Written by Michael Bigger. Follow me on Twitter.
On April 20, 2010, Tempur-Pedic (TPX) reported great earnings, and the stock went up 12 percent in after hours trading. Select Comfort, another bed manufacturer, went up to $9.05 (+5 percent) in reaction. I tweeted at that times that the earning report for TPX was an indication that the earning for SCSS would be good.
The cockraoch theory states that If you find one roach in the cupboard, there is usually more than one crawling in the same location.
On April 21, SCSS reported great earnings, and on April 22, the stock traded up to $11. If you bought SCSS on the TPX news, you generated a 21.5 percent return on your investment in a few days. This is the cockroach theory with a positive consequence.
This theory is a useful leading indicator for cyclical companies because a company's performance in the short run is more sensitive to the economy than to management skills. Companies in the same sector will tend to track one another.
The reverse is also true. In 2006, SCSS announced mediocre results. This should have been a warning sign for TPX investors. From mid-2006 to late 2007, TPX stock doubled. Eventually, TPX followed SCSS's lead and dropped from about 38 to 5. This is the version of the cockroach theory with a negative consequence.
I can think of many ways to incorporate roaches' behavior in my trading algorithm. What about you?
