Ian Woodward's Investing Blog

As I showed you in the note of July 26 Musings two notes ago and below, the group of stocks I was following to determine the top in the market is now broken.   There is one last chance for a last dance that my good friend Robert Minkowsky has suggested which is to take those stocks that have bucked the trend and are still heading northwards against the grain.  Watching a small list of these stocks which have already reported their earnings will give us a clue as to whether the recent drop in the market was like February 27^th for a week or so or whether this time we are headed down for a decent clean out.   Below is the list of eleven stocks to follow and the Index of these to show you that the Index is above the 9-dma (pink line).  If this Index breaks down, the party’s over!  Enjoy

Question:  I read that book “Trading for a Living” that someone recommended and it was good. He recommends a 2% stop, but someone on the board said to use a 6-7% stop… with 2% I keep getting stopped out same day, and with 6% it goes up a bit, but crashes back and I end up losing a bit. What kind of strategy can I use to overcome this problem? 

Answer:  You are not alone…the setting of stops in a Volatile Market as this is, leaves one frustrated more often than not.    It has been a while since I read Elder’s Book, but you need to look at page 260 again.  He was referring to risking no more than 2% of your ACCOUNT equity.  If you have a $100,000 account, then the most you should risk is $2000 on a trade.  If it is $20,000 then you can only risk $400 on the trade.   Let’s suppose you have 10 stocks of $10,000 each for a $100,000 account.  Now let’s suppose you have 500 shares of a $20 stock you can afford to set your stop at $16, lose $4/share and therefore $2000 total.  This is still only 2% of your total account of $100,000.  However, if you hit a bad patch and lose three or four of your trades in a row, and lose $8,000, then stop trading for the rest of the month.   

Now I am not suggesting for one minute you should lose 25% of your hard earned money on a trade.  You certainly should not sit around and let a 6%-8% loss turn into a 25% one before you act. I’m sure Elder never meant that as a standard rule for all trades.  The crafty Market Makers will invariably employ the spidery leg syndrome and swoop down and grab stocks with stop losses that are at around 6% down from the current price and then as quickly as you can say “Jack Rabbit”, they will trot back up again and cause those spidery legs you see (tails) on the end of daily stock prices.  That invariably happens at the start of the day.  The first tip is to try and stay away from such volatile stocks.   

The next point is that any stock that has lost 3% or more in a day is likely to go down further the next day, before it trots back up. Of course you need to watch the volume traded on that day.  if it is light then it may be that the stock is correcting in concert with a poor day in the market.  If on the other hand, it is a high volume day, then for sure you need to think about taking a stock off that is down >3% at the end of the day, and certainly if it is down 6%. 

There is generally two rules people use: 

1.  Support and Resistance Lines:  I’m sure you have watched Ron Brown’s movies on the HGSI Website, and how he always draws horizontal lines showing support and resistance.  Measure the distance from your expected entry point and either set your stop loss at just below that support or pass on the trade if it is too big a percentage to that support level.  In other words, you need to look for tight stocks and be very careful of loose stock patterns. 

2.  The second way is to use Average True Range (ATR):  You can do this on HGSI.  Most look to no more than 2ATR as the limit of their stop loss tolerance.  This then makes allowances for the volatility of the stock and therefore sets different levels for tight or loose stocks.  A tight stock by our definition is one that flies like the geese, straight along the 17-dma from lower left to upper right or an LLUR as we call it for short.  Try to find such beasts.  They are the best long term winners.   

Of course, if you have made 10% or more say in a matter of a few days to a week, and especially these days, then you should make sure to raise your stop loss to ensure that you don’t let a reasonable gain turn into a losing trade.  Again, you may play snakes and ladders with your money (see a note below for what I mean), but that is a caution that we are currently in a highly volatile market.   In the days of wine and roses, I used to say that each base was worth 25% and if you hit a home run you make 100% or a “hundy” as I call it.  Those days are gone for now…the market won’t let you make more than 10%/base for a home run of 40 to 50% maximum unless you are on a huge winner.  I switched thoughts to a Baseball analogy, but I’m sure you get the point.   

One last thought, if you made a little money on a good stock and it ends up taking some back to virtually a very minor gain, wait for the pullback to finish and then take it again.  Most of us fail to take another ride and on the second chance, it will invariably trot off into the sunset, leaving you behind waving feverishly to let you on.  Then like an unruly dog chasing fast cars you buy it far too extended and get whacked. 

Best Regards, Ian.

Identifying Tops and Bottoms in Market Indexes are always difficult.  However the High Growth Stock Investing (HGSI) software has a unique set of indicators of unusual events in the ebb and flow of the market that give early warning to sit up and take notice. There are three such indicators which all use the proprietary Visual Filter Back Test (VFB) function which enables showing when a specific set of conditions is met.  The appropriate color coding can be used to highlight positive and negative conditions with green and magenta/red, respectively. 

The three indicators featured below are the Eureka, Kahuna and Tsunami as discussed briefly below.  I have used the latest pictures for the Nasdaq to show how these proprietary Indicators were flashing red these past few weeks and should be followed as the days and weeks progress: 

The Kahuna: The first unique indicator provides “one-day” snapshots of major up or down days in the market, i.e. Volatility, as depicted by the long green and red candles in the Price window.  Those conditions are captured by the Kahuna Indicator which has four conditions depending on the extent of the 1-Day change in both Price and Volume.  We use light green and dark green to indicate Little or Big Kahunas on up day and magenta and dark red to indicate the reverse, respectively.  The value to the user is several fold in visually depicting the Volatility in addition to Price and Volume in the market.  Clusters of these green and red bars give clues to market topping or the beginning of a new move, as shown in the chart below:

Note the light green, dark green, magenta and dark red in the window above the Price Window showing the various types of “Kahuna days” over the past year.  When the bars are closer together that depicts heavy volatility and a sense that the Nasdaq Composite Index is running out of steam and may be due for a correction.  This is apparent from Jan. to late Feb. and again in mid-May to July in 2007. 

The Eureka: The second type of unique Indicator works hand-in-glove with the Kahuna and is called the Eureka.  It is shown in dark grey in the Volume Window on the same chart above.  The Eureka uses a totally different set of conditions based on the ARMS Index than the Kahuna, and is aimed to depict unusually strong accumulation, primarily at the start or continuation of a bull run.  When green Kahunas and grey Eurekas appear closely in the same week it usually signifies the start of a new rally.  However, when a Eureka signal appears towards the end of a Rally as it did in mid-June, it invariably signals caution of a potential correction to come.   Please note that these Indicators can be placed in any window at the whim and fancy of the user.

The Tsunami: The chart below shows the VFB indicator being overlaid on the Price sub-window to show a particular market index condition identified and named as “Tsunami” by Ian Woodward. Tsunami conditions were met where you see the chart color coded green and magenta, representing a bull run or a correction, respectively. Once an Index like the Nasdaq has shown signs of choppiness, the Tsunami will first show alternate green and pink zones and then a long downdraft of pink denoting a broken Index. 

The Tsunami conditions that give the above visual effect are essentially triggered by the Index or stock falling below or rising above the middle Bollinger Band (BB) as shown in the above chart.  Note that when the Nasdaq Composite Index is rising, it sits between the middle and upper BB and is shown in green.  When the Index falls between the middle and lower BB it is shown in red.  The panoramic “pictograph” immediately conveys the feeling of a rally or a correction in the Nasdaq Index and information to the user to either buy, or hold or sell depending on their investing style.

Prior to the Market opening this week I said in my Musings note of the 22^nd July (see notes below) that we were probably due for a down week.  Sad to say it happened. 

For your convenience I show the table below of then and now (shown in red)

The Market Indexes finished the week on a sour note, particularly in the last hour when they sold off heavily.  Both Google and Caterpillar reported disappointing earnings. This suggests that the Markets may have more on the downside at the start of the week. 

Six important things to watch going into this week (23July):                                     

                                                                                                                            26July

1.  The Down Jones Transportation Index – Must hold at 5225 and bounce up        5069.43

2. The Philadelphia Semiconductor Index – Must hold at 535                                 511.94
3. The Nasdaq 100 Index – Must stay above 1995                                               1970.97
4. The Volatility Index – Must come back down below 15.00                                    21.65
5. The 10 Year Bond Yield Index– Must stay below 49.50                                       47.92
6. Watch GOOG, RIMM, AAPL and FSLR – Must hold with minor loss.
7. As we can see only one item is not broken…the Ten Year Bond Yield (TNX), which will be good for equities but bad for the bonds.  The triple A’s are running into trouble.

    

   The $64 question now is what’s next.  The answer is simple…the numbers shown above must quickly turn back above the “Lines in the Sand” or we are headed down for a decent correction and a further clean out.

    

   The Twenty Stocks I recently follow shows the Index has turned down drastically, so all-in-all we have a bleak outlook:

    

Warren Buffet once said “You don’t know who is swimming naked until the tide goes out”. 

At this very moment in time there are only two things playing tug of war in the market that matter: 

1. The Earnings season is in full swing and by and large there is no question that the earnings are showing strong results especially in the technology arena.  That on top of the fact that the Tech Sector has been dormant coupled with a weak dollar has given a fillip to the Large Cap stocks. However, I don’t have to tell you that the Small Cap Russell 2000 is being hammered.   

2. The sub-prime fiasco is not behind us by any means.  The latest casualty is Countrywide Credit.  In addition, it seems that the credit market is finding difficulty in closing the Chrysler deal which suggests there is a lot more bad news which will take longer to unwind and will last a lot longer than next week when the majority of the EPS reports will be out.   Let’s cut to the chase as to what matters of all the things that can affect the stock market in the next two weeks:  

1.  The strong Earnings Reports confirm that I was right in the July Newsletter to raise the year-end estimate for the S&P500 Growth Rate from 10% to 15% over 2006.  That is the fuel that is keeping the stock market up, because the P-E is at fair market value.  That is the only reason that this market keeps chugging along at this point in time.  However, that swan song cannot last forever without a pause to refresh.     

2. There is a major disconnect in the opinions of the gurus on the sub-prime stuff regarding the size of the potential damage:

    a. The administration including Ben Bernanke implies things are under control though admits there is a problem.

     b. Bill Gross who is the Bond King has turned bearish and you can read his stuff to your hearts content at pimco.com or look him up on Google.  For him to turn bearish raises most eyebrows, including mine.   

    c. If the markets come to a grinding halt on getting the Chrysler deal together that will favor Bill Gross’ point of view, as that spills over into more than sub-prime alone.  Late breaking news says “The backlog of buyout debt just got a few billion dollars bigger. Chrysler has postponed a $12 billion financing intended to help fund its pending sale to Cerberus Capital Management”.  

My point is that we have only about ten days of grace before we begin to see the tide go out on the former and maybe the latter.  So be patient and play close to the exits and you will soon see which one or both are naked…but, make sure you have your swim suit on and protect your Capital! 

Meanwhile, take great comfort that the EPS Reports are strong and play the long side with stocks that have strong earnings already out and bucking the current volatility.  Or seek out those stocks that have disappointed and are vulnerable.  Never short a strong stock till it is wounded.   However, I note that some stocks such as GOOG, MICC, SNHY, BTJ and SPWR which have all been recent leaders are looking a trifle droopy and that is invariably the best clue that a correction is imminent if not already underway.   It’s always “Your Call”.  

Best regards, Ian.