I was sharing a new portfolio of stocks with a friend the other day when he asked, “How did you pick the stocks in the portfolio?”

“I filtered through the 300 stocks that I follow closely and found all the stocks that were performing extremely well and are at or near new 52 week highs,” I said.

“Seriously?” my friend queried.

His disbelief was understandable.

You see, my friend and I both got interested in the stock market at about the same time, nearly 20 years ago. We had done our best to buy promising technology stocks that looked like great bargains.

I’m forever grateful that I didn’t have much money to put into the markets at that time …

What I do today is literally nothing like what I did 20 years ago. Today I look for the strongest stocks with long term trends. I look for stocks like Nike (NKE):

Nike

Nike is a good example of a stock that has been performing very well for years now … and I’ve come to believe that past performance is one of the better predictors of future results.

It’s not that the same urges that drove my decision making 20 years ago are completely extinct.

I’m still tempted by stocks like Anadarko Petroleum, down 70% from its highs:

Anadarko

And Yamana Gold, down as much as 93% from its highs!

Yamana

But today I have a deep appreciation of the fact that just because a stock has already fallen 50%, doesn’t mean that it can’t fall another 50%. In fact I marvel that I ever did believe that just because a stock had fallen 50% meant that it was a “bargain.”

One of the reasons that we get caught in this trap is because we continue to use the old high in the stock as our frame of reference. Take Yamana Gold again as a case in point. If we focus in on the last 4 years we can see that it made a high just above $20 in late 2012.

Yamana Chart

Quick question …

How many times has this stock fallen 50% since its $20 high?

You’re probably going to find this hard to believe but it has fallen 50% almost 4 times!

How can that be? Here are the numbers.

Numbers

Yamana Gold made a closing high of $20.39 on November 8, 2012. It completed its first 50% drop on June 20, 2013 when it passed through $10.20. It then fell another 50% when it passed through $5.10 on October 30, 2014 and another 50% after that by July 15, 2015 when it moved through $2.55.

Yamana’s low was on January 19, 2016 at $1.41, which was another 45% below the third 50% drop at $2.55!

Here’s how that looks on our chart:

Yamana Gold

Amazing, isn’t it?

If you’ll permit me a quick mathematical and charting aside, I’d like to mention that there is a way that you can visually appreciate the successive 50% drops a bit better. We can make the right axis “log-scaled.”

Log-scaled charts use logarithmic steps on the right axis instead of arithmetic steps. In the above chart we are using steps of plus 2 along the right axis – 2, 4, 6, 8, etc.

In the following chart we use steps of times 2 instead – 2.5, 5.0, 10, 20.

Yamana Gold1

Using this logarithmic approach to our right axis scale allows us to appreciate that that move down from $5.10 to $2.55, for example, is about the same distance down as the move from $20.39 to $10.20. They are both 50% drops.

So the next time you’re getting tempted by a stock that’s down 50% off its highs, remember that it could just as easily fall another 50% … and then another 50% again. And, if you think of it, turn on log-scaling on your charts so you can see the big picture.

Stay smart,

Richard_Signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops