Jubak's Journal
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How to beat the short-term traders
Painfully, I've learned today's market is dominated by fast-money traders. That creates an opportunity for the investor with a longer time horizon.
By Jim Jubak
Mistakes, mistakes, mistakes. The best thing that I can say about the mistakes I made in October is that, while they cost me (and you, if you follow my picks -- my apologies), they taught me something important about the nature of the current stock market.
And that expensive lesson is? The short-term direction of this market is being set right now by hedge funds and other fast money. These traders represent a lot of cash -- there's now about $1 trillion invested in hedge funds alone, according to Hedge Fund Research -- but relatively few strategies. All this has increased the speed with which a favored sector can sell off -- and the speed with which it can recover.
That has made this a market of mini-rallies, as the hot money rushes into and then out of a sector. And it has led to a situation where momentum in an asset class, a sector or even a stock can turn on a dime because so many big traders are looking at the same technical indicators to guide their buys and sells.
I didn't fully account -- that's a polite way of saying "I messed up big" -- for the character of this market when I bought Dril-Quip (DRQ, news, msgs), Ultra Petroleum (UPL, news, msgs) and Arris Group (ARRS, news, msgs) on Sept. 16, Sept. 30 and Oct. 21, respectively. I set stop-loss targets about 15% below the purchase prices to protect my portfolio from taking a big hit. The extreme volatility of this market, however, turned what is normally a decent strategy for limiting losses into an invitation for the market to whipsaw my portfolio. As hot-money traders took profits in the energy sector and sold off the shares of any technology company announcing even the slightest disappointment, these three stocks dropped quickly through my stop-loss targets.
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Stop loss, miss gain
Then, having dropped a quick 20 cents to 55 cents a share below my 15% stop-loss target, each of the stocks stabilized and rallied.
The most painful example: Dril-Quip fell from my purchase price of $43.90 on Sept. 16 to a $37.50 close on Oct. 18, triggering a sell since I had set my stop-loss target at $38. Then, after touching a closing bottom at $36.52 on Oct. 20, the stock reversed course. On Nov. 4, Dril-Quip closed at $47.25.
Damage? A loss of 15% on the downside from my purchase price to my stop-loss-triggered sell. And, of course, the pain of watching the stock then climb by 25% from my selling price. If, instead of selling, I'd simply held through the fall and rise, I'd be looking at a profit of about 7%.
What separates my analysis of this mistake from ordinary, garden-variety 20-20 hindsight is that I can see similar patterns all across the market during this period. And that convinces me that I'm not looking at some piece of individual stupidity or bad luck on my part. Rather, it is an essential characteristic of today's stock market -- and a lesson I can use to increase my profits from this market.
Take a look at the price behavior of the energy sector as a whole over the last two months. The Amex Oil Index ($XOI.X) hit its recent high on Sept. 29 at 1,091 and then began a fall that took it to a low of 912 on Oct. 20.
Why the tumble? Well, you can point to an equivalent fall in the price of oil as a big reason. The spot price of West Texas Intermediate hit its peak at $70.23 a barrel on Sept. 1 and then fell to a low of $60.02 on Oct. 10. It was under $60 on Monday.
Notice anything else though? The fall in energy stocks corresponds almost exactly to the end of the third quarter. (It appears some traders sold on Sept. 29 to beat the end-of- quarter rush on Sept. 30, which was a Friday -- traditionally the worst day of the week to sell.)
A paltry, but locked-in, return
It sure looks like all those hot-money hedge funds and other traders who had made solid profits on the energy rally in the quarter wanted to lock in profits before the gains disappeared. Hard to prove, but the circumstantial case is certainly worth considering.
The average hedge fund, according to Standard & Poor's, went nowhere in the first six months of 2005: The average gain was just 0.13%. Hey, that's better than the 1.7% decline in the Standard & Poor's 500 Index ($INX) -- but not exactly the kind of return that earns a hedge-fund manager the glowing thanks of grateful clients (or that justifies high management fees).
And then came the third quarter, where, thanks to gains in utilities and energy stocks, the average hedge fund climbed 2.3%. Still not great, since the S&P 500 index gained 3.15% in the period, but enough to put the average hedge fund solidly in the black for the year.
Put yourself in the shoes of that average hedge-fund manager. Are you looking to risk that gain if oil prices or energy stock prices show the least signs of cracking? Of course not. In fact, the smartest thing to do would be to sell before prices have any chance to retreat and lock in that performance for the quarter and year to date.
The timing of the rally that ended the decline in energy stocks is just as interesting. Spot oil prices continued to fall, reaching $59.85 on Nov. 1. But the prices of energy stocks began to climb anyway. The price of oil and the price of energy stocks had decoupled.
What's intriguing to me, as I try to characterize this market, is the price levels at which energy stocks reversed course. The Amex Oil index had fallen 16% from its high on Sept. 29 to its Oct. 20 low. A drop that big corresponds to the well-known traditional definition of a correction (and consequently of a bargain). And, in this case, it corresponds almost exactly to the bottom of the index's trading range as described by a technical indicator such as Bollinger Bands. (See for yourself: You can create Bollinger bands with our charting tool -- look under "Analysis" and "Price Indicators," and then under "Settings" to set the bands for 50 days and 2 standard deviations.)
Strikingly enough, the top of the Amex Oil index corresponds very closely to the top of the trading range.
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