A letter from Tom Dorsey, reprinted per his permission.
A few thoughts on the market as you asked.
There are two sides to the market - Fundamentals which answer the question "what to buy" and Technicals which answer the question "when to buy". In the end, the irrefutable law of supply and demand will win. If there are more buyers, than sellers willing to sell, the stock will rise. Conversely if there are more sellers, than buyers willing to buy, the stock will decline. If buying and selling are equal, the stock price will remain the same. There is nothing else.
What causes this imbalance between supply and demand lies with the fundamentals of the underlying stock. When these fundamentals change, the market is the first to know, next are those who have their name on the company or their money in the company. Lastly, the analyst on Wall Street who relies on information from the company. The latter is why Forbes did a feature article December 15, 1997 on the inaccuracies of fundamental research from Wall Street.
One must understand the role of the fundamental analyst to know why this happens. One of the smartest people on Wall Street is Steve Einhorn, the head of research and strategy at Goldman Sachs. He once said, in response to a Bloomberg study done in 1994, on the inaccuracy of fundamental research on Wall Street: "If the market goes down, that's not their call. Their call is, what's the best stock in my group. In my opinion, their advice is good." I agree with Steve whole heartedly. "If the market goes down it's not their call" suggests that evaluation of large group rotation, like technology, is not what they are paid to do. They are paid to recommend the best companies, fundamentally, in the sectors they follow. These guys and gals on Wall Street are the smartest people in the investment business but they are missing half the equation. That is, the supply/demand relationship of the stocks they recommend.
As an example. Semiconductors rotated in October, as you know, from above the 70% bullish level which is high risk level. Intel subsequently declined from $102 to a low around $67. There has been no fundamental change in Intel to warrant such a drop. However, semi stocks all go in sync when the sector moves out of favor. The stock clearly began producing lower tops and multiple sell signals on the way down shouting to anyone that wanted to listen, "get out!". Recently, we have been recommending Intel and it is probably going back to $102. You remember the "Lure of the Squares" I taught you when you were out here studying with us.
This brings me to the market. This is the most important consideration an investor can make. Is the offensive team or the defensive team on the field? A study done by The University of Chicago, suggests that 80% of the risk in any stock is in the market and the sector. However, most investors place 80% of their effort on the stock. This is a major mistake and usually results in losses. The NYSE Bullish Percent, created by A.W. Cohen in 1955, is the best evaluator of this risk level. It is not a predictor of direction, simply an exceptional evaluator of risk.
You will remember back in September and early October, we went defensive on the market simply because 76% of the stock on the NYSE were displaying point & figure charts that were on buy signals. This might sound funny to some as this is a very happy time when most stocks are on buy signals. It is a time where few investors are disconcerted at all.
It is also the time where everyone is in that wants to be in. The availability of demand is very low at this juncture to fuel anymore upside action in the market as everyone is fully invested. The best time to buy is when the opposite is true where there are less than 30%
of the stock on buy signals as everyone has sold that wants to sell. Sectors are evaluated the same way.
The concept is to try to buy low. This is a strange concept on Wall Street as the new thought is to buy high and find a greater fool to buy it from you at a higher price. We watch for low levels in the NYSE Bullish Percent and then we find the low sectors on their bullish percent indexes. We have the best of all worlds when a cover story in a mainstream magazine, suggests there is no hope for the sector. We then know one can buy with impunity.
Next you need to work from an inventory. Every other business you know of works from inventories, why not the investment business. The idea of an inventory would encompass finding the best fundamentally sound stocks you can, from sources you deem responsible and good, and work from those stocks. Sources like Value Line, Standard & Poors, your brokerage firm research, Zachs, The Prudent Speculator (which I like as value plays) and then put those stocks into an inventory. Like the best Oil Service companies for instance.
This will help you bring that fire hose down from a blast to a trickle. You would then keep the Point & Figure charts of those stocks as the charts would alert you when to buy and what stock to buy. This helps you fit the fundamentals with the technicals which is critical. The best plays are value plays (fundamentally sound stocks that are beaten down and beginning to show signs demand is back in control).
Managing the trade is important. If you buy the stock right, look for a long term play out of it. Forget picking dimes up in front of bull dozers. It will result in disaster. If you buy a stock and it breaks down but the fundamentals remain strong, plan to increase your position on the first buy signal on the point & figure chart after the decline.
You should probably limit exposure to one stock no more than 10% of a portfolio and begin to scale into the stock with a 5% weighting. Then add on subsequent breakouts if the stock is going well for you or, average down using the method I just mentioned. This all suggests you are attempting to buy low not chase strength.
The reason you can do these things with the point & figure method is that this method gives you clear buy and sell signals where no subjectivity is involved. There are no gray areas concerning buy or sell signals on the point & figure chart, as you know. Because of this, we also have the ability to count these signals and compare the New Buy and New Sell signals given in the market, sector, country or what ever. The bullish percents come from this concept.
Where are we now? We have been on defense (with a brief respite around the year end rally) since October with the NYSE stocks and since October with the OTC stocks. This means that strong fundamentals and strong technicals will probably be overruled by the market. Sector reversals will also be short lived and overruled by the market in general. When the defensive team is on the field it means just that, DEFENSE. Don't be afraid to lose opportunity, as we can always get more of that. It's money that's hard to make up.
Short sales are best but you must only sell short those stocks that are below their bearish resistance line, have negative fundamentals, and negative relative strength. Then short
the stock on reversals back up near the trend line with a stop (that is entered on the floor of the exchange) on the first buy signal that is given. Oh, and naturally the sector should be on defense too. In other words, stack the odds in your favor before you embark on the trade. Most investors don't think of this.
Keep it simple. Every method of technical analysis works in the right hands, it's just that the point & figure method works in the majority of hands. Can you imagine feeling confident with Gann Angles, or Cycles or Fibbinocci Retracement numbers? There are analysts out there that are very good at these things but most investors are not.
The point & figure method is simply a logical, organized way of recording the imbalance between supply and demand. It is also the oldest method in America, over 100 years old. There must be some reason it has weathered bull, bear and neutral markets for the last 100 years and is still around. I even know of one analyst that does a great job at astrology. I simply am not smart enough to catch on. Supply & demand, economics 101 is as far as one needs to go to be very successful in the market.
Options are another story. As you know, I developed and managed an options strategy department for 9 years at Wheat First Securities, a great firm in VA. I know what works and what doesn't. Keep it simple here too. Buy in the money calls or puts as stock substitutes. Never over leverage as this is the major reason people get wiped out. If you
are a 500 share buyer of stock then only buy 5 calls or puts. Never, never over leverage or buy out of the money calls. You must also go more than 6 weeks out and I prefer to go out 6 months if possible and don't forget there are LEAPS.
If you would like me to focus in on one topic in a day or so I'll be happy to do so.
Tom Dorsey |
