The idea is a straightforward strategy to navigate market corrections, identify strong stocks and secure consistent gains. The question you need to ask yourself is simple: do I own a tennis ball or an egg?
Deutsche Version
«Simplicity is the ultimate sophistication»
Leonardo da Vinci, Italian polymath (1452–1519)
When to hold and when to fold?
This is one of the most difficult questions when it comes to investing.
Buying stocks is easy. But when should you sell? I addressed this question in an earlier article. But from time to time the market moves up in a dull way, making it difficult to make decisions.
We are in such a market right now. Goldilocks of sorts, driven by moderate growth and inflation returning down to reasonable levels – the dish is neither too cold nor too hot. Everything turns out to be «just right». Yet, on top comes the fact that the market is starting to be more and more driven by narratives. The leaders of these narratives are rising strongly, while the broad market is just treading water at best.
Only a few stocks provide the performance and outperform the underlying index, while the rest of your portfolio does not move, neither down nor up. The latter are too good to sell, but too bad to ignore. They test our patience.
Does it ring a bell for you this year?
Percentage of S&P 500 stocks outperforming the S&P 500 over the calendar year
Anything to do with artificial intelligence (AI) is driving the market today.
To dig the rabbit hole deeper, the main beneficiaries, semiconductors as the shovel suppliers of AI with Nvidia as the poster child, are a textbook example of today’s market behavior. In fresh and strong bull markets, three out of four stocks rise with the market. So, when only a handful of stocks outperform the market, like it is the case today, it is a sign of a maturing bull market or a negatively skewed risk/reward ratio, at least for now. Thin air, as we like to call it.
Moreover, the few current winners are benefiting from a self-fulfilling prophecy. Why is that? Because they are the only ones doing better than all the others. As they determine the current narrative, market participants and passive money begin to chase them in a FOMO («fear of missing out») manner independent of the fundamentals. These inflows accelerate the stronger movement.
I always use my favorite chart from 1720 for such behavior. My friend Alfons Cortés, a market veteran in what he calls his 53rd year of apprenticeship, has also just written about this in his latest article (available only in German).
Isaac Newton and the South Sea Stock Bubble, December 1718–1721
Apart from the AI narrative, we are confronted with a simple fact: There is a large percentage of businesses that underperform during such a calm and steady bull market as we are currently experiencing. If they do not rise now, when will they? When times are even better for stocks than they are now? Most likely not. So, you probably own a weaker or struggling company.
Remember that only 4% of all stocks are responsible for the total return of the S&P 500. Furthermore, buy and hold or «our favorite holding period is forever» is an illusion. Warren Buffett, who is often quoted in this context, held 60% of the 230 stocks he ever bought for less than a year. He held only nine of them for at least a decade. In other words, Buffett sold his losers quickly and let the winners run, as everyone should do. But that just does not sound like a rousing marketing strategy.
In today’s market environment, it is imperative to separate the wheat from the chaff. Therefore, every time the market suffers a setback, you need to ask yourself a simple question.
Do I own a tennis ball or an egg?
Market corrections are inevitable. In fact, they should be seen as healthy. And they offer valuable insights into the market and your portfolio.
Why? Because the most meaningful part of a stock’s price performance is its behavior during pullbacks. Here you can tell whether you are holding a tennis ball or an egg. How do you know which is which?
By observing the relative performance of the stock.
Does it bounce back like a tennis ball or does it splat like an egg? The best stocks usually recover the fastest. After a stock has gone up, at some point there will be a short-term drop in the price. If it is a healthy stock, the dips are short and are soon supported by buying that should propel the stock to new highs within a few days or weeks – it bounces back like a tennis ball.
An example are the two healthcare companies Novo Nordisk, a business we own, and Pfizer, a business we do not own. Notice how quickly Novo Nordisk bounced back like a tennis ball after the market pullback in 2022 and hits new highs, while Pfizer turns out to be an egg.
Novo Nordisk, Pfizer and S&P 500 during the autumn 2022 pullback:
Novo Nordisk, Pfizer & S&P 500 since the autumn 2022 pullback:
What applies to price action – the «Good Chart» – also applies to fundamentals – the «Good Story».
As an investor, how can you best prepare yourself to survive the inevitable sharp corrections and bear markets in your lifetime? Make sure you have tennis balls (stocks of high quality companies) in your portfolio and not eggs (low quality stocks) that will splat after hitting the ground. In a broad stock market correction, both will fall. High quality eventually recovers, low quality not.
Instead of focusing on your winners, you need to eliminate your losers, the eggs, from your portfolio. Or as Peter Lynch put it: Selling the winners and holding the losers is like cutting the flowers and watering the weeds. Incidentally, this is Warren Buffett’s favorite quote, which he even highlighted in his 1988 annual letter. Precisely: cut your losses quickly and let your winners run.
You see, it does not matter whether you focus on the fundamentals or the technicals of a stock. It is quite simple. You want to play with tennis balls in both parts of the equation. With chart patterns, it is just a little easier to follow.
Ultimately, simplicity is the highest level of sophistication.
And we only need to know two things:
Tennis balls bounce.
Eggs do not.
