Sunday, October 30, 2011

Why I Think The Bears Are All Wet

There are many different ways to look at the market, and different conclusions will often be reached depending on one's perspective.  Since the 2009 low, most people who have been looking at the market action through the lens of elliott wave analysis have been overly and persistently bearish, as have those that view the market from a fundamental perspective, for the most part.  However, sometimes the problem with either of these viewpoints is that they impose an expectation about what will or should happen as opposed to what is actually happening which leads to rigid positions.  Being rigid and being profitable are pretty much exclusive.  Personally I'd rather be profitable.  I'll save being right for engineering and academic work.

When we look at a long term chart of the QQQ Nasdaq 100 ETF, it is very easy to see that there are two key levels going back to 2000.  The first level which was a resistance zone for some time was from about 50 to 54. The Qs were repelled from this level 4 separate time over the last 4_1/2 years.  In January of this year there was a clear break above the 2007 high of 55.07 in January followed by a return to the broken resistance level in August and October.  Had the August and October lows failed a more substantial decline would have probably occurred, but the fact is that October has seen one of the best rallies in the last 25 years, which is clearly evident on the monthly chart below.  The median line for the Qs going back to the 2002 low has held in conjunction with the May 2001 swing high.  At this point there is very little reason to believe that the Qs will not move in a sustained way up to the next resistance level at the May 2000 swing low which is conjoined by the upper channel line around 70 to 72.



Trying to get a handle on the market's moves over the last 2_1/2 years has been difficult for most everyone.  It hasn't been anything like 1994 to 2000 or 2000 to 2002 when the trends were persistent and clear.  Even so, the overwhelming evidence is that the market wants to go higher despite the abundant economic and elliott wave evidence to the contrary.  I think it would be in trader's best interest to continue with a generally long side approach until there is a clear break of the August/October 2011 lows or there is clear evidence of distribution at the next resistance level for the Qs.  Overall, in my opinion the market is in a 5 year pattern described by Gann as a 2-1-2 where the market goes up for 2 years, sideways to down for 1 year, and then up for 2 more years.  It is not exact and the transitions are not always easy to navigate, but this puts the top of this rally at sometime between 2013 and 2014.  If that is correct, there is a long way to go.

Besides trading the indexes, how can traders take advantage of this rally in individual stocks? It is easy to waste many hours trying to find stocks to trade, and much of the services available and sold are designed to help traders make stock selections.  In my experience, costly experience, most of this is a waste of time.  There are really only 3 categories of stocks that make good trading candidates:  1) fundamentally undervalued stocks with rising earnings and revenue forecasts, 2) high relative strength stocks that are outperforming the market, but that have not yet reached a climax stage, and 3) high beta stocks that have exaggerated swings relative to the market.

In the early years of my trading I spent countless hours trying to find the best stock screens.  It was total waste of time.  You can find great stocks to trade in literally about 30 minutes once every 3 months.  There are different ways to find fundamentally undervalued stocks, but the simplest and easiest I've found is presented in the book The Little Book That Beats The Market by Joel Greenblatt.  I developed screens in TC2000 and in online stock screeners that come close to matching his methods, but the simplest way is to just go to his free site http://www.magicformulainvesting.com/welcome.html.  I run his screen with 2 or 3 different levels of market cap about once a quarter and come up with a list of about 20 to 30 stocks I like.  I don't just accept his list.  I want to see expected earnings growth above 15% and a nice looking chart.

High relative strength stocks are easy to find.  Just setup up your stock screener to sort by relative strength.  I troll through the first 100 or so stocks and pick the ones that have strong persistent trends, then I see if they have decent ROE and earnings growth.  I usually end up with 20 to 50 stocks on this list.  This is how I found QCOR back in 2008, which I have successfully traded several times including the recent advance off of the September low.  I also use IBD, but you have to be careful as a lot of their stock lists have stocks that are in or are approaching distribution stages.  It's interesting that QCOR was not mentioned much in IBD until it exceeded $20.  I first bought it around $6.

Finally, I sort the Nasdaq 100 stocks by beta and pick the top 10 to 12 stocks.  When I see a nice setup like I did with WYNN recently, I trade it.

I just run these screens once a quarter.  There is little reason to waste time doing it more often.  It won't improve your results much and may hurt them.  There's no reason to pay for expensive stock picking services.  I just use Worden Brothers Stockfinder and TC2000 to do my charting and screening, and I subscribe to IBD.

Using these methods and employing the trading techniques I have described on this blog, I have reduced the total amount of time that I spend analyzing the market and picking stocks to around 15 minutes a day.  I spend more time writing this blog than I do trading.  Currently, my annual returns are running around 40% over the last 4 years.  It's possible to do better occasionally, but realistically few traders are going to do better than 20% to 40% on average, although some do consistently achieve 60% to 100% returns.  These are the stars.  It would nice to be a star, but consistency is the most important thing, and if you have enough capital, you can do just fine on 20% to 40% a year.

I hope this helps.  Have a great week trading!

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