10673; 7/22/02, 7532), when the long-term investor stands to seea large part of his slowly accumulated gains wiped out in a few days. Theshort-term trader, in such catastrophes, will be taken out by his stop–lossorders, or his market orders, with only moderate losses, and will still havehis capital largely intact to use in the new trend as it develops. EN: The besttechnical analysts’ opinion in “modern times” is that even long-term investorsshould not grin and bear a Bear Market. This is a necessity only for bank trustdepartments and large Wall Street firms which cannot afford to offend their investment banking clients by suggesting that their retail clients should sell their holdings.Finally, before we get on with the subject of tactics, the operations weare speaking of are those of the small- and medium-sized trader. The methods suggested here, either for getting into a market or getting out of it, willapply to the purchase or sale of odd lots, 100 shares, 200 shares, and sometimes up to lots of thousands of shares or more of a stock, depending on theactivity and the market for the particular issue. The same methods wouldnot work for the trader who was dealing in 10,000-share blocks (except inthe largest issues), since in such cases, his own purchases or sales wouldseriously affect the price of the stock. Such large-scale operations are in aspecial field which is governed by the same basic trends and strategy, butwhich requires a different type of market tactics. EN: Or, put another way, asMagee said to me one time, a mouse can go where an elephant can’t.
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365
ENE LAST-Weekly 01/11/2002
705040302010
1998
1999
2000
2001
Created with TradeStation 2000i by Omega Research 1999
FIGURE 201.0. If an investor only learned one thing from this book, and it werethis one thing, that one thing might be the salvation of his portfolio, or his retirementplan (if all his assets in the investment plan were shares of Enron). Instead, theemployees of Enron made a major mistake in not having a diversified retirementportfolio – they had all their eggs in one basket, their income and savings came fromone source. But diversification is not even the crucial lesson here. The lesson is getout of the stock when it reverses. The corollary of that lesson is, never buy a stockin a downtrend. And there is even a more important lesson: Never buy a stock whenit is in a swan dive. So obvious you say. Not so obvious at the time for portfoliomanagers for the University of Miami who continued to accumulate Enron stockeven as it neared earth at 100 miles an hour. Of course they had sophisticated (?)company. The Motley Fools had a death grip on the stock all the way to the bottom.
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chapter 18.1
Strategy and Tacticsfor the Long-Term InvestorWhat’s a Speculator, What’s an Investor?In the years since Magee wrote Chapter 18, some different connotations haveattached themselves to the terms “speculator” and “investor.” A great cultural shift has also occurred. The days when the New Haven (New York,New Haven and Hartford Railroad) was a beacon of respectability (and lentluster to its investor) and paid good dividends are gone forever. And so isthe New Haven. In fact, after the turn of the century, corporations saw achange in investor sentiment about dividends. Investors wanted capitalappreciation and cared less for dividends. In fact it has lately been consideredthe mark of a “growth stock” not to pay dividends. Evidently, the days ofthe New Haven are gone forever, when an “investor” was one who bought,held, and collected dividends, and “speculators” were slightly suspect menlike Magee who played the medium-term trends and bought “unchic,”“speculative” stocks. It all has a sepia tone to it.Yesterday’s speculator might be called a medium-term investor today.While the term “speculator” could still be applied to anyone who“trades” the market, today that old-time speculator and his kind would morelikely be called traders than speculators. Commodity traders who have nobusiness interest in the contracts they exchange are always referred to asspeculators, as opposed to commercials, who are hedgers and users of thecommodities they trade. Now “day traders” might be considered the equivalent of the old-time speculators. And only the passive, in the opinion ofthis editor, never trade at all and sit on their holdings during Bear Markets.On the spectrum of investors, from investor to gambler, the old “NewHaven Investor” who “wants his dividends” is pretty rare these days, and,again, may be one of those trust departments which doesn’t want to get suedand so stays out of stocks which go up. After all, prudent men don’t “tradein volatile stocks” but “invest in safe issues, like bonds,” which only loseabout 1.5–2.0% of their purchasing value per year, but preserve the illusionof having “preserved principal.”
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One Definition of the Long-Term InvestorLet us take as a long-term investor now one who expects to at least trackmarket returns, for it has been demonstrated over a relatively long periodof time that this can be done by passive indexing. At the turn of the century,as this is written, it would seem neither long-term nor medium-term norshort-term investors think about the risks involved in matching the marketsince, entering the third millennium, it has been so many years since wehave had a really vicious Bear Market. Dow 36000? This is a passing phase.As each Bull Market reaches higher and higher, the odds are lower and lowerthat it will continue — historic Bull Markets of the 1990s notwithstanding.What then are the strategy and tactics for the long-term investor toachieve a goal of matching the market? (EN9: Is it necessary to remind thereader of Chapter 5.1 and the Dow Theory?)Let us remark immediately that the tactics Magee described for thespeculator — or trader if you will — are not at all in conflict with theshort-term tactics used occasionally by the long-term investor. As buying orselling time approaches the stops of the long-term investor, that investorbecomes a trader. Then he can and should adopt the trader’s tactics. Sooneror later the focus even narrows to real time at the moment of trade execution.Interestingly, the charting techniques we have described here work ontick-by-tick data in real time also. So if the trader wants to enter into thereal-time environment, he can attempt to time his trade right down to thereal-time chart formations. Of course, only the really active and skilledlong-term investor will be concerned with squeezing the last half point orpoints out of his position. But this illustration of the time focus is addressedto any investor or trader or speculator to demonstrate the fractal nature ofboth price data and the applicability of Magee-type technical analysis to it.
The Strategy of the Long-Term InvestorThe strategy of the long-term investor is to catch the long trends — toparticipate in trades which last months and years. But this strategy does notintend to be sucked into long Bear Markets. Rather, portfolios are liquidatedor hedged when Bear Market signals are received. As has been previouslyseen in examples of the performance of (more or less) mechanical DowTheory (Chapter 5), this kind of performance can be quite satisfactory —better indeed than buy-and-hold strategies which have come much intovogue because of the Clinton–Gore Bull Markets of the 1990s.If the goal is to beat not only the markets but the mutual funds (only20% of which outperform the market over the long term anyway), thenpassive indexing is the most likely strategy. This may be done in a numberof ways — index funds, buying the basket, buying the futures, etc. But themost attractive method might be the use of the SPDRs and DIAMONDS andthe like. The tactics may be calibrated to the risk tolerance and character ofthe investor. He might hedge or sell on Dow Theory signals, or on breaks
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of the 200-day moving average, or on breaks of the long-term or intermediatetrends lines with a filter (Magee recommended 2%, and this might be calibrated to the character of the markets, and increased to 3% or a factor relevantto actual market volatility). Instruments we have previously discussed —SPDRs, DIAMONDS, index futures, and options — can be used to executethese tactics.Suffice it to say that every strategy must provide for the plan gone wrong,in other words the dreaded Bear Market. Bear Markets would not be sofearsome if the average investor did not insist on seeing only the long sideof the market. Long-term strategies go out the window quickly when bloodruns on the floor of the NYSE. The well-prepared technical investor has aplan which provides for the liquidation of positions gone bad and presumably the discipline to execute it.This involves the regular recomputation of stops as markets go in theplanned direction, and ruthless liquidation of losers which do not perform.One may think of a portfolio as a fruit tree. Weak branches must be prunedto improve the yield. Stop computation is treated in a number of places inthis book (cf. Chapter 27). For the investor trading long term, this may be,as an example only and not as a recommendation, the breaking of the 200-daymoving average and/or the breaking of a long-term trendline. The 200-daymoving average is widely believed to be the long-term trend indicator, andbelieving will sometimes make it come true. EN9: Let me emphasize here that“200” is a parameter and an example. Personal research may fit a better parameterto the actual market.In reality, more than the 200-day or a manually drawn trendline should belooked at. The chart patterns comprising the portfolio should be consideredalso, as well as charts of major indexes and averages. Also consider the condition of the averages and their components — their technical state — whetherthey are topping, consolidating, trending as indicated by their charts.
Rhythmic InvestingIn addition, if Chapter 31 on “Not All in One Basket” is weighed seriously,one might be rolling a portfolio from long to short gradually in naturalrhythm with the markets and in harmony with the Magee Evaluative Indexdescribed there. That is the preferred strategy of the authors and editor ofthis book.These things all depend on the goals, temperament, and character of theinvestor. If he is going to spend full time on the markets, he is probably nota long-term investor. Such men eat well and sleep soundly at night. Thetrader is lean and hungry — not necessarily for money, but for activity. Itbehooves one to know his type as a trader or investor. And knowing one’stype or character is best established before finding it out in the markets, asthe markets can be an expensive place to search for self-knowledge.There is no inherent conflict in holding long-term positions and alsoattempting to profit from intermediate trends, depending on the amount of
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capital in hand. It depends on how much time and energy and capital theinvestor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows. Pay attention tothe major indexes and averages and buy on breakouts, at the bottoms ofconsolidations and on pullbacks. Sell or hedge on the breaking oftrendlines, calculated on basing points (see Chapter 28) and the penetrationof support zones.The long-term investor will accept greater swings against his positionthan the intermediate-term trader or speculator. As an example with themethod of using basing points in Chapter 28, the speculator is using a“3-day-away rule,” whereas a long-term investor might be using a 4-weekbasing point or some such analogy. And, if interested, when he suspects oranalyzes that a long Bull Market is approaching a climax, he might adoptthe 3-day rule also, or even begin following his stock with a daily stop justunder the market. Beware though. Professionals look for stops just underthe close of the previous day in situations such as these.It would be wise not to confuse long term investing with “buy and hold”or as it was expressed in one investment fad in the 1970s, “one decisioninvesting.” As an example of this misguided thinking, in 1972, the “best andbrightest” investment analysts (fundamental) on the Street picked a portfolioof stocks for the generation, or twenty years. The companies would bedifficult to argue with as the crème de la crème of American business. Afterall who could qvetch at Avon, Eastman Kodak, IBM, Polaroid (unless hehappened to look at Figure 253), Sears Roebuck, and Xerox? Even today ifyou didn’t have a close eye on the market, you would immediately respond,“blue chips.” Here is a table showing the stocks and the results achievedover the long term.
StockAvon ProductsEastman KodakIBMPolaroidSears RoebuckXerox
Price4/14/72
Price12/31/92
PercentChange
61.0042.4739.5065.7521.6747.37
27.6932.2625.1931.1317.1326.42
(54.6)%(24.0)%(36.2)%(52.7)%(21.0)%(44.2)%
Charts showing activity for IBM and Xerox appear on the followingpages.
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45 IBM LAST-Monthly 02/26/199340353025
20
15
101970
1975
1980
1985
1990
FIGURE 201.1. The questionable—even bizarre—results of “one-decision investing” are amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a decade high to see it decline by more than 50%. It subsequentlyrecovered to double from their original recommendation. Ah, sweet justification!Only, unfortunately, at the end of 20 years to see it rest approximately 40% beneaththe recommendation. The analytical lines give some hint of how a technician mighthave traded the issue. I like to say that there are bulls, bears, and ostriches, andanyone who followed this one-decision investment proves my case.
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Figure 201.1.1 Like IBM in the previous figure, Xerox was recommended at a placewhere it should have been sold instead of bought. The comments there might applyto the chart here. The foolishness of “buy and hold” or “one decision investing” isamply illustrated by observing the long term swings of the stock and thus of theinvestor's equity. Technical analysis is intended to be an antidote to such foolishness.
SummaryThe long-term investor attempts to catch major market moves — thoselasting hundreds, if not thousands of Dow points and stay in trades for manymonths if not years.Within this time frame he expects to take secondary trends against hisposition. Depending on his temperament and inclination, he may attemptto hedge his portfolio upon recognizing secondary market moves againsthis primary direction.His preference for stocks and portfolio will be for market leaders, forbaskets that reproduce the major indexes (or Index Shares) as the ballast forhis portfolio, and he may choose some speculative stocks to add spice to hisportfolio.
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In spite of his penchant for long-lasting trades he will not tolerate weak,losing, or underperforming stocks. They are the shortest of his trades. Hewill cut losses and let profits run, the truest of the market maxims and theleast understood by unsuccessful investors. The other maxim least understood by investors is “buy strength, sell weakness.”Truly sophisticated investors attempt to participate in Bear Markettrends also. This is the greatest difference between professional and generalinvestors — professionals have no bias against the short side.For the convenience of day traders, the URL of Gamblers Anonymousis noted: www.gamblersanonymous.org.
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chapter nineteen
The All-Important DetailsIn this chapter and the one following, we take up a number of elementarysuggestions which are intended largely for the benefit of those who havenever kept charts before. Much of this will seem obvious and repetitive tothe advanced student, although even he may find some thoughts that willsimplify his work. The beginner should read these chapters carefully anduse them for later reference.The details of how and when you keep the charts will not guaranteeyou profits. But if you fail to work out these details in such a way as to makeyour work easy, as part of a regular systematic routine, you cannot expectto keep up your charts properly, or to make any profits either.Charting, and analyzing your charts, is not a difficult process, nor willit take too much of your time if you have determined on a reasonable numberof charts, and if you have arranged for doing the work regularly, meaningevery day without fail.You will need a source of data — the day’s market prices and volume.If you live in a big city, your evening paper will carry the complete list, andyou can plan to set aside a certain period before dinner, or after dinner, orduring the evening. If you cannot allot such a period and keep it sacredagainst all other social or business obligations, then plan to do the chartingin the morning. But set a definite time and let nothing interfere, ever, or youare lost. EN: Of course, this process is radically simplified by automated computerdownloading procedures and access to data sources and Internet sites. But theprinciple is the same.You should have a suitable place to work and keep your charts. If it isat home, in the dining room or living room, other members of the familyshould understand that what you are doing is important. You should be ableto shut the door and work without interruption. The light should be brightand as free from shadows as possible. (It makes a big difference, especiallyif you are keeping a large number of charts.) The ordinary desk lamp throwsa reflected glare directly across the paper and into the eyes. It can be a strainif you are doing much of this close work. Better to have an overhead light,placed just a few inches in front of your head and a convenient distanceabove; and if this light can be a fluorescent fixture using two 40-watt lamps,you will get almost perfect shadowless lighting. These suggestions apply, ofcourse, in case you are not working by daylight.
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Have plenty of room. A big desk top, a dining room table, with a largeclear space for chart books, extra sheets, pencils, scratch paper, ruler, calculator, computer equipment, and anything else you need. If your workingsurface is fairly low, say 28 or 29 inches from the floor, it will be less tiringthan the usual 30-inch desk height.Whether you are working in ink or in pencil, pick out the writing toolthat is easiest for you to use. If you are using pencils, try several differentmakes and degrees of hardness. Find one that is hard enough not to smudgetoo easily, and yet is not so hard that you have to bear down to make a cleanblack mark. The wrong kind of pencil can tire you and irritate you morethan you realize. Also, have plenty of pencils, a dozen at least, well-sharpened, so that as soon as one becomes a trifle dull and you are not getting aclean, fine line, you can simply lay it aside and continue at once with anotherfresh-sharpened pencil.Keep your charts in loose-leaf books, with big enough rings to maketurning the pages easy. Don’t overcrowd the books. Get new books if avolume is too crowded. Finished charts may be kept in file folders. The onlyones that need to be in the books are the current sheets and the sheets forthe immediately preceding period. If possible, use a seven-ring binder. Pagesare easily torn loose from two- and three-ring binders, but seven rings willhold the pages safely and you will seldom have one tear out.The charts you keep will become increasingly valuable to you as thechart history builds up. The old chart sheets will be very helpful to you forreference. Provide a file or space where they can be indexed and kept inchronological order, and also file folders for brokers’ slips, dividend notices,corporate reports, clippings and articles, notes on your own methods, andanalyses and special studies of the work you are doing.In this connection you will, of course, keep a simple but complete recordof each purchase, sale, dividend, etc., on stocks you have bought or sold.This record will make your work much easier when the time comes to figureout income taxes. It will also give you all the statistical information you needto judge the results of your trading operations.EN: At the beginning of my investment career, and often in the middle of it, Ithought the above was cracker-barrel wisdom. The longer I last the more I think thathomespun wisdom might be the best kind to have in investing — somewhat likeMark Twain, who was astounded at how much his father increased in wisdom theolder Twain himself got.We may restate the modest homilies above: Be serious. Be methodical. Be disciplined. Be business-like. Anyone who succeeds in investing without these qualitiesis the recipient of blind luck and will be fortunate not to fall into a hole before hiscareer is over.These thoughts occur when one is wondering how Magee would have viewed theadvent of the microcomputer and its impact on technical analysis and investing. Mighthe have said, “What hath this tool wrought?! — Wonders and abominations!!”Given the possibilities for complicating analysis and operations when confrontedwith all the bells and whistles of the average computer software package, the investor
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must maintain perspective. What, then, are the all-important details in practicingtechnical analysis with the aid of a computer?
The Simplest and Most Direct Way to Use a Computerfor Charting AnalysisIn reality, the computer can be used as a simple tool to do a simple job. There isnothing inherently complicated about keeping a chart on a computer. All computersoftware packages enable bar charting. And many, if not most, enable many otherkinds of charting, from candlesticks to oscillator charting. The process, in almost allcommercially available packages, is so simple that explaining it here would besuperfluous (cf. Resources, Appendix D, for demonstrations), except to say, ingeneral, it consists of retrieving data, updating the program’s price database, andclicking an icon to run a chart. The software packages themselves explain theirfeatures better than can be done here. What is important here is to give perspective.In this respect, charting can be done with quite expensive programs and alsoon publicly available free programs, or freeware. Charting can also be done withinteractive charting programs on many Internet sites. The basic bar chart can beenhanced with an unending number of technical studies — moving averages, oscillators, etc., etc. Therein lies the danger. Chart analysis in itself is a qualitativeprocess. Decorating graphic charts with number-driven information and studies canlead the general investor astray — and into confusion and indecision.So the first preference of this analyst is to keep the process as simple as possible.Get the data. Draw a chart. Analyze the patterns. Consider the volume. Draw theappropriate analytical lines. This can usually be done by the program on the screen.Often a better graphic picture may be obtained by printing the chart and handdrawing the analytical lines. And this brings to the fore one of the main problemsof almost all the software packages — that screen graphics are poor and, at least toold chartists, disorienting. They are especially disorienting to analysts who areaccustomed to working on Tekniplat chart paper. With passing editions of Resources,this problem will be dealt with. (EN9: In the intervening years since the 8thEdition two things have occurred: the Editor adjusted to modern technologyand the technology achieved a level of excellence acceptable to a carpinganalyst. Internet technical analysis sites such as stockcharts.com andprophet.net improved to be surprisingly valuable resources at unbelievablylow prices – even free.)The question of graphic representation of the facts is worth noting as a persistentone. To a certain extent, the individual analyst will solve this conundrum byadapting his eye and mind to a graphic environment, using one graphic methodconsistently and seeing how it relates to the facts in the market. John Magee-orientedsolutions to this problem will be available on the web site, www.edwards-magee.com.In Resources, the reader may see some examples of very simple and inexpensivesoftware packages and Internet sites which are quite adequate to the required tasksof charting technical analysis, as well as more complex number-driven analysis.
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SummaryThe computer is an invaluable tool for analysis. Use of it will enable thefollowing:• Data may be acquired automatically via Internet or dial-up sites at little orno cost. Some of these even offer real-time data, which is a way for theunsophisticated trader to go broke in real time; but which the generalinvestor may desire on the day of executing a trade. Many of these sitesoffer every kind of analysis from respectable technical analysis (usually toocomplicated) to extraterrestrial channeling.• A computer package and Internet portfolio sites will give the analyst virtually effortless portfolio accounting and mark to the market prices — avaluable device to have to keep the investor from mixing his cash and accrualaccounting, as Magee says.• The computer will enable processing of a hitherto unimaginable degree. Anunlimited number of stocks may be analyzed. Choosing those to trade witha computer will be dealt with in Chapters 20 and 21.• Resources (Appendix D) contains information on software packages whichthe reader may try and purchase at quite reasonable prices. In all likelihood,the least expensive of these will be adequate to the needs of most generalinvestors. In addition, I present a brief discussion of Internet sites andresources.
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chapter twenty
The Kind of Stocks We Want —The Speculator’s ViewpointThe specifications of the kind of stock we want to chart are fairly simple,and they are few. We want a stock which will enable us to make a profitthrough trading operations. That means a stock whose price will move overa wide enough range to make trading worthwhile. There are those who areconcerned mainly with safety of principal and the assurance of income froma stock. For them, there are (EN9: Or were.) stocks which afford a veryconsiderable degree of stability. You may (and probably will) want to keepa substantial part of your total capital in stocks of this type. They move ina narrow price range. They are extremely resistant to downside breaks inthe market. They are also (and necessarily) unresponsive to fast upsidemoves in the market as a whole. These stocks are highly desirable for theconservative investor. However, they are not the most suitable issues fortrading operations, since their swings are small, and commissions wouldtend to diminish the narrow trading profits that could be taken. Also, theydo not make the sharp, clear chart patterns of the more speculative issues,but move in rounding, sluggish undulations. (EN9: These remarks reflect abygone time. The described stocks by and large went the way of the Dodo. When Tcan disappear from the market as a factor there is no place to hide, except in bonds,which, when stagnant, only lose real value at the rate of inflation and loss ofpurchasing power of the dollar. And even bonds should be subject to frequentreevaluation using the tools described in this book.)To amplify this comment and explain a bit about what underlies whatwe are doing, let us assume a certain company has two issues of stock, apreferred and a common. Since (we will assume) the concern has a certainsteady minimum profit which it has earned for years, sufficient to pay thepreferred dividend, the continuance of these dividends seems practicallyassured. But the dividends on the preferred are fixed at, let us say, 6%. Nowthe common stock gets all that is left. In one year, there may be 50 cents ashare for the common stockholders. The next year, there may be $2.00 a shareor four times as much. In a case like this, if there are no other factors, youwould expect the preferred stock to sell at a fairly steady price without muchchange, whereas the common stock is subject to a “leverage” and mightshoot up to four times its former value. The more speculative issues represent379
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either a business which is, by its nature, uncertain as to net profit from yearto year, where the volume of business or the profit margin fluctuates widely,or one in which the majority of the “sure” net profit has been sheared offfor the benefit of senior obligations. There are also other factors that affectthe speculative swing of a stock, and, as a result, one issue may be verysensitive and another extremely conservative; and between them therewould be all shades and degrees of sensitivity or risk. It is enough here tonote briefly that the nature of the business itself does not always account forthe habits of the stock, since the other factors may be very important. Butmost stocks have a fairly well-defined “swing” power, and you can usuallydetermine by past performance how a stock will behave in the future as tothe extent of its swing. (EN9: Or we might say, short-term volatility and long-termrange.)Incidentally, for short-term trading (EN9: Amusing in the modern context.By short-term trading Magee means trad