Is This The Bottom?

• July 30, 2002
• Martin Rini

IS THIS THE BOTTOM?SIZE=”2″ FACE=”Arial”>

There are many bullish signals that have developed in the last week that make one
want to declare that the bottom is in.  And, it might be….however, as a good
investor, we are always prepared for alternate scenarios and as such we will not
be surprised if the market decides it will yet go lower.  But, anybody
who was not visiting another planet for the last month was aware the market
was crashing and as such, if they were going to do anything about their investments have
already done so.  The selling is not yet all over, mutual fund redemptions
hit a new record last week but if this bottom holds, the selling will subside and
at the moment, we have a bullish bias but will continue to be aware the primary trend
is still down but it MAY be turning. With the above in mind, we are going to try
the upside for a change but of course being prepared for the worst should
the market turn against us.  So today, we are going to select a stock and
while we care about the direction of the market as it is nice to have the wind at
our backs, what we really care about are the micro decisions as they affect the trade.

 

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In follow-up on our last e-mail we said we were going to discuss stock selection
techniques and how one might go about analyzing a stock and having decision criteria
for buying or selling.  I hear quite frequently “I don’t have the
time”, ” I am a long-term investor” etc.  My feeling is
that most people are looking at data and hearing news that is difficult to analyze
and they were not trained to analyze it.  For example, are PE ratios more important
than the opinions of CNN and if a company comes out with a promising new product,
is that more important than the fact they lost money last year? 

 

So when they look at the information, it is many times contradictory, they do not
come to any conclusions and as a default they maintain their current investment posture
and become long-term investors if they own it and continue to sit on the
sidelines if they are out.   To much data, the info is to complex 
and we need to cut through it to make investment decisions.

 

The technique I am going to talk about is one that takes about 60 seconds to make
a buy or sell decision, the info is easily available on many web sites, it is widely
used by mutual fund managers as entry or exit criteria, and since these are the folks
who largely drive market momentum, it is a technique that deserves one’s attention.

 

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A moving average is a statistic that measures the average price of a stock over a
range of days.  For instance, a widely followed moving average is the 200 day
moving average (DMA).  The moving average represents the collective opinion
of buyers and sellers of a stock over a wider time window than just a day. 
When the price of a stock crosses it’s moving average, this can represent a signal
to investors..  It is a buy signal, a sell signal, or perhaps, just a warning
signal.  Let’s look closer at the Worthington Industries chart, our buy
candidate.

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Notice that had you followed the rule of selling when price crosses the 200DMA (the
brown line) to the downside you would have been taken out of this stock at $15
in Jan/2000 and saved the angst of watching your investment depreciate by 70%
as other “buy&hold” investors have done.  (I’ll save my “buy
and hold” speech for a later column but this tactic is best practiced in an
ascending market, not a declining one.)

 

Had you again followed the 200DMA rule of buying or selling when price crosses the
moving average, you would have entered this stock at $9-10 in early 2001.  Notice
that the price touched the 200DMA line on multiple occasions during 2001 and 2002,
always bouncing up after the touch.  This is where the concept of being on guard
comes in ….when the price is moving towards the 200 DMA the question that one should
ask is, “will it go through or will it bounce?”  The 200 DMA represents
support for a stock and many people see the stock as being at a “value”
level when it approaches that price and it thereby triggers buy orders sending it
back up. 

 

Sometimes the bulls and bears can slug it out for an extended time (see Feb
and Mar of 2001) as no single side dominates as first the bulls are in control of
a stock and then the momentum shifts back to the bears.    Notice Sept
2001 when it crossed to the downside, hit a price of $9.79 and then rebounded. 
What should a disciplined investor have done?  Well, the system is not perfect,
it is guidance, a decision rule that in general works.  But following the rule,
one would have had to exit only to reenter a few days later.  While one
would have incurred a commision (an possible tax consequences)  one never knows
and the stock price could have continued heading south and an exit was
a small insurance premium to pay for avoiding a potential catastrophe.  To avoid
these kinds of head fakes, some investors add another rule, the “two closes”
rule.  Only sell if you have two sequential closes below the moving average. 
This avoids one day head fakes that sometimes cause premature exits.

 

Sometimes people use the 50 day average rather than the 200 in that it reflects a
more current expression of group opinion of a stock as expressed by way of the price
they are willing to buy or sell.   The 50DMA works just like the 200
except it’s buy or sell signals are developed sooner than the 200…..which is good…..the
downside is that it also generates more decisions.  Whether you decide to use
the  50 or the 200 DMA in your stock buying and selling decisions they
will help with making an objective decision independent of news stories, talking
heads or what passes as stock analysis from your favorite brokerage firm.  This
technique will get you out before a crash and in before the stock has run out of
steam.

 

WHY WE LIKE WORTHINGTONSIZE=”2″ FACE=”Arial”>

Worthington happens to be a stock that has many characteristics that make it a possible
investment opportunity at this time.   While it is easy enough to research,
(I do not have much faith in these kinds of articles but see footnote)
I can tell you what the market thinks of it and at the moment they are bullish on
Worthington.  Here are the tangible characteristics as identifiable from observing
the crowd of buyers and sellers.

 

– Above 200 DMA

– Just crossed the 50 DMA to the upside

– Buying pressure on increasing price and increasing volume as it makes new
highs in June and July.

– In strong uptrend.

– Strong relative strength while rest of market is tanking.

– Trying to break out to new high.

– Recovering from a pullback as it reverts to primary trend.

 

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The other thing I like about Worthington is the price and risk profile.  At
this time, one can enter at a price of about $17.25 and if you used the 50DMA
as a selling rule and if the investment went against us we could and would exit at
about $16.27 for aprox. $1 of risk, only 5.2% of downside.  It is currently
moving up at the rate of .50 cents per month and if it turns out to be the long term
investment we are hoping for, in a year we would have made 35% on our investment,
a favorable risk/reward ratio.  So, if one wanted to nibble, this isn’t a bad
place to try.  For those of you still sitting on NASDAQ stocks, still caught
in a death spiral, this may be a good place to launch a recovery attempts.

 

I will be placing an order on Monday morning and also entering a protective stop
loss as soon as the initial order is filled.  Should it move in the preferred
direction, north, we will be taking profits on half the position as soon as we have
$1.00 of profitability and then we will let the remainder of our position ride. 
So once we are in,  I will also be thinking about selling  half my position
at $18.25 the same time I enter my protective stop-loss. 

 

For example, if one buys 1000 shares we would plan to sell 500 shares and
take $500 out of the trade in a couple of days at which time we will move our stop
on the remainder of the position to breakeven once the 200DMA is higher than
the breakeven price trail the stop at the 200DMA level. 

 

This initial sale is important in that barring a strange event (SEC investigation,
insider manipulation,etc.) with the stock, given the stock moves in our direction
in the short run, this simple act, the sale, will insure both short and long-run
profitability of the investment.   The idea that one can hold a stock and
not be at risk is such a novel concept it completely changes the psychology of investing
and allows one to be more comfortable holding positions for longer periods and become
the buy & hold investor that we all want to be.  Only this time, we are
going to buy and hold a profitable position.

 

The entry into a stock position is always the most dangerous time in a stock trade
as one tries and gets into a profitable position and negate risk.  So in the
first couple of days of the trade, we will need to do some tweaking.  After
that, decisions usually flatten out and as long as one has a protective stop-loss
placed with their broker, a daily or weekly review of the price in relation to the
moving average is enough.  This can be done on daily prices and intra-day stock
watching is not necessary.

 

If the price goes against us right away,  we will be prepared and allow ourselves
to be stopped out and accept the 5% loss.  Remember, it is a pace, not
a race so just a nibble at this time and keep your powder dry.  If this is the
real bottom, there will be plenty of buying opportunities in the future.