Whatever Your Time Frame, These Ideas Should Lead You To Great Trading Opportunities

  • October 12, 2004
  • Kenneth Tower

 

Editor’s
Note:

For this
week’s Guest Commentary, I am pleased to present Ken Tower, CMT, of Cybertrader.

Brice

 

 

Stock
Selection Affects Market Perception

 

Sometimes the answer to a
single question reveals a great deal about a person’s trading / active investing
style.  Here’s the question:  “What is your opinion of market action in the
third quarter of 2004?”  If your answer was “pretty good,” you’re doing a good
job of stock selection.  If your answer was “pretty bad,” let me offer you a few
suggestions that will lead you to better trading opportunities. 

 

The third quarter was a
frustrating one for most investors and particularly for traders.  While the
broad market averages declined by only 2% or 3%, the Nasdaq declined by more
than 7%.  Most media outlets include the Dow, S&P 500, and Nasdaq Composite when
they report how the market is doing.  But the Nasdaq Composite is so dominated
by technology stocks that I don’t consider it an accurate reflection of the
broad market (it reflects the technology sector better than the overall
market).  So, while the quarter was flat overall, the market wasn’t flat on a
day-to-day basis, nor did all stocks perform equally.

 

Winners and
Losers

 

It’s easy to get a variety of
views on market action in the third quarter because the market had distinct
groups of winners and losers.  We’ve already noted that measures of the broad
market were nearly flat for the quarter, but now let’s look beneath the
surface.  Semiconductor stocks fell sharply with the $SOX index falling by 20%. 
Anyone trying to make money buying semiconductor stocks had a very difficult, if
not impossible, time.  Meanwhile, energy stocks were strong.  The $XOI (an index
dominated by big oil companies) rose 10% as did the $XNG, an index of natural
gas stocks.  Oil service and equipment companies fared even better as the $OSX
rose by 12%.  Making money by buying stocks in these groups was relatively
easy.  A group of traders or active investors trying to harvest profits in
technology stocks during the third quarter will have a very negative perception
of market activity, while a group trading energy stocks will answer; “pretty
good”.

 

Stock
Selection is Key

“So how do you know that energy stocks will be the good ones for the
quarter?” is likely to be your next question.  The unsatisfying answer is that
you don’t know.  Perhaps back in the Garden of Eden trading was easy.  But these
days one can only try to identify the stocks with the best prospects and then
apply risk management techniques in order to “cut your losses short” while
“letting your profits run.”  This may seem difficult to accept, and it would be
nice if there were a way that you could know which stocks will do best,
but there is not.  Trading is a skill.  To become proficient, one needs to learn
the basics and then practice, practice, practice. 

 

Trading
Strategy:  Consumer vs. Store Owner

Picking the stocks you believe are most likely to provide excess returns
(remember, you can invest in an index fund and avoid the additional effort and
risk involved with trading if you only require average returns) is difficult,
but generally involves starting with either a list of the stocks that have been
doing the best or the worst in recent trading.  Those with a consumer mentality
will be looking at the weakest stocks, those that are said to be “on sale.”  The
consumer wishes to buy something for the lowest possible price and then use it. 
A much better approach for traders is to pick from the stocks that have been
recent winners.  That’s more of a store owner’s strategy.  The store owner wants
to buy products that can be sold for a profit.  While he doesn’t wish to sell
shoddy merchandise, he doesn’t particularly care which brands of breakfast
cereal he sells, just as long as he can sell them for a profit!  That’s why the
first of my “Three Pillars of Trading” is “Buy Strength.”  Looking back to the
end of the second quarter, you would find that the $XOI has just made a
multi-year high.  At the same time, the $SOX wasn’t even close to the high it
made earlier in 2004, never mind its multi-year high.  The trader who uses the
“Buy Strength” strategy would have ignored the stocks in the $SOX and
investigated the groups and individual stocks within the energy sector.  He
would then have found some great stocks to buy and captured some profits.  If
making profits is not the goal of your trading, why do you do it? 

 

Screening
Made Easy

This type of screening is often called a “Top-Down” approach to stock
selection.  That’s because you first look at the overall market averages,
followed by the sectors and groups before finally getting down to individual
stocks.  Of course, you don’t have to go all the way down to individual issues
(some of you may wish to stop at the group level and a variety of ETFs —
essentially mutual funds that trade like stocks – make it easy to trade an
entire sector or group).  To top it all off, it doesn’t take much time!  To
follow this technique, start by creating a list of the S&P Sector SPYDERS. 
These are ETFs that track the main industry sectors within the S&P 500.  They
aren’t perfect, but they’re a great place to start.  Now every time you’re
thinking about finding a stock to buy start by looking at a broad market average
(the S&P 500 for example).  What has it been doing?  Is it going up or down?  Is
it above its short-term moving averages?  Where is it in relation to its 200 day
moving average?  Next look at those sector SPYDERS.  In our firm’s software (StreetSmart
Pro and CyberTrader Pro) one may bring up charts of each with a double click on
the symbol.  However you accomplish it, check out the chart of each of the nine
sectors.  With a little practice, in about sixty seconds you’ll have reviewed
the entire market.  If you’re looking for buy ideas, concentrate on the two that
have been advancing the fastest and ignore the rest.  Now that you’ve identified
the strongest sectors of the market, you can drill down a bit further to see
their component groups.  Hopefully your software has a tool that makes this a
snap (ours is called the Sector Tool).  Here again we’ll focus our attention on
the groups with the best performance.  In a matter of minutes we’ve identified a
short list of stocks worthy of detailed analysis. 

 

Pitfalls

The drawback to this strategy is that people are uncomfortable buying stocks
that are already going up.  This is the store owner strategy rather than the
consumer strategy with which we’re all more familiar.  We worry that we’ll “buy
the top.”  Well, sometimes you will.  But this should not dissuade you from the
strategy.  Every strategy has its pitfalls.  “Averaging down” is a favored
technique of investors, but here one risks investing in stocks that will
eventually go bankrupt, taking the stock price to zero.  No matter what your
strategy, risk management is a key element.  In fact, it’s the most difficult
element to master. 

 

Risk
Management

I mentioned before that trading is a skill.  Let’s see if we can draw a useful
lesson for traders from another skill – driving.  Imagine yourself driving down
the interstate at 70mph.  You notice that the cars ahead of you are slowing
down.  What do you do?  You slow down!  You recognize that you are in the car
because you’re trying to get somewhere and that if you crash your car, you’ll be
delayed, perhaps indefinitely.  But somehow people have trouble applying this
simple understanding to trading or active investing.  Traders notice when one of
their holdings begins to decline in price, but too often they take no action! 
They don’t want to sell because they wonder why the price is falling. 
Drivers don’t refuse to slow down because they don’t know why the traffic
in front of them is slowing.  They just slow down.  Traders and active investors
must follow the same rules.  They must always take defensive action when
one of their holdings begins to falter.  Sometimes the stock will turn around
and go back up just as sometimes on the interstate you’ll be able to quickly
return to 70mph, but on the interstate no one complains that they had to move
their foot back to the gas pedal.  Again traders need to adopt the same
mentality.  If your stock begins to rise and gives you another buy signal, get
back in!  No sitting around whining!  Yes, it’s unfortunate, and yes, you wish
you could avoid getting out and then getting back in (generally at a higher
price), but that’s the only way to keep from crashing your portfolio. 

 

Conclusion

Regardless of whether you’re a short-term trader or a long-term trader, adopting
a philosophy of “buying strength” and following a simple “Top-Down” stock
selection strategy should lead you to a series of great trading opportunities. 
Looking ahead to the 4th quarter, we again identify the energy sector
(XLE*) as one worthy of further consideration.  Additionally, we note that the
utility (XLU*), industrial (XLI*), and materials (XLB*) sectors are making new
highs for 2004.  These are the four strongest sectors.  Start with energy and
add one of the other three for further exploration.  These sectors are most
likely to produce the 4th quarter’s upside surprises.  This is how to
drive your portfolio to success.

 

Ken Tower, CMT

 

 For more in-depth review
of Stock Selection, Risk Management, or Stock Screening techniques, view Ken
Tower’s online webcasts on these topics at

www.schwab.com/atseminars

 

* Schwab Capital Markets makes
a market in these stocks.