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Wall Street's Secret Behind the Netflix Collapse

Written By Brian Hicks

Posted October 28, 2011

The markets are rigged.

A recent survey by Prudential Financial found most investors have figured it out — and they’re done with it.

The survey revealed 58% of investors have lost faith in the stock market; 44% say they’re not putting any more money into it.

Who can blame them?

After the “flash crash,” a market with 70% of all daily trading volume is done between computers and stocks that live and die on the Fed’s decision to pump another trillion dollars into the system.

It’s not as easy as it was 20 or 30 years ago…

But a few times a year, the tables get turned around. Disciplined investors armed with experience and knowledge can reap huge rewards while Wall Street loses a fortune.

We’re right in the middle of one of those times now.

The Best Time to Be an Investor

The best time to be an investor is earnings season.

Sure, it’s a volatile time. Stocks swing wildly. A positive surprise or not meeting expectations can send shares soaring or plummeting in a matter of seconds.

But earnings season is also the time some of the best opportunities are presented…

Legendary value investor Seth Klarman described Wall Street perfectly in a speech a few years ago:

“Most investors tend to project near-term trends — both favorable and adverse — indefinitely into the future.”

And after an earnings announcement, Wall Street projects whatever happened over the last three months into the long term.

Good news turns into great news after analysts input this into their spreadsheets and compound it over many years ahead.

Bad news turns into terrible news after the same thing happens in reverse.

From Boom to Bust

Netflix (NASDAQ: NFLX) was the Wall Street darling of 2011.

Its steady subscriber growth led to parabolic surges in revenues and earnings with alarming consistency.

Netflix Subscriber Growth Chart 

The analysts and investors consistently bought Netflix shares. They pushed Netflix shares from a low of $40 to more than $300 in just two years.

The higher Netflix went, the more the analysts loved it…

Goldman Sachs, Oppenheimer, Citigroup, Credit Suisse, Atlantic Equities, Piper Jaffray, and Barclays Capital all had “buy” ratings on Netflix in the past year as Netflix was setting new (and unsustainable) highs.

Everything was perfect. Sales were soaring. The stock was rising. Everyone who wanted in was in.

But there was a problem.

This Time is Never Different

At $300 a share, there was no one left to buy, and Netflix shares were priced for perfection — a dangerous combination.

Earlier this year, your editor advised:

Another “micro bubble” has formed…

The major analysts have fallen in love with [Netflix]. Jefferies & Company has it rated a “Buy.” Oppenheimer recently upgraded it from “Underperform” to “Outperform.” Citigroup upgraded it to “Buy” last April and has kept the rating…

As we know, great expectations inevitably lead to great disappointments.

Netflix is going to have a tough time meeting up to even greater expectations the market will have for it throughout the rest of 2011. Any decline in the growth rate (we expect Netflix will continue to grow, just not fast enough for Wall Street) could send Netflix shares that walked up stairs down an elevator with little warning.

A few months later, Netflix’s meteoric rise wasn’t any different than any other significant upswing in history.

NFLX announced earlier this week not only did it not add more than one million new subscribers, as the company had done consistently for the last couple of years, but it actually lost 800,000 subscribers.

Perfection didn’t come. Great expectations quickly turned into great disappointment. Netflix shares collapsed:

 Netflix Stock Collapse Chart

Shares were falling steadily. Then this week, they lost 30% overnight. The drop capped off an overall 75% downswing in just four months.

As you should expect, Wall Street was “shocked” at the disappointing results (and how they could be wrong again?).

They’ve all turned extremely bearish. All of the firms that said “buy” at $300 a share are now saying “sell” at $80 a share.

The normally positive spinmeistering analysts have become exceptionally bearish:

“Looks like the nuclear winter scenario is playing out for Netflix” — Susquehanna Financial

“[Netflix] management has failed to rebuild faith in the stock, which is still expensive and mispriced by value standards” Janney Capital

“Netflix’s earnings trajectory has deteriorated” Goldman Sachs

“Nuclear winter.” “Deteriorated.” “Failed.”

Those are words you never hear analysts say…

When you do hear them, you know we’ve reached an extreme low.

Weak Hands and Big Profits

In the three days since Netflix released its “shockingly” poor quarterly results, investors have run for the exits.

Trading volume has been massive. More than 66 million shares traded hands in the two days after the news. That’s more than four times the average volume.

But here’s the thing: Netflix has less than 56 million shares outstanding.

The staggeringly high volume is a clear indicator that anyone who wanted to sell has sold.

It’s the exact opposite situation of when Netflix was at $300 a share, every $2,000 suit said “buy,” and there were no buyers left. Now every analyst says “sell” and there are very few buyers of Netflix.

If history is any example, Netflix probably has a very bright future from this point. Although, as a word of caution, it’s going to take a long time to get there…

More importantly, Netflix provides the example of how earnings season gives you all the advantages.

Party Like It’s 2002

In the end, Wall Street may be rigged.

They may be peddling shares to the public which venture capital investors and corporate insiders paid a fraction of what they’re issued to the public for.

They may be running computers trading between themselves at the speed of light, quietly stealing pennies from regular investors like you and me.

But now is not the time to join the increasing majority of investors and walk away.

Investors have been steadily quitting stocks for the last couple of years. As mentioned above, 44% aren’t putting any more money into the markets.

This is exactly what happened in 2002 after the tech crash. A survey by Eaton Vance at the time found 61% of investors wanted less risk. One in five investors also said they’re cutting back the amount of money they’re putting in stocks…

The S&P 500 went on to climb another 90% in the five years after investors were scared out of stocks.

There are the times and strategies you can use rig Wall Street in your favor. Earnings season is one of these times.

Being a contrarian is the best strategy with the most rewards for the least risk.

Don’t give up on stocks now. Fortunes will be made in the next several years for the few who ride out the more frustrating times.

Good investing,

 Andrew Mickey Signature

Andrew Mickey
Editor, Wealth Daily