Believe it or not, there are a select group of unscrupulous business persons and Wall Street traders that will overhype a news event just to get you to buy their sh*t.

If you aren’t aware that such people exist in this world, allow me to tell you a very quick story.

When I began trading, I was probably suckered into a “hot stock tip” more times than I care to remember thanks to the lure of fast money.

Just like an easy mark before getting conned, I walked into a situation blind as a bat, dumb as a stump and 99% convinced that I could make money no matter what.

Truth is, I lost money about 7 times out of 10 of the time I chased the fast money.

Why?

It’s very simple.  When the smart money was selling into the breaking news, the dumb money (e.g. Me) came stumbling in like a clueless 18 year old kid at freshman orientation.

So when a news story broke or one sector had outperformed the broad market, CNBC and other media outlets would naturally shift their focus to that story.  A few pundits would say it’s a great money making opportunity, a few traders would say it can outperform the S&P 500, and boom… I clicked the buy button.

In reality, the same traders who had bought days, weeks, maybe months ahead of me were cashing out when just as I was buying in.

An Overhyped Stock Turns into a Momentum Trade

When President Obama was sworn into office in January 2009, it was assumed that he would spearhead a left wing/liberal movement that would use all means necessary to place a ban on the sale of handguns.

Naturally, a few media personalities did their little dance to create a media sensation around the issue.  Like clockwork, a small panic breaks out among conservatives and gun enthusiasts.

On a daily basis, I could find a half a dozen stories in my RSS Reader between January 2009 to April 2009 explaining why the 2008 recession would turn into a second Great Depression.  They foretold of worthless paper dollars, gold coins would become our default currency and panic would grip the world as capitalism imploded on itself.

Of course, you would also need a sizeable cache of Guns & Ammo to shoot your starving neighbors since they were going to steal your last can of SpaghettiOs.

Thus began the mad dash to gun shops and pawn shops all across the U.S.

Case in point, Beretta firearms saw a 66% surge in gun sales in the first quarter of 2009.  Other handgun companies, like Smith & Wesson, experienced similar results.

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Not surprisingly, stock prices for handgun suppliers skyrocketed as sales increased.

For example, checkout shares of Smith & Wesson.  This highly volatile, fast paced momentum stock saw a 250% gain in share price in just 4 months.

Seems like a great investment right?  You could be right… but probably not!

…

Avoid Stocks with Huge Short Term Returns

Stocks that have received a spike in news coverage that positively portray their company or recently released important data that affects their earnings will generally see a spike in stock price.

In the case of Smith & Wesson, let’s figure out why it’s stock price tripled in value in just four months.

1. Fearmongering.  People feared the worst as the recession worsened and stock market uncertainty plagued the six o’clock news.  This is a classic example of the fear trade.
2. Overhyping.  Media personalities (think Rush Limbaugh) will create buzz around an issue to boost their ratings, influence their readers and hope to attract more like minded (or easily convinced) members to their cause.
3. Surge in product sales.  Handgun manufacturers did see a surge in sales, and justifiably, higher earnings should cause the stock price to rise to match a historical Price/Earnings ratio.
4. Momentum traders.  Wall Street traders will detect the rapid move in price, and constantly bid up the stock price like sharks in a feeding frenzy since they’re no different than sharks looking for an easy meal.  For evidence, checkout the surge in trading volume in the Smith & Wesson stock chart above in late February.  It should also be noted that these traders will sell the stock even faster than they bought into it to preserve their profits.

While all of these reasons are catalysts for moving a stock in the short term, they rarely manifest themselves as slow and steady reasons to buy the stock at such an elevated price.   Therefore, these reasons are not the type of factors you should consider when you’re buying a stock a Smith & Wesson as a long term investment.

How to Avoid the Overhyped, Overbought Stocks

The reason to avoid this type of stock is likely obvious by now (e.g. price is too high, traders are selling into rally, etc), but here are a few easy tricks you can use to protect yourself from making the same mistakes I did in my younger years.

1. Check the stock chart.  The first thing you should always do before buying a stock is look at the stock’s recent performance.  If a stock has jumped 10% higher in a single day, run up 20% in the last week, or even doubled in the last month — don’t buy it!   If it’s on your “must buy” list, then make a habit to check the stock price once or twice a day.  After it has pulled back to an attractive bargain, then buy it.  Patience is an absolute must if you wish to play the market timing game.  Of course, if you’re an investor instead of a trader, you can place as much value in this advice as you see fit.
2. Leave emotion at the door.  If you feel a little surge of adrenaline watching a news report, back away.  Don’t listen to your fight or flight hormones when it involves your money.
3. Buying a stock because of breaking news is the wrong thing to do.  When you see that breaking news report that makes you want to buy, just know that millions of other like minded investors saw that news report at the same time you did.  For your own edification, take a look at the real time data the next time a serious news story breaks on a major news network.  The action is incredibly volatile and millions of dollars are made, and lost, in a matter of seconds.

As most experienced investors will tell you, slowly accumulating shares by dollar cost averaging into the market when the news is at the absolute worst is what separates the experienced investors from the rest of the crowd.

So how about you?  Have you made a bad investment in the past related to a news report, magazine article or blog post?  How did you make out?

Disclosure:  I do not own, nor have I traded SWHC prior to writing this blog post.  I also hold no malice toward gun owners or the right to bear arms.  I use Smith & Wesson and Beretta only as case studies in a classic example of stock speculation related to the fear trade.

by kcdsTM