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Spotting Tops
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Two great investment themes create the day-to-day tension in the stock market: capital appreciation and capital preservation. We have historically—and I think inaccurately—called capital appreciation by a different name: "buy and hold." I have shown that buy and hold has no place in the logical investing lexicon and that buy and homework must be the modus operandi. Buy and hold presumes, preposterously, that tops—permanent impairment of stocks after a certain attained height—don't exist. Yet dozens of tops are formed every week that could wipe out whatever capital appreciation you may have gained by buying and holding. Tops are the bane of all investing. At a top buy and hold is the enemy and capital preservation becomes king.

Yet the amount of attention paid to spotting and avoiding holding after a top in the investment canon is paltry when you consider the damage and the havoc that tops can wreak on your portfolio. If there were genuine scrutiny and rigor to how stocks originate in the first place, if there were somehow some strictures about what kind of stocks are "suitable" for investment, we wouldn't have to worry about tops. All stocks would generate solid returns, save a handful that fail. Those would be chalked up as occasional accidents that happen, nothing more than that. We would factor them in; a diversified portfolio would cushion whatever damage an occasional top might generate.

Unfortunately, we are never at a loss for bad stocks in the mar­ket. Virtually any company can issue stock without much scrutiny from the feds beyond the securities equivalent of a name, rank, and serial number. Recently, the SEC revealed the names of some thirty stocks that traded with multiple billions in capitalization that had no companies underneath them. That's right, they were made-up companies—shells—that had no earnings, revenues, or even, in some cases, headquarters or employees. These nonexistent companies traded freely for years in the hundreds of millions of shares without being flagged by any authority. The government didn't blow the whistle on the stocks until most of them had been reduced to zero, of course, not before robbing unsuspecting "investors n —if you can call this process investing—-of billions of dollars in wealth. Before the government halted trading in these empty, worthless vehicles, they had been blessed, de facto, as if they were operating companies with real financials. No government entity ever came out and said, "Be careful, these aren't real companies." You can't expect the SEC or the exchanges to protect us from the fraudsters, though. And there's too much corruption out there for the SEC to be a cop on the valuation beat; it's not the government's job to examine whether a stock is worth something or nothing at all.

You can't rely on the market to sort them out correctly, either. It fails so often to do that job that you should have lost whatever faith you might have had in the screening and valuation processes of the collective wisdom of the market by now. But many of you still haven't been disabused of the market's illogic because of the buy-and-hold brainwashing that Wall Street relies upon to keep you from taking back your assets under its management. If you knew what the Street knows, you would rather be in control of the money yourself. That way your guard would be up and you could be more vigilant than Wall Streeters want to be, or, given the conflicts of interests they live under, can afford to be.

Although we are a nation that has produced stocks with phenomenal long-term returns from both dividends and stock appreciation, we are also a nation that has produced more investment fads, more short-term gimmickry, and more white-collar corruption leading to multi-billion-dollar losses than any nation other than Japan during that country's phenomenal bubble (which is still bursting). There are tons of stocks that don't deserve even to trade and a myriad of others that are topping right now and could be incredibly dangerous to your financial health.

For me, spotting a top is the equivalent of embarking on a long and winding train ride and trying to figure out if the engine's about to jump the tracks any time soon. We know nearly all trains get to their destinations, yet we accept the fact that occasional derailments do happen. This chapter's about trying to get as much mileage out of stock as possible, but not so much that you hang on while the stock jumps the track or plummets through a broken trestle. Sometimes, you've got to jump off the train to survive. It's no sin to do so and, of course, it would be pretty stupid if you knew a crash was coming and you stuck around for it. Yet, despite the common sense of it, my view is not the prevailing wisdom on Wall Street.

On Wall Street "sell" is a dirty word and tops don't exist; they are only temporary breakdowns that will eventually be surmounted. When I first got to Goldman Sachs I remember asking people, "When do I tell clients to sell? What's the exit plan?" The greybeards would say, "When the stock gets downgraded; that's when you sell." But downgrades, when they happen, most often come after the train has abandoned the track. The selling process is pretty alien, especially when another portion of a firm might be vying for business of the company that might be downgraded, and that business is a much larger business than whatever trading profits can be made in the stock. Even though Eliot Spitzer, the New York State attorney general, has performed yeoman's work vetting this process, it still happens as long as investment banking and research are under the same roof. You just don't get a lot of correct sell recommendations on Wall Street, and when you do, it is usually too late to sell. Indeed, there are hundreds of texts and analysts that can tell you when to buy. But selling is considered to be a sporadic, haphazard art. I contend that selling and knowing when to sell are more important than knowing when to buy. That's been the lesson during the last seven years where the S&P 500 com­pounded at 5 percent and many stocks lost you tons of money during that period. I have spent much of my life poring over chartbooks looking for patterns, looking for repetitive warning signs that would get you out before the top. I wanted to find a commonality, or a set of commonalities, that could be warning bells for stocks that otherwise would be too dangerous to touch, the stocks that produce short-term gains in almost parabolic style, the stocks that go up fast but fall even faster. The idea behind such reasoning is that you shouldn't deny yourself an iVillage or a Commerce One or an eBay on the way up, provided you know when to get out. You can own the sizzling stocks, take the huge gains that they provide, and then exit before the steak gets burned.

Spotting tops allows you to embrace lots more equities, including riskier ones that can be very rewarding, much more rewarding than most people think possible. If you hone your selling skills, you can take advantage of the four- and five-fold rallies that can occur in unseasoned merchandise, even if, in the end, the merchandise craters to zero—as long as it does so without you on board. This flexibility has made me fortunes even as it has created a legion of Cramer-haters who think that I have no right to hop off the griddle. This top stuff truly is like cooking. You can cook something to perfection. If you take it off before you get it there, nobody's happy, but you can always throw it back on. But once it is burned, it's finished, done, destroyed. Why stay on the griddle for that punishment when you can learn to spot the moment something's about to get fried into oblivion? This bit of cooking advice is better than anything you will ever get from most investment books. I can't tell you how many times recognizing that things have gotten too hot after a big run has allowed me to take terrific gains even as others say, "Hold it, I thought you said you liked this stock, you can't sell it now." My view? You bet I can. I am not sticking around for my meal to burn to a crisp even if I liked it a moment before. That's foolish. These are stocks; just like food, they can vaporize in an instant. They can and do go bad, all the time.

The more we are wedded to stocks, the more we ignore the changes that might be occurring in the ever-fluctuating landscape, changes that might knock our companies out if we aren't careful. Ideology's an unsteady crutch in this game; the more we have of it, the more money we will lose. This is a business of flexibility; you may have to like a stock one minute and hate it the next because the fundamentals underneath change that fast. If you think this is a business of firm, resolute stands no matter what the facts say, you are going to end up poor as a church mouse. That's no way to run money, your own or others'.

Let me give you a couple of other caveats to the top process. First, this is not a chapter on spotting markettops. I am focusing on when to sell individual stocks, although I reach a conclusion about the entire market and when it should be sold, more as a recognition that there have been and will be "tops" in the S&P 500 that will last long enough that they should be solidified. However, I always believe the casino will be open, and if you take it case by case, game by game, that's a lot better than saying, "That's it, I want everything out." That's worked only once, in the third week of March 2000.I don't suspect we will see such a renegade market bubble in our lifetime. If anything, I am far more concerned with some sort of biblical seven lean years after seven fat years. I don't mind mixing biblical metaphors with Vegas-style reasoning. By now you know that I think that any analogies to casinos are far-fetched; the table games have much more rigorous rules and regulations. Letting you bet on a bogus entity—something that happens with stocks all of the time—would be ruinous to the house, and the casino business just wouldn't allow it to happen. Same with illegal NFL gambling, which I regard as much more honest and less rigged than much of what passes for fair in the stock market.

Second, I am not a technician, and this is not a collection of chart patterns that lead up to tops. Chart people spot many tops; in fact, they spot many more tops than there are. That's just not valuable to me. In fact, one of the biggest mistakes I ever had in my career was to be short Genentech based on a classic top formation, which, a prominent technician told me, ninety-nine times out of hundred produced a significant decline. I got my face handed to me when, the next week, Genentech got a humongous takeover bid! I had to buy the stock back up about 70 percent. Nasty, embarrassing, and astonishingly costly. As I hung up on the technician after cussing him out for the hot tip, he was squealing, "But the chart says it should go down!" To heck with the chart! To heck with the chartists! Except Mrs. Cramer, who still manages to integrate the fundies and accepts that the chart can never be the final judgment, but can be consulted to generate ideas.

Nor am I talking about temporary fluctuations in stocks, avoiding short-term drops. If you follow my rules on portfolio management— my bulls-bears-and-pigs mantra that involves talung a little something off the table as a stock goes up—these short-term tops, false tops so to speak, take care of themselves. You quickly put the money back to work in the same equity at a lower, cooler level. Low taxes and low transaction costs now allow such moves. This kind of approach not only is important, it is prudent in a world gone buy-and-hold haywire.

The real danger of false tops is that you might be spooked out of a high-quality stock; they are hard to find and you should treasure them for as long as they last, not jettison them quickly for some lesser merchandise. Sometimes it takes months to develop really good ideas. You should depart from them only when you have serious reservations such as the kind I am about to explain to you.

No, I am addressing here the basic reasons why, unfortunately, at times, you should abandon stocks you know and love. They are reasons why you should take the money off the table and look elsewhere for opportunity because something has changed, something in the landscape either for the equity or the company itself has gone sour or is about to go sour and very few people know it. Here are the main antagonists to buy and hold, the place where tops are in sight and you can assume that the train will derail if you stay along for the ride.

1. Competition. The most common form of top explains why you must stay involved with the day-to-day operations of your companies, why you can't do "buy and hold but have to do homework instead: the competitive top, when someone else comes in and destroys your company's business. You can tell when the competition is heating up only if you stay vigilant and monitor not just your company but the whole industry, one of the main reasons why I say you need to give your portfolio one hour a week per position if you are going to get it right. Seventy percent of the tops I have studied have this dominant competitive characteristic at their roots. Typically, the company itself doesn't see it coming. You may own a company with fairly decent margins on sales that is forecasting great multiyear visibility because it has terrific market share and has vanquished its competitors. Suddenly a new entrant comes in, one who can make the same product or do the same service or sell the same goods as your company, but with lower margins. The new competitor, if it means business, and they often do, will destroy your company even as your company pretends that such a thing can't happen, or doesn't even know that a competitor is lurking because it is watching only the existing players, not anyone off the radar screen.

Let's examine the greatest top I have ever seen in my life, the top involving United States Surgical. Everyone who was anybody in the market owned U.S. Surgical during the 1990s. It was a universal principle that you had to have stock in this dominator of the surgical staples, because it had sky's-the-limit growth with no competition and unlimited market potential. USS had a revolutionary proprietary technology of staples that could be used instead of stitches. USS's business was big, bigger than big. It was the only stock you just had to own.

In the 1990s I worked as a trustee to a fund that owned 8 percent of the stock. The position kept going up and it became a bigger and bigger portion of the fund simply because of the mammoth capital appreciation. I grew worried that we were too levered to the stock and demanded that we sell some because I thought we were being pigs. I must have asked them to take some profits for almost two years because I thought it was so rich, but no top ever developed and the stock just kept increasing in price. I ended up being kicked off the board in part because I was so negative about this wonderful stock that I felt just couldn't continue forever. It apparently could.

Just when everybody loved this stock and it was among the most widely held equities in the country, with the highest gross margins of any mass-produced product I had ever seen, Johnson & Johnson, which made Band-Aids and a lot of hospital and surgical products, decided that it had had enough of United States Surgical's domination in the operating room. Management at JNJ made up its mind that it was going to challenge USS. Management made this judgment even though everyone on Wall Street thought that USS couldn't be removed from its hammerlock on America's operating rooms. Critics of JNJ and supporters of USS thought it was reckless for JNJ even to think about taking on USS. There was one key difference between JNJ and USS. USS had high margins on its staples, JNJ had low margins on its Band-Aids and its other hospital-based commodity products. JNJ made very little money on Band-Aids; USS made huge money on its staples. If JNJ had any success at all, the company would be able to raise its margins because a new higher-margined product, staples, would be a part of its mix.

At the time JNJ announced it was moving into USS's business, USS was at $120. Every one of the USS analysts ignored the JNJ threat; most USS analysts didn't even follow the stock of JNJ. Others felt that stodgy JNJ couldn't possibly beat fleet-footed USS. I knew it didn't matter. Given that JNJ's margins would increase even if it sold its staples for half the price of USS's it was only a matter of time before USS's margins were cut to ribbons and the stock slid. I looked at the margins of the two companies and decided that USS was finished, kaput, done for. I shorted every share I could get.

As JNJ moved in with its lower-priced alternative, USS slid from $120 to $80. At that level those USS adherents who were in denial about JNJ started talking about price competition in the operating room. Heck, USS had never done anything but raise prices. Now it was cutting them?

The stock went to $30 overnight on that kind of talk as USS's margins tumbled in a price war. None of the USS acolytes even saw the JNJ train coming. If you were following only USS, you were totally blind- sided. I covered the stock in the mid 20s, but I could have waited because it went still lower before ultimately, spent and confused, the company succumbed to a takeover bid.

Rule number one when you are riding a great long: Always assume that there is someone out there who could come in and make your company's product for less with lower margins. A committed com­petitor moving into your company's area with overall gross margins that are lower than the margins your company has signals the time to run, not hide. This kind of pattern happens over and over again in everything from tech to tampons. No one-product or two-product company with high margins can withstand a well-capitalized lower- margined competitor. Given that the competitor tends to be of the Merck or IBM or Intel or Oracle, Procter & Gamble or JNJ variety—a global behemoth with lower margins than any specialty players—you have to be totally on top of what could be a terrific momentum situation one day and a stupendously overvalued stock the next. In fact, much of the big top of the year 2000 was directly related to established, well-known, but lower-margined tech companies barging in on lots of little specialty dot-com companies that had one product and high margins. The market was littered with stocks that went from $100 or even $200 to zero almost overnight, and you would never have known to get off if you were just talking to the target companies themselves. Viant and Scient, billion-dollar consulting companies one minute, were bankrupt consulting companies the next when IBM and EDS moved in. Tampax, a fantastic single-brand company, got side- swiped when Procter and JNJ moved in with products that crushed Tampax's margins but elevated their own. None of these little companies and their acolytes on Wall Street saw the locomotive was out of control and about to jump the track. These were horrid accidents just waiting to happen. Simply put, when you hear about new competition, you must worry, whether you would like to or not. Not unimportantly, the periods of profound underperformance for Intel have come when AMD geared up with a competitive offering. Similarly, much of the underperformance for Microsoft in the 2003-2004 period before the big dividend change was related to competition from Linux provider Red Hat. Did these cause tops? We still don't know. Your takeaway should be that you must never underestimate the power of the competition to hurt your stock, even if it doesn't immediately hurt the company.

2. Vagueness. Whenever a management is vague about specifics, whenever a management tells you it isn't worried about the numbers, or that it doesn't want to be constrained by the projections or by the forecasts because it is talking and thinking about bigger things, sell the stock. There are no bigger things than the numbers. This is not a game of trying to make people feel better or making them more broad- minded. This is not a liberal arts bull session. It's a business of hitting the numbers. When management goes vague in an interview—any interview—run for the hills. You've got a real top on your hands. Spotting this type of top can be done only if you do the homework and read about the companies that you own. You have to search for the interviews and watch them when they come on television just to see whether they are shucking and jiving or they are sticking by the hard facts.

This method, analyzing the vagueness, is how I discovered the top at Sunbeam, another one of those classic falls from grace that took a tremendous number of value and growth managers with it.

A1 Dunlap, the now disgraced former CEO of Sunbeam, came into my office when the stock was riding high, in the mid 40s. He used to come on TV, notably Squawk Box, and be very adamant about the projections, the numbers. Adamant and positive. One time, after a TV appearance, he decided to swing by my office. Comes in with the sun­glasses. Oh yeah, always distrust guys with sunglasses in a room without a lot of light like my trading room, where I hated the glare from the lights on my machines. He wanted to talk to me and my partner at the time, Jeff Berkowitz, about new products, notably some heart monitor gizmo for dogs. I kid you not. The pet market's huge, he's telling us. Berkowitz says that's super, great to hear, but how's the quarter? Dunlap looks at him with contempt and drones on about the dog heart monitor. So Jeff asks again. Dunlap ignores him and starts talking about a new gas grill that's in four parts, down from thirty. Much easier to put together, he says. I start talking about how much time it took me to put together the grill I had bought at Fortunoff a few weeks before, parts all over the place, and it still didn't work when I finished it. Berkowitz? He's listening and nodding, and then he says to Dunlap, "How's sales from grills?" Dunlap fires back that Wal-Mart and Kmart can't get enough Sunbeam products. Jeff persists, wanting to know real sales data, something that Dunlap had always provided before when asked. "Are sales good right now?" Jeff asks. That's it, Dunlap blows his top. He turns to me and asks how much more of this crap does he have to take? I wink at Jeff. Jeff steps out and sells every share.

When someone who talks up his business at every turn, who is incessantly upbeat, suddenly won't talk about the numbers and won't brag about the business, and instead wants to talk about a heart monitor for dogs, you've got a classic tell that the business has gone sour. A year later Sunbeam was bankrupt.

How else can vagueness manifest itself? A company that formerly wanted to tell you everything about its future no longer wants to give guidance, or says it can't forecast its business. That's a top because the buyers and owners of that stock most definitely owned it because they liked the predictability that the company no longer has. Another form of vagueness can be a company that won't give you breakdowns of sales when it used to, especially when it is saying it can't do this for competitive reasons. General Electric is the single most competitive company I know and it gives you all the data. Shame on those who won't.

Vagueness can also be bravado. Scott Butera, the Trump executive in charge of casinos, told us not to worry about the numbers because bankruptcy would be averted, making the $2 DJT, Trump casino stock, look like a buy. When the stock got cut to 37C immediately after the bankruptcy, you shouldn't have had to worry, because bravado without numbers spells a top, and you should have already sold.

Vagueness, like competition, is something that you can find out about only if you are paying attention and are benchmarking the company. If you don't listen to the conference calls and don't read the interviews or articles, how will you know about new competition and how will you know when management's gone vague? The chart sure as heck won't tell you! Only vigilance will get you out before the top strikes when management has gone opaque.

3. Overexpansion. Nothing defeats a company's dreams like over- expansion. I have written throughout this book that growth is all that matters. In the end, if you can't create growth organically you either have to buy growth or you have to use steroids to grow. Knowing when a company is overexpanding and expanding too quickly, the functional equivalent of steroids, is integral to spotting a top ahead of a train wreck.

Unfortunately, overexpansion is inherently difficult to analyze. It is tough to spot because Wall Street doesn't want you to spot it. Wall Street masks the problems of too much growth. That's because Wall Street loves acquisitions and rapid expansion, the primary ways to make quick growth happen. Acquisitions can make for instant growth, but they can also make for instant problems. Frenetic store openings or office expansions strain a young management's atten­tion and dollars. Both are catastrophic to the core enterprise unless checked by some degree of common sense as well as the wisdom to stand up to the growth jihadists who populate mutual and hedge funds.

Often companies do acquisitions to please analysts who are working hand in glove with another department at their firm that does M&A work. An investment house makes more money doing M&A than any other activity, but the babe-in-the-woods managements that come to Wall Street don't know that. They want to please the analysts, the analysts want payback from bonuses that are controlled by the hierarchy, and the hierarchy knows nothing generates fees like M&A. The investment bankers want to do the deal, any deal, all deals! If a company cannot grow numbers fast enough on Wall Street, it has to go buy the numbers or succumb to downgrades, and those are often too much for unseasoned managements to recover from.

The integration of the takeovers, though, is something so difficult, so taxing, that even the pros screw it up. Time and time again after a company makes an acquisition, the analysts dutifully raise numbers and the stocks initially go higher. I almost always sell into that hoopla because the acquisitions don't go smoothly in most cases and the numbers come down when they don't.

What's the sell signal here if you can't pull the trigger when the numbers go higher? I will give you the code. Whenever you hear management talk about "integration problems" as in "integration problems are slowing our ability to merge these two entities," run, don't walk, to the exit. All deals have integration problems; they are a given. If they are affecting the numbers to the point that management has to acknowledge them, believe me, that's fatal.

Some companies are so desperate for growth that they do acquisitions at any cost. That's what destroyed the once-great AT&T. Michael Armstrong, the former CEO, felt his company was too stodgy and simply wasn't growing fast enough to please the Wall Street analysts who were measuring the company's growth against what we now know to have been the bogus and inflated numbers of competitor MCI-WorldCom. So Armstrong let a bunch of bankers and glad- handing analysts talk him into spending money to make acquisitions so he could grow numbers. Of course, the integration couldn't be done easily, the debt costs were unbearable, and eventually the company virtually collapsed under its own weight in borrowings. The tip-off for that collapse, the top-spotter so to speak, was the unbelievably aggressive acquisition strategy, one that happened at a pace that no management could possibly accommodate. Enron did the same; it made a flood of acquisitions and transactions designed strictly to mask the real lack of growth and the inability of management to create products or business lines itself to put points on the board. Not all companies are meant to be fast growers. Revolutionizing a slow grower into a fast grower is almost impossible; don't fall for it.

If you don't believe me, just remind yourself of what happened with AOL Time Warner. AOL made that acquisition, we now know, because business had slowed dramatically. The only way to mask that incredible slowdown was to buy another company and throw every­body, every doubter, off the scent. It was a brilliant plan. If you had sold AOL when it made that deal you'd have locked in a huge gain at a time when everyone talked about one plus one equals three. Of course a half plus one doesn't even equal one if you pay many times the worth of that half. Everyone who held still has losses and will, I believe, for many years to come. It was just that bad and desperate a combination.

Of course there will be companies that make intelligent acquisi­tions that don't signal the end of their growth. Procter & Gamble has made several acquisitions that have boosted its bottom line successfully; so has General Electric. But they were measured and considered and incremental to their core businesses, not roll-the-dice mergers done one after another to throw you off the scent. GE and P&G are established companies where mergers and acquisitions are part of the business structure. They are not anemic growers desperate to please by trying to integrate new businesses into existing product lines. P&G and GE, by the way, have never had integration problems in all the years I have been following those two great companies.

Overexpansion doesn't happen just through acquisitions. Retail­ers, which are under tremendous pressure to grow to please Wall Street, have often opened too many stores at once just to meet the demands of analysts who like their stocks. When you see companies put up a phenomenal number of stores all at once relative to their base, I think you have to shoot first and ask questions later. It just isn't possible for a management to maintain the quality control through that kind of expansion. It is a sign of weakness, not strength. It is also why, when a company is in extreme growth mode, I look at same-store sales, not total sales, to detect a fiasco. When retailers are growing by leaps and bounds you can't gauge a business from total sales: Adding stores overnight grows bigger numbers. So look at same-store sales, "comp store sales" as they are known, to judge how much the existing business is being hurt by the expansion.

By the way, that's one of the reasons that I would urge you, if you decide to own the stock of a retailer, to visit the stores regularly. I was able to spot a top in Restoration Hardware by a combination of visiting stores and monitoring that company's breakneck expansion to please Wall Street. When I got yelled at in the local store at the Short Hills mall, even though I had to be one of the biggest patrons of the chain, that set me to work on what ultimately turned out to be a mag­nificent short sale.

These companies, by the way, almost never recover when they expand at that pace, which is why I am so adamant that when you see this kind of nonmeasured expansion you have to hit the ejection button. The ultimate top is formed when a company stumbles after breakneck expansion, any company. Don't even attempt to bottom- fish; there tends to be no there, there. Particularly when the expansion is of the "roll-up" variety, where the home office keeps issuing stock to buy mom-and-pop companies. Once the earnings cool and the stock flops, there's no way to get the momentum back. No mom and pop will sacrifice its hard-earned businesses for that devalued currency. The Street is littered with bankrupt companies that didn't understand that ironclad law.

4. Government blindside. The front page of the New York Times spots more tops than the business page. That's because governments, both federal and state, can do more to hurt companies or permanently debilitate their earnings than any competitor. Oddly, though, the Wall Street analysts who are supposed to flag the real problems for companies to us mortals who await their verdicts don't pay much attention to government edicts. The large institutions that control the marginal shares of companies are so focused on earnings growth from internal sources that they, too, miss the big negatives that can come from any administration.

In the late 1990s, for example, the greatest stocks, the most recession-proof stocks, were the nursing home stocks. These had mo­mentum and a thesis, the graying of America. All of the major investment houses embraced the aging theme, and everyone presumed that the government would just keep paying major portions of the nursing home bills for the elderly. Wasn't that the politically popular position? Didn't the elderly control lots of key states and vote their pocket- books? That was the logic, certainly, of the lofty multiples these stocks sold at in the late 1990s.

Perhaps the most popular stock of the era, Genesis Health Ventures, a gigantic East Coast nursing home chain that kept issuing stock to roll up mom-and-pop nursing homes, just kept roaring and roaring higher as this thesis ascended. But President Clinton, right before the turn of the century, decided he had to rein in some health-care costs lest the country slip back into deficit spending. The feds decided, virtually out of nowhere, to change the reimbursement rate to operators of nursing homes. The companies didn't see it coming. The analysts didn't see it coming. Yet, when it happened, it was devastating news de­livered from the front page of the New York Times. I recently looked up the First Call notes—the analysts' contemporaneous comments—and not one flagged the articles that were hidden in plain sight on the front page of the paper of record. They all missed it. This reimbursement change was the single most devastating piece of news ever, but the stocks just hung there as the owners and their analyst buddies ignored the guillotine that slammed down on the news pages. Once the reimbursement rates changed, every one of these companies went from great longs to great shorts, overnight. Genesis Health, the bellwether of the industry, the gold standard, would be in bankruptcy within a year. It went bankrupt while many of the buy recommendations were still intact.

How do you spot this kind of top? You have to start by reading the front pages, not just the business sections, of the New York Times, the Wall Street Journal, USA Today, and the Washington Post. I start my day with them, electronically, inserting my stocks' names in their indices to see where the articles come up. I never constrain myself to the business sections; that's just foolish.

During the downfall of Genesis, I spoke to a relative who had sold a company to Genesis Health. The stock had just fallen 10 points from its top and every analyst was telling me to buy it. I asked him what I should do. He had a simple answer: "Don't you read the papers? The businesses are finished." I told him that couldn't be because the companies were all saying not to worry. He said they were saying that to the analysts, urging them to keep a stiff upper lip, but in truth they were petrified. The great nursing home buy-and-hold craze was a huge top the moment that the reimbursement rates changed. It never came back.

Similarly, DoubleClick, among the most successful of the dot­coms and among the quickest to reach a multi-billion-dollar valua­tion, decided at what amounted to its peak that it was going to enter the business of knowing everything about its customers. It paid a couple of billion dollars for Abacus, a marketing company with a huge database of users. No sooner had the deal been completed than the government questioned whether these kinds of services invaded consumers' privacy. DoubleClick ultimately had to write off billions of dollars as it misjudged the political tremors that were evident for all to feel. As is typical, the analysts took their cue from the smug Dou- bleClick folks, who never knew what had hit them. Still don't for that matter.

I got hit by one of these governmental blindsides just last year when I rode Forest Labs, a drug company, all the way down from what now appears to have been a certain top. My mistake? I didn't take seriously the notion that the FDA and Congress would begin to focus on the suicide rates of young children on antidepressants, the core of the growth for Forest Lab's most important drug, Lexapro. The analysts didn't believe it, either. But it was right on the front page when the stock was in the 70s. Thirty points later, when the analysts finally started addressing the problem, it was too late for me. One of my largest losses since I left my hedge fund.

5. Top in retail. Retail tops are easy to spot. Some think you can spot them by measuring same-store sales, sales that are compared on an apples-to-apples basis. If sales in one store were $1 million in year one and $900,000 in year two, that's a same-store sales decline of 10 per­cent for that store. I like that as a measure of rapid-growing retailers, but for mature retailers, I use a different litmus test. Companies have good months and bad, and while the same-store sales are important, they inconsistently call more tops than they should. False tops are the bane of investors who own retailers, so you have to be very careful not to exit just because a company, particularly an apparel company, had a bad month.

No, the real top in retail comes when a retailer has stores in every state, when there are no new areas in which to expand. Every retailer, whether it be Gap or Wal-Mart or Kohl's or Home Depot or the Limited or Toys R Us, hits a wall when that happens. I love to own retailers early in their growth cycle when they are regional going national: lots of states ahead, and if the concept is a good one you can use every single same-store sales decline to buy more. But, and it is a huge but, once all of the locations are used up, as represented by a truly national pres­ence, I have no desire ever to own that retailer again. It's been a terrific way to own these stocks, and I have managed to get the maximum out of every one of the majors and then leave them, never to own them again when they cracked into the last corners and crannies of American malls. Be careful. Analysts hate to get off retail horses while they are running; they will deny that this nationwide test matters. I know better; it works every time.

6. Fad stock tops. I can't blame anyone for playing any fad. The runs we have had in everything from Reebok to Palm to Research in Motion have been fantastic. There's always a product out there that is in short supply because it has caught the fancy of the American consumer. You can make fortunes as the stocks go higher. But as soon as the supply catches up to demand, whether it be iPods built by Apple Computer or aerobic sneakers made by Reebok, you must sell it and never look back.

How do you spot a fad top? You have to monitor the stores that sell the product. You have to listen to the conference calls. I was able to sell fads at the top in everything from Palms to Filas to Guess jeans to Keds simply by listening to the conference calls of places that sell these goods, not by the managements of the companies themselves, who never saw the tops coming. As long as the merchants said they couldn't get enough of the product, I knew I was fine and the stock would go higher. Once they said that they had enough product to be able to meet the demand, there was no price at which I wouldn't sell the supplying company's stock. It's just that simple. But if you are going to play a fad, and you don't have the time to listen to conference calls where the fad product is sold, a Best Buy or a Radio Shack for electronics, a JC Penney or Federated for a clothing line, you are going to be crushed like a bug on a windshield. Doing that extra homework, checking outside what management of your company has to say, will save you from holding the stock after a top and losing a fortune, especially because as is typical with fads, the fortune is huge but ephemeral to all but those who pay attention to the outlets where the product is sold.

7. In-the-hole secondary. One of the incredibly easy tops to spy is when a company does a "deep in the hole" secondary after a huge run. Talk about sure tops. When a company sells stock that is at a huge discount to the last sale of its equity, that's a gigantic red flag that will soon turn into the Jolly Roger to steal your gains.

At one time in the 1990s, Iomega developed a cult following. It had a Zip drive that people thought was proprietary and was always going to be in short supply. The Iomegans worshiped the stock. Me? I don't worship any stock. But I recognize that a cult following can be milked for all it's worth. Investors and friends would chastise me, saying that it was simply a piece of junk that was overly loved. I said, So what? The stock is in tight supply; the short sellers are killing themselves over it; and I am riding it until I see a secondary that is priced in the hole for it, meaning a piece of merchandise from insiders at the company that is sold by underwriters at a substantial discount to the last sale. When that happens, you sell, period, and you never look back. That's because the insiders know the jig is up. The real institutional buyers, the smart guys, have no appetite for the merchandise. Voila, immediately after the short squeeze is alleviated, the chart goes bad, the institutions puke it up, and the stock just dies. That's exactly what happened in Iomega. The stock went from $1 to $50 and then came down to $40, where Iomega priced a secondary at $35. Okay, I didn't get out at $50, but I was able to hit that $35 bid provided by the underwriters who, foolishly, tried to support the stock. What a home run. Another few months and it would have been a strikeout.

I can't tell you how many in-the-hole secondaries were done between October 1999 and October 2000, the ultimate topping-out period for the market. Every one of the major dot-coms did these in-the-hole secondaries. It got to be like shooting fish in a barrel; you could own them until the deal came, and then you had to blow them to kingdom come. One reason why I had such a big year in 2000 was that after every one of these in-the-hole secondaries I went short the stocks that did them. You can't get a clearer top tell.

In case you still need help in understanding this one and remembering how vital it is that you sell when you see one of these secondaries that is sold deep and still doesn't hold, let me tell you the story of DIGI.

If there was a stock that embodied the more manic years of my hedge fund, it was DSC Communications, stock symbol DIGI. We owned it from $25 to $75, and it was the type of ramp that used to make our day, every day. Oh we loved DIGI. Jeff Berkowitz had just joined our firm out of the Goldman Sachs research department, where he covered tech. My wife headed the trading desk then. When we had a great stock going, my wife used to lead us in chants about it. They always chanted and played music with bongos and drums at her old shop to alleviate the pressure, and she had brought that style to our desk. Her chanting sounded like a mixture of "King of the Congo" by Kipling and a Gregorian version of the Florida State Seminole cheerleaders at the big game against the hated Gators. Every time the hope-filled stock would rise more than a dollar she would start in with "Didg-ee, Didg-ee, Didg-ee" until the stock would be up a couple of smackers. She would directly attribute the stock's levitation to the mystical powers of her chanting. Of course, it was DIGI's growth that drove it, but the stock business does have a strange karma to it at times.

In the meantime, the beat of the whole market was being set by DIGI's earnings-estimate increases, the real tonic that moved the stock higher. When estimates weren't being upped, DIGI was busy announcing contract after contract from Baby Bells and foreign companies that would eventually lead to higher earnings.

A day never seemed to go by without hot news for DIGI. This stock was telephony's gift to the Street. It had everything: fiber to the loop, home video, pay TV, you name it. It was the equivalent of Lucent, Cisco, and Nortel all rolled up into one when those stocks were revered on Wall Street.

The stock, like any hot stock of consequence, also attracted the attention of the shorts, who, every day, would die a thousand deaths as the stock would be taken and taken and taken. We would all be glued to our screens watching this marvelous animal leap through whole new handles (each new $10 level is a handle: $10, $20, $30). As the offerings lifted we would wonder aloud what short fund would be cremated today by DIGI. Short squeezes, possible takeover, earnings- estimate increases, contracts—we lapped it all up and hoped it could go on forever. We were, for all intents and purposes, the DIGI Fund.

And then one day Goldman Sachs filed a secondary for a boatload of insiders at DIGI who hadn't done any selling of late. Sometimes these big holdings get bunched and sold all at once, and that's what Goldman did with the stock of the DIGI insiders. The offering was gigantic, big enough to sate everyone's interest who wanted it. It over­whelmed the market, as these secondaries often do. The deal was big enough to allow as many short sellers who wanted to cover in on the stock that had been tight as a drum and unavailable to borrow. (Funds had sold the stock short, hoping it would go down, and then couldn't physically deliver the stock because, of course, they didn't own it, and they couldn't find any stock to borrow.) The secondary was big enough to alleviate the squeeze that had helped propel this stock so far.

Suddenly, DIGI the rock of Gibraltar became DIGI the house of cards. The day the big slug of merchandise was priced, the stock was abnormally soft. The offering got priced right through the bid, deep in the hole. It still seemed shaky, even though it was much lower than where the stock sold the day before.

The moment it was priced my wife turned to me and said, "DIGI is done-ee." I told her not to be ridiculous, that this stock had all the right moves, big orders coming, some I even knew about, and that we had to go right back in and play the DIGI game. She nodded to me, smiled, and sold every share we owned. Hundreds of thousands of shares. She just drilled the bid, the big juicy syndicate bid, and just like that DIGI was out of our lives. I was furious. I knew good things were about to occur. She just laughed.

The stock didn't hold that price. Others puked it, too. Others who knew what Karen knew, which is that deep-in-the-hole secondaries are like fire in your portfolio. The stock soon broke down and wilted. By midmorning. I felt like I had lost a limb. I didn't understand Karen's rules yet. I thought we should just buy it again. Where would I ever find as good a story as this? I demanded to get back in. She said absolutely not, that we were going to wait until the guillotine stopped falling.

The stock rolled down again the next day and the next. Then, a week later, DIGI lost a contract that I thought it should surely have won, to the manufacturing arm (later Lucent) of what was then AT&T. This was the first big order Lucent had won of the type and it virtually gave the darned thing away to get the business. (See low-margin enterprises versus high-margin enterprises and tops, above.)

DIGI's stock never recovered from that loss. The very next quarter it missed numbers. And then it blew about a half-dozen quarters until it finally got so low that Alcatel snapped it up for below where the whole move started.

If you had paid attention only to the analysts—almost all of whom loved DIGI and didn't downgrade it until shortly before the Alcatel bid—or if you had just focused on the company, or if you had fallen in love and decided that buy and hold was all that mattered, you would have given it all back and then some.

But if you followed the simple rule, Sell the deep-in-the-hole secondary, because it's being done for mystical reasons you don't know but will most certainly soon find out, you will get out with your gains intact and a smile perpetually on your face.

8. Accounting mayhem. The final top that manifests itself with frequency is the accounting shenanigans top. The main reason a company jiggers the numbers is that it can't make them. When a company can't make its estimates and resorts to these kinds of games, whether the company is Tyco or Cardinal Health or Bristol-Myers or Enron or Schering-Plough, you simply must sell it. There is no excuse, no justification to hold on to it. I have a sign that says "Accounting irregularities equals sell" on my quote machine. Mistakenly, in the post- Sarbanes-Oxley period, when I thought that the courts had gotten so tough that you had to be out of your mind to pull off this kind of legerdemain, I took the sign down. A week later Nortel, at $7, an­nounced that it had found some irregularities. I was off my guard. I held instead of selling. The stock promptly went to $3.I couldn't ever recover the money invested.

Never hold on when these come up. Never. Cendant is still not back to where it was when it first served notice that its accounting was shaky. It's simply the kiss of death when these tricks surface. You must shoot first and not even bother to ask questions later. Will you end up selling some stocks too soon because of this? No doubt. But would you end up selling all of the accounting disasters higher than where they ended up? Yes, 100 percent of the time.

9. Holland Tunnel Diner top. We have whole markets that are like the griddle in that diner I described earlier (see page 147), where the market is just so darned red hot that you have to take something off the heat or get burned. Sometimes that will cause you to lose some of a good stock that keeps going higher; other times it will allow you to avoid a top or lessen exposure to a stock that has topped. Unlike the other tops, of course, it is more of a look and feel than a set measure. But when a red-hot market is coupled with an S&P oscillator reading of +5 or more and there are more than 50 percent bulls, you better believe the merchandise is going to fry. (Through its own proprietary 0scillator, which I pay to consult, the McGraw-Hill Company's S&P Division keeps track of overbought and oversold markets.) Holland Tunnel Diner tops are often followed by 7-10 percent declines that the market eventually recovers from. But you would be amazed at how many stocks top for good during those viciously heated moments. Don't let your portfolio be cooked with them.

When I got out of the market in March 2000,I was heavily criticized because I had been so bullish just a few weeks before. But tops are like that. Right before you reach the summit, things are cooking to perfection and you want to be in. You have to be in to get those great gains. But one moment past and you have lethally overstayed your welcome. Don't be afraid to change your mind. This is one place where when the heat is too hot, you must get out of the kitchen.

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