ing of trends of shorter length than DowWaves), we are thinking about the habits of the stock which are only partlydetermined by the business it represents. Purchase of stock in one companywhich has a somewhat uncertain or fluctuating profit record may be moreconservative than purchase of a highly leveraged stock of another companywhose basic business is steadier and more conservative. We will take up thematter of determining these risk constants a little later.One should also understand that the short sale of a stock does not implyany feeling that the country is going to the dogs or even that the concernrepresented is going to the dogs. Such a sale merely indicates your beliefthat the stock may be temporarily overpriced; that earnings or dividendsmay have been abnormal in recent years and are likely to be reduced; orthat for one reason or another, the stock of the company may be worth a bitless than it has been worth.For technical trading, we want a fairly speculative stock, one which willmake sizable swings up in a Bullish Trend, and down in a Bearish Trend.The very factors which tend to make a stock safe and desirable to the investormay make it entirely unsuitable for trading. And with certain reservations,which we will take up, the more speculative the stock the better it is for ourpurposes.EN: Entering the third millennium (since we Anglo-Saxons started counting —the fourth or fifth by other measures) the distinctions between “speculative” stocksand every other kind of stock has grown increasingly blurry. Rather than apply aperhaps pejorative (in the minds of some readers) term like “speculative” to otherwiseinnocent stocks, we would do better to describe stocks as wide ranging or narrowranging, as volatile or nonvolatile. Stocks may then be evaluated one against anotherby their betas and historical volatilities, statistical data easy to obtain. “Betas” and“volatilities” are dealt with in Chapters 24 and 42.In line with this more current thinking, there is another question for readers ofthis book and that is the choice of trading (or investment) instruments for the longterm investor. That question is taken up by the editor in Chapter 20.1.
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GOOD YEAR TIRE1ST PREFERRED
GOOD YEAR TIRECOMMON120112104
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FIGURES 202 and 203. Opportunity vs. security. Here (at left) is Goodyear Common, representing the residual interest in all profits after senior obligations have beenmet, compared (at right) with the Goodyear $5.00 Preferred, which carries a highdegree of assurance that the $5.00 dividend will be met, but no promise of furtherparticipation in profits. Monthly range of each stock for the same 54-month periodis shown on a ratio scale. As the Common makes an advance of over 300%, thePreferred advances about 25%, leveling off at a point which represents the maximumprice investors are willing to pay for the sure $5.00 dividend.
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chapter 20.1
The Kind of Stocks We Want —The Long-Term Investor’sViewpointChanging Opinions About Conservative InvestingVirtually no one invests like the conservative investor described above inChapter 20 — except perhaps trust departments of antediluvian banks. Theremay be some investors still out there who are so risk averse that they stillfollow the method described. Bank trust departments may be still doing it.They used to do it so the trust beneficiaries couldn’t sue them. Of course,they should be sued for incompetence. But that is the reason trust departments exist, in order to give legal cover (the so-called “prudent man rule”)to trustees in case of suit by beneficiaries. Most enlightened trust departments and trustees now probably follow indexing or other more productivestrategies in order to cater to new understandings of the prudent man rule.A beneficiary of a trust which has been mismanaged or has radically underperformed the market should certainly seek redress.“Indexing” refers to the practice of constructing a portfolio so as toreplicate or closely reproduce the behavior of a widely followed index suchas the S&P 500 or the Dow–Jones Industrials. These portfolios never trackthe Indexes exactly because the advisors and funds who manage them takemanagement fees and expenses. These fees are generally less than fees andexpenses on actively managed funds, but in fact are not necessary for theprivate investor to pay. Unnecessary because even the tyro investor can nowuse “Index Shares” (e.g., DIA, SPY, QQQQ, etc....) or other proxy instrumentsto do what the funds and professionals do. Essentially what indexing doesis track the Averages, a strategy which was impossible or difficult (expensive)when Magee examined it, as in Chapter 15. (EN9: In the opinion of this editorhiring a management company to run an indexing strategy is imprudent and awaste of capital. Much better for the investor to invest directly AND to exit themarket when uptrends end and reverse. This is a much better strategy than “passiveindexing”which cleverly manages to capture both lossses and profits in theAverages.)
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The Kinds of Stocks Long-Term Investors WantPerhaps one of the most important actualizations of this eighth edition is tobring current this book’s treatment of the Averages, noting that it is nowpossible to trade the Averages in stock-like instruments. This fact deservesto be marked as an vitally important development in modern markets. Theimportance, if it is not obvious, was explained in detail in Strategies and Tacticsfor the Long-Term Investor, Chapter 18.1. This chapter will confine itself todescribing facilities for trading and investing in the Averages and Indexes.In 1993 the American Stock Exchange (AMEX) introduced trading inSPDRs™ or Standard & Poor’s Depositary Receipts, an Exchange-tradedunit investment trust based on the S&P 500 Composite Stock Price Index.The AMEX calls these securities Index Shares™, a name they also use forother similar instruments. As noted above, large investors and funds havelong traded “baskets” of stocks representing the S&P 500, obviously anactivity requiring large capital. And in fact a certain class of investmentmanagers and funds have practiced “passive investing” meaning indexing,primarily for large clients.The purchase and liquidation of these and other “baskets” is one formof “program trading.”Recognizing the utility of this investment practice, the AMEX createdthe SPDR as a proxy instrument to allow the smaller investor to practice thesame strategy. The effectiveness of this product introduction may be measured by public participation in the trading of the SPDR (SPY). By 2000,almost $15 billion was invested in SPDRs with more than 100,000,000 sharesoutstanding. These units allow the investor to buy or sell the entire portfolioor basket of the S&P 500 stocks just as he would an individual stock. Butthe capital required to do so is radically reduced.In 1998, the AMEX introduced DIAMONDS™ (DIA), Index Shares onthe Dow–Jones Industrial Average™, which is analogous in every way tothe SPDRs. Thus an investor may “buy the Dow–Jones Industrial Average.”So in current financial markets, it is possible to “buy the market,” unlikethose conditions under which Edwards and Magee operated.
Construction of the Index Shares and Similar InstrumentsThe AMEX unit investment trusts are constructed to replicate the composition of their base instrument. The SPDR, for example, is an instrument whichrepresents 1/10 of the full value of a basket of the S&P stocks and trades onthe AMEX, just like a stock. Other characteristics of stocks are also reproduced. Long life: the SPDR Trust lasts into the 22nd century. Quarterlydividends: quarterly cash dividends are paid on the SPDRs reproducingdividends accumulated on the stocks of the S&P 500. Even dividend reinvestment is possible, and the units may be traded on the AMEX duringregular trading hours. Under normal conditions, there should be little variance in the price of the SPDR relative to the S&P 500.
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These elements, as discussed for SPDRs, are common to all the IndexShares — DIAMONDS, WEBs, etc. There are, of course, some expenses andcosts to using the Index Shares — a small price to pay for the use of theinstrument, and generally less than the costs of a fund. Index Shares are alsomuch more flexible for the independent investor. Among other advantagesthe private investor can control the tax consequences of his investment,which is not possible in funds.Other Exchanges have created similar security instruments or derivatives or futures to replicate or track the well-known averages and indexes.Among these are tracking shares or index shares or futures (let us call them“instruments”) on other indexes (Russell, Nikkei, etc.) or options on thefutures or indexes until there is a bewildering array of instruments availablefor trading, investing, and hedging. Among the more important exchangesand instruments traded are the Chicago Board of Trade (futures and optionson futures on the Dow); the Chicago Mercantile Exchange (futures on theS&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell 2000, andNASDAQ 100); Chicago Board Options Exchange (S&P 100 and 500options)…. This, by no means, is an exhaustive list. All the futures andoptions which matter will be found listed in The Wall Street Journal underFutures Prices, or Futures Options Prices.This book does not deal in comprehensive detail with futures andoptions. But it is worth mentioning these exchanges and their futures andoptions products because of the facility that they offer the investor and traderfor hedging portfolios in Index shares and Average trading, not to mentionopportunities for speculating.Briefly, hedging is the practice of being neutral in the market. That is,one might be long the DIAMONDS and buy a put option on the DJIA at theChicago Board of Trade, meaning that advances in the DJIA would result inprofits in the DIAMONDS, and a loss of premium in the put. Conversely, adecline in the Dow would result in profits in the put and losses in theDIAMONDS. As this area is not the province of this book, this is a highlysimplified description of a hedge. Nevertheless, the reader should see andunderstand that hedging can be a very important strategy. Hedging can takethe place of liquidation of a portfolio when the analyst recognizes a changeof trend or unstable conditions but does not wish to incur taxes, or wishesto defer them.
An Outline of Instruments Availablefor Trading and InvestingIt would be herculean to attempt to list the entire panoply of averages,indexes, futures and options available for trading — herculean due to thefact that new trading instruments are constantly in creation, and due to thefact that, now operating at Internet speed, we may expect the rate of changeto accelerate. In addition to those listed above, there are WEBS (World EquityBenchmarks — meaning that exposure to world markets may be arranged).
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In all, approximately 30 or more Index Share units or instruments wereavailable for trading on the AMEX at the turn of the century, in addition toDIAMONDS and SPDRs. Similar instruments exist on the Philadelphia andin Chicago, and others are being created daily. In order to reduce the confusion, the general investor will probably find the major indexes of the mostimportance. The more instruments one deals with the more complicatedbecome the strategy and tactics. Therefore, the Dow, the S&P 500, and theNASDAQ composite (DIA, SPY, QQQQ) are probably sufficient for the purposes of the gentleman (or gentlelady) investor. The Mid-Caps, the Nikkei,etc., etc., begin to come into play when the trader begins to try to catch sectorrotation, fads, short-term cycles, etc.
The Importance of These Instruments: Diversification,Dampened Risks, Tax, and, Most Important,Technical RegularityIt would be difficult to underestimate the importance of these new tradinginstruments. First of all, they afford the private investor what was previouslyreserved for the large capital trader — the ultimate in market diversification.The S&P 500 represents stocks comprising 69% of the value of stocks on theNYSE. Buying it is literally buying the American economy. The 30 DowIndustrial stocks represent the most important symbol in the American economy — and perhaps in the world. Investors are well advised to pay attentionto both averages if they would fare well in the markets. Note the plural:markets. These two averages now have the influence or clout that once theDow alone had to express the state of the markets and stocks in general.Buying the SPDR or DIAMOND then represents the immediate acquisition of a diversified portfolio. And buying the NASDAQ or QQQQ givesone immediate exposure to the more speculative and volatile sector of theAmerican economy. Given the long-term bullish bias of the averages andthe American economy, it is difficult to argue with this as both strategy andtactics for the long-term investor. This does not mean that positions shouldbe taken blindly without thought, or that positions should not be monitored.On the contrary, recall if you will the record of the Dow Theory. Even forthe long-term investor, Bear Markets should not be allowed to destroy liquidity and equity value. These questions are discussed at greater length inChapter 18.1.While we believe these instruments are good vehicles, it is wise toremember Magee’s frequent admonition (less important now than whenspoken) that it is a market of stocks, not a stock market. Meaning that whenthe tide is flowing down with the Dow and S&P, prudence and care mustbe used in taking long positions in stocks which are in doubt as to direction.And it is worth noting that investments in these instruments will be lessprofitable than an astutely chosen individual stock. For example, Qualcommappreciated approximately 240% (temporarily) in 1999–2000 compared to
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about 24% in the S&P over the same period. Those who bought Qualcommat its top and sold it at the bottom of its reaction lost about 75% or about$148 a share. Traders in Qualcomm tended to obsess and pay hyperattentionto the stock, while investors in the SPDRs reviewed it once a week or less,or told their computers or their brokers to give them a call if it broke thetrendline, or entered stops. Then they slept at night and had eupeptic digestion.Other advantages accrue to the trading of the SPDRs. Ownership of afund can result in tax liabilities as managers adjust portfolios to reflectchanging membership in the fund or withdrawals in capital by irate stockholders. Since Index Shares last into the 22nd century the long-term investorhas no need to realize gains and pay taxes. Bear markets may be dealt withby hedging with other instruments — futures, options, or proxy baskets ofstock, or individual stocks, and accepting the tax consequences of thesetrades.John Magee aptly observed before the direct trading of the averages waspossible that the Dow–Jones Industrials were very regular and dependablefrom the technical point of view. This observation is annotated at some lengthin comments on Dow Theory in Chapters 5.1 and 36. So the investor in theIndex Shares may have a smoother time technically than a trader of anindividual stock.
SummaryThe long-term investor and mid-term speculator attempt to capture longsecular (as well as cyclical) trends in the markets. They shun frequent tradingand capital-eroding transactions.They recognize that risk fluctuates with time and trend and they knowthat frequent turnover benefits mainly the broker. The strategy of thelong-term investor may be to match the market by using funds or SPDRs orbaskets. But he does not like to participate in bear trends. He hedges orliquidates his positions on major trend shifts. And in fact he may even shortthe indices if his analysis indicates major bear markets.If he desires to outperform the market (which will happen automaticallyif he follows the methods of this work), he finds some individual speculativestocks to trade in addition to his foundation portfolio. Depending on his risktolerance, he may always be somewhat hedged. When long the indices, hefinds some stocks in downtrends to short. When he is short the indices hefinds some strong stocks to hold long. There is no excuse for a moderatelyskilled and reasonably capitalized investor to lose money over the long termin the market.
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1500 SPX LAST-Monthly1400Created with TradeStation www.TradeStation.com1300120011001000900800700600500
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FIGURE 203.1. S&P. Here the benefits of relaxed long-term investing may be seen,buttressed, of course, by the longest and handsomest Bull Market in American historyin the Clinton–Gore years. At the end of this record, the effects of public enthusiasm(or as Chairman Greenspan of the Fed said, “irrational exuberance” vide tulipomania)can be seen in the wide undisciplined swings (best seen in Figure 203.2). Dotted linerepresents 150-day (approximately) Moving Average.
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SPY LAST-DailyCreated with TradeStation www.TardeStation.com
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144.999139.999134.999129.999124.999119.999114.999109.999104.99999.99994.999240000020000001600000120000080000004000000
5/19986/19987/19988/19989/1998 10/1998 11/1998 12/1998 99 2/19993/19994/1999 5/1999 6/1999 7/1999 8/1999 9/1999 10/1999 11/1999 12/1999 00
FIGURE 203.2. SPDR. For illustration, here is a chart of the AMEX Index Share, theSPYDR, or share based on the S&P 500. The costs and benefits of this instrument asan investment vehicle are explored in the text of Chapter 20.1. After the, what shallwe call it, crash?, of 1998 (the Asian Economic Flu crash), the fan lines tell a story,as does the last phase of the chart where the market whips in what appears aBroadening Top. EN9: Note that this Broadening Top was identified in 1999–2000, beforethe crash. See Figure 203.3.
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$INX - Weekly USA
1464 .00
B
1356.00
C
1255.00
1193.031100 .001156.851077.90
1076.00
996.00
D
938.57
922.00
854.00
1
3
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2003
20042005Created with TradeStation
21998
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FIGURE 203.3. The S&P 500 in all its glory and tragedy. An especially good portraitby Holbein, the younger. The Broadening Top pointed out in Figure 203.2 in 2000foretold the decline of the S&P to below 790 – not quite 50% but close enough tocatch the eye. Especially fine lessons here, besides the Broadening Top lesson. All ofthem screaming for action. The broken trendline at A, the broken trendline at B, thebroken “neckline” or horizontal line at C. Notice the close correspondence of thebreak at B and C. The next lesson is not to buy down trends until a clear bottom ismade in a major bear market. And clearly no bottom is made until the Kilroy Bottomat 1 – 2 – 3. Even then the least risky trade for the long term investor is when theKilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time.
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chapter twenty-one
Selection of Stocks to ChartThe trader who operates on the “fundamental” basis, making his commitments on his analysis of earnings, dividends, corporate management, prospects for the industry, etc., will usually (of necessity) confine himself to afew stocks or a single group of stocks in the same field.To the contrary, the technical trader, using daily charts, should have alarge portfolio of issues. Since he is primarily interested in the technical chartpatterns, he will not try to make an exhaustive study of the background ofeach company. In fact, the characteristics of the stocks themselves, as theyact in the market, are more important to him than what these companiesmake or what they are earning. This is because, although the stocks representownership in the company, the capital structure, “leverage,” and floatingsupply of the stock may (and very often does) mean fluctuations in the stockprice that are not directly in proportion to changes in the affairs of thebusiness.You will also find many cases where the stock of a well-regarded, wellmanaged, long-established concern, whose latest earnings report showsincreased profits, and with a long record of dividends paid, would not be agood buy at the market price. It may be overpriced and due for a seriousdepreciation. You will find other cases where a stock, which apparentlyrepresents no great promise of either earnings or dividends, suddenly startsa series of spectacular moves upward, and is indicated clearly as a buy. Ofcourse, the answer, in each case, is that the records available apply to thepast, not the future; and very often, chart action will indicate the insideknowledge of those who are in possession of facts the public has not yetreceived.To change our example to something more easily visualized: there aretwo houses for sale. One is a fine, well-built, modern home in an attractivepart of town at, say, $200,000 — and the other property, a somewhat shabbysix-family tenement in a less attractive section, at the same price of $200,000.There is no question which is the “better” house. But in a case like this, themarket for well-built single homes at this price may be poor, while thedemand for apartments may be good. The six-family house may be the betterinvestment.And then again, we have the question of what is conservative and whatis highly speculative. It is not always enough to judge from the type ofbusiness of the company itself. You may have a highly conservative concern,391
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carrying on a stable volume of business, with a long record of successfuloperation. And yet, if there are bonds, debentures, preferred stocks, andother senior obligations, the common stock may be subject to wide fluctuations. Also, if the issue is small, or if a large part of it is closely held, youwill have a “leverage” effect which results in wide swings in the stock.Therefore, in choosing your stock to chart, you will want to consider thekind of stock and its character and habits in the market, rather than thebusiness of the concern it represents. We will come back to this point andshow you how you can shape up a list that will give you the kind of stocksyou want for trading.Meanwhile, the question “How Many Charts?” has been left hanging.One answer to this is that the more stocks you chart, the more good opportunities you will have. Many stocks, even of active issues, will go throughlong periods when the chart tells nothing — when, indeed, there is nothingmuch to tell. In a period of stability, the chart simply indicates that it is aperiod of stability, and the only possible trading activity would be purchasesand sales at the Bottoms and Tops of its undulations. The charts are moreinformative when a change in the situation occurs; they will signal a changeof trend as soon as (and usually before) the news of the changed conditionshas come out. If you have enough charts, you will always have some stocksmaking decisive and clear-cut moves either up or down, at any time.You should, therefore, keep as many charts as you can. Don’t bite offmore than you can chew, however. A man with only 15 minutes to half anhour a day for this work might have to confine himself to 20 or 30 charts. Itwould be much better if he could have 100. And if he is in a position to givea major part of his time to the work, he could very well run as many as300 charts. A most important word of caution is indicated here. Don’t startanything you can’t finish. It is better to have too few at the beginning thantoo many. Then, if you find that you can add others, you will be in a betterposition, from your experience, to pick out the ones you want to include.But if you start with too many charts, begin to run behind with your analyses,you will not be getting the best use from your portfolio, and it would bebetter to cut down at once. EN: Magee’s admonitions are still in effect for themanual chartist. The modern computer-equipped investor has a different problem.He can chart every issue in the market every day. The question becomes, how manycan he effectively study and analyze? There is even a computer answer to thisquestion. Namely, the cybertrader can program the computer to report stocks on anexception basis. For example, “Computer, show me all the stocks which are abovetheir 50-day moving average and which have unusual volume.”From what we have already been over, you know that it is possible tochart anything that is sold in identical units in a free competitive market.This includes, of course, all kinds of commodities, bonds, debentures, whenissued contracts, etc., as well as stocks. You may have some special interestwhich will call for charting something outside the field of stocks. Well andgood.
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In general, however, you will want to chart active, listed stocks of wellestablished corporations. There is no reason an unlisted stock cannot becharted, but ordinarily, the only figures you can obtain on it are the bid andoffer prices. On these stocks, you do not have a published statement of thevolume of sales each day or any record of prices at which sales actually tookplace, and those are essential to the charting of daily technical action. Therefore, you will usually be charting stocks which are listed on some exchange.This is also an advantage, since concerns listed on the larger exchanges arerequired to meet certain conditions, publish certain information, and complywith definite rules and practices. In this book, most of the examples havebeen taken from stocks listed on the New York Stock Exchange. There arethousands of issues traded on the NYSE, and these stocks represent everytype of security, from the most conservative to the most speculative, fromthe cheapest to the most expensive, and they include every principal typeof industry and business. However, there is no reason that stocks should notbe chosen from the American Stock Exchange, the NASDAQ, or from anyother exchange in this country, or for that matter, in some other country. Sofar as the chart action is concerned, the patterns and their meanings will be thesame. (Editor’s italics.)EN9: In general the stocks to watch, or chart, will tend to leap out of the haystackof stocks. For stock pickers Investors Business Daily is in the constant process ofsifting the markets for nuggets with its CANSLIM system. (Not a recommendationto use that system, only a recommendation to examine every tool that might be ofuse.) Stocks which appear suddenly on the most active lists of prophet.net andstockcharts.com might bear examination by the chart analyst. Optionable stockswhich suddenly show a radical change in implied volatility. Stocks which pop upwith suspicious volume spikes compared to average volume. And with Internet andsoftware packages one might construct a filter to be informed by the computer ofstocks breaking their 14, 44, 150, and 200 day moving averages. 14 because someprofessionals think the public thinks in this time frame; 44 because some think fundsthink in 44 day time frames. The others because everyone thinks they are important.
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chapter twenty-two
Selection of Stocks toChart — ContinuedIn choosing your stocks, you will probably look for the greatest diversity inthe kind of industry. Since you are not specializing in the detailed study ofa single group, you will try to get stocks from as many different groups aspossible. You will want to include mines and oils, rails and chemicals, liquorsand amusements, airlines, util