Gil Morales and Dr. Christian Kacher — Part II
No one has had a more massive impact on the careers of so many of this era’s most outstanding growth-stock pickers than Bill O’Neil, chairman of institutional research firm William O’Neil + Co., and founder of Investor’s Business Daily. Players with names like Moses, Ryan, Kuhn, Cooper, Morales, Kacher, and Freestone, are but a few on the long list of traders that have rolled up eye-popping results using the combination of fundamental and technical concepts outlined by O’Neil in his seminal book How to Make Money in Stocks.” He’s taken things a step further by writing another book, 24 Essential Lessons for Investment Success, recently released on McGraw-Hill and available at href=”https://www.amazon.com/exec/obidos/redirect-home/tradehardcom”>amazon.com.
In TradeHard.com’s continuing series of interviews with traders, I sat down with Gil Morales, head of institutional services at William O’Neil + Co., and Dr. Christian Kacher, portfolio manager at William O’Neil + Co.
Conducted Jan. 6, 2000, the following represents the second of a two-part series of interviews with Morales and Kacher.
Kevin N. Marder: Obviously, when we last talked a few weeks ago, it was a much different market climate. To me, the toughest decision is the sell-to-nail-down-a-profit decision. The sell-to-cut-a-loss decision is much simpler, while I think the buy decision might be somewhere in between. What would your advice be to intermediate-term traders to better time their exit points?
Morales: Basically, there are three ways a stock will top. No. 1, you will either be making new highs on less and less volume, which we call wedging. Or you will have a climax, blow-off type of move where the stock has its biggest one-day range from the time the market turned — in other words, from the day that you had the follow-through in the market. The stock will have gone on a tear and at the very end of it you’re gapping up on huge volume and you’ve got the widest spread, almost as if there’s a rush to get into the stock. At that point, it’s almost capitulation on the buyside. We’re looking for that, a climax type move. And you had that in a number of the leaders that were occurring. For instance, you saw ^SUNW^ when it got up above 80, it was up 7 1/2 points in one day which was the biggest one-day point rise throughout the move. So we kind of got a signal there to start losing some of the position.
Kacher: Not only that, but after it made that huge, 7-point move, it came in and then started to wedge over the next few weeks.
Morales: Right. In other words, you rallied from that low at 70 1/2 up toward 80 and your volume was declining pretty much daily. And so that’s giving you some signs. In the case of a stock like Sun, it’s an institutional-quality company. They’re a key to the build out of the Internet infrastructure. It’s possible the stock will have to go through a period of base-building. But in any case, we think the stock has topped for now.
Kacher: This thing is probably going to find its level. It’s actually finding support at the 50-day (moving average), because institutions will come in and support the stock. A lot of these institutions own millions of shares of this company. However, if this market is going to fall further, Sun might come in further. Our whole take is why have your money in a stock that at best is going to go sideways and base build for a number of weeks.
Marder: I know that Bill O’Neil likes to say that big gains need a lot of time to build. Now when you say that you don’t particularly want to sit in a stock that’s forming a base, does that mean you would exit the position now and then if it rebuilds and maybe breaks above 80 you might get back in?
Kacher: I wouldn’t exit here. It’s easy to sell early — it’s hard to sell late. Early would have been to sell–
Morales: –into the climax move at about 80 and into the wedge.
Kacher: Or you could easily have sold into the wedge in the mid- to high-70s. Now it’s right at the 50-day. So I wouldn’t be selling right here because you’re at support and it might bounce. If it bounces up into the low- to mid-70s, I’d probably be selling off the rest of my position.
Marder: How would you have handled ^JDSU^?
Morales: JDSU came out of a narrow base and broke out at about 135, ran up very rapidly, and then you finally had one last day where you had the biggest one-day point move since the breakout. That’s sort of like capitulation buying. So it’s kind of like it works in reverse for selling. And then the stock picked up volume for three days in a row. And that stock, in our view, has topped. Now that doesn’t mean it’s dead and it’s going to collapse to 40 or something like that. What it means is at best it’s going to have to build a whole new base and set up again. At worst, it has topped and could go into a long-term decline, the severity of which you can’t really gauge and we’re not even going to try to.
Marder: Realizing that you do not own the stock, let’s hypothetically say you did and let’s say you bought it coming out of that October breakout there, around 68 or 69. Now let’s just say you held on to the position and it formed that base in November and early-December and then it broke out again a couple of weeks ago. Right now would you be tempted to just hang on to the thing and hope that it forms a base with say 150 or so as the low?
Morales: It depends on my cost basis.
Marder: Let’s say you got in at around 69 or so and you have a pretty good profit.
Morales: At 69? You might try to hold it. One of the things we’ll do is let’s say I have a position at 69 on the breakout and I’ve ridden that thing all the way up. I would probably sell half of the position here, and then let the market tell me what to do with the rest of it. If it starts to come under severe distribution, and there’s no rally, then maybe I’d lose it all. There’s nothing wrong with making money. And that means nailing down profits. People shouldn’t feel that they have to sit with everything forever. Now we know people who’ve owned ^HD^ and ^CSCO^ for 10 years and of course they’ve had to sit through all of this. But they’ve been fortunate that they have a low cost basis. Buying right when the market turns and not hesitating on an O’Neil follow-through day is key because you have a low cost basis in most of your stocks and you can afford to maybe sit and watch a little bit here.
| “…the color of the market is different now. I don’t want to have all my money on the table. I’d be taking at least half of it off, if not all of it.” — Dr. Christian Kacher |
Kacher: Whether to hold is a very personal decision and has to do with your timeframe. Some people like to have a very long-term orientation with the market and ride through these little corrections that we experience. With something like JDSU, it’s had a series of little corrections all the way up from 20. So some fund managers might have gotten in very, very early and have held it the entire way and they’re not going to be selling it here because they’ve got much longer horizons and the company is a leader in its space. Other traders might have a little shorter-term orientation. Personally, had I bought it at 65 or 70, I would have already sold at least one-half of the position because the tone of the market has changed. We were in a nice uptrend on the Nasdaq. The Nasdaq has broken that trend to the downside. That tells me the color of the market is different now. I don’t want to have all my money on the table. I’d be taking at least half of it off, if not all of it.
Marder: Was there one particular day on the Nasdaq that you thought was the turning point?
Kacher: Tuesday (Jan. 4). If you looked at the S&P, the Dow, the Nasdaq, and the Internet index, they were all down huge. That’s one of the signals. Last April 13 or 14, the Nasdaq and the Internet indices got clobbered after these huge runups. I was looking for that kind of sign in this market. And Tuesday’s sell off was that sign.
Morales: And on Tuesday, the other thing you saw was a number of the big leaders get clipped. Oracle down 10 and Sun was down something like that. A lot of coincidental factors all occurring together kind of gave us a sign that we had to start selling. It doesn’t necessarily mean that you run to cash right away. But you do start cutting back and you nail down some profits. We’ve been very fortunate and we sat through those questionable days when people were nervous in November and we got those powerful moves through December. When I look at where I stand right now, I’m pretty much back to where I was a week before the end of the year even after taking it on the chin just a little bit as I’m selling out of my positions here.
Marder: That’s pretty significant, then.
Morales: For us, it is.
Marder: You’re saying two or three days of losses took away a couple weeks of gains, then?
Morales: Yeah, but you were getting tremendous gains.
Kacher: The nice thing about this style is that you can run your account up a few hundred percent in a good market and then give back maybe 10% of all those gains you’ve made. Basically, if you’re quick to exit, you can hold on to the majority of your gains and just sit. The best thing actually right now — and this is what takes a lot of discipline on my part, which is what I fail to adhere to time and time again — is stay out of the market now. The tone has changed. The best thing I can do is to not trade until the market sets up again. But I can tell you right now I’m going to get my feet wet, put my toe in the water here and there, just because I like to feel that I’m still playing the market. But at least I will play it with very small positions so that if I am wrong, and I probably will be wrong in this topsy-turvy, choppy market we’re going to be in, I won’t get my head handed to me.
Marder: So that means that you might extend yourself up to 30%-40% long instead of 100%-200% long?
Kacher: Or I might go more like 10% long and 10% short, just kind of dabbling here and there. If I see something that looks good and I feel like I can scalp some profits, I might do that. It’s really meaningless. I never make a killing when the market gets choppy like I feel it’s going to. I find it’s tough for me to short and make real money on the short side. That’s not my forte by any means. So I try not to play hard.
Marder: Meanwhile, back at the ranch, Gil never finished his discussion on the three ways a stock can top.
Morales: I gave you an example of a climax top, which can be thought of like capitulation selling or capitulation buying. And that will be the final move in a stock. The other one is where you get wedging activity. In other words, the stock continues to move higher but your volume is declining. One stock that I have as an example is ^VRTY^, which I bought on the breakout in September at around 26. It ran all the way up pretty rapidly to 60 or so. But you’ll notice that as the stock was going to the 48 level up into that last final move up to 60, you had no volume. That stock is actually wedging up. I sold into that move up. I didn’t get out at the top, but I saw that wedging and that was danger. And then of course the stock breaks once and makes one final attempt to rally to new highs which you’ll often see, and then it just blows apart and it came out with poor earnings and that’s the end of it.
Now the third way stocks will top is a failed late-stage breakout. A good example is ^RAZF^. Here’s a stock that broke out down around 40, ran up and then tried to set up again, and tried to break out again. It was very choppy and you’ll even notice that the failed breakout occurred as the stock wedged up toward 100 the last few days. There was no volume there. Once that thing starts to come back into its base it should be sold. So those are the three ways stocks will top and that’s what we’re looking for. It’s tricky and I think people should study Bill’s book How to Make Money in Stocks, where he goes over every single one of his sell rules. His new book I think is a much more succinct and simpler explanation of how these things top. It’s a good starting place.
Marder: And the new book is called what, Gil?
Morales: The new one is called 24 Essential Lessons for Investment Success.
Marder: Actually, I have it right here on my desk.
Morales: I do want to make one comment on the market. You can’t say the market has topped and we’re going into a bear market. What you can say is that we’re in a correction. An intermediate, short-term correction is what we can say right now. As this develops, we’ll find out if we’re in a bear market. However, you have a few groups, Internet–E-Commerce, Internet–Software, Enterprise–Software, and some of the networking stocks that were the leading groups. They all launched and had these big moves. Now they’re all topping and going into bases, or they’ve topped for good. The lower-quality ones are done. And this is where you find out which of them were going up just because of the market and which of these stocks are actually fundamentally sound stories that have further upside and better longer-term potential. So now what we’re looking for is if we are in a short-to-intermediate-term correction. Generally what will happen is you’ll see new leadership emerge to continue the market move. Right now, we can’t identify that because we’re just starting this correction here. But I do think people need to be reading Investor’s Business Daily to monitor when those groups come up because you’ll see it when you see new highs among stocks in certain groups. These will all show up when we start to come out of this, assuming we’re able to. This is the time when people get out of the market and just kind of go away. I think that’s a mistake. Traders need to be attuned to what’s going on as you’re in the correction. This is your time to identify true leaders and new leaders. For us, Investor’s Business Daily is about the only way to keep track of that and I think all traders should be looking at that, aside from looking at the TradeHard.com site. That’s key right here.
Marder: Yes, and your comprehensive institutional product, WONDA (William O’Neil Direct Access), would be a third way to keep abreast of these changes.
Morales: A lot of people make the mistake of giving up on the market when in fact this is your time to be culling through and finding out where the new strength lies. To us, that’s the beauty of corrections or bear markets.
Kacher: To weed out the weaklings, essentially. Right now you can look at it as forming the left-hand side of the cup. We’re right in that process. The strongest stocks will form the left-hand side of that cup, but their cups aren’t going to be quite so deep. They’re going to be resistant to selling off and they’re going to form these pretty nice cups and it’s going to be pretty obvious what the next leaders are going to be when the market turns back around.
Marder: When you say we’re forming the left side of the cup, Chris, are you talking about looking at the Nasdaq Composite in general?
Kacher: You can take a look at the market indices or individual stocks. A lot of these stocks have corrected 20%-30% off their peaks. That is the left-hand side of the cup. Now we don’t know how deep this cup is going to go. Some of the weaker names are going to be off more than that, especially if the market comes off more than it already has.
Morales: And right now you don’t know for sure if in fact those are left sides of cups. They still have to form the right side and some of those will just go into downtrends.
Kacher: Right. Some of these stocks will not form cups at all. It’s over for the real weak ones.
Marder: Let’s talk about the short side for a second. What’s interesting to me is how many people think shorting stocks is just as easy as going long. All you do, according to them, is just switch the parameters that you’re looking for technically. My take on that is that shorting is many times more difficult because you’re dealing with the emotion of fear, which is a much more extreme human emotion than, say, greed or hope.
Kacher: That’s a good point, actually. Interestingly, you can see that degree on the chart. If you look at a chart right-side up and you look at the uptrend, a lot of these uptrends are pretty nice and have a normal rhythm to them. It doesn’t take a whole lot to be able to sit in a position on these uptrends. If you take a stock that’s breaking down and you turn its chart over, you will actually see a cup as well, but it will be a lot more choppy. The volatility on a declining stock is much, much greater than the volatility of a stock that’s in an uptrend. That’s kind of a general rule that you can actually see on the charts.
Marder: So wouldn’t that make the timing of a short sale so much more critical, then, to get it right as opposed to on the long side?
Kacher: Exactly. And you can also get whipped out of your position that much more easily. Because on the short side when a stock drops, it will violently lurch back up, shaking you out of your position.
| “I don’t think that it’s going to pay to go short right here.” — Gil Morales |
Morales: I don’t think that it’s going to pay to go short right here. I think it’s very possible for the market from this point to rally sharply back to new highs and run you in. Our studies show that the optimal time to be shorting is three to four months after a stock has topped. This is precisely for the same reason that Chris is talking about. If you take a stock that’s gone into a decline, and you flip the chart upside down so that now it’s like your looking at the chart in reverse, a lot of times these things make these upside-down cup-and-handle patterns. It may take three to four months to form that whole pattern. And that’s generally when the optimal time to short is. Shorting right now is probably dangerous and getting a little more obvious. Generally, the type of pattern we look for is a stock that has topped, based on the three criteria that I mentioned earlier. Once a stock has topped, it will go through the 50-day moving average on huge volume, and then you’ll get kind of a wedging rally, in other words a rally where the volume is declining on the way up, back up to or through the 50-day moving average. Then when that stock goes back through the 50-day moving average on volume, that’s your shorting point.
So that’s the way we would short. But the market goes up a lot more than it goes down. I’ve never made much money shorting and neither has Bill O’Neil. And he’s been in the market 45 years. Bill will tell you he’s never made big money shorting for the simple reason that it’s easy to get run in. And it’s much more violent to the downside. The trends are more violent and volatile and you can get shaken out. You can study any stock that’s been in a prolonged downtrend: You get these violent rallies and they’ll run the stock right up your nose and you’ve got to be covered. If you look at ^RAZF^, it gave us all the topping signs we look for, up in the 90-100 area. Then the stock broke the 50-day, down to 70, goes through 70, finds support, then rallies back up to the 50-day, then reverses on huge volume. So as soon as that stock reversed back to the 50-day today, you could have shorted that stock. That’s a good example of how shorting should be done. But, again, I don’t really recommend it as a way to try and make big money in the market because it’s just too difficult.
Kacher: There’s another problem with shorting some of these stocks, especially some of the thinner ones like Razorfish. Let’s say you try to get on board a short position at 83 when it was topping. Well, because of the uptick rule (whereby you can only short on an uptick), you might not get that uptick until 78 or 79, 4 or 5 points from where you initially saw it. Often when a stock does uptick, it’ll run 2 or 3 points beyond where you’ve shorted it. Now you’re 2 or 3 points in the hole and that can scare you right out of the position. So in five minutes you can already be down a few percent and get scared out. In fact, some of my shortest plays in the market have been on short positions.
Morales: Some of my biggest and fastest losses have been on the short side! I don’t think I’ve ever lost big money faster than when I tried to short ^CNET^ back in April. I remember that. I shorted the stock, walked away from my desk, came back 20 minutes later, and the thing was 22 points up on me.
Marder: Whoaaa.
Morales: So that’s what can happen.
| “…shorting is a totally different animal.” — Dr. Christian Kacher |
Kacher: There might be some people out there that are really good on the short side. I’m sure there are people that are consistently good. But shorting is a totally different animal. I think that when you’re playing the markets your personality is oriented a certain way — toward either being really good on the long side or really good on the short side or playing the market on a short-term level or a long-term level. It all has to do with your personality. To be able to change your personality is like trying to change the color of your eyes — it’s a very difficult thing to do. So to be able to switch gears from going long to all of a sudden going short…unless you’re a really short-term trader and you’re doing all of these daytrades I think it’s pretty tough to do for most people.
Morales: However, you’re able to short and make a lot of money, right Kevin?
Marder: You know I’ve never put on a short trade. I’ll just hang out in cash until the market sets up again. In 1990, when I read Bill’s first book, How to Make Money in Stocks, I noted that Bill had made money in only two of the prior nine bear markets, or something similar.
Morales: Even then, it’s not very much and it’s not worth the trouble. You go through 50 bottles of Tums and Rolaids and what’s the point? For 10% or 20%? I’d rather go to cash, study my mistakes from the previous upcycle, and be ready to go when that market turns.
Marder: Generally, when we get an important intermediate bottom, such as we saw in October, and a powerful advance follows with great leadership and potent volume, the first pullback is a pullback that can be bought, though this shouldn’t be done blindly, of course. Is that the way you see this?
Morales: If you have a stock that’s acting well and has strong fundamentals and has pulled back to what looks like a logical point and it’s not undergoing huge distribution, maybe you could add to your position, say on a move down to the 50-day. In general, when we get this type of action, we just have to become very defensive. Especially, when people make as much money as they’ve made, you want to keep that. So that’s primarily what we’re concerned about at this point, keeping what we’ve made.
Kacher: Again, we’re seeing a lot of leaders coming down very fast from their peaks. Whenever we see that kind of action across the board in top-quality names, that’s a serious caution flag. You had better be at least off margin in this kind of market environment otherwise you can get your head handed to you. A lot of these big leaders are already off 15%-20% from their highs. So if you’re on margin, you double that loss off your peak, which is devastating. You don’t want to get into that position. If you run your account up quite a bit, you have a lot more cushion. But the whole idea is to give back as little as possible.
Morales: Your question is related to duration. In other words, we’re only about 12 weeks out from the follow-through day. You’re saying is this about the right duration to go through an initial short- or intermediate-term correction? In most cases, yes. Right now, all we can say is that we’re certain we’re in a short- to intermediate-term correction. It could be a broader top, but–
Kacher: –the markets are actually a lot faster today than they’ve ever been before. So the cycles are compressed.
Morales: Right. We talked about that in the last interview. And maybe they are. And given the fact that they could be compressed, you can’t get into the business of telling the market what to do right here.
Kacher: You’ve just got to look at the averages and the leaders and they’re going to tell you what to do, when to get out and when to get back in.
Morales: Also, if you’ve been in the market for a period of time, you can get a sense of what the market’s going to give you, going from bull market to bull market. How much can these things go up? One way that we can gauge a move in a stock is to look at the P/E expansion. Our studies show that the average P/E expansion is 120%-130%. So we’re looking at the P/E ratios of the leaders when the market followed through, in this case on Oct. 28. What were those ratios and what have they expanded to today? Some of them are even more than 130%…200%, 250%, and more. But once we’re at that number, we’re starting to ask ourselves how much further can this really go? And also, we’re mindful of the fact that our objective is to make money and keep it. And again, Bill will tell you this: There’s nothing wrong with taking profits. You’re either going to sell too early or too late. Accept that, and you’re not going to get everything the market gives you, but you can get a good chunk of that and you should be grateful for that. We certainly are.
| “When you feel like you’re God and you can print money on demand, that’s probably time to be selling.” — Gil Morales |
Kacher: Trading the markets is very Zen activity. Gil and I always talk about that, just in having the right mental balance that will give you the right balance on when to sell and when to buy. The whole thing is you don’t want to sell too early in the run-up and you don’t want to sell too late after the market has peaked. It’s like walking a tightrope. And you’ve got to have a lot of concentration and focus and you don’t want to let your emotions get involved because then you’re not focused anymore. These markets are so sharp and so much more volatile than they’ve ever been, that timing and your window of opportunity to get in or get out of the market is so much shorter than it’s ever been. The optimal window of opportunity to get out of this market was about a day, maybe a couple of days. You can catch the bounces if you don’t get out on the first day; the market will rally back and there will be some more exit points. But if you wait, say a week, your account could be devastated. This was exemplified by April 1999, when in one week the averages came unglued by 20% or something, especially if you were in some of the highflying Internet stocks. Some of those things were off 40% from their peak — in one week. So it’s really critical that you’ve got day-to-day focus on the market and you don’t carried away by your profits. Ego is another problem. Ego can be devastating. I firmly believe that if you have an ego when you’re trading the markets, you will potentially give back what you’ve made. Ego will keep you in when you’re supposed to get out.
Morales: Make sure you’re operating with a system that has a set of rules. You operate on that so that you’re outside of your own head and outside of your own emotions. I’ve seen a lot of people get very ebullient in the last week or so going into the end of 1999. There’s a lot of euphoria. Everybody’s talking about quitting their jobs. In fact I went to the doctor on Monday and he even told me he was thinking about quitting his practice and daytrading. And I thought “Oh boy, we’re in trouble now.” And sure enough, the next day was the top.
When you feel like you’re God and you can print money on demand, that’s probably time to be selling.
Marder: It’s been real. Thanks for your time.