A Google Confession–WW-GMI: +1

I have a confession tonight.   The past few days I have been saying that I do not fight a downtrend and stay mainly in cash or short.   Well, I am not perfect. I could not resist nibbling at a stock that was resisting the downtrend.   For several weeks now, Cramer has been recommending GOOG as a great buy.   (I know I criticized Cramer yesterday for not urging viewers to go short or to cash, but he is not perfect either. We can forgive him.)   Cramer maintains that GOOG will earn about $7 per share (total profit/total number of shares) this year.   If the company has a PE ratio (price per share/earnings per share) like Yahoo’s (PE=55), then the stock could reach a price of around $385 (PE: 55=385/7).   Now, I can’t just take Cramer’s word for it.   I have to go to the charts to see if the stock is acting well. Wklygoog_1 You may remember that GOOG came public in a Dutch auction around August, 2004 at around $100.   (Click on weekly chart to enlarge.) The media pundits all said that the stock was too expensive.   That was a buy signal.   The pros probably wanted to accumulate the stock without competing with the little guys.   So the stock hesitated for a few days and then climbed to $216 by February, 2005.   The stock doubled in less than one year!

Remember I wrote a few posts ago about my desire to find rockets as Darvas did–stocks that will go to the moon?   Well, Darvas wrote that one thing he looked for in a stock was a doubling in the past year.   The best predictor of a person’s behavior is his/her past behavior.   The same is true for stocks.   Want to find a stock that will double in the next year–find one that has already doubled in the past year.   Don’t take my word for it.   Look up some of the winners of the past bull market– DELL, CSCO and more recently, CME, BOOM, FORD and HANS.   Rockets keep doubling and hitting new highs and always appear too expensive. You do want to go to the moon, don’t you?   So GOOG passed that test.   It was also trading near an all time high, another characteristic of a rocket.

GOOG declined for a few months and gapped up to a new high in late April (see daily chart) on huge volume, when great earnings were released.Googdly_1 Clearly, people with a lot of money were purchasing this $200 stock.   Was it too late for me to buy?   Was the rise just caused by bears covering their short sales? (buying back the shares they had borrowed from their brokers and sold in anticipation that they could buy back them back at a cheaper price, and pocket the difference in price)   Well, this is what I am trying to share with you tonight– I have found that many stocks begin their advance or decline with a huge gap in price. The trick is to wait to see if the gap is filled.   If the stock keeps on rising to new heights without closing the gap, it is often a sign of tremendous strength. (Note that in January, 2005, a similar gap up was quickly filled—and failed.)   I use TC2005 to scan the entire market for   stocks that have gapped up or down.

So, I bought a few shares of GOOG a few days after the gap, at around 220, and immediately placed a stop order to sell them around $214, if the stock started to close the gap.   In other words, I was willing to take the risk of losing about $7 per share in exchange for the possibility of a profit of $50 or more per share.   I have no idea if GOOG will continue to rise or not.   My point is that I have placed my wager and can now separate myself emotionally from the stock.   I will either profit or lose a little.   (If you are unwilling to have a lot of small losses you should not trade stocks.) I don’t even watch GOOG very much.   Remember, Darvas made his fortune when he was out of the country and far away from the market.   The further one is away from the market, the less the emotion that can kill one’s judgment, and the trade. GOOG closed today at $228.50.

What I want you to understand from this example is the strategy to purchase a potential rocket, and then to place an immediate stop order to control your potential loss if you are wrong.   (Note: A stop order to sell at $214 becomes a market order to sell as soon as the stock trades at or below the stop price.   This does not guarantee the price I will get when I sell the stock.   If GOOG gapped down from above $214 and opened at $210 one day, I would be sold out at the next price, probably around $210.   This would be a relatively rare event, but there is always this risk when using sell stops.)   The next decision I have is when to increase my position if the   stock continues to rise and where to raise my sell stop to.   Livermore and Darvas would make a small pilot buy and then add to the position only if the stock rose, proving them correct in their first purchase.   NEVER BUY MORE OF A STOCK THAT HAS DECLINED–NEVER THROW GOOD $$$ AFTER BAD.   Just take your loss, admit you were wrong and learn from your mistake.

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The WW-GMI moved to +1 today!   Wwmi504 There were 103 new 52 week   highs in the universe of 4,000 stocks that I follow.   However, the IBD Mutual Fund Index remains below its declining 50 day moving average.   The WW-Daily SPY index will turn positive tomorrow if SPY closes above 117 tomorrow.   If this rally proves to have legs, I will begin to close out my put options and go long. The private education stocks were weak again today– APOL (-3.56%) and COCO (-.80%).   I am ready to turn on a dime if this market shows me a definite change in trend.   If it is a real change in trend, I will have plenty of time to gradually take on my line of stocks.   Have a great trading day.

Let’s hope that Charles Kirk’s relative will get better soon and that he will return to writing his excellent blog soon, at www.thekirkreport.com.

Fed Up With This Market?

“October.        This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”

Mark Twain, The Tragedy of Pudd’nhead Wilson, 13, 1894

Why did Mark Twain pick on October first, 35 years before the big crash?   Was he a closet market technician into long term cycles?   However, he was smart enough to protect his reputation by naming a few other months.

The WW-GMI is not a leading indicator.   It is a summary of the indicators I watch to tell me the current trend.   By definition, the index will not register a strong market until after the turn has come.   The WW-GMI is still zero. (click on the table to enlarge)Index502 There were only 12 “successful” 10 day new highs today.   (See prior posts for indicator definitions.) However, we did see that 88/4000 stocks hit a 52 week high today.   The QQQQ would have to close above 35.84 to get me interested.   It closed at 35.12.   The SPY would have to close above 116.70, it closed today not too far away, at 116.40.   Note that I said, to get me interested, not to get me confident to buy.   I expect that the end of this decline will come with a bang, not a whimper.   But I never marry a scenario.   I just wait to see how the market behaves. You have to observe the glass carefully for a while to determine if it was half full or half empty.

Everyone is glued to the Fed tomorrow.   It is possible they could say something that could make this market explode to the upside.   However, I shall wait until things happen, and will not jump the gun.   Right now, my portfolio is 10% short, all through owning puts that expire at least 2 months from now.   I can afford to wait out any minor bounce, as long as the indexes do not violate their downtrends.   If they do, I will sell the puts.   I never go against the trend.   In a coming post, I will describe why I think buying puts in a declining market makes sense (and dollars). I also think that put options can be used with minimal risk and will show you how.

Many thanks to www.thekirkreport.com for mentioning my blog.   I check Kirk’s blog every day for his keen insights, and welcome his referrals.   Check some of my earlier posts to undertstand my trading philosophy and background.

IBD Meetup Group Night

Tonight was Investor’s Business Daily Meetup Group night.   Investors all over the world who are interested in IBD trading strategies can meet on the last Wednesday of each month to share their insights on investing and trading.   Tonight, about nine of us met at a local restaurant.   There is a core group of regulars with a few newcomers attending once in a while. Tonight it was all experienced members who are fairly addicted to trading the market.   We all study stock charts, read IBD, and use many of the IBD investing tools.

Tonight’s meeting was different than the other meetings   that I have attended during the past year.   No one circulated piles of charts of promising industries or stocks to buy.   The discussions were subdued and everyone said that no one was making much money trading. They were licking their wounds and lamenting that this   was the worst market in a long time.

Read moreIBD Meetup Group Night

The Downtrend Continues?

“Want to know how to make a small fortune in the stock market?
Start with a large fortune!”

I thought you would probably want me to back off of the strategy discussion (see yesterday’s post) and to return to my take on the market.   A number of people have written to me about going short.   This interest, together with the skepticism about the market’s rally in the media cause me to pause, just a little.   However, I do not reverse direction until my market indicators start to change. So, I wait, mainly in cash and put options in my IRA.   (I did sell my one small long position, MHS–I got tired of holding anything at odds with the general market trend.) The attached chart (click on it to enlarge) Irxx shows the consistent rising trend in short term interest rates that started in May, 2004. (I have asked the TC2005 support staff at Worden.com to tell me the basis for this index, and will report back on their answer.) The Fed’s persistent pressure on rates is one of the obstacles to a rising market.   Historically, in its fear of inflation, the Fed typically misjudges how much to put on the brakes and eventually brings the market and the economy to a screeching halt.   (In spite of this track record, traders tend to delude themselves into thinking that this time will be different and we will get a “soft landing.”) This short term interest rate index has been hugging its rising 10 week moving average for months, and just bounced off of the average to a new high, after a few weeks of a plateau.   This renewed rise is not a good omen.   A consistent reversal in this index will probably foreshadow a subsequent bottom in the market–but not immediately.   So, we will keep an eye on this index.

IBD’s Monday edition published a put/call ratio of   .86.   This means that 86 puts were traded for every 100 calls.   (Puts are options that gain when the underlying security falls; calls gain as a security rises.   In other words, puts are bets by option traders that a security will fall, calls are bets on a rise.   Did I imply that people are gambling?)   This ratio is a contrarian indicator, which means that it typically predicts the opposite type of   market movement than would be expected from the trades.   If an extremely high number of option traders are bearish (buying more   puts than calls) then the market often tends to rise, at least short term.   People are most scared at bottoms and overly optimistic at tops.   Most of the time, traders are more bullish than bearish and the p/c ratio is below .80.   When it stays above .80 for a while and gets above 1.0, the market usually is in store for a bounce.   The current ratio is not at an extreme.   However, if it breaks 1.0 this week it may signal short term   strength in the market.   If the P/C ratio   starts to trend lower in this depressing environment, say below .60, watch out below!

I am short some housing stocks.   It is rare that I find so many companies in an industry with the charts looking so sick.   Here are a few, in no special order:   RYL,OHB,LR,LEN,MDC,MHO,DHOM,WCI,SPF,DHI.   I did not run out of ugly symbols, but you get the picture.   Even   lofty NVR appears to have broken its uptrend on a number of large volume declines.   Is it too late to sell these?   Who knows, but the current trend is obvious to me.   Could insiders possibly be showing us something about the future of housing?   Watch behavior,   not words.

I hope you have a good trading day tomorrow.   The trend is your friend.

WishingWealth 10 day successful new high index:   4/22 19;   4/21   28;   4/20   12 (for definition, see Madness post)

Put me on, IRA

Well, the market didn’t collapse today.  So what. Did you really think it would just tank like it did in 1987?    Most people hope it is over, and think that a further decline is not justified by the state of business, and especially, with all the bargains that have now materialized. However, the market always goes further than everyone thinks is justified–up or down.    This bear has plenty of time to smell the roses before it hibernates again.  It will take its own time.  Especially ominous–the short term interest rate index I follow jumped today–as much as it did when this rise in rates began in the first week of January.  Is something going to convince the Fed to become more aggressive?  Stay tuned.

Experienced traders do not care which way the market goes, as long as it moves in a trend.  Do you really believe the old adage, "Don’t sell America short?"  While the market spends most of the time going up, when we can buy stocks, why not profit in those periods of decline, when we can sell stocks short?  A good bear lasts 10 or more months and prices decline quicker than they go up–fear is quite a motivator. Why play only one side of the game.

Selling short scares people.  You ask your broker to borrow someone elses shares so you can sell them at the  current price.  He puts the proceeds in your account, but you can’t touch the money until you give back the shares you borrowed. When the stock falls, you buy the shares back at the lower price and give them back to the broker. You, however, get to keep the difference between the price you first sold the shares at and the subsequent buy back price (sell short at 80, buy back at 70–you make $10/share). What scares everyone is the idea that if the stock rises, you have to buy it back at a higher price and the price could theoretically go to a gazillion.  However, when you own a stock, the most it can fall is to zero.

Now, this fear of an infinite loss from a short sale is unrealistic.  When you buy a stock at, say 50, you place a stop order to  automatically sell your shares and "stop your loss" at an acceptable price, say 48.  If the stock falls to 48 you get sold out and take your loss.  You just reverse this for stocks you have sold short.  Sell short at 50, place a stop order to buy if the stock rises to 52.  Either way you have a strategy in place to limit your losses.  (Note, if the stock gaps up or down–jumps up or down in price and skips over your stop price–you may have a larger loss than your stop order would indicate.)

Now, to sell short I must trade in 100 share blocks in a margin account.  Margin, because the broker will charge me interest when he lends me the shares to sell short.  But I can’t trade on margin in my IRA account.  However, some brokers allow customers to trade options in an IRA.  Enter the Put option, IRA. 

A put option gives me the right to sell 100 shares to someone at a set price for a set time.  Thus, if I think stock XYZ, which is trading at 50 is going to decline, I could purchase a put option to sell 100 shares of XYZ at 50 (or 55, or 60 etc.) good for a few weeks or months.  I could then buy the stock, if it declines, to say, 45 and put them to someone at 50.  But I do not have to purchase the shares.  If XYZ declines, the put option (which trades like a stock on the option exchange) will increase in value and I can sell the option at a profit.  But if XYX rises, I can sell the option at a small loss or let it expire worthless.  Either way, if the stock rises, the most I can lose is the cost of the option.  So much for the myth of the infinite loss from selling short.

I can even buy put options on the stock market indexes (QQQQ, DIA) or ETF’s, if I think we are in a bear market–all in my IRA.  I cannot possibly cover all of the ins and outs of options here.  I am just trying to whet your appetite and show you how I profit from a declining market.  For a primer on options go to the learning center at www.cboe.com.  I disregard the media pundits looking for the rare rising stock to purchase and bet on the many stocks that are declining.