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What's the best month to buy tech stocks? To sell an energy asset? And what is the one-day of the year that you should never, ever trade on? Answers to these and other questions are just some of the insights that Joe Terranova shares in Buy High, Sell Higher.
Terranova is a series regular on CNBC's Fast Money and the Chief Market Strategist for Virtus Investment Partners, a firm with over $25 billion in assets under management. Prior to joining Virtus, he spent 18 years at MBF Clearing Corp., where he was the director of trading and managed more than 300 traders. And as viewers of CNBC's Fast Money know, Joe is a master at demystifying the forces that drive today's markets. So why not let him show you how to use telltale signs to spot investments that are poised for lift-off.
Millions of dollars were on the line.
It was Monday, August 22, 2005, and it seemed as if only one news story mattered that week: a hurricane named Katrina was barreling toward the Gulf Coast. Of course, a week before the storm made landfall at New Orleans, no one knew that it would become the costliest natural disaster in American history. On the twenty-second, Katrina was just another storm.
MBF, my employer at the time, was and still is one of the biggest natural gas and oil trading firms in the world. For professional investors, disasters and other major global events provide opportunities in which fortunes can be won or lost. For example, in 1992, George Soros famously risked $10 billion when he shorted the British pound. The British government had insisted that it would not devalue the British sterling, but Soros was skeptical. On September 16, 1992, a day that would become known as Black Wednesday, he bet $10 billion against the pound. Soros was right, and he made a profit of $958 million in a single day (and a total of $2 billion from all of his investments against the pound at that time).
Of course, Soros hasn’t been the only one to capitalize on others’ misfortunes. As early as 2005, hedge fund manager John Paulson spotted an impending disaster and a great opportunity developing in the U.S. housing market. Paulson and his team’s foresight led them to make the greatest trade in financial history, and in 2007 Paulson made a staggering $15 billion by shorting the housing market. However, for every career-making success, there are those investing ideas that destroy fortunes and break firms.
As Katrina approached the United States, my colleagues at MBF and I were not willing to take a Soros- or Paulson-sized position on whether the storm would hit or miss New Orleans. Instead, our plan was to stay on the sidelines. What we did at MBF in August 2005 holds a less dramatic but far more useful lesson for the average investor than Soros’s and Paulson’s profitable plays.
In August 2005, neither my boss, MBF’s owner, Mark Fisher, nor I was trying to figure out some intricate plan to profit from the hurricane. We were not going to play the hurricane, but we needed to make sure that the storm didn’t play us. It’s important to understand that when a large market event hits, volatility spikes. In most instances, the retail investor doesn’t have the ability to navigate through that volatility. A professional trader does, but most retail investors simply do not know what to do in a situation like that. That’s why individual investors often lose money in an event like Katrina. The professionals understand that at times like Katrina, it’s not about making money; it’s about preserving capital.
In the days leading up to the storm, Mark was looking at the big picture, attempting to calculate the impact of the hurricane on the structure of the energy market. The goal was to reduce our risk—to manage our risk first—which is what the vast majority of investors don’t understand. Manage your risk first, and you are sure to come back to fight another day. That’s the number one priority with something as big as Katrina—or even with something as small as a quarterly earnings report from a company in which you own stock.
In summer 2005, with Hurricane Katrina looming, if any trader had a large position in natural gas and the market went against him, he would have been forced to liquidate his position and take a substantial loss. Being forced into a decision is not a winning investment strategy. Nobody has a sustainable track record of profits when they’re forced by the market to make a decision. The investors who are successful are those who avoid having their decisions dictated by the market. The best traders make their own decisions and do not allow outside events to force their hand.
Hurricane Katrina posed two potential outcomes that worried us. In a hurricane, most people incorrectly assume that the price of oil spikes because of the threat of an impending shortage. That’s wrong, though, because the president simply could release oil from the strategic petroleum reserve to satisfy the need for oil. It’s not oil that matters. It’s gasoline, a by-product of oil which is produced in refineries. Refineries are littered throughout the Gulf Coast. And what do refineries need? They need electrical power to run them. They also need to remain dry. So the two worst things that could happen to refineries are that they lose power and they flood.
If the hurricane hit, the prices of gasoline, heating oil, and natural gas would skyrocket because the pipelines would have to be shut, creating a scarcity of those commodities. In that instance, had an investor been “long” oil (meaning that investors expected prices to rise), he would have made a great deal of money after the hurricane did its damage in the Gulf. Had the hurricane missed, then the prices of those same commodities would have fallen by a significant margin once that risk was taken out of the market.
My title at MBF was director of trading. One of my many responsibilities was to manage risk and to make sure that we never bet the firm on a single trade or event. I had seventy-five proprietary traders putting the firm’s money to work plus junior traders and interns—about three hundred team members reported to me in all. I was dubbed the “Liquidator” because everyone knew that when I showed up on the trading floor, located at the World Financial Center right on the Hudson River, my job was to get a trader out of a particular position by selling large blocks of a particular asset. This happened frequently, almost always when one of our traders was down a lot of money and just could not pull the trigger to take his losses and preserve his capital. However, my job entailed more than simply selling commodities or securities. My job had a technical side, too. Mark entrusted me to see the big picture and to ensure that the firm’s risk was properly allocated.
The toughest part of my job was taking a trader out of the game. Like a baseball team manager relieving a starting pitcher and taking him off the mound, my job was to take that trader out of the pit. It wasn’t always easy, and taking a trader out of the pit often meant tense moments for both of us. Still, I loved my job, and I never forgot how far I had come: I had grown up in Valley Stream, Long Island, a working-class town just a few miles outside of the superwealthy Five Towns community. As a kid, I needed to hold down three paper routes—for Newsday, the Mail Leader (a local paper), and the Daily News—in order to have some spending money. Now I held a leadership position in one of the great trading firms in the country—a firm that was headed for a potential crisis unless I was able to effectively protect its coffers from overeager traders trying to bet big on an uncertain event.
Aside from keeping an eye on what our traders were doing that morning, I needed to understand their mental state. And the mental state of most of my traders leading up to Katrina was lousy, to say the least.
Katrina was scheduled to make landfall on August 29, the Monday morning after what is known among my colleagues as “Guilt Week”—the week between the end of summer camp and the start of the school year (Guilt Week started on August 22 that year). This was the week when all of the dads and moms who hadn’t spent much time with their children all summer took the week off to be with their families, flocking to beaches and other kid-friendly destinations.
However, Guilt Week was just a part of the story. Our traders also were away from the trading pits because they had grown increasingly frustrated with the price of natural gas and its inability to reach the milestone price of $10 per BTU (or British thermal unit, a measurement of heat created by burning a material). As it was, on one of the most potentially profitable trading days of the year, August 22, most of our traders had decided to take the week off.
So, when news of a potential hurricane hit the wires on that Monday, the twenty-second, the oil and natural gas trading pits were eerily quiet. For weeks, our traders expected the price of natural gas to top $10, but it never happened. It didn’t really matter why gas wasn’t topping $10—it could have been for any number of reasons, any of them right or wrong. The point was that it just could not get there. As a result, even though our traders knew that searching for a valid reason to explain the price of gas was a fool’s errand, they were a frustrated group. I knew this firsthand because my eldest son was christened the week before at St. Joseph’s Church in Hewlett, Long Island. All our traders attended the reception at Carltun on the Park but did little else there but complain about the price of natural gas. Most of them sold all their natural gas positions and decided to go on what felt to them like a forced vacation during Guilt Week.
With most of our A-team at the beach, news of a possible hurricane ignited a new bull market in natural gas that Monday. Natural gas closed that day at $9.564 after hitting a low of $9.032 and a high of $9.840. The price of natural gas fluctuated 80 cents (or 8½ percent) that day—a significant percentage for a commodity trading under $10. That only made things worse because my traders had been waiting for weeks for the price of natural gas to pop, and the first day they stepped away from the pits, the price surged. The traders already were discouraged, and then this once-in-a-decade event happened. Because most of the spouses of our traders knew almost nothing about trading, they couldn’t have cared less whether natural gas was trading at $10. This forced our traders to internalize the pain, since there was no one at home they could talk to about what was happening back at work.
When word spread of the hurricane, our traders could not get back to the trading pits fast enough—Guilt Week or not. But it took most of our traders until Wednesday—two or three days since the price of natural gas spiked—to return from wherever they had taken their families. When they got back to the office, they were all in foul moods. They were an ornery group when they left and even more ornery when they returned. The fragile state of our traders’ egos required a particular kind of leadership. I had to be their priest, rabbi, and psychologist all at the same time. This meant dozens of one-on-one sessions during which I could talk these traders off the cliff edge and assure them that all would work out well in the end. I always did this in their favorite places, their home turfs, whether it was their favorite bagel shop or sushi restaurant, or wherever they felt most comfortable. I explained to them that I understood their pain while simultaneously helping them to look past the present to a more favorable future that I knew would be there as long as they were able to improve their attitudes and change their mind-sets.
These counseling sessions served as yet another reminder about the connection between emotions and trading. When a trader gets out of rhythm mentally, he loses his balance. He often becomes focused on the upside, not on what he could lose. It’s easy for him to forget that he needs to protect his downside first. Our conversations were not so much about what could be made during Katrina, but on what could be lost. I encouraged my traders to consider the worst-case scenario of every potential trade.
The price of natural gas hadn’t hit $10 in about two years, so those traders who were most bullish on natural gas took this as an omen that a huge breakout was in the offing. Since many of our traders had been bullish on natural gas, they would have made a great deal of money that Monday, just trading for the day. That was one of the contributing factors that caused them the most pain. They all knew they could have bought in at just over $9 and had many opportunities to sell up to $9.80. By Tuesday, August 23, it was clear that the hurricane had the potential to destroy vital oil assets in the Gulf. If that happened—if there were a direct hit on the oil platforms and refineries—the price of oil and natural gas would skyrocket. However, we knew that approximately two out of every three hurricanes usually fizzled out; they usually missed the most vital targets. That was the main reason many of our traders—even some who had been bullish on natural gas—wanted to short natural gas before the hurricane swept through the Gulf (once the hurricane missed, the price of oil and natural gas would drop immediately and by a large percentage). Managing traders during times like these can be a challenge, and Katrina was no exception.
On that Wednesday, August 24, the price of natural gas finally traded above $10 during the day, but it closed at $9.98. That Friday, seventy-two hours before the storm hit, natural gas once again rose to $10, trading at an intraday high of $10.07. However, natural gas could not sustain that price, and it closed at $9.79 that day. That price told me that most traders did not expect the storm to hit and damage key infrastructure in the Gulf. Had more traders expected a direct hit of the storm, the price would have closed significantly higher than $10.
One of the things that I was so focused on that week, and what I wanted my traders to understand, was that it did not matter to me what their profit-and-loss statements looked like on Monday morning (August 29). Trading or investing should not be reduced to guesswork, which is exactly what would have happened had I allowed traders to bet their hunches on this potential hurricane. I had a lot of guys say to me on that Friday, “If this is a dud, let’s short the market, because we’re going to make a lot of money.” I knew intuitively that this was precisely the worst way to view this event.
Instead, my job was to get my traders to look past the moment and understand the big picture. Instead of allowing them to play their hunches, I made them liquidate their positions before the storm hit, because we just didn’t know what was going to happen. The only thing we could be sure of was that when the storm rendered its verdict on Monday morning, there would be an imbalance in the energy market one way or the other. I wanted my traders to have plenty of ammunition in order to take advantage of the opportunities that surely would be created. If the hurricane made landfall in Louisiana and Texas, it would take out refineries along the way and cause a huge shift upward in the price of natural gas that could go on for months, creating great weeks of opportunities for our traders. If it missed, the price would take a nosedive and likely return to its pre-Katrina equilibrium. However, taking any significant position before Katrina made landfall would constitute gambling, and gambling and trading are never the same thing.
Many people erroneously equate gambling with trading, but successful traders never gamble on their investments. Traders can calculate risk based on a potential outcome or, in this case, a price direction based on historical data. In addition, professional traders are astute at price pattern recognition (the movement of assets based on similar events from the past). Many good traders have photographic memories. They can remember seeing similar price movements in the market and correlating it back so they’ll know how to trade if history does repeat itself. That is what separates traders from gamblers. Good traders wait for opportunities that they can identify as a result of their experience and knowledge honed by years of observing the capital markets. In contrast, most gamblers throw caution to the wind and usually just guess on how something will come out.
On the Friday before the storm hit land, my job was to make absolutely sure that my traders had position flexibility the following week. I knew come Monday there would be thousands of traders, less disciplined than the MBF team, who had guessed wrong and would be forced to liquidate. I wanted my guys to be in a position to take advantage of the opportunity that was going to exist when others were being forced to liquidate their losing positions. I knew that if the hurricane hit vital assets in the Gulf, then the $10 natural gas target would be blown away. Fortunately, we were able successfully to liquidate hundreds of contracts before the storm hit.
Today we know that the storm was the most violent in history and wreaked a huge amount of damage on the oil platforms and other key infrastructure. That caused the price of natural gas (and other oil products) to surge by more than 20 percent to $12 the first trading day after Katrina hit. Had I allowed our traders to keep their short positions, it would have wiped out much of the traders’ year-to-date profits. (One hedge fund, the now-defunct Amaranth, originally played Katrina correctly, but then tried to repeat that success during the 2006 hurricane season by wagering the entire firm on energy contracts, leading to losses of more than $6 billion when that storm failed to strike the Gulf Coast and the price of natural gas fell more than 20 percent. Amaranth was wiped out by that play.)
Because MBF was liquid going into the event, Hurricane Katrina created a great trading environment for the rest of the year (see figure I.2). When there is an actual, physical supply disruption, it takes many months for that market to return to normal. You can’t build a new refinery or repair a damaged one overnight. That was how we knew that we would have a favorable trading opportunity for many months to come.
When I look back, how I worked with my traders during that fateful week remains one of the highlights of my career. We went on to have a record September, October, November, and December. That was because of the restraint we showed before the advent of the storm and how we used the capital that we had preserved to make a killing in the lengthy bull market in natural gas that resulted from Katrina. It was as if the entire structure of the natural gas market had been altered and put on a multimonth tear after the storm.
What happened to the price of natural gas the day the storm hit set the tone for the natural gas market for the rest of the year (see figure I.2). The storm made landfall in southeast Louisiana on August 29, 2005. On that day alone, the price of natural gas opened at $11.95, traded as high as $12.07, and closed at $10.84. However, that was only the start of the great bull market in natural gas. In fact, by December 2005, the price of natural gas traded as high as $15.78. That is the kind of price action that traders yearn for, often for months or years, because it creates such a great opportunity to rack up huge profits for months.
In 2005, in my role of director of trading, I made more money than I ever made in any other year of my life up to that point. And it was all because during Guilt Week I focused on limiting risk and putting each of our traders in a position to participate in the aftermath of the storm. Rather than playing a hunch going in, Katrina and our ability to profit from it hammered home an insight that has become a key tenet in my investing philosophy: never make big bets on arbitrary events that simply cannot be predicted either way with any certainty. Compulsive people and gamblers spend their money on hunches and make arbitrary bets. They let their emotions get the best of them. Savvy traders and investors manage risk, monitor the market, and put themselves in positions to succeed. This idea may sound obvious, but if you think about some of your investing decisions—and you’re honest with yourself—you’ll probably be forced to admit that you’ve been gambling when you thought you were investing.
My colleagues and I celebrated a very profitable 2005 with the ultimate holiday party. We rented out the nightclub Crobar and spent many hundreds of thousands of dollars on a party that I’ll never forget. We had such a great year that we were able to hire three pop stars that night: Reina, Rihanna, and LL Cool J. Things just didn’t get better than that in the trading game.
Katrina turned out to be a classic case of buying high and selling higher. After the storm hit the price of natural gas soared, hitting a new 52-week high (as shown in Figure I.2). MBF’s traders still had a large window that allowed them to trade natural gas for months and make money along the way. That is the best way to make money in any market: identifying those rare opportunities in which one identifies assets that can break out and deliver outsized returns.
The way that the best professional traders were thinking about markets during the Katrina catastrophe holds lessons for today’s individual investors. Why? Because in the ensuing five years, individual investors have seen even the safest precincts of the stock market experience the kind of volatility that once were reserved for commodities. For better or worse, we’re all traders now. And even if Vanguard’s John Bogle or Charles Schwab is tucking your ultraconservative portfolio into bed at night, you need to understand that the markets are irreparably changed and that relying solely on the old rules is a recipe for disaster.
Lastly, there is one more important reason why investment professionals view the market differently in 2011 than we did pre-Katrina. Since the Great Recession and the fall of Lehman Brothers in September 2008, it hasn’t only been volatility in equities and commodities that has surged. The other important change is that uncertainty has surged as well. The new normal is characterized by fear and uncertainty, and not just for retail investors. New times demand new tactics: welcome to buying high and selling higher.
Before I introduce you to the new model, I don’t expect you to take me on my word that the classic investing strategy—known as buy-and-hold investing—is broken. So let’s look at the data. A buy-and-hold strategy might have been a solid investment tactic during the last great bull market (1982–2000), but no longer. If buy-and-hold investing still worked, then an investor would have been able to buy an S&P Index Fund in 2000, put it in his or her portfolio, and ride it like an escalator until 2010. That’s not the case. The S&P was down roughly 10 percent in the past decade.
To drive home the point further, let’s look at the vaunted company Microsoft, which was a growth stock from 1981 to 2001. It traded as high as $59 per share in 2000. However, within a year that stock, once considered a great growth stock, traded in the $20–$30 range. But buying Microsoft in 2000 would have been a mistake, since it has not exceeded $40 since then and in early 2011 still traded at less than $30 per share.
Buying Microsoft (MSFT) at any time after 2001 and holding it would have been a losing proposition in the “New Normal” (see figure I.3). A $10,000 investment in MSFT in early 2000 would be worth less than $5,000 today. I would much prefer stocks and commodities that have outperformed the averages and its peers than those that have fared far worse.
Microsoft is just one of many companies that struggled during the first decade of the new millennium. Many have called this decade the Lost Decade, a similar phenomenon to what Japan’s markets experienced in the 1980s and 1990s. Japan is in much worse shape, though, as its markets are still off 75 percent from their 1989 high. I do not consider the last decade as the Lost Decade. To me it was the Decade of the Emerging Market (see chapter 2).
If investors should no longer buy and hold blue chips like Microsoft, then what should they do? Investors need to change their mind-set. They must become more tactical in their investments. Individual investors need to be more active in managing their own money. They must learn to think more like traders, but with this caveat: do not day-trade. I do not recommend trading every day or even every week. That is a losing proposition. However, sticking one’s head in the sand by ignoring quarterly statements from your stockbroker—which many “experts” recommend—is an even worse proposition.
This does not mean selling and buying stocks every week or two just to generate activity. It means selling or building up a particular holding (also known as “trading around positions”) and shifting allocations six to eight times a year. We’re active managers of every other aspect of our lives, so why would we not be active managers in terms of wealth creation?
If you put more time into researching the purchase of your new car or a major appliance than you did your last stock trade, then you may need to step up your due diligence if you want to thrive in today’s markets. This means spending more time each week researching macro trends, the stock market, and individual stocks. If you are wondering where you will find the time to do that, just think of how many hours you might spend surfing the Net each week or the time you lose watching television. Doesn’t it make more sense to focus instead on something that will determine the quality of your retirement and your ability to send your children to the college of their choice?
One of the greatest epiphanies in my career—and the first step in making the transition from being a “buy-low, sell-high” investor to a “buy-high, sell-higher” one—is learning how to be in the confidence business. Here’s what I mean: whether we are shopping at Costco or tracking tech stocks, most of us have been trained to look for bargains. This may work when you’re stocking up on five-pound tubs of Motts applesauce, but it doesn’t necessarily work when you’re trying to make money on shares of Apple. The reason it is profitable to be in the confidence business is that rather than buying stocks that are making new lows (or, as I like to call it, the “catching falling knives” business), the confidence business is all about buying stocks that the market likes: stocks with momentum, stocks that are outperforming the average benchmark indexes like the S&P 500, and, more specifically, stocks that are outperforming other stocks in the same sector. Both measures are the essence of relative outperformance. (Relative outperformance is comparing an asset’s performance to a different asset or index.) This method of selecting stocks is superior to trying to buy stocks on the cheap. When we buy low and sell high, we’re really just buying stocks that appear to be bargains but really are sucker bets because momentum—and the majority of investors and traders—is going against them.
This idea of buying high and selling higher goes against the basic principle of value investing—one of the most touted methods of investing for decades. Like buy-and hold investing, the typical model of value investing also is broken (value investing is simply buying securities that are priced lower than their intrinsic value). In today’s volatile markets, it is often the value stock that turns into a rapidly devaluing one when the markets start to roll over. In contrast to Microsoft, an investor could have bought the innovative company 3M in 2000 and fared far better than if he had bought Microsoft. At the beginning of 1995, 3M was trading at around $29 per share. In late 2000, 3M exceeded $60 per share before closing that year near $50. So, although 3M was not cheap, it was still a good value because it was a rising star. Buying 3M at any time between $50 and $60 would have been a smart buy, even though the stock was up significantly over the prior five years. In July 2007, at the height of the market, 3M hit an all-time high of just under $96 per share.
However, investors could not have simply bought that stock and tucked it away for their retirement. That’s because the liquidity crisis of 2008–09 caused 3M to drop all the way down to the low $40s in March 2009. The price movement of 3M shows why buy-and-hold is no longer a viable investing model (see figure I.4). Buying high and selling higher is a much better technique than buying low and hoping that the stock you just bought for cheap—a stock that may be in a tailspin—will somehow turn around and deliver big profits.
I realize these are pretty bold claims, and hindsight is 20/20. After all, who am I to say that the tried-and-true philosophies of buy-and-hold investing and value investing are flawed? I am not an academic like Benjamin Graham and David Dodd were when the Wall Street Crash of 1929 prompted them to come up with a new, safe investing method. The result of their research, Security Analysis, became the bible of value investing, the sacred text for many of today’s leading investors, including Warren Buffett.
I am not a PhD. I’m just a regular guy who is in the markets every day, observing, learning, and honing my discipline. And Buy High, Sell Higher is my response to the series of jaw-dropping events that I have witnessed in the markets in recent years—events that have made me realize that the average investor needs a new plan if he is going to survive and profit in a market that Graham and Dodd would barely recognize. And I believe that anyone who is prepared to do his homework and be prepared for the unexpected can become a better investor if he willingly embraces the concept of buying high and selling higher.
Of course, no one wins in the markets all the time, and I am by no means an investor with a perfect track record. I have made some boneheaded mistakes—plenty of them. I have held stocks far too long and sold them far too soon. I’ve taken on excessive risk. But I like to think that I have matured and evolved as an investor during the past few years. Discipline has been my top priority and it has turned me into a much more effective investor.
I’ve also taken the time to figure out what I’m good at—and what I’m not. I was a failure as a pit trader. In fact, it makes perfect sense that I would fail at pit trading. I am by nature an introvert, and the best pit traders are outgoing, gregarious people who have no fear of trading in such a public, crowded arena. But even if I were outgoing and gregarious, that would not have been a game changer. I also lacked the necessary discipline to be a successful pit trader. But today I enjoy success because I practice all of the advice I’ve learned working shoulder to shoulder with great traders like my mentor, Mark Fisher. Fisher was—and still is—an incredible trader because he lived the edict of protecting the downside first. Fisher also taught me the importance of doing my homework.
Finally, if there is a lesson to be taken away from the way MBF avoided the fate of Amaranth and ended up having a banner year after Hurricane Katrina, it is to be ready for the unexpected. I have learned that the unexpected can have a profound effect on a particular stock or on the market as a whole. For example, in his wildest dreams, President Barack Obama would never have predicted that there would be an ecological disaster in the Gulf of Mexico during his second year in the White House. If he had been asked at his inauguration for the ten things he was most worried about occurring during his presidency, the BP disaster would never have made the list. The same thing would have been true if in 2006 you had asked Lehman Brothers CEO Richard Fuld about what would eventually bring his 158-year-old investment bank crashing down in the fall of 2008.
If these major unexpected events have taught us anything, it is that anything is possible, and investors need to understand and embrace that reality. Having a rainy-day fund is one of the greatest tools in the investors’ arsenals. It affords them the opportunity to buy high and sell higher when these once-in-a-blue-moon opportunities come up.
One of the realities of investing is that it is much easier to get into the market than to get out of it. In fact, there are no barriers to entry into the stock market. Anyone with a stockbroker or an online brokerage account can buy a stock and make a case for why it is worth buying now.
It is far more difficult to figure out when to sell a stock or exit a position, particularly if you are facing a potential loss. Selling a stock that you have held for years at a loss is an admission of failure, and few among us like to admit failure.
It also is difficult for most investors to buy a stock after it has run up, say, five or ten points in the span of a few days or weeks. They feel that they missed their best chance to buy into that stock. Similarly, most investors do not want to buy stocks after they have hit a 52-week high. These are some of the reasons why so many retail investors fail. They have the wrong mind-set going in.
If you are going to buy high and sell higher, you’ll need to understand how to pick your point of entry for each investment. In this chapter, we’ll look at what it means to buy confidence, as well as how to come up with your own “buy signs” by using some basic fundamental and technical analysis. Fundamental analysis is more of a snapshot of a security at a given point in time. Three classic books I would recommend on these topics are Jesse Livermore’s Reminiscences of a Stock Operator (for fundamental analysis), John Murphy’s Technical Analysis of the Financial Markets, and Jack Schwager’s Market Wizards. I’ll also show you how to look at moving averages and trading volume to determine when to get into the market. It may sound like a lot of heavy lifting, but if you can spot patterns in other aspects of your life, you’ll be able to do it with the market.
The stock market has a way of scaring some people away from stocks that have momentum—which might be heading higher. On the other hand, the inability to understand downward momentum sometimes makes people stay with other investments—losing investments that are headed lower—far longer than they should.
As investors, we’re always asking, “What if?” What if I get out and the stock goes higher and higher? But this is where we go wrong. I have heard many so-called experts say that the key to trading is to buy low and sell high. I couldn’t disagree more. The key to investing is to buy high but sell even higher. That’s what trading and investing are really all about.
When you buy low and sell high, you might be right four out of five times—if you are really lucky. However, it’s the fifth time, that one time out of five, when you buy a stock that really tanks, when you lose all of your gains plus some. That’s why I urge investors to stay away from the “buy low, sell high” strategy.
When you buy high, you are buying confidence. You are buying a security in which there is conviction surrounding that stock and its price. People are paying that premium, a higher price, which is what makes this strategy far more reliable than the alternative. And confidence has a way of feeding on itself—attracting more and more buyers to that particular security, propelling the stock ever higher.
There is one more critical reason for eschewing the falling-knife method of investing. When you buy a stock that is consistently making new lows or has just made a 52-week low, you have no point of reference to tell you what to do with that stock (i.e., when to sell or reduce your position). When I say there are no reference points when buying falling knives, I mean that many investors lack the ability to identify that stock’s risk, to quantify or calculate its risk, or to find a price point where risk can be established. Put another way, once an asset has fallen through its 52-week low, no investor, professional or otherwise, has any idea on how much farther that security can fall. As a result, investors have no idea when to sell or reduce their holdings.
For those who have limited knowledge on what to look for when analyzing a stock, don’t worry. In my experience, only a small percentage of retail investors know what to look for when evaluating different kinds of opportunities. It is through technical analysis and fundamental analysis that stock market pros analyze a particular security. While this is not a book on either (there are plenty of good books and websites devoted to both), it is important to mention them here so that you will know how to conduct further research on these methods of analysis, and have at least a working knowledge of them so that the examples I use in the book are readily understandable.
I have been surprised that so many individual investors who hold stocks have less of a working knowledge of either type of analysis—something I also have heard from many money and wealth managers who work with affluent investors. This information is so vital that I suggest you start here but do additional research on your own. Throughout the book I will be discussing specific securities and how they are faring when measured against certain key indicators, such as a “moving average.” As someone who aspires to buy high and sell higher, I have found that technical analysis (a method of analyzing a security based on data, statistics, and patterns) is a more useful method of analyzing stocks than fundamental analysis (a method of analyzing a security based on its financials, operations, and prospects). Here are a few words about each.
Moving averages, which are no more than the average price of an asset over a certain period of time, are used by experienced market professionals to identify future trends based on past performance. Conducting this type of analysis comes under the heading of technical analysis, which uses charts to help predict the future price of a security.
When you buy a stock that is making new highs (as opposed to new lows), you have several points of reference, such as the 50-day, 100-day, and 200-day moving averages. You can find all three of these moving averages in minutes for any security on hundreds of free sites like Yahoo! Finance (finance.yahoo.com).
All three of these reference points (50-day, 100-day, and 200-day) are used as important indicators of strength and confidence. When buying higher—buying confidence—sometimes there are so many points of reference that it can become difficult to pick which one to use. Because it is perceived to be the most reliable over the longest period of time, the 200-day moving average is the one most used by most market professionals. I use it as my top indicator, and I recommend that you stick to that one as your chief indicator of strength. When a stock falls through that key benchmark, you are likely to see the stock sell off because that is what the pros are looking at. And you want to be among the first to get out—not the last.
However, sometimes an asset is moving so quickly that a 200-day moving average is simply too long a period to be of much help to an investor. In some cases, you must tighten your indicators and shorten your duration period of analysis. By way of example here, we’ll look at commodities, which generally are much more volatile than stocks and, therefore, are better examples for our purposes. Volatility in equities generally spikes in down markets. Because of that, a stock that is sliding isn’t going to break the 200-day moving average. However, using a 50-day moving average as a reference point for stocks might be more useful.
For example, Apple (APPL) fell below the 50-day moving average during the credit crisis of September 2008. In early 2009, Apple began to challenge the 50-day moving average. By that, I mean that Apple was trying to break above that reference point and it did. That moment was the precursor to Apple’s confidence story. By April 2009, Apple started to build, and it never fell below the 200-day moving average again. So the 50-day moving average proved to be a very useful Mason-Dixon Line for determining when to trim and when to add to a position in Apple.
In very volatile periods, it is better to use a 50-day moving average as a reference point rather than a 200-day moving average. This is especially true for commodities. For example, in 2008, when oil was racing to $147 per barrel (up from $20 a barrel a few years earlier), a 200-day average simply would not work in helping you to figure out the direction of the price of oil. In that case, I used a maximum 50-day moving average to figure out when to pare down my holdings. Anything greater than a 50-day would not be helpful in telling me what I needed to know about the future direction of that stock.
You need to use common sense in figuring out which moving average to use. However, 80 percent of the time, a 200-day moving average will serve you well, but if an asset seems to be moving at 100 miles per hour when the rest of the market is going at about 40, then that is a situation that calls for you to tighten up the indicators as outlined above.
Another way that market professionals analyze stocks comes under the heading of fundamental analysis (as opposed to technical analysis). Fundamental analysis uses financial statements and other qualitative and quantitative data to measure a security’s value at a particular point in time. For example, when an expert says that Exxon Mobil (XOM) has a strong “balance sheet” because it has so much cash on hand, she is telling investors that this is a company in strong financial health. (A balance sheet measure a firm’s assets, liabilities, and shareholder equity.) This is a textbook example of fundamental analysis.
Fundamental analysis also can include macro issues such as the overall growth prospects of an industry or the economy as a whole, but most traders use fundamental analysis to look at company-specific criteria such as earnings, future growth prospects, and anything else that might help a company achieve some sort of sustainable competitive advantage. For example, when you hear someone say that a stock is trading at a P/E ratio of 5, that means that the stock has a current share price (P) of $10 and earnings per share (E) of $2 (10 ÷2 = 5). Companies with high P/E ratios generally are considered more risky than those with lower ratios.
Buying high and selling higher involves a process. To teach you how the process works, I want to use an actual example of an investing opportunity I didn’t catch quickly enough. In order to give you more insight into what I look for in a stock, we are going to look back at a specific opportunity that provided investors a large window in which to get in. I kick myself on this one, because it was right there in clear sight and I missed it.
It starts with the assumptions I held in late 2009. Going into 2010, I looked at the airline industry, and rather than strength I saw vulnerability. I figured with the slowdown in consumer spending, people would be cutting back, which would have an adverse effect on the airlines. However, there were clearly identifiable signs that Continental (CAL) was a stock to buy and it was an easy trade to follow, both by doing some fundamental analysis (e.g., strong earnings, increased capacity) and technical analysis (the price of the stock was signaling a buy). Let’s take a closer look at both.
Fundamentally, tremendous shifts had occurred in Continental Airlines’ business plan, which I will discuss in a moment. Other airlines also made some meaningful changes to their businesses, but they did not move as quickly as CAL, so they were not as attractive.
Following the credit crisis of 2008, there was no shortage of rumors that the airline industry was going to be the next to be nationalized (like the financial giants Fannie Mae and Freddie Mac) or bailed out like the auto industry. However, there was absolutely no truth to those rumors.
In fact, the reality was the management of the airline industry did a better job than any other industry in the United States of changing and adapting quickly to the great recession of 2008–09. They managed the bottom line phenomenally, cut back costs, and introduced secondary fees—fees that consumers had never been accustomed to previously: bag fees, seat fees, extra-leg-room fees. They began to charge for things like food and eventually even for blankets. In the process of making those changes, airlines reduced capacity, making them more efficient businesses. All of these factors helped the fundamentals of the company.
In essence, by making the changes they did, even though consumers hated the changes, most airlines improved upon their business model in a significant way. They were now getting revenue for things like standby fees and other things that would have been unthinkable only a year or two earlier. They adapted their model so that their businesses could make money in the slow-growth environment that existed in 2009.
Now let’s see how the stock performed against the backdrop I just described. In early January 2009, Continental traded as high as $21.83. During the first quarter of 2009, which I like to call “the winter of our discontent,” Continental sold off to a low on March 9, an “Armageddon” low of $6.37. The stock was down a stunning 75 percent from its most recent high (see figure 1.1).
Continental spent the remainder of the year recovering and got as high as $17.65 on October 15, 2009, about six weeks before Thanksgiving. The key is to determine when to get into that stock in order to buy it high and sell it higher. From a technical basis (that is, from how it looked on the charts when compared to key moving average indicators), the window started to open at the end of November.
I do not like to trade on Mondays (“Turnaround Tuesdays” have a way of reversing Monday’s action, making Monday’s trade a fool’s bet). After a weekend, and especially after a holiday weekend, traders often have had a tough few days with their kids and in-laws, and they come in Monday looking to blow off some steam. That often has the effect of a market that is trading not on fundamentals but on emotion. I’d much rather digest the information and make my decision the next day. Monday, November 30, the first day back after the Thanksgiving holiday, was no exception.
After Continental made a high of $17.65 on October 15, it retreated through the end of October into early November and gave investors no indication or signal technically that it should be a buy (see figure 1.2).
On November 30, the stock opened at $13.54. It proceeded to rally throughout the day, up to $14.30. It closed at $14.26. Why was I following the price of the stock so closely? Because that close came within six cents of a return north of the 50-day moving average, which was at $14.32. If it had settled at $14.33, it would have been above the 50-, 100-, and 200-day moving averages, which, as I stated before, is a very strong sign of strength. In addition, the 30-day average volume had not exceeded the average 30-day volume since November 9. But November 30 was a day that we identify as the beginning of a potential opportunity.
The key day was the next day, Tuesday—Turnaround Tuesday—the first day one should have looked at possibly getting into that stock. On Tuesday, December 1, CAL closed above the 50-, 100-, and 200-day moving averages for the first time since January 2009. However, there was one bearish signal as well, which investors needed to take into account: the 30-day volume. Although the volume rose that day, it did not exceed the average 30-day average volume. That is important. Volume tells you the rest of the “buy high, sell higher” story. That’s because it is another strong indicator of a stock’s strength. Weak volume indicates that a stock is lacking in confidence—that the confidence story has not yet built up. It also tells a supply-and-demand story because demand for a specific equity is measured in terms of volume, particularly in the acceleration of volume. If the moving average is the speedometer on a professional trader’s dashboard, the volume is the RPM gauge. Although the volume rose that day, it did not exceed the 30-day average volume. The horsepower wasn’t there.
At that point, I would have correctly advised investors to be patient and not pull the trigger on this stock at this point. Once again, that was because the 30-day volume did not reinforce buying into that stock at that time.
The important thing to recognize here is that I was building a case for buying the stock. On December 1, which was Turnaround Tuesday, I had CAL on my radar screen as a stock I potentially wanted to own. On Wednesday, December 2, the volume exceeded the average 30-day volume for the first time since November 9. The stock did 9.35 million shares, and the average 30-day volume was 7.84 million. The higher-than-average 30-day volume, along with the fact that the stock continued to trade above the 50-, 100-, and 200-day moving averages, formed a definite buy sign. This is a stock I should have bought going into the close, which was $15.67 on December 2.
Indicators were aligned. Volume was strong. With two closes above the 200-day moving average, a buy sign was present. I should have been in that trade at $15.67. However, this was such a solid opportunity that it offered future points to get in.
In the ensuing days and weeks, an investor could have bought the stock and put in a 3 percent stop loss order on it, which is 47 cents. A 3 percent decline from $15.67 (47 cents) puts the stop loss order at $15.20. The key is that had you bought the stock then and put in that stop loss order, you would never have been stopped out. (A stop loss order is an order placed by an investor to automatically sell that security when it falls to or below a predetermined level.) Since hitting that price of $15.67, CAL never traded at $15.20 or below. This was shaping up to be a pretty remarkable opportunity. Here it was late 2009, and the stock remained well north of where I should have bought it.
Not only did I miss the trade, I tried to “fade the trade,” meaning shorting the stock, and I lost money (fading, or shorting, a stock is when an investor tries to profit on the falling price of a particular asset). Why did I get it so wrong?
I stumbled on this one so badly because I had such a negative view of the airline industry going in. I tried to sell the airlines short in February 2009. Looking back, I realized what I had missed. When I rolled up my sleeves and really looked at it, I saw this as an example of a tremendous opportunity. That’s because the actual risk on buying CAL when all the stars aligned was only 3 percent, which seems incredible. But that’s all it was—the downside of this trade was 3 percent.
For the record, I personally don’t like to buy a stock and say, “I am going to risk 3 percent” and then put a stop loss order in at that point. Instead, I like to find a point of reference. I identify something that I can see either technically or fundamentally on a given asset and work with that. I might look for the stock to fall through its 50-, 100-, or 200-day moving average. Or I might see volume start to fall. Or I will use a time stop. That is, if I don’t get the results I am looking for in, say, three months, I will sell that security. In many cases, if I have done all the right prep work, that stock or commodity should not violate the 3 percent stop in any event. When I get it right, I guarantee that in every instance, both of those conditions—a point-of-reference stop or a time stop—will never exceed the 3 percent. I like to keep a very tight leash on the stocks that I buy because, like the best of investors, I am always monitoring the downside. Investors who say that 3 percent seems like a very narrow range are correct. But remember, the key is to keep your losses to an absolute minimum those times when you are wrong so that when you get it right, you can be sure that your gains are greater than your losses.
You might be asking how to time the market so effectively. After all, you probably have a full-time job and don’t have eighty hours a week to devote to watching your stocks and the financial markets. However, you don’t need to be a market genius to get in on the Continental Airlines trade we just discussed. Say, like me, you missed the CAL play in fall 2009. Going forward, the market almost always gives you a second chance to get back in. You had a sell-off that provided you another chance to buy into the stock. When was that? It was during the Flash Crash of 2010.
On May 6, 2010, the Dow roiled as investors worried about the debt crisis that was sending Greece into a political and economic frenzy. During the day, the Dow lost 900 points—and recovered them within a matter of minutes. It was the second-largest intraday point swing (1,010.14 points) and the biggest one-day decline (998.5 points) in the Dow’s history. On October 10, 2008, the Dow had the largest intraday trading range of 1,018.77 points. The Flash Crash made all the headlines the next day. What made it so noteworthy was that the entire market dropped so quickly and that no one could figure out why it happened.
Investors who had not only a disciplined system in place but a clear investing strategy and a written investment plan could have weathered the Flash Crash much better than those who didn’t.
The Flash Crash is something to really think about, because you’re probably going to say this doesn’t make sense. I want you to think about something. As powerful as that Flash Crash was, it even respected the 3 percent down rule on Continental Airlines, meaning even a thousand-point drop in the Dow did not cause investors to get out of the stock.
Let’s summarize: We identified December 2 as the moment to flip the switch on Continental Airlines. Why? We finally got volume back above the 30-day average volume. We also were above the 50-, 100-, and 200-day moving averages; we’ve had a second consecutive settlement (closes) above that. I like to use two consecutive closes above all three of those moving averages, and that was the first time that happened since January. $15.20 was the line in the sand, the point that an investor holding the stock should have been out of the trade.
The other real key here is that the price of the stock continued to rise. You didn’t have to get in those first days of December. The window of opportunity stayed open for months to come. You could have bought that stock at any point along the way. It never got below $15.20. It proceeded to rise until April 15, 2010, to $24.29, an increase of 55 percent from the first entry point of $15.67. You do not have to be a trader to cash in on this stock. This was such a great investment that you could have bought that stock and held it for a year and still made money.
There is one more interesting wrinkle to the Continental Airlines story worth noting. On the same day I indicated that the stock was beginning to become a buy—December 1—Goldman Sachs downgraded Continental’s debt. This is usually perceived to be a negative, and might make many investors avoid the stock. However, this was a case of debt being downgraded and the market just shrugging it off. The stock did not react negatively to the news. It is important to note that downgrading the company’s debt is not the same thing as downgrading the stock. A debt downgrade should be perceived as far more onerous and a structural change for the company’s balance sheet and earnings growth potential. Downgrading the stock is cyclical and can be quickly reversed with a favorable revision higher.
The last concept I want to discuss here is “maximize winners, minimize losers.” What does that mean, exactly? In essence, it’s one of the things I think investors don’t do enough. It’s about setting priorities: first, protect the downside and recognize that when you have a winning stock, you need to stay with it and not sell it too early (you want to maximize the amount of your gains). Most people, when they have a profit, like to immediately sell the stock and ring the cash register. The key is recognizing how to stay with your winners. Most people take their profits way too soon. That’s one of the key issues that I’ve found in dealing with other traders. In subsequent chapters, I will show you what to look for so that you can maximize your winners and reap greater profits from your best investments.
One of the greatest mistakes investors make is trading first and rationalizing the trade later. If I asked a hundred investors how many of them have a written investing plan in place, I am confident that at least seventy-five would have to admit they didn’t.
In this chapter, I’ll show you where to get your investing ideas and how to transform them into buying opportunities. You’ll also understand how macro forces like the global economy, commodity prices, and what the Federal Reserve is up to can help or hinder your ideas. Finally, I will summarize one of my recent investment plans so that you can see how these elements all come together to form an investing strategy.
The first thing every investor needs to do is to devise a strategy. Every investor needs to have a plan that’s tangible, that’s written, and that can be referred back to whenever necessary. Only with such a plan can you look back and say, “Here’s what I said. Here’s where I want to be.”
One of the greatest professional football coaches of all time, Bill Walsh of the San Francisco 49ers, always had the first twenty to twenty-five plays scripted before his team ever took the field. That’s one of the reasons Walsh’s team won six division titles, three NFC Championship titles, and three Super Bowls.
People who watch shows like CNBC’s Fast Money (a show of which I am one of the hosts) probably think that all of the things we discuss are things we know intuitively or can rattle off because we are stock market sages. That’s nowhere near the truth. Although I have learned a great deal about the financial markets over the years, I still spend at least a couple of hours every day reading company reports and filings and other pertinent documents (such as a company’s 10K, which is like an annual report but includes more in-depth data on the firm’s financials, management team, and so forth), not to mention watching the overall market action as well as the price movements of particular stocks, other investments, and potential investments.
I mean no disrespect by this, but I think that most investors are lazy. Many love the rush of trading, but few want to put in the time and effort necessary to become more effective investors.
Whatever the amount of time you devote to investing, at least 90 percent should be spent doing research, monitoring the market environment, and developing a strategic investment plan. One of the best places to start a plan is with allocation: How much money are you going to devote to the market this year? Where, when, and how are you going to deploy your capital? But before you start thinking about how much you want to invest or what kind of profits you’re looking for, you need to think about what’s at stake.
Sports has a concept called the salary cap. The salary cap sets the maximum amount of money a sports team can pay its entire roster of players as well as how much a team can spend for each of its individual players. Similarly, I like to think of myself as the general manager of my own investments, complete with salary caps for my entire portfolio as well as for individual investments.
So, for part of my investing plan, at the beginning of each year, I set a maximum amount of money that I will allocate to the markets that year, as well as a minimum amount. For example, I might decide to allocate no more than $100,000 to the market in the upcoming year and no less than $50,000. The actual maximum and minimum amounts matter less than setting that overall investing salary cap for the entire portfolio.
I also set a salary cap for each investment. This helps to ensure that I am at least minimally diversified in my portfolio. I make sure that no more than one third of the value of my total portfolio is devoted to any one sector, such as energy or technology. The maximum amount that I allocate to any one “player” (i.e., investment) in any one year is 12 percent of the total investment. I insert a time element to each player/investment when establishing my salary caps, and I evaluate all my investments on a quarterly or monthly basis.
I also set a limit to the total number of players that I can have on my team at any one time. I set that number at a minimum of nine players and a maximum of twenty-two players. You may ask how I came up with twenty-two. I believe in the consistency of numbers, and I have found that this number has worked very well for me. Any more than twenty-two stocks make it difficult to manage that portfolio.
Bringing the salary cap concept to your investments also allows you to maintain position flexibility, since you are consistently paring down or selling positions (i.e., players), and that helps you to have cash in hand when an attractive opportunity comes along. We’ll talk more about position flexibility in chapter 7, but suffice to say here that maintaining position flexibility means leaving yourself in a position to take advantage of the one or two market anomalies per year that present themselves as investing opportunities. It’s not just about having the cash or resources on hand to make these investments; it’s also about not placing yourself in a position where you are holding nonperforming assets that tie up your capital.
The reality is that in most asset classes, only three or four buy signs pop up during the course of the year. (These changes in the prices of individual stocks are different from the opportunities that come along every few years.) The Continental Airlines example from the previous chapter is one of those rare opportunities. Again, you need position flexibility. Having a salary cap in place helps bring flexibility to your investing plan so you can be ready when opportunities come along.
A salary cap is just the beginning. Every investor has to craft his or her own strategic plan, including which asset classes to be invested in during the course of the year (e.g., stocks, bonds, cash), how to be allocated, where and when to get into the market, where and when to get out, and how long to give each investment to pan out. However, the key is to start with a macro picture of the entire investment arena.
Before you can select specific stocks and sectors, you have to determine if this is going to be a positive year for equities, and if so, which sectors or areas you will focus on. You may decide instead that commodities may be the better investment theme (for more on commodities, see chapter 9). This decision-making process is one in which you need to measure the potential for corporations to expand margins and earnings per share. You have to measure supply and demand. You have to measure the global demand for natural resources. You have to understand the potential trajectory for interest rates and currencies. Once you have researched these areas, you will have a better sense of whether to focus on stocks, commodities, or other assets. Once the macro plan is written, then you can focus on developing a list of potential, specific assets and securities that you want to watch and buy.
Creating such a plan will force you to be more cognizant of each asset in your portfolio. For example, you may have a stock that you have held in your portfolio for eighteen months even though it has dropped by 30 percent. Some experts will call that a long-term investment. That’s ridiculous. That’s not a long-term investment; that’s a bad investment. We’ve reached a point now where we clearly need to identify it as such. Your investment plan can help you recognize which investments you should buy or sell—or hold—depending on how they are helping you reach your investing goals. And although your written plan is a guide, it also can be a little fluid. Each year, I make a plan, I write it down, and I update my thinking quarterly and also make adjustments monthly. I will show investors how they need to attack this critical task later in this chapter.
Professional traders know that doing their homework—their due diligence—is crucial to successful investing. As mentioned, a good 90 percent of your time should be spent researching and preparing to invest. Part of that means you should be investigating potential investments.
People often ask me what they should be reading to make sure they are staying abreast of the markets, macro trends, and more targeted information as well as what sectors to invest in and what stocks to buy. This is a key question, and the good news is that with the advent of the Internet, there are scores of places to turn to in order to get up to speed on essential topics that will shape your investment plan.
Reading publications and accessing social websites is only the beginning of your search for investing information. In recent years, many investment banking firms, such as Merrill Lynch and Morgan Stanley, have vastly increased the amount of educational resources they make available to their clients. One very helpful addition has been videotaped roundtable discussions of investment professionals. I have found these roundtables to be immensely helpful (and you often can watch these on the web via investment company websites).
In fact, I also have hosted roundtables over the years. Seated around me are portfolio managers who are experts in different asset classes. I also listen in on investing roundtables and find that I always come away with at least a new idea or two that was not on my radar screen before the event. I do the same thing when I appear on Fast Money. When fellow panelists Karen Finerman, Tim Seymour, Pete Najarian, and Guy Adami mention a trend, a stock, or an investing idea that I have not thought of, I write it down so I can research it and possibly act on it later.
There are many other useful educational opportunities available through brokers and other financial sites. For example, online brokerage firms like TD Ameritrade (tdameritrade.com) and Fidelity (fidelity.com) offer a great many opportunities for investors to gain access to financial experts who can widen their view of the markets. They offer these via their own websites or link up with other educational firms that offer a plethora of investing webcasts, courses, market and trading discussions, etc.
Some educational events are more macro-oriented, looking at different global markets, while others are so micro-oriented as to recommend specific stocks. The key is to avail yourself of the resources that your broker’s site or other sites offer, almost always for free, to clients.
In order to put together a coherent investing plan, you want to make sure that you have put in the time and research so that you have a sense of where you want to invest in the year ahead.
I write a comprehensive investing plan once a quarter. I have found this to be necessary in order to have a plan and an outlook and a portfolio that are reflective of both macro and micro trends and events.
You could start to build your plan at any time of the year so long as you give yourself a good six weeks of researching and watching the market before you start investing. Once I hit Black Friday (the day after Thanksgiving), I begin in earnest to put together my strategy for the coming year. In fact, I schedule an 8:00 a.m. conference call with my team at Virtus Investments (my current firm) to go over the plan within a few days of Black Friday. That’s the perfect time to do so since not all that much happens in the financial markets between then and the end of the year. With about five weeks before the end of the year, it is an ideal time to begin gathering the research you will need to put together a coherent plan.
How do you know what to put in your investment plan? The key is to start with the big picture by identifying macro trends that likely will have an impact on the financial markets in the year ahead. What will you need to monitor on a consistent basis, and what can you set aside?
In order to put together a plan, you need to be able to answer certain questions. I am a big believer of making sure that you see the forest for the trees. That’s why I suggest you start by answering these types of questions:
Where is market sentiment right now? Is it in an uptrend or a downtrend? Is it overly optimistic or pessimistic? If it is the former, asset prices might be overvalued. If it is the latter, markets might continue to be weak, or there might be signs of a reversal and an opportunity in the very near future. If you determine that the market has run up too quickly, you might want to be underinvested until sentiment shifts. However, if markets appear attractive because the market is down, say, 2,000 points in the last quarter, a turnaround might be close at hand. There is a saying that “bull markets climb a wall of worry.” That’s because when people are worried, they usually keep a lot of money on the sidelines. Once any kind of good news hits, there is ample capital out there to fuel a market rally.
How is the global economy doing? How is China, one of the countries fueling global growth, doing? What about other key countries, such as Germany? Germany is a pivotal country to watch. If you look back to the European debt crisis in May 2010, everyone was worried about Greece, Portugal, and Spain. However, I was rather adamant that the United States would work our way through that headwind. I really wasn’t concerned about it. The reason why I took such comfort is that the strongest link to the U.S. economy in the European zone is Germany, and the economic numbers out of Germany during that period suggested to me that the problem was contained to those few countries like Greece and Spain. As Germany goes, so goes Europe. An analysis of other countries will help you navigate your way through your plan. If you do not know which countries are experiencing the greatest growth, then any investment plan you attempt to write will be incomplete at best and way off the mark at worst.
Is fiscal policy coming out of Washington favorable or restrictive to the stock market? Are new policies out of Washington encouraging or discouraging growth? Sometimes it is difficult to know, since there could be different types of programs all in effect at the same time—some that are good for the market and others that are bad. You need to see how the market is reacting to these programs, or if the markets are ignoring these policies altogether. Favorable programs would include lowering taxes, government stimulus packages, and regulation that encourages global trade, to name a few. An illustration of the market having a bad reaction to news from Washington was the events of the late summer of 2011. On July 25, 2011, it became clear that Congress and the president would not be able to adopt the necessary fiscal measures to reduce the long-term deficit enough to avoid the country’s AAA credit rating being downgraded by S&P, one of the three major rating agencies. On that July day, the S&P 500 was trading at 1344.32. Because of the unfavorable fiscal policy emanating from Washington, and the subsequent downgrade by S&P, the market declined over the next nine trading sessions to 1101.54—roughly an 18 percent drop.
Is the Fed helping to increase liquidity, or are they in a tightening phase where they are restricting liquidity? The Federal Reserve, better known as “the Fed,” is the central bank of the United States. It sets the monetary policy (interest rates), regulates the banking system, and maintains the soundness of the nation’s financial system. The key for investors is how the Fed manages the country’s interest rates. Equities do better during easing (that is, when rates are being lowered) and usually do not perform well in the transitional phase between easing and tightening policies (tightening means “raising interest rates”). This is critical and relatively easy to monitor.
What about the value of the U.S. dollar? The value of the dollar is a critical factor in figuring out what is happening in the overall economy. Let’s say the U.S. economy is challenged and struggling for growth. The only way to stimulate growth is by cheapening currency to make goods and services globally more attractive to other nations to buy. That is why most countries try to devalue their currency: to increase total revenue for their goods and services from abroad (demand generally goes up when prices go down). Companies that do a significant amount of their business overseas (say, 40 percent or more) are likely to benefit from a weak dollar. However, if your economy is doing well—growing by, say, 4 to 5 percent—you want it reflected in the strength of your currency. In that instance, people want to own your currency. They want the capital that flows into your currency. They want that extra yield. A strong dollar and a strong GDP—really the most accurate measure of Main Street’s standard of living—mean a strong economy. Absent that strength, the overall stock market benefits from a weak dollar.
What is happening with commodities? I tend to look at precious metals, oil, base metals, and natural gas. Unfortunately, there is no valid index or metric that investors can watch as a benchmark for commodities. However, since 2002, investors typically use the dollar indexes as indications of where commodities should be (if the U.S. dollar is weak, commodities should be strong). It is important to note, though, that this likely will change in the future.
I also think that within the framework of my strategy, I understand seasonality and how to play seasonality. What do I mean by that? Let’s look at oil. Oil historically tends to be weak during the first quarter of the year. Generally, if you look back on it, the most vulnerability in the commodities space is in the beginning of the year, and that includes gold. I also pay particularly close attention to copper. That’s because copper is the metal most used in building the infrastructure of growing countries like China and Brazil. In fact, market pros call copper “Doctor Copper” because it is the asset most indicative of a strong global economy.
Excerpted from Buy High, Sell Higher by Terranova, Joe Copyright © 2012 by Terranova, Joe. Excerpted by permission.
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Prologue: Investing Lessons from Hurricane Katrina 1
Part I Think Like a Professional
1 Buy High, Sell Higher 21
2 Strategize First, Trade Second 36
3 Keep an Investing Calendar 65
4 Build Your Investing Team 79
Part II Execute Like a Professional
5 Understand Timing, Herds, and Diversification 107
6 Know When to Enter and Exit the Market 135
7 Maintain Position Flexibility 166
8 Recognize Momentum Changes 189
9 Invest in Commodities 212
Appendix. Sample Investing Calendar plus Supporting Commentary 241
Posted July 17, 2013
Posted February 21, 2012
I thought this book was exceptional. I've read several financial books and this by far is THE BEST!! The author provides truly understandable scenerios, and best practices to follow. I learned something new everytime I read it. I was able to test the knowledge in the book by following the authors instructions. I became confident in fundamental and technical analysis day by day. I will use this book as a reference guide from this point forward without hesitation.....Not to sound over zealous, but I would recommend this book to anyone looking to improve their knowledge in the equities trading business.Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.
Posted May 9, 2012
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Posted April 2, 2012
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