May 26th, 2009

Grading "Talking Heads"

Hope everyone had a restful and reflective Memorial Day …. and are prepared for a rough and tumble June. A reader and, if he doesn’t object, now a correspondence friend asked an interesting question:

“The more research I do, and the more I read, it seems charts can tell the entire story of a stock’s future. How often do you find yourself wrong?”

An interesting but difficult question to answer. Very few athletes continually bowl perfect games, daily hit holes-in-one, only pitch perfect games or hit an .800 batting average. But some traders and investors incorrectly assume that if they hold a loser long enough it will eventually break even, perhaps even make some money. Or in a misguided tactic they decide to buy more shares to average down their cost, lowering the break even point.

The challenge is to accept making mistakes in the market but hope that you’re right more than around 60% of the time. Strive to keep losers to a minimum but when you do have one, make sure you cut your losses quickly. [The IBD convention is to sell any stock that falls more than 8% below what they consider to be the ideal entry point.]

When it comes to the pro’s you expect them to do better than average. It reminds me of a recent Cramer segment where he felt vindicated due to a study by two finance professors at some no-name business school. They concluded that his recommendations performed better than the benchmark averages. But to his credit, Cramer confessed that trying to calculate performance was complicated so he couldn’t really go into the methodology of how the professors assembled their results.

The difficulty in performance arises because “talking heads” can issue buy recommendations without ever really putting targets or time frames on them. Without a goal, it’s difficult following up to see if the goal was ever met. I came across a place, though, that attempted doing just that: CXO Advisory Group’s Guru Grades. They critique around 60 of the most well-known prognosticators including: Ken Fisher, Dan Sullivan, Joe Mauldin, Marc Farber and, yes, Jim Cramer. In addition to those in the summary, another 50 each an individual page detailing the evaluation process and conclusion. In total, about 48% of the recommendations were wrong and about 50% of the pro’s got half or less of the recommendations correct.

My answer to the question (and partly as a defense) is that 1) if you are relatively skilled at chart reading, 2) look at charts across a number of time horizons, 3) always make your investment decision within the context of the industry sectors “popularity” and 4) are aware of the overall market’s health and trend then a losing position arises usually not from misreading a chart but from poorly timed execution due to:

  • being blindsided by a later unforeseen and unanticipated corporate event
  • buying a stock too early thereby running the risk that you have to hold until the move begins or, even worse, having it morph into a bearish pattern and move.
  • due to indecision or fear, waiting too long, to buy a stock thereby running the risk that it is at the end of a major move.
  • owning a stock and not understanding or seeing that its losing Industry Group support
  • Not timing the market correctly

My reader went on to ask,

“I’m sure any chart can break down, but as of now I can’t think of a stock that you’ve touted that hasn’t performed well over the past couple of months. It’s tempting to simply focus on charts and, when the time is right, buy several more of the companies on your list. Then I can look for promising patterns indefinitely. Is that too simplistic?”

I threw that in not only because it was complementary but also to make a point. I can’t actually take credit for the performance of “my picks” because the initial stage of the market’s life cycle, the Accumulation Phase, is very special and unique.

I’ve used the metaphor here before because it’s a perfect description. Most stocks have been beaten down and are lined up like race horses in the starting gate, all waiting at the same place for the race to begin. When the starting bell rings (i.e., when fear sudsides, some better economic news starts to appear and the huge cache of money sitting on the sidelines starts poring into the market), some stocks may be faster or get an earlier jump out of the gate, some may have a delayed start but most begin moving up around the same time.

It’s actually easy at this stage (I bet you don’t hear this from too many other bloggers or “talking heads”). This doesn’t happen in later stages because stocks run at different paces and different courses. Individual circumstances soon begin to overwhelm market factors and some stocks begin to stumble. At some point, when the market needs to rest, to regain its energy, to consolidte, other stocks fail to regain momentum and fall far behind in the race. By the time the market enters the final Distribution Phase before becoming the next Bear Market, all the stocks that started the race show an extremely wide range performances.

The only thing we need to worry about now is that the right-shoulder of this market reversal pattern doesn’t fail. We’re anxious to see that this shoulder has a bottom, the market turns back up and the 180-day, the neckline and, ultimately, the 300-day moving average is crossed over. Then the race can really begin. Giddyup!

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