The following was sent to advisory clients in 2001. Please note that these people were not active traders and they were not short-sellers. It is not necessary to know the meaning of terms like "linear regression slope" and "r-squared." There are many other very useful tools available to investors and traders. There is not a single specific lesson here. However, the weather analogy is good and you can get a sense of how a money manager who is bent on high performance thinks. Note the hesitancy mentioned toward trading during the first half-hour of the day or so (the playground of amateurs), and the focus on risk vs. potential reward. The terms "my studies" and "my studies suggested" are vague. The problem was that my readers would not comprehend what I was saying if I became "clearer." Hopefully, if you study our tutorials (there are many more to come), you will be able to understand some of these things. Bear in mind that the Dow Jones Industrial Average is adjusted from time to time, and that a level of 10,000 when this was written may not be 10,000 now.
Looking for Stock Market Signals
Evaluating the market is like predicting weather. Weather forecasters speak in terms of probabilities, not certainties. "There is an 80% chance of rain tomorrow." If the forecaster knows that prevailing wind currents and pressure zones will continue till tomorrow, he might be able to say "it will rain tomorrow." However, there are too many variables that interact and modify each other to be certain about tomorrow. Think of the complexity of the atmosphere. In it there are many currents, eddies, crosscurrents, large and small whirlpools, hot and cold layers, and high and low pressure fronts. These collide and rub against each other, spinning off, glancing off, bouncing off, merging with, canceling out, or in some other way reacting with each other. The forecaster checks his indicators (pressure, wind, moisture, and so on) to make sense of what is going on, to weigh the probabilities of different outcomes and to give us the result of his analysis. The market also has many currents, cross currents, eddies, and so on. The complexity of their interactions and the severity of their negative repercussions is greatly magnified at times like those we have been experiencing, just as turbulence is greatly magnified in an atmospheric storm. Thus, I have an arsenal of metrics and indicators (I use both technical and fundamental studies) available to help me estimate when the probabilities switch from favoring cash to favoring investment.
In my last update, I mentioned that the recent "up-trend" was not yet statistically significant. That is, it could not yet be differentiated from market "noise" (see my comments about the linear regression slope and r-squared). In the last paragraph, I said a penetration of at least 10,031.45 on the Dow would be necessary for "significance." Please see the enclosed chart. It covers the last ten days, and each price bar represents 15 minutes. You can see that we had a "fake" breakthrough on the fifth. My studies suggested waiting rather than investing. The market deteriorated in the last minutes of trading. The next day it looked as though we had our breakthrough. However, my studies again suggested we wait rather than invest. However, the apparent breakthrough did prompt me to issue a fax alert (if you are not set up for these fax alerts and want to receive them, please let me know. They are very rare, so you haven’t really missed many). The fax alert read as follows.
Yesterday, our indicators generated a "buy" signal on the market. Throughout the day, whether or not we were going to get the signal was "iffy," but in the last minutes the market came on with considerable strength (never buy or sell in a stampede) and gave us the desired signal. Thus, we were prepared to make purchases today. However, we try to avoid taking action in the first hour of trading. As today wore on, we saw counter-trend momentum components begin to set in. This raised the issue of whether we had been given a false buy signal or "sucker’s bait" yesterday.
It is most likely that our "buy" signal was as reliable and actionable as such signals get. However, the introduction of negative momentum components to the market’s action today gave us what will likely be a temporary cautionary bias. The market did, in fact close slightly lower today, so the wait did not cost us. Actually, the prices of a number of our target stocks are a little better now than they were yesterday. Even when the market was up today, some of our target stocks were "backing and filling" (backing off from recent short-term moves). We want these stocks to back off enough to enter our "buy zones" (some are attractive at this time). Thus, even if the market starts up again, we will buy or not buy on the basis of whether our targets are attractive. We are buying individual stocks, after all, not the market. The market’s direction simply gives us our bias. The "buy" signal on the market changed our bias from "stay in cash" to "it’s okay to start buying." Individual stocks will dictate our specific buy/sell decisions.
We will probably stay on the sidelines in the early morning tomorrow (that is our normal procedure). Then, if it appears that the counter-trend momentum is losing strength, we may begin to purchase the stocks that meet our "buy" parameters. It is common (but not necessary) for the market to experience a pullback after a breakthrough in order to "test" support at the breakout level. If we see this beginning to happen, we will prefer to wait while the reactionary move plays itself out. If this does not happen and we still do not buy right away, do not let it concern you. Any such delay will be for causes that warrant the delay (we are balancing risk vs. reward). When the problems causing the delay are resolved, we will go forward.
So far, the problems have not been corrected. Price action like that of 12/12/01 cause market reporters to make excited comments like "the market made a remarkable turnaround at the end of the day" (similar to a Paul Kangas comment on The Nightly Business Report). However, the chart shows that the end of the day turnaround that excited some observers easily fits within the boundaries of a continuing downtrend. So far, the move above 10,000 has been nothing more than "sucker’s bait."
My short-term expectation is that the Dow may well test the 9700 level. How it behaves between now and then will give us clues about whether it is going lower. Under most conditions, I would expect the market to stay in a trading range (go sideways awhile as it swings between two boundaries) until it can break through 10,000 in earnest. However, given the present valuations in the market and current intermediate-term momentum, the current declining trend may continue awhile. The most appropriate way of dealing with the present situation is to continue to monitor our metrics and indicators until we see probabilities favoring investment rather than cash.
If the current negative momentum abates and we enter a trading range, we will likely take a few positions. This statement is almost redundant because that could happen at any time anyway, depending on how a stock looks in the given market environment. However, if we enter a trading range, positions would be taken with a little less apprehension. That’s because entering a trading range increases the probabilities that an upside breakout will occur. Nevertheless, there is always a chance (far less likely) of an exit to the downside, so I do not want to be fully invested until the overall trend of the market is up rather than down or sideways. The only stocks we are considering now are those that have maintained an up-trend even through September 11th or that have started a recovery in spite of events on that date. There are not many such stocks left, but those that remain show remarkable resistance to downward market pressures. Thus, even in a mildly declining market, certain positions may be viable. We have not taken more positions before now because pattern breakdown rates have been high (i.e., risk was relatively high). Also, keeping most of our powder dry will enable us to snap up better bargains as the opportunities arise.
12/26/01. So far, the Dow has been able to sustain levels above 10,000 for five days. Today, it gained more than 50 points but it did so on extremely light volume. This makes it a non-significant move. The longer the market can stay above 10,000, the better the chances of a new up-trend. However, we must see it move on heavy volume. Thus, even though the market has satisfied some price and time requirements for a bullish stance, it has not satisfied volume requirements. The jury is therefore still out, and we await further developments. ~ Dr. Felt