In search of the magic market mix

In search of the magic market mix
Cup of chart patterns with an ounce fundamentals?
Not being late for the gravy train
Exit signs – Knowing what to look for and when...
Get Zanger's list of Ten Key Stock Considerations free.
Get free daily market commentaries here
Suggested Reading – Useful Resources

To stay tuned to the latest chart and market updates, please check our website version of this newsletter at http://tradesystemguru.com/content/blogcategory/54/88/ 

Quote of the Month:

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited." ― George Soros

(Readers may recognize that this quote is not new ― it's is one of my favorites and one that I repeat to myself before trading.)

In search of the magic market recipe

When stock prices have been rising and the economy is healthy, it is easy to become complacent. In a strong bull market, all you really have to do is buy to make money. Traders hunt for stocks that have the best momentum plays. Fundamental investors look for stocks that represent the best value based on the assumption that the market is rational and that money gravitates to stocks that have the best revenues and earnings.

But many were forced to re-learn the art of playing the market in the wake of the most recent stock correction. Listen to any financial television or radio program and you'll hear an unending stream of fundamental pundits preaching the benefits of finding value in times of trouble. As far as they are concerned, why pay full price for a stock when you can get it at a discount when the market is weaker?

But there is one major problem with the fundamental approach that is rarely mentioned. Well actually, there are three serious problems with it. 

First and foremost is the myth that through good times and bad, markets behave rationally. That is to say that any stock is perfectly priced based on the assumption that as a group "the market" knows all there is to know about the company and what its stock is worth at any given time.  If this were true, stocks would go up as long as revenues and earnings were growing and would come down as soon as revenues and earnings showed signs of weakening. Second, taking this approach one step further, the pure fundamental player believes that the best time to buy is when prices fall during a correction. If the stock continues to drop, as is usually the case in a bear market, you eventually go broke with this practice of averaging down. 

Third and most important, this approach is based on assumptions. If only one proves wrong, the method will fail and could generate significant losses. Primarily, it assumes that earnings rise ahead of stock price in a rally and at market peaks, earnings weaken ahead of stock price. Second and more importantly, this philosophy assumes that market participants are fully able to logically and unemotionally react to the latest news and corporate reports and make cold, rational decisions with regards to what a stock is worth.

Are these assumptions valid? Thanks to technology, there is a relatively easy way to find out. One way of examining the ability of a company to produce profits is the price/earnings ratio – the ratio of stock price divided by earnings. Value investors believe that companies with low PE ratios represent attractive investment candidates.

Will the data support or challenge this age-old investment approach?

Cup of chart patterns with an ounce of fundamentals

As we see in Figure 1, Apple Computer (AAPL) began to rise as the last recovery was getting underway in 2003. What the next chart shows is that stock price began to rise rapidly well in advance of a similar increase in earnings as evidenced by PEs rising above 100 in May 2003.

1-AAPL-VV-060510

Figure 1 – Weekly chart of Apple Computer (AAPL) showing rising stock price together with earnings growth (GRT), the Price/Earnings ratio (PE) and earnings per share (EPS) between early 2003 and June 2010. Chart courtesy of VectorVest.com

Between April 11 and May 16, AAPL jumped from $6.56 to $9.40 (up 44%). Over the same period, AAPL earnings per share dropped from $0.10 to $0.09. Earnings did not match the 44% jump in stock price until the middle of October. In the three months before the stock's rise, earnings actually dropped more than 40%. Earnings growth (GRT) a leading estimate of earnings also didn't provide any reason for buying the stock. As the red line in the chart below shows, it only began to show a measurable increase until late October as well. In other words, the market paid a premium for AAPL stock well in advance of any sizable earnings increase.

Let's examine the AAPL chart in more detail. As we see, price rose well ahead of earnings growth in red (point 1). Next price continued to rise even as earnings growth declined (point 2). Then we see stock price recover following a significant decline in earnings growth (point 3).  After the 2007-8 market meltdown AAPL began to climb again in March 2009 well ahead of a rise in earnings.

So AAPL rose as earnings were falling in mid-2003, then rose again as earnings growth ramped up in 2004 and into 2005. But AAPL continued to rise in 2006 while earnings growth declined. Eventually AAPL stock dropped in 2007 and again in 2008 after a prolonged period of a decline in earnings growth (red). But then the stock price again rose ahead of earnings growth.

So how is the investor supposed to know when to buy and when to sell? Fundamentals alone did not provide reliable signals.

In late October 2004 as the rally was gathering momentum, Dan Zanger was identifying the market leaders in his newsletter The Zanger Report. (If you haven't read our two-part interview of Zanger, be sure to check it out at http://tradesystemguru.com/content/view/300/61/ ).

2-AAPL-2-DZ-102604

Figure 2 – Daily chart of Apple Computer from October 26, 2004 showing the breakaway gap followed by the bullish flag pattern, one of Zanger's favorite bull patterns.  Courtesy of The Zanger Report

Here was his take on Apple Computer at the time. Zanger looks for stocks showing compelling chart patterns on rising volume. But he also looks for companies with a number of important fundamental characteristics – ten of them to be exact but more about them later.

Top of his list of key characteristics is earnings power – the ability of the company to grow earnings at least 40% quarter-over-quarter and ideally above 40% from the same quarter the year before in the latest quarter.

Next, let's look at stock chart patterns together with earnings and sales growth. As the chart shows, earnings growth continued to increase from 2003 through 2004 but so did sales growth. Then in late 2004, Apple stock absolutely took off as evidenced by the breakaway gap and bullish flag pattern. Note what happened after Zanger sent out the above chart. (You may have noticed that the price in Figure 2 is double the price in Figure 3 because the latter was produced after the 2 for 1 stock split). AAPL took off!

3-AAPL-3-102604

Figure 3 – Weekly chart showing AAPL along with fundamentals in late 2003 through 2004. Chart courtesy of VectorVest.com

Not being late for the gravy train

Google (GOOG) is another stock that has been leading the market since its initial pubic offering in August 2004. But because it was new, it was a stock that fundamental and value investors largely overlooked. After all, what value investor in his right mind would seriously consider owning a stock with a Price/Earnings ratio north of 85?

But although the PE didn't spend any significant time below the still lofty level of 30 until 2008, the stock ran up from $108 in August 2004 to more than $700 by December 2007, an incredible gain of more than 540% in just three years! Interestingly, the lowest GOOG P/E has dropped to since going public was 22 in November 2008, a valuation still considered fairly high by fundamental standards. 

4-GOOG-091404

Figure 4 – Not long after its Initial Public Offering, Zanger begin to write about Google (GOOG) in The Zanger Report. Here is his take on September 14, 2004. Courtesy of The Zanger Report

In the next chart, we compare Google fundamentals with stock price movement. By the end of October 2004, quarter-over-quarter earnings growth jumped to nearly 40% and earnings-per-share were $2.62. Earnings growth stayed glued between 30 and 40% for the next three years until late 2007. It is interesting to note that by its peak in October 2007, earnings growth had been slowly but steadily declining for nearly two years.

So at what point did the fundamentals look attractive on Google? The simple answer is never.

At the International Federation of Technical Analysis Conference in Vancouver in November 2005 which I was lucky enough to attend, Dan Zanger gave the keynote presentation to a group of analysts and professional money managers. Google had been his biggest winner by a wide margin that year.

At the end of his presentation which included a thorough analysis of GOOG, Zanger asked the audience of roughly 120 how many had owned or still owned GOOG. Only three hands went up. Zanger responded with disbelief prompting him to ask obvious question. How could so many industry professionals have missed the year's most powerful stock play – one that had earned him more $10 million alone?  Needless to say, a lot of people in the room were asking themselves the same question.

One big reason is that Google never made much sense from a fundamental perspective. It was a strict momentum play – and one that required fast reflexes and brass cajones. Those who made money had to jump in fast on when it rallied and make a quick exit when the play was over. And there was no shortage of opportunities. From its 2004 debut, it rallied nearly 600% to its October 2007 high. 

5-GOOG-060510

Figure 5 – Weekly chart of Google from August 2004 through June 2010 showing the steady rise to above $700, correction back to $250, resurgence to $600 then another correction. Do you see any fundamentals that would have caused investors to buy or sell this stock at the right times?  Chart courtesy of VectorVest.com

Exit Signs – Knowing what to look for and when...

Fundamentals provide little reliable advance warning of when a stock is getting ready to rally. As Zanger says, he likes to see steadily improving earnings on any stock he is looking to buy but uses chart patterns to tell him when to buy.

But are fundamentals any better at warning of an impending correction? In the charts above, earnings growth peaked and started declining years before a correction ensued. I have found that this is generally the case.

Nowhere was this clearer than in the new home market in 2005 and 2006. In Figure 6 we see that Residential/Commercial Builders as a group broke down well before there was any fundamental warning that trouble was developing. Take a look at earnings growth (GRT), earnings per share and the Price/Earnings ratio. The first warning came at point 1 with the break in the long-term uptrend. Traders got a second warning with the break in the head & shoulders neckline at point 2 in Figure 6. Fundamentals showed the first signs of weakness point 3 as earnings per share began to slip. Next (point 4) earnings growth to PE (GPE) began to drop followed by a measurable drop in the earnings growth rate (GRT) a couple of months later. But by this time, much of the stock price damage had already been done!

In other words, investors who waited for fundamentals to tell them when to sell were severely punished.

6-BuildingIndustry_030207

Figure 6 – Daily chart of the VectorVest of Residential/Commercial Builders from 2004 to 2007 showing how the group performed as the new home market was peaking. As the chart shows, price gave an exit warning far in advance of a breakdown in fundamentals. Chart courtesy of VectorVest.com

Here are some interesting comments from Dan Zanger in a recent article for Stocks & Commodities magazine that sum up his approach to finding market-leading stocks.

"It is a bad idea to rely solely on fundamentals to get you into or out of a stock. By the time the fundamentals tell us it's time to buy or warn of stock or industry weakness, stock prices have already made their move. The efficient market hypothesis is little more than a fundamentally flawed placebo for the technically challenged! And when volatility and emotions run high, which is the case around important tops and bottoms, markets are anything but efficient!

"That is not to say that fundamentals aren't important. If a company misses its earnings expectations, its stock price can get crushed when they're reported. This is why it is safest to stand aside until earnings have been published. So while unexpected reports can also warn of changing business conditions, more often than not the effect is short-term.

"What is more important for me is getting a sense of the larger earnings trend and corporate picture. Before I buy a stock, I need to see a strong ramp-up in earnings. Quarterly earnings need to be up a minimum of 30 to 40% from the same quarter the previous year before a company captures my interest (after accounting for seasonality and other industry cyclical factors)."

What are his most important trading tools?

"I simply rely on chart patterns and volume." 

So what is he looking at in markets right now? Dan has generously agreed to share his June 9, 2010 The Zanger Report with MMM readers free. See for yourself what market leading stocks he is watching. Go to http://www.chartpattern.com/articles/news06-09-10.cfm

For a list of the ten key fundamentals Zanger looks for in a stock and how he uses them to pick trading candidates, email me at tsgnewsnet [at] gmail.com (replace [at] with @ and remove spaces).  Please put "Zanger article" in the subject line.

Suggested Reading:

Trading chart patterns and the market – An interview with Dan Zanger

http://tradesystemguru.com/content/view/300/61/

Zanger, Dan and Blackman, Matt [2010]. "Is Trading That Simple?"

Working Money. May 5, 2010

Blackman, Matt [2003]. "Chart Patterns, Trading, And Dan Zanger,"
Interview, Technical Analysis of STOCKS COMMODITIES, Volume 21: August.

Understanding Chart Patterns

http://www.chartpattern.com/understanding_chart_patterns.html

Dan Zanger's 10 Golden Stock Trading Rules

http://www.chartpattern.com/10_golden_rules.html


Disclaimer

The Macro Market Monitor obtains information from sources deemed to be reliable; however, The Macro Market Monitor does not guarantee the accuracy of any of the information provided. The Macro Market Monitor makes no warranties, expressed or implied, as to the fitness of the information for any purpose, or to results obtained by individuals using the information. We may or may not be invested in any investments cited above.

In no event shall The Macro Market Monitor be held liable for direct, indirect, or incidental damages resulting from the use of the information found on or distributed through this website. The Macro Market Monitor shall be indemnified and held harmless from any actions, claims, proceedings, or liabilities with respect to the information and its use.

The Macro Market Monitor does not make specific trading recommendations or provide individualized market advice. All information provided is to be construed as opinions and is intended to be used as an educational information service only. We encourage investors to contact a registered securities representative prior to making any investment or related decisions.

Any and all forecasts and opinions expressed herein are for discussion purposes only and are not intended to constitute investment or trading advice.




Posted 06-16-2010 4:22 PM by Matt Blackman