December 11th, 2012

Our Discipline: A Case Study in MED

As I’ve written here often, I believe the best approach for the typical individual investor is to manage their portfolios employing the following three steps: 1) a well-founded, unemotional approach to market timing, 2) the notion of industry group rotation and 3) diversification that spreads risk among a fairly large number of individual stocks (i.e., investing approximately equal amounts among stocks in the portfolio).

Put another way, the portfolio management effort down to answering the following questions: How much money should be put at risk in the stock market at any particular moment and, if new money is to be put to work, which stocks should be added to the portfolio? 

I solved the first question for myself several years ago.  I collected data back to 1963 on the daily S&P 500 Index and, by asking a series of “what-if” questions determined when it would have been better to have invested money in the market making an average return than having it sit idle on the sidelines.  Or, stated in the reverse, when would having money sit on the sidelines been better for long-term returns than had it been invested earning an average market return?  The analysis resulted in my Market Momentum Meter, an unemotional barometer of market sentiment, that allows me to shut my ears to all the media noise and hype about what they claim is “Breaking News” and focus instead on the truth about conditions conducive to momentum-driven markets over the past 50 years.  Following the Meter’s signals over the long run, investors could have avoided market crashes while still taking advantage of the bull market runs.  I can attest to the fact it helped me avoid the worst of the 2007-09 Financial Crisis Crash.

Once the Meter signals that it’s relatively “safe” to put new money to work in the market,  I use a two-step approach for finding the stocks best for carrying that risk.  I scan all stocks to find those that meet one of four different sets of criteria and, once having narrowed down the population of publicly-traded stocks, I look at their charts to find those that might have a good chance of crossing above levels that stymied their past advances (in other words, those that look like they could soon breakout across significant, long-term resistance trendlines). The first stocks to breakout are first in line as investment candidates.  The discipline requires me to sometimes be fairly active and at other times to do nothing but unemotionally watch the Portfolio run with the market or sit idle safely protected in cash.

The debate/negotiations in Washington has brought us again to a crucial market pivot point.  The Meter indicates that when market conditions look as they do today it might have been best for us to have money invested.  I have begun running those scans to begin finding those stocks that look like they’re ready to trigger Buy Points in their charts by crossing above key resistance levels.

While 75% of the stocks currently in the Portfolio show gains and 69% have outperformed the S&P 500 since their purchase, few have delivered the sort of results as has MED since its purchase last March.  I had never heard of Medifast when it dropped through one of the Scans and presented a compelling chart.  When I purchased the stock, I wrote in the Instant Alert to Members that the stock is “a product of yesterday’s Stocks-on-the-Move scan.  It has formed an inverted head-and-shoulders reversal pattern at what I hope will be the bottom of a multi-year descending wedge pattern.”  Since then, the stock has advanced 95%:

As the usual disclaimer says, “Past performance is no guarantee of future performance”.  But, I believe in the discipline and am using it today to find the next batch of stocks some of which, with some patience and luck, will hopefully deliver what turns out to be the outstanding performers over the next nine months or a year.

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November 29th, 2012

Head-and-Shoulders Patterns: FDX Case Study

The key point in yesterday’s discussion of the GLD and AAPL head-and-shoulders patterns can be summed up in the post’s last paragraph:

“……. no matter how good these chart patterns may look a year from now, unless and until they cross their necklines, there’s no certainty today that they won’t fail to deliver.  While getting in early will produce a greater return, the trade entails significant risk that the stock actually winds up moving in the opposite direction.”

The point perhaps not made emphatically enough is that even though head-and-shoulders stock chart patterns appears on the surface to be similar to the results of a series of random coin tosses there is a major difference between the two should the price/value cross the neckline.  The result of coin tosses merrily continues on a random path, the path in the prices/values in stocks, indexes and commodities subsequent to a cross of the neckline usually becomes impacted by a feedback loop know as “momentum”.

When they see new highs or lows being set as the price/value crosses the neckline, investors expect, even anticipate, a continuation of the prevailing trend.  That predisposition causes them to place trades (either buy if a cross above or sell if a cross below the neckline) in anticipation of being able to close those positions some time in the future at a profit.  Coin tosses have no connection with the future but investors do.

The trading rule, therefore, is that investors should wait to commit to their prospective position until momentum is launched and the signal in the form of a neckline cross is evident.  [This presumes that a neckline is something obvious and concrete but that’s the topic for the next post.]

Let’s look at another example of that trading rule.  One advisory service recently substantiated their large position in FDX (Federal Express) by arguing that FDX was restructuring their operations so that their Express division is “refined” and their Ground operation “will lead to better margins and more market-share take against UPS.”  Somebody has to perform good fundamental analysis but it’s not clear whether individual investors are equipped or has the time to uncover and evaluate such information.  Large institutional investors (what I call “the heard”) do and what we can do is to follow their footprints in their hunt for big game.

If only a small percentage of the herd know or arrive at the same conclusion as the above the FDX analysis then price action in FDX shares will not be impacted dramatically.  If the analysis is correct and is reflected in operating results, the rest of the herd will join the chase and price momentum will begin.  If its efforts, the FDX shares will languish at best and fall at worst.  I would want to buy the shares only after, and not before, sufficient numbers of investors begin to believe in the FDX transformation and the shares begin to rise.

FDX stock has been restrained from continuing its uptrend by a resistance trendline (“neckline”) for over 5 years.  It isn’t relevant to the trading strategy whether you envision an emerging inverted head-and-shoulder pattern (square 1) or the longer-term ascending triangle (square 2).  To believe the story, you have to “show me the money”. You need to see the shares cross above the resistance trendline (the “neckline”) to have confidence that the uptrend momentum is sufficiently sustainable before foregoing other opportunities and putting your good money into FDX stock.  As my slogan says, “fundamental analysis is subjective, momentum is a fact.”

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