be a terrific buying opportunity. However, the fact that there was no precipitating event for the 1,000-point decline, no real rhyme or reason for it, only served to scare people even more about the stock market. The whole asset class was tarnished more in fourteen minutes of trading than when banks and brokers crashed in 2008 and high-flying dotbombs went off in 2000. The exit from the building has pretty much continued unbridled since the Flash Crash, aided by several other similar but smaller crashettes, as we call them, including perhaps the most bizarre of all: a total shutdown of the NASDAQ for three hours, the Flash Freeze. Unfortunately, these terrifying mechanistic obstacles have occurred during an incredibly good performance for the stock market. But can anyone blame those who flee? I understand the reasoning. Who would risk their hard-earned dollars on the stocks of even the strongest companies with the biggest dividends, the best earnings track records and most bountiful balance sheets, when their market capitalizations can be cut in half, or even more, during the time it takes to brush your teeth, shower and get dressed in the morning?
It's not just events like the Flash Crash, though, that confound people about this asset class and drive them to either more tangible investments like real estate or less rewarding ones like corporate and treasury bonds. There's the day-to-day interchange between stocks and bonds themselves, where the bond market seems to call the tune regularly over the stock market, even though it seems many companies should be immune to such movements. There's the "macro" tug of events, the impact of important economic influences, like jobless claims or pronouncements by the Federal Reserve or aggregate retail and home sales numbers, and how they can impact many of your stocks that you might believe shouldn't be buffeted by such extraneous issues. Even more disturbing is the role of a Cyprus bank failure, a Spanish employment report, a riot in Brazil or a slowing Chinese industrial production number on your purely domestic holdings, many of which might have nothing whatsoever to do with those overseas events.
And it's not just these big news items that can impact stocks in mysterious ways. These days there is an intense sector pull on stocks that almost at all times overwhelms the individual characteristics of individual companies. People ask me, "What kind of insanity allows good companies and bad companies to trade in lockstep?" How can you be careful and prudent in picking stocks when the worst stocks in a group can pull down the best ones? What an obstacle to the homework that's now become, what a roadblock to serious investing. How can the performance of an individual company not matter if it's put in an index of companies that it's beating the pants off and they all go down at once?
Then there's the impact of the "micro," the individual news coming out of individual companies that you might be investing in. You've navigated the flash crashes, accepted the bizarre role that bonds and big-government data may have on your stocks; you know the Fed's pronouncements can impact stocks in strange ways that you can't figure out and that the bad stocks can take down your good ones. But how can a stock you own not go up on good earnings news? How can it not rally when its quarterly sales are stellar and it raises its dividend and reloads its buyback? What the heck is that all about? That's not the way it used to be. How can you protect yourself from this seeming lunacy, let alone profit from it?
These are all the new mitigating factors that we must now calculate before we can decide whether we should even own stocks, let alone select individual equities for our portfolios. That's why I want to break down, one by one, each of these hard-to-fathom distortions to all stocks before we get into the weeds and learn how to select, buy and own individual stocks for the long haul. We can't possibly be in shape to own stocks until we can live with the roller coaster of volatility caused by all of these mysterious and often profoundly negative events that have taken root since the time my previous book was published.
So let's get started examining the other-worldly forces that can impact your stocks in a way that can often trump the businesses that these pieces of paper are supposed to track. Let me give you the mechanics of how and why stocks can move without anything happening at the underlying companies themselves.
Sometimes I just have to own the fact that the whole time I've been picking stocks and espousing their virtues, I have skipped over perhaps the most basic part of the stock market's anatomy: the actual pressure put on stocks from buyers and sellers. While every single one of the extraneous forces that I just mentioned plays a role in a stock's movement, it all still comes down to the fact that a stock goes up when there are more buyers than sellers, and a stock goes down when more people want out than want in at any given moment.
As someone who's been analyzing stocks for most of his life, I have often taken for granted this tug-of-war between buyers and sellers. But I know from interactions with so many of you that I had better explain the underlying process of a stock's movement right here, right now, before I suggest which stocks will move and why they will do so. So many times people ask me or tweet me, "Jim, which book of yours can help me, a beginning stock market investor?" While many of my books and articles delve into what can move a stock, none of them has explained why a given stock moves the way it does, something that often eludes not just the beginners but those with years of experience trying, and failing, to pick good stocks. Without that initial understanding, the whole thing feels a bit like alchemy at best, or a rigged contest at worst. Surely, we think, given the prevalence of insider information, lots of stocks go higher because someone has the skinny and we don't. While the now rampant federal prosecutions are needed because plenty of people do know information and trade on that information illegally, that's profoundly not why the vast majority of stocks move up or down in a given session.
What moves stocks, what makes them gain or lose pennies, dimes or dollars, is a process that mystifies many and puts them at a huge disadvantage if they don't know how these jumps and dives actually occur. They get confused, angry even. Why bother to try investing carefully if you have no idea what moves the stocks you own? If you get frustrated because stock movements seem so illogical-a pretty universal complaint these days- then you've come to the right place. I am certain you can improve your financial health if you become attuned to the way stocks really do work.
First, let me tell you a story about how hard it is to even figure out what moves a stock, and why you aren't alone in being confused by it. It's a story about when I was starting out, when I, too, didn't understand what could cause a stock to move up or down a dollar.
Before I got to Goldman Sachs in 1983 as an intern, I was fascinated to learn what was behind a stock's given move, despite nothing new or of import happening at the company the stock was supposed to stand for. Sure, a big earnings surprise could impact a stock's price. But those reports come out only four days a year. How about the 361 other days when nothing material occurs? I know that investor meetings, high-level resignations and appointments, product introductions and changes in analysts' opinions can occur. Nevertheless, those too can be considered to have only an ephemeral impact. When I first walked into Goldman Sachs I considered myself a legitimate student of the stock market, but deep down I was always befuddled when a stock jumped a quarter or a half or a point seemingly based on nothing. (We used fractions back then, not pennies.) Was it stock news I didn't know about but would know if I toiled at an in-the-know place like Goldman Sachs? Was it a cascade of buyers who just couldn't wait for something that I didn't even know about? Did one person know something no one else did, and he left enough tracks that others followed him? Was it insider trading ahead of a good earnings report that a chump like me just didn't know yet? What caused these seemingly random moves that defined the range of that day's trading?
In one of my countless interviews with Goldman Sachs (about a dozen over a year just to get a summer internship), one of the executives said I could ask him anything I wanted about the market. The interviewing process had been tedious if not futile by then, and I figured if I hadn't gotten the job by now I was never going to get it anyway, so I blurted out what was actually on my mind. I believe the same question is on the mind of the vast majority of you reading this or watching my show: What makes a stock move-I mean, really move? What gets it going? What takes it from $9 to $10 in a single session, when nothing's happening, nothing at all, at the enterprise that's being traded?
The market was open for trading, so the exec said, "You really want to know? Okay, watch this: I will make a move happen. Keep your eyes on the symbol SRR." That was the stock symbol for Stride Rite, a shoe company known for its Keds label, which at the time was trading at $9. I was sitting in front of a quote machine called a Quotron, a priceless relic of a different era. Only a limited number of machines had the prices you now see routinely on every PC or cell phone, making you a far more powerful and intelligent trader than I was in the old days, despite the fact that the market has become far more difficult to fathom on a daily basis. The Quotron showed that the SRR stock's last sale was at $9. That was the quote line. Next to that were two numbers, 9 and 9⅛, and two more numbers with an x between them: 100 x 100. That meant that someone was willing to buy 100 shares at $9 and someone else was willing to sell 100 shares at $9⅛. Who knows who they were and what they had in mind beyond that, but you could "hit the bid" for 100 shares, selling them at $9, or you could "take the offer" and purchase 100 shares for $9⅛. Markets don't trade like this anymore; now stocks trade in penny increments, and many stocks are so "deep" or filled with so many buyers and sellers that you can sell thousands of shares or even 10,000 shares at the exact same price and not move the stock at all. But the gist of the example remains relevant, as huge buyers can and do overwhelm large sellers every moment in the market. Given that I am trying to show you how I could be so obtuse and almost afraid to learn because it could reveal my ignorance, let's let the example suffice.
I was totally glued to these flashing green numbers, thinking, What's going to happen next? There's no reason for the stock to move. Nothing's new. It's just another random day at the company that makes Top-Siders and Keds Champion Oxfords.
The exec knew he had me on the hook. He said, "Ready?" I nodded. He then picked up the phone and called one of Goldman Sachs' in-house traders. "Eddie, take 50,000 Stride Rite, with a 9.25 top." In English that means Eddie was just ordered to buy 50,000 shares of Stride Rite, with a limit of $9.25 and not a penny more, to "get in," or purchase, all 50,000 shares. The trader could do what he wanted to buy the 50,000 shares, as long as he did not exceed the top of 91/4, or pay more than $9.25. Next thing I know, the green line on the Quotron is going nuts and the stock is jumping straight up to $9.25. Just like that. Yep, in no more than thirty seconds, maybe less, Stride Rite has gone from $9 a share to $9.25. Twenty-five cents gained if you owned Stride Rite because Jim Cramer wanted to see how a stock moves.
Eddie calls back after the green stops flickering at 91/4 and says, loud enough so I can hear it, "You've got 6,500 shares in at slightly more than nine and an eighth," and he's now "working the order," trying to get the rest of the stock, 43,500 shares, purchased at 91/4 or less.
Eddie goes on to explain that he had no choice but to move the stock to $9.25 in order to get that meager amount in. He adds, "Look, there's nothing offered in size right now up anywhere near here," meaning that there are no real sellers offering to part with shares at that moment anywhere in sight at the 91/4 level or even above that limit. Eddie then suggests that he might have to take the stock of Stride Rite all the way to $10 per share to get all 50,000 shares in if "your guy" is in a hurry. Hmm, I think to myself, I'm the "guy"! The exec says, "Stay there for a few minutes," code for Eddie to bid up to $9.25 "out loud," meaning "Show my bid on the green screen to see if that will draw out sellers." Suddenly, I see on the screen "9.25 9.375, 1000 x 100," with Goldman's trader trying to execute my order, bidding for 1,000 shares and some nameless soul offering just 100 shares an eighth above where we are willing to pay. It stays that way for about a full minute with nothing happening at all. The last sale is $9.25 and there's nothing doing. Bored, point proven, the exec tells Eddie to "walk away," to hold up the order for now, "and let's see if someone shows up as a seller." A few minutes go by and no one surfaces as a seller, so the exec gets Eddie on the horn again and cancels the remaining buy ticket.
The exec turns to me and says, "You want to see that stock move up a dollar, you take the top off," meaning if he doesn't limit his buy order of 50,000 to $9.25 he will have to pay perhaps as much as $10, in Eddie's judgment, to bring out enough sellers to get the job done and complete the order. There, right in front of me, was my anatomy of a one-point gain. The $1 move up in Stride Rite would occur not because of a terrific earnings report, not because of a takeover, not because of an analyst upgrade and not because of a new model Ked, but because this Goldman exec placed a very large order relative to the market capitalization of the entire company, at that time $500 million, and demanded that it be filled quickly with no limit.
When you've wondered why a stock went up on no news, you might have heard reasons like "more demand than supply" or "more buyers than sellers." You probably wanted to shoot the person who gave you that kind of glib answer. You wanted to know what the buyer knew, what insight he had that you didn't, what the "real" reason was. You thought the response was totally lacking in candor. I too always hated that kind of "explanation"- until I saw Stride Rite jump from $9 to $9.25 in less time than it takes to run from one end of a football field to another and back again. And I know it could have gone to $10 if that exec simply pressed the issue to demonstrate how a stock can rally a dollar on nothing, indeed nothing at all.
I could only imagine what the good people sitting in Stride Rite's headquarters, then in Cambridge, Massachusetts, would be thinking if SRR suddenly rose to $10. Takeover? Some news that even the CEO didn't know about? The absurdity of it all was palpable, but in the end, there was simply more demand than supply and a larger buyer was overwhelming all sellers at that moment. The supercilious answer was the correct one. And the scales were lifted from my eyes. I had been part of a vast conspiracy to move Stride Rite higher-at least that's how it would have appeared to the outside world if we had continued to press it-and all that had really happened was a larger order had been placed than the volume of the Stride Rite market could handle at that minute. I am sure that had we reversed course and tried to dump 50,000 shares all at once, we could have just as easily smashed through the $9 level and taken the stock to the $8s if we were in a hurry. And yet all that would have happened at Stride Rite that day was a bunch of shoes would have been made and still another bunch would have been sold. Just like any other day.
Of course, not all stocks are like Stride Rite was, a thin or lightly traded stock with a relatively small market capitalization. But you get the picture. Stocks move when supply overwhelms demand over a very short period of time. That's what propels or pushes down stocks when nothing's happening. That was the real answer to my question.
This exercise isn't an idle one but one that could have serious consequences for you if you don't enter your order right, with a limit and not "at the market." Let's go back to the original purchase order. Think of the options the buyer had. Instead of putting a limit on his buy, he could have said, "Buy me 50,000 shares at the market." Given that 6,500 shares took the stock to $9.25, it is entirely possible that a market order, meaning "Buy everything in sight until you got to 50,000," might take it to $10 or even beyond, because a market order without proper guidance is just an order to pay whatever you can, even if it moves a stock. Now, most of you won't be buying stocks in that quantity. However, it is entirely possible that in the time between when that market order is placed and when it is fully executed, you might be putting in an order to buy 100 shares of Stride Rite at the market-no limit. You have no idea what's happening with the stock. But I bet you thought you could buy it around the price you saw it trading at, $9 a share. Next thing you know, because of someone's aggressive market order, you just paid $10 for a stock you thought you could purchase for no more than $9.25 at worst. You've just made a horrible trade. You have a miserable basis, and you feel totally betrayed by the process. Then, of course, now that the buyer is done, next thing you know, SRR's back at $9 as sellers at last see nothing's going on at the company and decide to take advantage of the temporary rise and get out at better prices than they deserve. That's why, beyond solving the mystery of why a stock can jump on no news, you need to protect yourself from this insanity by using limit orders. That's also why I always admonish you to stick by a price and not deviate: precisely because you now know what-or who-can move a stock.
Of course, if there actually is some news, some positive surprise to earnings, we accept this hazard. We're in there buying with everyone else on the news, and we accept the consequences. It's just that, as I said earlier, that kind of instantaneous earnings reappraisal happens only four times a year. The rest of the time it's pretty much as I have just traced out. That's why the wise customer puts the top, or limit, on the order.
Let me tell you the much larger takeaway of this story in the new world we find ourselves in now. The whole Stride Rite exercise is actually a mini-version of what happened that day in the Flash Crash, except the orders that day caused the whole stock market to plummet, not increase. For reasons I am about to show you, the stock futures are very powerful, and with a surprisingly small amount of money relative to the actual size of the stock market, a seller can overwhelm all buyers very quickly, especially in a skittish market where some extraneous event might be occurring that you don't know about that's now linked electronically to our market at the speed of light.
Just as there were no sellers lined up in time to meet my 50,000-share Stride Rite buy order until I took the stock up to $10, there weren't enough buyers lined up that fateful afternoon to match the selling that stemmed from stock index futures selling. If the orders had been smaller-there were multiple sellers at that level, not just one "guy"-and the sellers were willing to take their time rather than burst in with market orders that had to be executed immediately, the disaster would not have occurred. But the sellers at that moment had much more stock "to go" than the buyers had to buy, all the way down in price, so that stocks could get cut in half in a few minutes. That's, again, why I say, Please, people, use limit orders! Can you imagine if you went in to sell 200 shares of Procter & Gamble when it was at $60, using a market order, and you ended up getting a report that you sold it at $40? Yet that's exactly what happened to thousands of people on that Flash Crash day. That's why a limit order is prudent and a market order is reckless, and always will be until the government figures out how to stop trading in the whole market when these events occur. And it sure isn't doing that now.
Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC