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  • The Anatomy of a Stock Market Overreaction

The Anatomy of a Stock Market Overreaction

Many of you may have heard of an academic theory called the "efficient markets” hypothesis. 

This is where we normally would pull up some wonky definition of this concept, but we are going to go straight into our own version of it… 

The “efficient markets” hypothesis argues that the stock price of a stock at any given time perfectly considers all of the information available into that price. The stock is reasonably and accurately priced based on this information. 

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This means there is no way of beating the market or making excess profits because all of the information is in there. 

NOW – we ALL know this isn’t the case! 

Our trading strategies have regularly and consistently booked excess profits (versus just buying the stock market indices) across the last five years. 

The key is to take advantage of human psychology and how it impacts share prices. 

In today's HX Daily, we will discuss the recent price action in our recent HX Trader and HX Income Free Idea recommendation for Adobe, Inc. (NASDAQ: ADBE). 

We aim to understand how short-term psychology intersects with stock price and company fundamentals. 

You may already be familiar with Adobe, the company, and our thesis, and you can revisit it here. 

Let’s look at a stock chart across the last year to discuss what is currently happening with the shares… 

The chart shows the stock price, volume, and our favorite technical indicator – the "relative strength index" or "RSI."  (Read more about the importance of RSI here.) 

The first thing to note about the stock is that – up until Friday – it had done very well. It rallied from below $350 in mid-May last year to above $635 in December 2023 and February 2024. This means that stock was up almost +80% in less than a year. 

The chart shows that the stock sold off in mid-February when we first recommended the shares to our paid subscribers. 

The catalyst at the time was the "introduction" of a video product by artificial intelligence leader ChatGPT. We use quotes around "introduction" because the product is unavailable, and there is no timeframe for it to be available. 

Our view was that this would have no impact on the company fundamentals in any relevant time frame for trading the shares, say six months or less. 

We felt the stock had sold off due to profit-taking after a good run (+20% since the end of November), some uneasiness in software shares across the board, and momentum around everything "AI." 

The same flood of investors rushing into AI names like NVDA could also put selling pressure on any stock that even has a perception of AI-related weakness, whether that weakness is present or not. 

We believed there would be a very brief "freak out" by AI momentum investors (fear and short sellers) that would abate. As investors digested the "news" about Sora, they would realize it was not a real threat anytime soon. Then selling would abate, and buyers would step in to take advantage of the lower price of a great company. 

The shares sold off from $627 on February 9 to a low of $541 on February 20. That is a -14%. 

We recommended selling put options on the shares on that day – February 20. 

Look at the stock chart, and you can see that our theory looked like it was playing out. The stock bottomed and was grinding higher, trading as high as $585, or +8% from the low. 

Then, the company reported earnings after the market close on Thursday, February 14. 

We wrote a thorough review of that report and our recommendation here. 

The company beat on both revenue and earnings but still disappointed on forward guidance. 

The explanation for the sell-off was weaker-than-expected revenue guidance for revenue overall and for "new recurring creative business." 

Overall revenue guidance was "$5.25 billion to $5.3 billion" versus expectations of $5.31 billion. At the midpoint of the range, this would be a difference of—$35 million or 0.67%. 

The guidance for the "creative business" came in at $440 million versus $459 million, a difference of—$19 million or 0.36% of total revenue. 

As a result of these disappointments, the stock traded down from $570 to close at $492 or -14%. That is a market cap loss of over $35 billion in market capitalization! 

This is on the back of a potential revenue miss of $35 million. We say "potential" because this is the guidance, and they have a history of beating guidance. 

How does a loss of $35 billion on a change of $35 million in revenue make any sense? 

The way to understand this is to remember that STOCKS are NOT COMPANIES. 

The sellers (and short-sellers) were not selling their shares by saying to themselves – “this change in revenue guidance means the intrinsic value of these shares is now $35 billion less”. 

Instead, they were reacting to the data point in front of them and price momentum. 

Do YOU believe in the “efficient markets” hypothesis? What is the most recent example you have that proves it wrong? Let us know in the comment section below.

Some investors believe that they simply look at the "next" data point. If it is getting better, they buy. If it is getting worse, they sell. This is a pretty good overall strategy. 

In yesterday's HX Daily, we also discussed the influence of moving averages. 

ADBE broke through the 50-day and 100-day moving averages back on that original break in February. This means a large group of investors were sitting on losses. 

With this move, it broke through the 200-day moving average strongly. There are typically 22 trading days a month, so the average investor who bought this stock in the last ten months (almost a year) was now sitting on losses. 

Many investors accordingly used their "stop loss" and sold. 

Finally, the downward momentum and negative sentiment about the AI "threat" likely led to more people pressuring the shares. 

These all combined in a perfect storm to wipe out $35 billion of market cap on a miss of $35 million of revenue. 

This is a textbook example of why the stock market is NOT efficient. 

Is the stock market wrong? 

Well, the current price of a stock is NEVER wrong. It is the price at which shares are transacting, and by definition, it is the truth. 

Looking forward, though, we think the shares will move higher. Maybe not in the next day, week, or month, but we have seen this type of situation many times. 

A series of events conspires to motivate groups of shareholders to sell in the short term. The analysis, however, points to the low probability of this downward momentum continuing. 

The core of our thesis on ADBE was that this company beats numbers (which it did) and sees upward revisions to guidance. Here is that chart after last week's report… 

This stock is a BUY. 

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