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It's not about war, it's about prices
Here's why some traders say everything you need to know is in the stocks, not geopolitical gloom and doom. Plus, one trader's short list of predictable winners.
By Jon D. Markman
While stocks often seem to move in sync with political and social news events, the intersection is typically more coincidental than actual. And we are probably coming up to one of those moments when the two are going to disconnect.
I dont care about the war," says seasoned researcher and investor Robert Drach, who profitably pays absolutely no attention to the guesswork of when and why. Emotionally induced behavior has a very poor record. He can get away with his single-minded cynicism because his recommended portfolios have apparently never suffered a losing year (see his picks below)..
For stocks today, the most important timing milestones are not future U.N. inspection deadlines or tax-bill votes in Congress, but two dates in the recent past: July 24 and Oct. 10. On those otherwise unremarkable days, the broad stock market averages reversed sharply from hard downward spikes, creating isolated reversals, or bottoms, that loom large in the eyes and memories of investment pros.
To understand why, you should know that the ranks of market participants who focus on price action rather than fundamental business quality, called technical traders, have swelled in recent years in proportion to the ebbing of confidence in income reported by corporations. As bulls have lost faith in their ability to buy shares due simply to estimates of asset value in relation to companies lasting edge and earning power, they have turned to alternative methods of timing their purchases and sales.
Veteran technical traders like Terry Bedford, whose views are profiled in detail in my new book, Swing Trading: Power Strategies to Boost Profits and Cut Risk, have long made the case that price and volume action tell everything you need to know about the demand and supply of stock anyway, and that fundamentals are interesting but ultimately unimportant.
Time to kiss lower lows good-bye?
Bedford and his ilk, formerly out of the mainstream, now find themselves at the forefront of the market. Most spiked bottoms in the market, as well as tops, are given their exclamation points by big funds massive program trades tuned systematically to buy or sell all the stocks in the major indexes at these technical turning points.
At the moment, those trading programs appear to be aimed like 105 mm cannons at the lows established by the market on July 24 and Oct. 9. The key levels to watch are 775 for the S&P 500 ($INX), 7,489 or 7,215 for the Dow Jones Industrials ($INDU); and 1,192 and 1,108 for the Nasdaq Composite ($COMPX). Thats about a 7% drop from Fridays level for the S&P 500, a 5% to 8% drop for the Dow Jones Industrials and a 9% to 15% drop for the Nasdaq Composite.
Even traders who believe that deteriorating economic fundamentals, diminished fund buying power and war threats ultimately will push the indexes below their October levels are poised at this point for what technicians call a test of those lows. This means that if stocks continue to be pressured this week and next, bulls may ultimately concede a 7%-10% decline from this weeks prices and only defend their favorite names at those lines in the sand. And it means that if youre just a private investor whos been sitting on cash for the right opportunity to buy beaten-down, high-quality stocks, a return to those lows is the moment youre waiting for.
Without doubt the October level, since it is lower, is more meaningful than the July level. But here is where it gets tricky, for the market is a capricious beast and loves to pull a fast one.
Very often, successful short-sellers who see the bounce looming will start covering their positions early to avoid getting caught in the rush -- a job thats accomplished by buying stocks that have been pushed down a lot in recent months. And itchy-fingered bulls, seeing the unexpected pop in those badly battered names, often jump the gun and start their own bargain-hunting early. If both of these things happen at once, and something external to the market occurs to give investors a psychological boost, stocks can put in a new bottom that is quite a bit higher than the lows. And ever so enigmatically, folks who are waiting for an elegant double bottom are left waiting for an event that never occurs as stocks swoosh higher in a noisy rush.
Its quite possible, though not at all certain, that such a move began on Valentines Day. If so, it would be a poetic moment to kiss lower prices goodbye and stick a short-seller in the eye. News reporters will declare that the switch from down to up occurred as a result of some geopolitical event, like the erosion of war fears, while in truth the market was dancing to its own structural rhythm.
The only constant is change
Drach, of Drach Market Research and co-author of one of my favorite books on the game, High-Return, Low-Risk Investment, has also published one of the dullest and most homely weekly newsletters in America since 1977. His proposed positions rarely lose money, giving him the freedom of inattention to the niceties of marketing.
Drach likes to point out that investing is not a team sport, and that winners can only be successful at the expense of losers. He proposes that the best way to make money long term in the market is to never suffer the effects of negative compounding, so he scales into stocks only when he believes there is a 95% likelihood of a successful result. Those moments have been increasingly rare in recent years, and his followers have spent long periods of time with 20% or less of their funds in stocks. But when his quantitative time overlay method (see the book for an explanation) tells him that stocks have declined at a steep enough angle for a long enough period to justify exposure, he slides in over a two- to four-week period to take advantage.
Its always nice to call Drach when the market has cratered for several weeks straight, because you know youre going to hear what passes in his hometown of Tallahassee, Fla., for a happy voice. That was the case back in the third week of July last year, before the July 24 rebound, and it was the case again in the second week of October, before the Oct. 10 rebound. In both cases, his discipline called for buying stocks in a short window around the steepest part of those declines. And it called for unloading those same stocks after the follow-up steep advances. He ended 2002 with a modest 7% gain -- not a huge amount, but much better than the market benchmarks.
As you might have guessed by now, Drach told his readers to move 63% of their money into stocks a week ago. He expects to move to 100% invested if prices decline back toward those lows in coming weeks. Were buying now when sentiment is negative and well sell 'em back to the masses when theyre happy campers again, he said. Its all about buying inventory at wholesale and selling it at retail. The masses repetitively exhibit a mindset that whatever market condition they have most recently experienced will persist forever when, in fact, with all investment types the most constant aspect is change.
Drach's short list of predictable winners
His general theory is that most stocks dont have decent earnings predictability, so they dont deserve investment consideration. He focuses on buying only from a master list of 80 large stocks that hasnt changed much over the years. Companies like tobacco makers Altria (MO, news, msgs) (formerly Philip Morris) and UST Inc. (UST, news, msgs), financials Comerica (CMA, news, msgs) and Bank of Montreal (BMO, news, msgs) and consumer stocks like ServiceMaster (SVM, news, msgs), Johnson & Johnson (JNJ, news, msgs) and Home Depot (HD, news, msgs). He requires at least seven years of making earnings projections, notwithstanding a bad quarter from time to time, but will boot a company if it misses too often.
Extreme price dislocation in high-quality stocks attracts me to the market -- its pretty simple stuff, he says. Its pretty easy to be long here, with almost a third of our stocks registering lows in P/Es. Its times like these that give us a reasonable expectation of success. Irrespective of the prospects of recession, the decline in P/E ratios has been disproportionate.
For the past couple of years, Drach has yo-yoed in and out of stocks, but he thinks that the recent period of high volatility will come to an end before too much longer, allowing him to stay in his new positions. The last time he recalls coming into a year with so much discounting was 1991, when he followed a 2% up year with a 35% year. If hes worried at all about the prospect of hostilities, he wouldnt admit it. I dont care about the war -- just the 95% probability of success, he said, scoffing at the question. Emotionally induced behavior has a very poor record.
Drach is one of a kind. He permanently keeps the conventional wisdom sealed out of his mind with duct tape, and never varies. His current picks are MGIC Investment (MTG, news, msgs) under $41.89; Freddie Mac (FRE, news, msgs) under $55.18; Altria under $38.14; Bank of Montreal under $26.93; and SunTrust Banks (STI, news, msgs) under $55.71. If you are interested in some dividend yield, add UST under $28.45, ServiceMaster under $10.15, and Schering-Plough (SGP, news, msgs) under $18.50. These are not to be held any longer than it takes to make a decent profit. Ill keep you posted on his views as the year progresses.
Fine Print
Forgetting all about quality for a moment, dont forget that in the event the market starts to run, those low-priced, heavily shorted, cheap stocks in the S&P 500 Index should jump a bunch, as I noted last week. Heres a screen that shows the latest names. Looks like some of the top names are Calpine (CPN, news, msgs), Sprint PCS Group (PCS, news, msgs), Lucent Technologies (LU, news, msgs), Solectron (SLR, news, msgs) and Cortex Pharmaceuticals (COR, news, msgs). Im speaking at the Money Show in Orlando, Fla., this week, so if youre in the neighborhood, come on by. Ill be speaking twice on Thursday about new wrinkles in online investing, the subject of my first book, and once on Friday about swing trading, the subject of my new book. ... Drachs book is currently out of print, but there are used copies for sale at Amazon for more than $80. Considering that the original sold for under $25, it seems that his fans consider it fairly valuable. Drach says he asked his publishers, which have included McGraw-Hill and Penguin Putnam, not to print the book anymore because he believed they were price-gouging. He has promised to release his own new edition in May. He has no Web site; you can write him at 200 Westridge Dr., Tallahassee FL 32304. Speaking of books, Nancy Tengler, one of the first Strategy Lab participants, has a new one out. The former head of Fremont Investment Advisors in San Francisco and co-manager of its New Era Value Fund (FNEVX) explains how to calculate and use relative price-to-sales and relative dividend-yield measures in her book, New Era Value Investing: A Disciplined Approach to Buying Value and Growth Stocks. . Currently the method has her buying Citigroup (C, news, msgs) under $30 and selling Amgen (AMGN, news, msgs). She also likes Cisco Systems (CSCO, news, msgs) under $12.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. He neither owned nor was short any securities mentioned in this column at the time of publication, but positions can change at any time.
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