1. It’s riskier than going long. There’s no limit to how much you can lose.

2. The long term trend of the market is up, so you’re fighting the trend.

3. It’s immoral and un-American. Traders who sell short are taking food out of the mouths of widows and orphans.

4. When you sell a stock short, you pay a modest amount of interest and are liable for the occasional dividends that must be paid.

5. Selling short is a game for professionals only. Amateurs beware!

So the case against going short, now or ever, seems ironclad. I think such a conclusion is misguided. Briefly, looking at those reasons one more time:

1. “It’s risky”: I believe the risk is way over stated. The same traders who point out the upside risk of selling short think nothing of holding onto long positions through 50% drops. So yes, the sky’s the limit, and you can theoretically lose an unlimited amount of your capital. But if you’re limiting the size of your positions and limiting your losses as you should with all trades, whether you’re long or short, this is a non-issue.

2. “The long term trend is up.” Yes, the multi-generational trend is up. But every few decades, for a decade or two at a time, the long term trend is down—in which case that longer term trend is irrelevant. Then too, within those up trends, there are intervals lasting many months in which the trend is down. Lastly, whether you’re in an up trend or a down trend, every year many stocks go down.

3. “It’s immoral”: I think this belief is based on a misunderstanding of how markets work. But if you’re so sure it’s true, I suggest that every time you take a long position, you’re forcing the price up and that much further out of reach of the widows and orphans that were hoping to buy it lower. And even buy and hold traders eventually envision selling. How can even a sell order to liquidate be ethical, if any sell order puts downside pressure on the market?

4. “You incur the cost of interest and dividends.” I can’t argue with that. So that’s why I don’t Sell Short and Hope any more than I Buy and Hope.

5. “It’s for pros only.” We already know that professional money managers significantly underperform throwing darts. We also know, as O’Shaughnessy has pointed out, that  certain criteria such as low value ratios and high relative strength have a long history of beating the market. And as the charts on the key ratios that O’Shaughnessy reported on also make clear, stocks with high value ratios and low RS have historically significantly underperformed the overall market. Those with high value ratios went up the least in bull markets, and down the most in bear markets. Those with low RS went up the least in bull markets, and down the most in bear markets.

As a minimum then, for down markets, or for any stock that I’m considering shorting, I look for these two key ingredients:

1. High value ratios—high PE, high PB, high PCF, and especially high PSR

2. Low RS (relative strength).

In addition, I know from my own research that price/volume measures are also important. My favorite measure of this is IBD’s Accumulation/Distribution score. A score of D or E means that volume on down days has been significantly greater than volume on up days over the last 13 weeks. I take such a pattern to bode ill for the upside potential of such a stock. For whatever the reason, the big money is selling. I want a piece of the downside potential.

And since I have a basic understanding of chart patterns, I also look for stocks that are tracing out topping patterns, or that have already done so, are in downtrends, and are now rallying toward resistance. So I’m looking at underlying fundamentals (the value ratios), relative strength, price/volume action, and the charts. And lastly, since it’s no smarter to sell short on high value ratios than it is to go long exclusively on low value ratios, I’m going to wait for any potential short candidate to touch off sell signals before taking the plunge.

Having no crystal ball, I don’t know that the current market will work lower.  But I can know several things with certainty, and this is all I need to know:

1. This year, the key indexes have all dropped into bear market territory, and are currently in a choppy low volume rally. Setting aside the prognostications of analysts on both sides of the issue (half of whom history will prove dead wrong), I can know that much with certainty: This rally may be the beginning of a new bull market, but is more characteristic of bear market rallies.

2. If another leg down develops, it cannot do so without passing through trend lines drawn under the lows of the current rally. Those trend lines—no matter where they are drawn or how they are calculated—cannot be broken without triggering sell signals for any and all trend following systems. In my case, since most of my funds are in an IRA, that means that my system is going to generate sell signals for my current long positions, and buy signals for the bear market ETF’s that I’m not already in. I’m also going to be buying puts on any individual stocks that meet my bear market criteria.  

As a reminder, ETF’s are baskets of stocks that trade like stocks, but without the firm- specific risk that comes with individual stocks. There are now hundreds of ETF’s covering virtually every sector imaginable, and major countries.  You can go long or sell short China, Japan, Singapore, or even a mix of agricultural commodities. Bear market ETF’s move invesely to the underlying index. Most of these move in a 1 to 1 ratio: the ETF moves essentially in lock step with the sector it’s based on.  But there are also leveraged 2 for 1 ETF’s, which move 2 points for every one point that the underlying sector moves. For example, QID is a 2 for 1 Bear market version of QQQQ. For every point that QQQQ drops, QID will go up 2 points (the ratio is close but not perfect).  These offer an especially profitable opportunity in down markets.  Here’s a sampling of the main Index and Sector ETF’s, and their Bear Market counterparts:

None of these opportunities existed in the 2000-2002 bear market market.  So for traders in IRA’s, the choices were limited to cash or a few bear market Mutual Funds. Today, the opportunities are virtually limitless. ETF’s aren’t perfect. Leveraged ETF’s do not exactly move in lock step with their idealized 2 to 1 ratios. And the future is always uncertain. In any down market, there are always choices. You can lock down on your long positions as they deteriorate. You can go to cash. You can sell short, or buy bear market ETF’s.

Some traders look at the short side and see only risk. I see opportunity: AGA, MZZ, QID…. No, I don’t know which way the market’s headed. That’s why I’m going to be ready for either possibility.

Especially Recommended Reading:

Harding, Sy: Riding the Bear: How to Prosper in the Coming Bear Market, Adams Media Corp, Holbrook, Mass, 1999.

Jardine, Ross: Bear Market Game Plan: Strategies for Success in Choppy Markets, 2nd Edition, Marketplace Books, 2001.

O’Neil, William J and Gil Morales: How to Make Money Selling Stocks Short, John Wiley & Sons, NY, 2005.

Rothchild, John: The Bear Book: Survive and Profit in Ferocious Markets, John Wiley & Sons, NY, 1998.

Staley, Kathryn F, The Art of Short Selling, John Wiley & Sons, NY, 1997.

Weiss, Martin D., Crash Profits: Make Money When Stocks Sink and Soar, John Wiley

Tice, David:  http://www.prudentbear.com/  Tice has a reputation as a perma-bear.

            Before you throw out all of his ideas, I recommend taking a look at his

            “Must See Charts” and “Must See Articles.”

Related Stocks:  CCC

Related Stocks:  ACN

Jimmy Stewart (of It’s A Wonderful Life and Vertigo fame) performing his poem “Beau” about his dog on Johnny Carson.  I’ve never owned a dog, but I do love them.  I don’t really know why I loved this video, but it made me want to get a dog right now.

Could not be more excited for The Office.  Back September 25th!

Somebody’s pissed.

If I were you, I probably would have thrown up in my mouth a little if I had to read something like that.  It may have been painful to read, but it would have been written honestly.  The truth is, even as much as it is played up in movies, going to college is completely life-changing.  A year ago, I was a different person than I am today.  I have experienced things that have made me a better person, just as I have experienced things that I would not be comfortable telling my grandmother about.  It’s impossible for me to describe the way I lived my life last year at school to someone who has never experienced college.  College is not a chore, college is a party.  I don’t mean that in the literal sense, although that is certainly true.  Responsibilities and expectations of normal life do not exist while at school.  It is truly a surreal experience.  All the guys act like they are fifteen, and all the girls try to act like they havn’t gained weight (I kid, I kid).

I’m not sure what I am getting at, other than if you still have college ahead of you, it is something to look forward to, and if you are out of college, I hope you look back fondly on those years.  As I’m sure all of you already know, I decided in the spring to transfer from Indiana to the University of Illinois.  Although I will be a sophomore academically, I feel like an incoming freshman inside.  I am just as excited as I was last year, and just as nervous.  I know this year will bring many new experiences, good and bad.  In the next year’s time, I will live in my own apartment for the first time, turn 21, and move one year closer to being in the real world.  I wish you all good luck, whether it be at a school you love, a job you hate, or in whatever it is you may be doing.  Go Illini!

One of my favorite hip-hop songs/beats.

Related Stocks:  CY

Harry Potter and the Half-Blood Prince has been delayed.  Bummer!  Those who say the Harry Potter series is childish or juvenile obviously have not read them.  Last summer, I remember being giddy in anticipation of the release of the seventh and final book.  Although the movies don’t quite match the books, they are still very entertaining.  I’ll just have to wait another eight months!

I didn’t care for this song on first listen, but it has really grown on me.  Beautiful chords.

Maybe it’s just because I am really into the current olympics (who knew a group of straight guys could get legitimately excited about girls gymnastics?), but DAMN I really want them to come to Chicago in 2016.

Don,

Thanks for your comments.

Please note that the three studies reported in http://www.cxoadvisory.com/blog/external/blog8-11-08/ and http://www.cxoadvisory.com/blog/external/blog8-04-08/ are done by others. Prior to these studies, I had not noticed any formal studies on stop losses for some time. The authors of the studies are generally academics at universities, although I believe Andrew Lo ("When Do Stop-Loss Rules Stop Losses?") is probably well-grounded in real hedge fund activities. I assign highest credibility to the study in which he participated. As noted, this study concludes that “in the presence of momentum and/or regime-switching, stop-loss rules can add value.”

I do not have the resources to test all the permutations you suggest, but I can offer some general observations derived from reviewing hundreds of academic papers and practitioner claims:

 - Academic researchers tend to use somewhat simplified and rigid rules in their studies. These limitations may stem from data availability constraints, programming complexity or lack of theoretical arguments to support refining assumptions (related to a desire to avoid data mining/snooping bias). They sometimes focus on abstract statistical outcomes difficult for practitioners to interpret or implement.

 - Practitioners often rely on small samples and/or poor sampling methods. They tend to be very empirical in approach, incorporating substantial hindsight bias/data mining bias into their analyses (exacerbated by importing data mined rules from others). Many practitioner analyses do a poor job of addressing trading frictions. Some say that what they do is “more art than science.” The “foundational” books by Taleb and Aronson listed in the right margin of CXOadvisory.com are antidotes.

 I’ll take a look at the study you cite. You may be interested in the 30 items on trend following at http://www.cxoadvisory.com/blog/internal/blog-momentum-investing/.

Best regards,

Steve LeCompte

CXO Advisory Group LLC

(And here was my not to CXO)

Dear CXO, Thanks a bunch for your recent research on whether stops work. Although I'm not in a position to challenge the validity of your findings, as presented, I was really surprised at the results. I wonder if I might suggest adding a couple of variables to the mix? I'm a trend follower, with a fully automatic system. It has done fairly well over virtually all test periods, and in actual use (Don't ask about my discipline in sticking to it religiously!:) There are several ingredients that I believe are essential to a good system, and if stops are combined with those, I believe the very same parameters that you tested for would look better if whipsaw trades are filtered out at the onset. For instance: 1. If I only enter a trade on a high volume (say, at least 1 StDev above average) high range (ditto), with my own system, that has made a significant improvement. 2. I got the impression from your article that your stop would be moving up steadily as a move progresses. Does it stall out and go flat during brief consolidations? If not (mine does), I believe some simple rules to enforce that would also greatly improve the score. Years ago, as you probably know, Welles Wilder's Parabolic was all the rage, but a great drawback to it was that it automatically raised the stop into a parabolic curve, without regard to the stock or future's price and volatility. By modifying that, increasing the acceleration factor only if there are new highs (up to the max of .20), and decreasing it for every day that there is not a new high (down to a minimum of 0.00), made a great difference for me and my commodity clients. It greatly improved their score. 3. Throwing in any kind of long term filter also made a great difference. I'd really like to see your test rerun with some of these ideas. Thanks a bunch! PS: have you looked at this super report using a 10 ATR stop?

http://www.blackstarfunds.com/files/Does_trendfollowing_work_on_stocks.pdf

Related Stocks:  AGA

Related Stocks:  IXYS

“Nutrition”

My favorite web series, Jake And Amir.  The premise: two coworkers at College Humor, Jake, and the horribly inept, chicken nugget-loving Amir, and their disfunctional relationship.  Hilarious.

The Blueprint 3 is official!  Leaked track from Jay’s next album, produced by Kanye West!  Full track here.

JNJ's top line may never again grow faster than 10%, but with continued cost containment (pardon the alliteration) and share buybacks, EPS growth in the low teens is possible.

At today's levels, JNJ trades at a reasonable 15 times '09 earnings. The rule for JNJ earnings has consistently been to beat by a few cents per quarter. In this market environment, consistency like that demands a premium; its not a surprise to see this stock near new highs with a reasonable 2.6% yield.

JNJ has been helped with the currency translation, so like many multi-nationals, this most recent rally in the dollar, if sustained, could provide a headwind for earnings in 2009 and beyond.

Related Stocks:  JNJ

I have not been able to find any research that contradicts his findings.  There is, however, much that supports them (see especially David Dreman, Ibbotson & Associates, and Investor’s Business Daily in Bibliography). Before looking at his research, a caveat of sorts: there are a vast array of criteria used to select stocks–some of them actually rational—far more than can be discussed here.  Used singly, or in combination, over one period of time or another, one set of criteria or another will outperform all the others, even including the ones below. This includes your own personal favorite criteria, even if it means buying on the full moon and selling on the new. And apart from the entire subject of selection criteria, keep in mind that Rule One on limiting losses and letting profits run must at all times take precedence. To the extent that I’ve applied these criteria to my own trades, it has paid off. And for all of those trades that I’ve made in violation of these criteria, I’ve paid for it.        

As you read through these criteria, bear in mind, they are to be understood as principles, not rigid preconditions, and not necessarily sufficient alone to justify putting on a particular trade. And they are also for stocks in the aggregate, over time. Although flipping an evenly balanced coin many times will eventually result in about the same number of heads or tails, in the short run, one can still easily come up heads or tails dozens of times in a row.  These criteria provide a slight edge, so do not lead to an equal number of heads and tails over time.  Short term, they will behave very much like the coin. Long term, however, when applied to a series of trades over time, they become very profitable.

In a nutshell, here’s what O’Shaughnessy found: all else being equal,

1)      Size matters more than any other factor: in eight years out of ten, stocks of the smallest companies perform significantly above average, and it follows that the performance of the largest companies is significantly below average.  If the only change you make in your stock selections from now on is to give priority to smaller companies (say, under $500 million capitalization), you are likely to do much better than the overall market.

2)      Value ratios trounce growth measures in seven years out of ten. But the most popular value ratio, the PE (Price/Earnings), is not as significant or reliable as some others are.  The most significant and consistent is the PSR (Price/Sales). If the only change you make in your stock selections is to limit yourself to stocks with low value ratios, in the long run, you are likely to do much better than the overall market.

3)      “Growth” stocks, those with the highest rate of earnings increases over the last 1 to 5 years, in spite of the limitless hype, and against what may seem as obvious as Received Truth, in six years out of ten, perform way below average. If the only change you make in your stock selections is to avoid stocks with the highest rate of earnings increases, you are likely to do much better than the overall market.

4)      Momentum, as defined by RS (relative strength), is extremely important. Stocks that have gone up the most in the last 12 months are more likely to go up further in the next year than almost any other category of stocks.  Those that have fallen the most in the last 12 months are more likely to drop–and further– than any other category of stocks. If the only change you make in your stock selections is to limit yourself to stocks with high relative strength, and avoid those that have fallen the most, you are likely to do much better than the overall market.

5)      A high RS combined with low Value ratios gives the best absolute returns with risk much lower than that of so-called “Growth” stocks.

Taking these points one at a time: Looking at the entire universe of all stocks, year by year, from 1951-2003, the questions that he asked were:

To what extent does capitalization (total value of a company, based on the price per share times the number of shares in existence) matter?  Answer: a great deal.  The largest companies do far worse, and the smallest companies far better. During O’Shaughnessy’s study, $10,000 put into the average of all stocks would have grown to $2,677,557, but $10,000 put into the large caps would only have grown to $1,590,667. At the other extreme, $10,000 put into stocks under $25 million would have grown to $806 million (300 times more than the average stock).  Because the performance of stocks in the ultra small category dwarfs all others, those under $25 million need to be shown with their own chart: [Note: the following charts are based on O’Shaughnessy’s data from the second edition of his book, which shows year by year results]

As you can see, companies under $25 million did so much better than all other categories, that the performance of the 5 largest categories merges into a line near 0.

To see these other categories more clearly, here’s the chart of their performance, without the smallest group:

Overall, those over $500 million did somewhat worse than average, and those defined as “large” performed significantly (41%) worse than average. Definitions of capitalization categories vary considerably.  In his study, “large” was defined as the largest 1/6 of all stocks; currently this is greater than $1.145 billion.  Industry practice, however, is to define large as greater than $5 billion. These include most of the big corporations that you’re familiar with, your “blue chips,” the household names, the GE’s, Exxon’s, GM’s, IBM’s, and more recently, the Intel’s, Nike’s, and Microsoft’s.  However the line is drawn, the stocks (remember, the stock is not the company) of larger companies have far less profit potential. During his 45 year study, the smallest stocks out-performed large stocks in 32 years significantly (by an annual average of 36.3%), and under-performed large caps in the periods from 1969-1973, and 1984-1990 modestly (by an average of 10.7%). So, although it’s true that large caps occasionally modestly outperform small caps, in most years, and long-term, small caps significantly outperform.

Various authors, including O’Shaughnessy and David Dreman, while pointing out the vastly superior record of small caps, nevertheless warn against trading in them because of their illiquidity. This is actually a complete non-issue, since one can easily limit oneself to those that are highly liquid (with hundreds of thousands of shares traded daily). This applies to the smallest of the small, including so-called “penny” stocks, which are those trading under $5, or more generally under $1, depending on who’s defining them.  Penny stocks are widely reputed to be strictly for losers.  This is primarily because many of them have no sales and rarely even trade.  But if you reject all of the ultra small stocks with no liquidity or sales (these are the ones that understandably give penny stocks a bad name), and limit yourself to those traded on the major exchanges, you’re left with a few percent  (still, hundreds) that are highly tradable.  Historically, based on size alone, these have been far more profitable than average, so I don’t hesitate to trade these ultra small stocks, provided that they meet all of my other stringent criteria. The recent move to decimalization of stock prices has narrowed the bid/ask spread substantially, so that the difference between the buy and sell price is commonly about 1% even for the smallest of liquid stocks.   I have found that diversifying can reduce the somewhat greater volatility of small caps to well below that of the NASDAQ, without reducing the benefits that small caps offer.  If you ignore ultra small stocks because “they’re riskier,” you’re acting on a false premise, and throwing out the baby with the bath water.  But if you’re determined to limit yourself to larger and higher priced stocks, and select stocks based on the rest of these criteria, you will still be ahead of the game.

What about Value Ratios?  A value ratio is an objective attempt to assess the value of a stock, by comparing certain numbers on the company’s financial statements with the price of the company’s stock.  The traditional key measures are based on Earnings, Sales, Cash Flow, and Book Value.  More recently, the q ratio has come into use, as the most reliable of these.  Unfortunately, it’s not widely available, except for the market as a whole. There are many others, but these are the key measures–key, because they’ve been found over time to matter the most.  Each ratio is arrived at by dividing the current price of the stock by the annual earnings, sales, cash flow (= income plus depreciation and amortization), or book value (= assets less liabilities) per share. This gives you, respectively, the PE (Price/Earnings) ratio, the PSR (Price/Sales) ratio, the PCF (Price/Cash Flow) ratio, and the PB (Price/Book Value) ratio.  The q ratio is arrived at by dividing the Price by the replacement cost of the entire company and everything in it, in today’s dollars.  It was found by Nobel prize winner James Tobin to be significantly more accurate than the far more popular PE ratio in determining whether the market or a given stock is over or under valued.  When value ratios are low, this is an objective way of saying that, with regards to the earnings, sales, cash flow, etc., the stock is cheap.

1.      To what extent do low value ratios matter? (Traditionally, “low” means Price/Earnings, PE < 20; Price/Book, PB < 1.0; Price/Cash Flow, PCF < 1.0; Price/Sales Ratio, PSR < 1.0)  Answer: Overall, especially in conjunction with high Relative Strength, a great deal. Individually, however, they vary.  Although the PE ratio is the most popular of these, it is not actually the most significant.  Historically, a PE over 20 has been considered high. Under 10 is low.  The long-term average of the market is 13. Although it has topped out a bit over 20 at previous bull market highs, in the final stages of the 90’s bull market, the biggest winners had an average PE of 45 before their last big advance.  They reached an average of around 85 at the top.  On the other hand, they also fell the hardest when it was over. The NASDAQ, which is home to the majority of high tech stocks, dropped over 75% from its March 2000 high to its recent low.  The Dow, which is comprised of blue chips, has fallen 30%. Small caps with low value ratios have dropped minimally or even risen during this period.  A low PB (price/book) or PCF (price/cash flow), is even more important; a low PSR (price/sales/ratio) is extremely important; but the much touted high ROE ratio (return on equity) was found by O’Shaughnessy to have little or no value.  A stock (or mutual fund) with low value ratios may properly be thought of as cheap, all else being equal.  Cheapness is not a measure of price level, but of low value ratios. A $50 stock with low value ratios is “cheaper” than a penny stock with high ratios.  But don’t jump into a stock or mutual fund just because it’s cheap; stocks can be cheap for years, are often cheap for good reasons, and may well be on their way to getting much cheaper.

2.      To what extent does accelerating earnings growth, the key component in “growth” stocks, matter? Answer: Contrary to what would seem obvious, stocks that have had the greatest acceleration in earnings growth in the preceding 1-5 years have been unprofitable in almost all subsequent years, and an investment in these would have grown only from one fifth to one half as much as throwing darts.  It may defy all reason, but the truth is that prices of such stocks, at any given point in time, have already been bid up far beyond any price that their super earnings can justify.  In one long-term study, covering the period 1951 to 1997, it was found that 96.4% of growth companies were unable to sustain earnings growth past five years (2). In a related study, it has been calculated that “a strategy based on buying the 20% of companies with the highest actual or expected growth rates, while selling short those with the lowest, consistently would have underperformed the broad market by five percentage points a year since 1980.” (3) In spite of IBD’s claim that earnings are the best predictor of stocks prices, “there is no substantial …long-term historical relationship between corporate profits and stock prices.”(4)

3.      To what extent do momentum ratios matter? (momentum refers to how fast a stock is moving) Answer: more than almost any other ratio! It is well known that stocks spend most of the time (75-90%) fluctuating in what is essentially a sideways direction.  If there was only some way to know when a trend is beginning, or is underway.  There is (apart from charting concepts)!  Relative Strength (RS) measures the degree to which a stock has outperformed all other stocks in the last 12 months; a 99 is the highest score possible, and means that a stock has risen more (or fallen less) than 99% of all other stocks. A special note on cheapness: stocks that have fallen the most in the last 12 months, relative to all other stocks, therefore have the lowest RS ratios (lowest is a 1).  These are the least likely to go up in the following 12 months. In 45 years, $10,000 put into the lowest RS stocks each year would have grown to $43,040, vs. $2,677,557 throwing darts.  Over 1500 of the most widely hyped stocks of the 90’s dropped over 90%.  The majority of such stocks never fully recover.  It’s undoubtedly comforting to believe that they will recover, because they’re “good” companies, but remember, almost all of the companies that have ever existed, at some point in time have ceased to exist.  As IBD often points out, the opportunity has always been with new companies whose stocks are hitting new highs for the first time ever, not with fallen giants. The well publicized upward march of the major stock indexes over the decades, which is a key selling tool of brokers, is a major and unconscionable misrepresentation. This is true for a couple of reasons.  First, the indexes are shown in nominal terms (their gains are shown in points or dollars), rather than real ones (adjusted for inflation). It’s easier, and strongly works to the advantage of the brokerage industry to keep it that way.  Nevertheless, if you do not factor in the actual purchasing power of those gains, you unfortunately fail to see their real value after inflation. For example, the consumer price index has risen 6 fold since 1960, and 17 times since 1913.  Divide the current market by 6 or 17, respectively, to see how much it has really gained in terms of what you can buy with those gains (5). Second, putting the indexes in nominal terms masks the real loss that occurs during the prolonged down markets, and creates the impression of steady decent gains—the fabled 10% or so that is so often mentioned, as if it’s virtually a birth right (6). Gains of 10% are anything but assured, and are far from steady.  Furthermore, the indexes are composed of constantly changing stocks, the newest and the strongest. Those that have gone under are continuously deleted from the indexes. You are only seeing the survivors and the newcomers.  The  Dow itself only has one of its original stocks (GE).  The NASD, which is home to about 4000 stocks, delisted (mostly for financial reasons) 200 companies in 1996; 250 in 1997; 596 in 1998, 440 in 1999, and 630 more in the next two years.  From 1996-2001, NASD delisted 2116 stocks. During the great bull market of the 90’s, every year over half of all stocks went down.  In the last up year of the 90’s bull market (1999), 90% of all stocks went down.  That was before the top.  The real story of stocks is that new stocks often go up for a while, many disappear off the face of the earth, and all surviving stocks eventually go down.

4.      Combining low value ratios with high momentum (a high RS) gives the best increase with below average risk.  The reasoning behind this is: a) a low value ratio means that the stock is cheap, as determined by the relationship between its price and its sales, earnings, book value, or cash flow (for instance, sales are high, but the price doesn’t yet reflect this), and b) a high RS (in the 90’s), especially with a stock making a 52-week high on a great increase in volume (at least 100%; better yet, a few hundred percent), means that large traders anticipate that this stock will significantly outperform other stocks, and are placing real money on it.  (This is when you buy a “cheap” stock!)

EDGE: Some of the great traders interviewed by Jack Schwager speak of the necessity of having an “edge.”  The Roulette wheel has a small but persistent edge.  Slot machines steadily take about 2% of every dollar.  Value ratios accomplish the same thing in a slow but steady manner.  All of the studies done on them show that long term, stocks with low value ratios or high RS (relative strength) do a few percent better per year than average. This may not sound like much of an edge, but over time, it becomes immense.

$10,000 put into stocks with the lowest PE’s (Price/Earnings ratios) would have grown to $5,159,955, which is about double the All Stocks average. High PE’s are far worse: $10,000 put into stocks with the highest PE’s would have grown to $1,087,361, about 60% less than would have been possible by throwing darts.  So: if you were to use PE alone, lower is better than higher, but PE is not the best measure by itself, because it’s so easy for accountants to rig the earnings portion of this ratio. [But note further below the value of combining a low PE with a high RS].  Just to keep things in perspective, the low PE category had average annual returns of 17.33%, vs. 14.97% for the average of all stocks.  Although this is only a difference of 2.36% annually, long term the bottom line is approximately double that of throwing darts.

$10,000 put into stocks with the lowest PCF’s (Price/Cash Flow ratios) would have grown to $7,142,991, which is 2.67 times the All Stocks average.  Stocks with the lowest PCF had average annual returns of 18.08%, vs. 14.97% for the average stock, an edge of 3.11% annually. 

$10,000 put into stocks with the lowest PB’s (Price/Book ratios) would have grown to $8,670,540, which is more than triple the All Stocks average. Stocks with the lowest PB’s had average annual returns of 18.86%, vs. 14.97% for the average stock, an edge of 3.89% annually. 

$10,000 put into stocks with the lowest PSR’s (Price/Sales ratios) would have grown to $14,910,164, which is over 5 times the All Stocks average. Stocks with the lowest PSR’s had average annual returns of 19.85%, vs. 14.97% for the average stock, an edge of 4.88% annually. 

In case it’s of interest, here’s the breakdown of PSR’s, by deciles, for the 8210 stocks searchable through my broker’s website, as of 8/11/08:

10% of all stocks have a PSR under      0.29

20% have a PSR under                         0.60

30% have a PSR under                         0.94

40% have a PSR under                         1.42

50% have a PSR under                         2.25

60% have a PSR under                         4.15

70% have a PSR under                       74.00

71.6  % have a PSR under            15782.40

28.4 % have no PSR. Whatever the reason, I treat those as if they are the highest.        

Since the PSR is far and away the single most important value ratio, it might be interesting to see just how much difference it makes long term: Here are the details from O’Shaughnessy:

Decile (1 = lowest PSR = best) During his 45 year study:

1                      $10,000  grew to $14,910,164

2                      $10,000  grew to $  9,737,147

3                      $10,000  grew to $  9,646,689

4                      $10,000  grew to $  6,924,259

5                      $10,000  grew to $  3,505,492

6                      $10,000  grew to $  2,629,117

7                      $10,000  grew to $  1,406,604

8                      $10,000  grew to $     709,086

9                      $10,000  grew to $     291,074

10                  $10,000  grew to $       94,437

High PSR’s are toxic.  Low PSR’s are less risky and have infinitely more upside potential. Fortunately, there are thousands of stocks with low PSR’s, high tech included, so there’s no need to sacrifice standards to have a shot at stocks with what might sound like ultra high potential.  On any given day, there are some 3000 stocks in the lowest 3 deciles above.  Over the 45-year study, $10,000 in these would have increased some 1000 times in value.

(Special note for short sellers: A high PSR is one of the most profitable of all ratios; stocks with the highest PSR’s are likely to drop further than almost any other category of stocks. Therefore, if you’re shorting the market, a high PSR is an essential ingredient.) 

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Does anyone know of any long term studies on the validity of these particular pieces?  Thanks! Don

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1) My system does better than I did before I put it together

2) If I don't get in when my system says, then when do I?

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Lupe Fiasco.  Loved him before, but him KILLING IT reinforced it  Awesome performance!

Rage Against The Machine.  I started off their set in about row 10.  Amazing/Terrible experience for the next two songs, depending on how you want to look at it.  I got tossed around like a ragdoll, but eventually made it out alive about 100 feet back, where I enjoyed the rest of the show in safety.  More about the chaos here.  Unfortunately Wilco, a band I am really starting to enjoy, played at the same time as Rage.  This is the one and only time I will see Rage Against The Machine, so I opted to skip Wilco.  I hope to catch them live as soon as possible.

The Black Keys.  Up until two days before the festival, I had never even heard of this group.  They play simple blues rock like it should be played.

The Raconteurs.  Jack White and the rest of his band were incredible!  Another new favorite.

Due to the poor timing of my vacation, I was unable to go to Lolla again today and missed out on some of my favorites like Kanyeze and the great DJ Matt Roan but the two days that I did go were unforgettable!  As much as I liked all the acts mentioned above, the real star of the festival, of course, was Chicago.

But one thing is certain. If you exit a trade when your target is reached, you will never—I repeat, never—be in any of the huge moves that take place every year. This means you’d better be right often, and not run into any serious down moves while you’re waiting and hoping. As for the constantly rising targets set by the brokerage industry, these are nothing but sales gimmicks. So, from a practical point of view, whether they are arrived at through sane and sober in-depth fundamental or technical analysis, or just figments of the imagination of your typical Wall Street analysts, if you want to capture the maximum profit potential on every trade, there are no valid targets.

Think about it: all initial targets in a good move are exceeded. If you sell when the first one is reached, you’ll limit your profits (a major violation of Rule One), and never be aboard for the best moves. In a good move, analysts repeatedly project successively higher “targets.” But the final target is never reached, and as a result, if you’re planning on getting out when your final new “target” is reached, you are going to be holding till doomsday (the other major violation of Rule One). Although it is possible to know, based on value ratios, that a stock is cheap, which implies higher prices in an up market, or maybe only less damage in a down market, it is not possible to know whether any particular trade will in fact go up at all, or how far it will go, or when this may happen. “There is no air-tight science of stock pricing.”(2) There is not even a rough valid way of determining where the price of a stock should be. The decision to get out must be based on what your position is doing, not where you bought it or where your broker said it’s going. Its future potential can’t possibly depend on where you bought it or on what anyone thinks. Nor can it even be based on whether you’re at a profit or loss in it (assuming that it hasn’t hit your stop yet). This means you might hold it forever, or you might be out in the next few seconds. You may already have made far more on it than you had dreamed possible. If the trade is going your way and has not given you an objective reason to exit, hold on. This is because it has something very good going for it. Winners tend to keep winning! You may have doubled your money on it, and if you get out prematurely, you may leave ten times that on the table. Don’t get out because you’re afraid of losing a good profit. Instead, deal with the fear by raising your stop to lock in some of the paper profit and minimize the amount that you’re willing to give up, and continue to hold. This has the advantage of reducing fear, because you’ve just locked in a chunk of the profit, and guaranteed that you’ll be aboard if the move continues going your way. You’ve limited your downside risk, and still have unlimited potential on the upside. Alternatively, you may believe that there is infinitely more potential in the trade, but it’s just told you (by hitting your stop) to sell. If it has, or if you “forgot” to enter your stop but it has touched the stop price, get out right now! Your stop strategy should be reduced to absolutely objective criteria, and where money management is concerned, the only relevant information is what the price is doing to your money, not what you think it should do. Although it might seem counterintuitive to say this, the precise stop exit method, within reason, is not nearly as important as having some type of stop, without exception. Furthermore, your specific entry and exit rules are less important than the position sizing part of the system above (See Chapter 10). So, assuming that your stop is based on any of the following strategies, you will stand a better change of capturing most of the move. Suggested methods for trailing your stop (there are countless others not mentioned, 100% objective–some fairly technical; if you’d like some of these, let me know and I’ll give you some):

1. Hopefully, you got into your position on a high volume upside breakout from a sideways market. Your breakout point was a chart point, and so it only makes sense to use chart points to exit your position. Starting off, you placed your initial stop just under the most recent correction low. If the move goes your way, a series of upward zig-zags will typically develop. Each one will take days, weeks, or months. Every time the market recovers from one of these pullbacks, and moves to new highs, raise your stop to just under the new most recent correction low. Eventually, the upward stair step pattern will end, a series of downward zig-zags will begin, and you will be stopped out on the first of these. In this way, you will capture all of the move in between. You don’t get in at the bottom, and you don’t get out at the top, but you take a nice slice out of the middle. You’re not tying up your money during the 70-90% of the life of the stock when it’s going nowhere. You’re taking a piece out of it during the period in which it’s moving. And since it really isn’t possible to know the exact top or bottom when they occur, it’s very risky to try to pick tops and bottoms. The piece you take out of the move is the safest piece, because it’s built on a foundation of solid criteria, and begins with high momentum. If you are not extremely familiar with charts, I strongly recommend getting the basics down. Before looking at other alternatives to chart points, it’s fair to point out a few drawbacks to chart points. A) They’re so obvious, that other stops tend to cluster there, so you frequently will get filled a few ticks or worse below your stop; B) sometimes, the final ascent of a stock looks more like a parabolic curve, rising more and more steeply; the nearest meaningful chart point is further and further below. The biggest part of any move typically takes this shape, and since it’s so big, you want to capture as much of it as possible. Since it has risen at a steeper and steeper rate, you have more and more of the last part of your profit at risk, and this will almost certainly put pressure on you to exit prematurely. A common way of resolving a situation like this involves taking partial profits, but a far better way is to stay fully invested, and raise the stop in sync with the market, using a system like the Parabolic, which is in the public domain. I say far better, because to liquidate part of your position means to limit your profits. You don’t get moves like that every day, so if you systematically short-circuit the potential, you’ll end up with mediocre results long term. In the final ascent, the stop will move upwards daily in lockstep beneath the market, and will take you out very near the top when the move ends. [Let me know if you’d like, and I’ll give you the formulas in Excel.] Now, in case all of that sounds too complicated, and you’d prefer something effortless:

2. Each week, advance your stop to just under the 50 day moving average. I mention this because it’s the simplest stop strategy, though not the best. The market will often trade down to the 50, wobble above and below it a bit for a few days, clearing out all of the stops there, then move to new highs. But a stop here is the easiest, because it’s visible on practically all charts, and since it’s effortless, is more likely to be used. So this area will also be cluttered with other traders’ stops, and again, bad fills will happen. Nevertheless, when you compare what you give up on bad fills, with what you could give up if you don’t limit your loss, there really is no contest. So, even if this is the worst possible place to put a stop, it’s better than no stop, and will at least minimally meet the requirements of Rule One. OR

3. Trail your stop a distance of 3 times the Average True Range (3) below the current close. For what it’s worth, Van Tharp found this to be one of the best stop methods researched. The only reason that I don’t personally use it is that I believe I have a method that’s better.

4. If you happen to have a fully automatic statistically based program for determining when the trend has ended (which I do), use this system. [I’ll be happy to give you the formulas in it if you’d like. I’ve converted it into Excel.] The original tests were carried out in Fortran, PL/1, and Basic on a mainframe, on many years of commodity data, and averaged about 100% profits per year, using only 1/3 of equity at any one time. During a brief period years ago, when I had more money to work with, it generated a 70% net gain in 7 months. I also have developed a Position Sizing spreadsheet in Excel that tells you how many shares to buy. Lastly, I periodically transfer all completed trades to another spreadsheet, and then analyze it for information on the criteria that worked best, and for a report card on my adherence to my own rules. This is helping me develop discipline. I’ll go into that further in a subsequent chapter. You will run into many other selling rules, many of them based on fundamentals. For instance, “sell when there are one or two quarters of earnings disappointments.” If you wait that long, your position is typically already in free fall.

Summarizing: You can improve your profitability and minimize your losses through proper position sizing, systematic entering of stops, and by trailing a stop on profitable positions. Assuming you have a tight grip on risk control and profit control, you can improve your score a bit further by choosing stocks that meet certain stringent criteria, which, historically, have outperformed the averages.

Coming up in Chapter 12: Stock Selection Criteria that Work

Notes:

1) I plead guilty to sometimes exiting a stock that is lagging, even though it hasn’t hit its stop, to free up cash so that I can get into another one where the grass seems greener. I’ve observed on a few occasions that the one I was in took off like a rocket shortly after I got out. In 2000, 2001, and 2002 it paid off. But in 2003, I left a small fortune on the table with this strategy. Nevertheless, this practice (which is called the “pig at the trough” approach, because the stronger push out the weaker) is extremely common among successful traders, and is in fact the basis for the ValueLine system, O’Shaughnessy’s 45 year test, Schwab’s successful rating system, IBD’s Daily 100, etc. So on occasion I will still do this, and continue to monitor the overall results. See Schwager, Jack D, Stock Market Wizards, Harper Business, NY, 2001, pp 38,54

2) Shiller, Robert, Irrational Exuberance, Broadway Books, NY, 2000, pp 42-43

3) Tharp, Van K, Trade Your Way to Financial Freedom, McGraw Hill, 1998, p. 328. The ATR (Average True Range) is the average over the last “X” days of the true range, which is the largest of the following: (1) today’s high minus today’s low; (2) today’s high minus yesterday’s close; or (3) today’s low minus yesterday’s close.

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Other than attempts to find the bottom in Lehman, fishing in the financials still seems to be difficult. Even at these depressed prices, most of the larger financials are trading at or above book value. Assuming their book values are artificially inflated, the stocks can fall a bit before I would sense capitulation and find it worthwhile to go long. I've lightened up on my WFC short (I am one of the few investors who have shorted financials this year and have lost money on the shorts!).

From the long side, I was tempted to add to TEX or initiate a position in BUCY. Other the last two weeks, these would have been profitable. BUCY remains on my watchlist.

Financials I'd like to hop into on further weakness include WBS, FAF, and BAC.

As you can sense, there's little in the way of assurance on what I'm looking at. I find most securities to be fairly valued, and I think I'd lean slightly to the bearish side for the general market. Other than falling commodity prices, I don't see catalysts to improve the malaise of the economy.

Related Stocks:  BAC, BUCY, FAF, TEX, WBS

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Let’s hope he continues to torch on special teams.

It’s impossible to dislike this song/band.  The 90s were awesome.

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