My Trading Strategy, Part II

IT TAKES A ROCKET SCIENTIST!

(Copyright ©   2005, by Eric D. Wish.   All rights reserved.)

“There is no magic about buy signals. They are only devices by which we call our attention to stocks that have already begun to attract the attention of others.”

Burton Crane, The Sophisticated Investor, 1964, p. 49

Can you believe this?   The day after I tell you how much I admire Jim Rogers, he goes on television and tells everyone that   he   buys stocks that are near their lows and avoids those hitting new highs.   I guess I better set the record straight by telling you where I stand on this issue.   Assume you are looking over a field of rockets, all on their launching pads.   Your job is to determine which rocket will take you to the moon.    There are a number of ways to approach this problem.   One person might study all they could about the model of the rocket and its history.   They might find what similar rockets have done in the past and that a rocket with a particular size and payload should be able to go quite far.   This strategy is equivalent to the approach taken by the fundamental analyst.   He (or she) knows the company’s prior earnings and projections for the future.   He can tell you all the reasons why a particular company’s stock should do well–earnings, cash flow, sales, industry trends etc.   He can estimate the stocks “true” value.    The problem is that in spite of these great reasons for success, the rocket (or stock) might sit on the launch pad for a long time or may never take off!   An investor cannot wait long periods for a stock to fulfill its promise–lost time is lost money and lost opportunity.

Another strategy is to focus on rockets that have already taken off.   A rocket that has begun to climb and is accelerating may have a good chance of continuing to climb.   You might look at the thrust being generated by the rocket.   A huge thrust and increasing speed might signal a good candidate for a high flyer.   You could also look at the angle of ascent.   You may have to know little about the capabilities of this rocket model.   The fact that it has been launched and is climbing nicely may be enough to indicate that it is a good choice to take you on your trip to the moon.

The technical stock analyst follows a similar logic.   He looks for evidence that a stock is moving up.   The reasons why the stock is climbing are less important than the fact that the rocket has been successfully launched.   Increasing volume of trading as the stock advances indicates potential thrust to achieve new highs.   Moreover, you would never seek to find a surging rocket by selecting one that has fallen back towards the earth or is pointed downward.   The way to ride a rocket to the moon is to find one that is continually climbing higher towards the moon.  (An exception is a rocket that has reached new heights, fallen back for a while, and then has the power to regain lost ground and burst through to a new high.   I love such stocks.)

There is an analogous pair of approaches to human behavior in psychological theory.   The psychoanalyst spends most of his time trying to understand the unconscious motivation that he believes underlies behavior.   By analyzing ink blots and dreams and client free associations, the psychoanalyst hopes to help the client gain insight into his unconscious motivation in order to produce a change in behavior.   According to the psychoanalyst, pathological behavior is symptomatic of unconscious motivations that must be dealt with to achieve lasting behavior change.   Opposite to the psychoanalytic perspective is that of   the behaviorists, most famous of whom was B.F. Skinner.   The behaviorist is skeptical of even the existence of an unconscious and of cognitions.   One merely needs to focus on changing the behavior without regard to any underlying psychological processes.
I remember reading in graduate school the case study of a female patient who was inseparable from her broom.   The psychoanalyst on the case said that this behavior was indicative of some form of penis envy that needed to be worked out in therapy before the patient would give up the broom.   A behaviorist, on the other hand, broke the patient of the habit quickly, simply by rewarding or punishing (I do not remember which) the carrying of the broom, without any need to address the patient’s unconscious motivation!

I have always been more of a behaviorist in my approach to life.   Focus on the behavior and don’t worry about the hypothetical underlying cognitive processes.   Perhaps that is why I have been partial to the technical approach to stock analysis.   A more mundane reason is that it takes years of training and schooling to become a psychoanalyst–or a fundamental security analyst.

It turns out that both the technical and fundamental approaches to stocks represent extremes and it does not make sense to blindly follow just one of them.   Nicholas Darvas pointed out years ago that a blend of the two approaches is most effective.   One needs to choose a rocket that has been launched already, with extraordinary thrust (volume), and that shows signs of climbing to new heights.   At the same time, I want to know something about the capabilities of the rocket so I can increase the likelihood of selecting the rocket most likely to reach the moon.

Growth stocks really are like rockets.   One cannot predict (except for insiders) when one will be launched nor know how far it will travel once launched.   The key to picking winning stocks, as Crane’s definition of a buy signal quoted above implies, is to find a stock that has already shown strength through the buying of others, and to jump on for the ride.   Darvas used to say he had become a silent partner of the insiders.   By doing so, one increases the chances of success, but this approach in no way guarantees a winner.   A rocket can run out of fuel at anytime and fall to the earth.   However, I have learned that buying fallen or falling stocks, or stocks that have not yet shown strong buying is an ineffective way for me to make money in the market.   To make money as quickly as possible, one needs to buy stocks that have already been launched and are on a steady rising course (trend).
But just as bad weather can delay a launch or throw a rocket off course, so can the overall market environment.   It took me many years to appreciate that the best rules for picking stocks will fail in an adverse market environment.   One needs to determine the likely trend of the overall market as well as of specific stocks to have the best chance of success.

My method of trading stocks is based on minimizing risk, but not eliminating risk.   My technical tools and trading strategy enable me to increase my odds of success, while limiting my risk of loss.   In future posts, I will identify stocks that I think have lifted from the launch pad and may travel to the moon, but only when we are in a healthy market.

Tomorrow, I will return to the state of the market.