would liketo quickly review these for you.
The public is perhaps best reﬂected in an indicator of market activitycalled  “odd  lot  short  sales.”  This  index  simply  shows  the  percentage  oftransactions of fewer than 100 stocks that are being sold short. The think-ing is that an order for less than 100 shares is most likely an order from thepublic.  That’s  because  the  investor  placing  such  an  order  does  not  haveenough money to buy 100 shares where there’s usually a big commissionbreak.  This  should  reﬂect  public  money  (i.e.,  people  without  muchmoney)—in any event, the uninformed investor. We have records of odd lotshort sales dating all the way back to the 1920s. Looking at more recentdata  in  Figure  4.5,  we  see  they  have  a  very  good  record  of  being  heavyshort sellers right at market lows.
As an example, notice the odd lot short sales just before October 2000buy point. What we see is at that time 14 percent of the odd lotters’ totalactivity, longs and shorts, were on the short side. In other words, they be-came  aggressive  and  heavy  short  sellers  right  at  the  market  low,  exactlywhen they should have become buyers!
By the time January 2001 rolled around the short selling odd lottershad dipped down to about 4.5 percent, right at the market top! A study ofthe  recent  past  suggests  we  need  to  see  odd  lot  short  sales  get  above  10percent. That’s the time we should expect an important market low to beat hand.
It has not been in vogue by market analysts and technicians to monitorodd lot activity for quite some time now. I am of a different opinion. Per-
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ODD LOT SHORT SALES% OF TOTAL SALES
16%14%12%10%8%5%4%
OCT
JAN2001
APR
JUL
Figure 4.5 Odd Lot Short Sales
haps that’s because I have so ingrained in my work the study of these peo-ple—I have seen them do the wrong thing for so long. They do exactly theopposite of what we want to do. Plus, I don’t think markets always bottomthe exact same way. What I’m looking for is a preponderance of evidencethat the public is excessively bearish. That’s what you want to look for inthe spring of 2003 as well as the other buy points we anticipate out intothe future. If I notice just one of the sentiment indicators to be in the cor-rect zone, that’s enough for me to conﬁrm that a projected buying opportu-nity is indeed at hand.
ILL-ADVISED INVESTMENT ADVISERS
There are several ways of monitoring what the investment advisers are do-ing, and all need to be paid attention to, as these people have such a splen-did record of doing the wrong thing at the wrong time. Frequently they areworse than the public.
Investors  Intelligence,  an  advisory  service,  monitors  the  number  ofnewsletters and investment advisers that are bullish or bearish. (See Figure4.6.) Their records show that when 55 percent or more of these advisersbecome bullish the market is most likely to go down. Investors Intelligencebreaks its indicators down into a study of advisers who are bullish and ad-visers who are bearish.
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Figure 4.6 Ratio of Bulls to BearsSource: Investors Intelligence.
When  35  percent  or  fewer  of  these  advisers  are  bullish,  the  majority
are then bearish, and markets are most likely to go up.
Striking evidence of this comes from the market high seen in January2001. At that time over 60 percent of investment advisers were bullish inmid-February  just  before  the  Dow  Jones  Industrial  Average  took  a  rav-aging decline to the downside. Unfortunately, it has been some time sinceinvestment advisers were overly bearish. I suspect, however, as stock mar-ket prices continue to slide into our projected buy zone or just go ﬂat, wewill once again see the Investors Intelligence measure of investment advis-ers dip below 35 percent bullish.
This indicator can be viewed in Investor’s Business Daily; it usually ap-pears in the lower left-hand corner of the page showing the charts of mar-ket activity. This currently would be the last page of the ﬁrst section of thenewspaper. This value is reported on a weekly basis for your further under-standing of market activity.
We can use this same approach for measuring individual stock activity
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HOW TO USE THE BOND MARKET TO PREDICT THE STOCK MARKET
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as well. In Chapter 9 I will show you my sentiment index, which is a mea-sure of investor attitude toward individual issues as opposed to the entirestock market. Again you’ll see the same thing: When the index is showingexcessive investment advisory bullishness, an individual stock is most likelyto  go  down.  When  the  majority  of  investment  advisers’  attitudes  are  re-ﬂected in excessive pessimism, an individual stock goes up the vast major-ity of the time. Not all will every time, but it’s a better bet and a darn nearideal bet if the stock you are buying is fundamentally sound. There’s lotsmore coming on selection in just a few moments.
HOW TO USE THE BOND MARKET TO PREDICT THE STOCK MARKET
A long-term study of the relationship between the bond market—that is,interest rates—and the stock market forces the serious student to reach oneconclusion: Higher interest rates—that is, lower bond prices—are bearishfor stocks. There is a very good reason for this: When interest rates are in-creased, corporations must pay off their friendly bankers before they canpay off shareholders. At times such as this, dividends may be cut and earn-ings drop for several reasons.
If bankers have to be paid a greater amount than when interest rateswere low, then there’s no money left over for research and development orprimary expansion of the business. As if that is not enough, the problem ismagniﬁed  by  the  fact  the  customers  of  the  corporation  are  in  this  samepredicament. They now have less disposable income; thus they do what isonly natural—they cut back on orders. Sales of products and services de-cline because the net effect of higher interest rates is to take money out ofproductive circulation in the form of interest payments.
Of  course,  this  has  a  snowballing  effect.  Fear  then  sets  in,  causing
more cutbacks and leading investors to cash out of the market.
When a company can’t pay dividends or expand through research anddevelopment and more production, the stock of a company loses its upsidemomentum; earnings decline and shortly thereafter so does the price of thestock in question.
The  other  side  of  this  coin  is  that  when  interest  rates  are  loweredcompanies  have  more  money  to  advance  the  cause  of  their  business;credit is easier so they can ﬁnance further expansions to reach the goals
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they  have  on  their  agendas.  An  increase  in  money  supply  is  about the  same  as  a  decrease  in  interest  rates.  Both  are  positive  phenomena to  the  economy  and  the  ability  of  a  company  to  grow  and  have  moreprosperity.
Well, that’s the theory, and it is clearly borne out by a study of interestrates from the mid-1850s all the way into the year 2001. The problem isputting this theory into practical application. There are some very sophisti-cated mathematical models that seek to exploit this relationship betweenstocks and bonds by developing buy and sell signals. For the most part themath is not only complex but also difﬁcult to run, and some of the datasources are not easy for the average investor to come by. Some analysts aremore concerned about municipal bonds or Treasury bills or 10-year notesand  the  like,  others  about  the  electric  utility  index  on  the  PhiladelphiaStock Exchange! Really!
An additional problem presents itself in that sometimes bonds bottomshortly before the stock market bottoms while at other times the lead timemay be months instead of weeks. Some analysts, notably Gil Haller (TheHaller Theory, 1968), one of the most genuine people I have ever met inthis business, looked at the amount of change in Treasury bills on a per-centage basis to predict stock market rallies. His thesis was that a full per-centage point decrease in interest rates was enough to turn a down stockmarket into an up market.
I can simplify much of this approach to forecasting stock bottoms in amechanical fashion by using an index created by Welles Wilder and Gre-sham  Northcott.  The  index  was  ﬁrst  presented  to  investors  in  1978  in  abook  by  Wilder  entitled  New  Concepts  in  Technical  Trading.  There  aremany good indicators in this book. One of my favorites is known as thevolatility stop or volatility system.
This  is  a  trend-following  mechanism  that  works  by  taking  the  range(each day’s high minus the low) for the past seven days and then multiply-ing this average range by a factor usually in the 2.0 to 3.0 value. This is anamount  of  volatility,  which  is  then  subtracted  from  the  highest  closingprice in the uptrend.
What  is  created  is  a  ﬁlter  band  above  and  below  the  current  price.Should the stock price close below this point the assumption is the trendis down.
When prices have been below this volatility ﬁlter and close above thevolatility ﬁlter the trend is then considered to be up. This can be used ondaily or weekly charts.
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MARKET TIMING USING BONDS TO BUY AND SELL STOCKS
It is my observation that this volatility index, when applied to the bondmarket,  gives  us  an  indication  that  interest  rates  have  bottomed.  My assumption  is  that  if  the  trend  in  interest  rates  has  bottomed—that is, the bond market is beginning to rally—then stocks should shortly fol-low thereafter.
Figure 4.7 shows the bond market on a weekly basis with the volatilitystop. Our trading rule would be to look for a point to buy stocks when theweekly close of the bond market is above the volatility stop. This shouldtake place during a time stocks have been declining or a bear market hasbeen in existence. We are using the trend of bonds to buy stocks. When theweekly  close  of  bonds  is  greater  than  the  volatility  stop  we’ll  mark  off  apoint to buy stocks.
The next few ﬁgures show the results of this system from 1982 forward
Figure 4.7 Volatility Stop, Bonds 1982–1983
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so you can see for yourself. Please understand it is used only for entering themarket—this is not a sell short indicator.
On  Friday,  August  13,  1982,  bonds  closed  above  the  volatility  stop,suggesting  an  up  move  might  begin  in  stock  prices.  The  question  was,would it really begin? Well, the rest is history. As you can see that was thesame week stocks made the bottom that began the gargantuan bull marketthat has now been billed as the largest in the history of mankind.
As shown in Figure 4.8, the bear began to walk on Wall Street in 1984as stock prices declined into August of that year. Investors were worried.Was a new bear market beginning? Was this the start of a continuing mar-ket slide?
Those questions were argued from the boardrooms and barrooms ofWall Street to the bedrooms of Main Street. The argument could have beensettled by simply looking at what the bond market had been doing as thestock market continued declining. In the summer of 1984 bonds began torally; then in the week ending August 3 bonds closed above the volatility
Figure 4.8 Volatility Stop, Bonds 1984–1985
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stop, which was one week before the ultimate low in the bear market! Ourvolatility  stop  rule  heralded  the  resumption  of  a  major  bull  market.  Notbad for such a simple index. Would it work next time around?
By  late  1986  it  was  apparent  stocks  could  be  in  trouble  (see  Figure4.9). Although they had not moved substantially to the downside, they hadstagnated,  leading  investors  to  question  what  was  going  on.  Was  this  atime to buy or a time to sell?
Turning our attention to the bond market instead of newspaper head-lines, we would have noticed that in the week ending December 5, 1986,bonds once more closed above the volatility stop, suggesting it was time tobuy—a time for optimism, not pessimism. That buy signal gave birth toan  immediate  and  substantial  up  move  taking  stocks  to  a  new  all-timehigh in 1987.
Then, along came the crash of that year complete with the largest one-day market decline investors had ever seen in any market in any country.
Figure 4.9 Volatility Stop, Bonds 1986–1987
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(See Figure 4.10.) It was a true panic; brokerage ﬁrms went bust, investorswere  wiped  out,  and  mutual  funds  that  had  been  worth  $3  billion  weresuddenly  worth  $2  billion—all  in  the  blink  of  an  eye.  Blood  had  beenspilled on Wall Street in that fateful October, and investors panicked. Notknowing what to do they sold and sold more, causing massive liquidationand breaks in the prices of individual stocks. It was a far-reaching disaster.During the week of the crash I was on a safari in Africa. By the timethe  news  of  the  600-point  down  day  reached  where  I  was  staying,  theMount Kenya Safari Club, the panic had reached proportions we had onlyread about in the historic crash of 1929. Within hours, over two-thirds ofthe people staying at this luxurious resort packed their bags, changed theirﬂight schedules, and were headed home for damage control. Women werespotted crying in the dining room, with their ashen-faced men. It was not apretty sight, but then losing money never is.
Had those investors simply taken the time to study the bond marketthey would have seen something bullish beyond belief: Black Friday—that
Figure 4.10 Volatility Stop, Bonds 1988–1989
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is, Friday October 23, 1987—saw the bond market once more close abovethe volatility stop. The crash was over almost as quickly as it began. Thecrash of 1987 consolidated, and the market regained its control and breathas a new bull market began. What actually began the new bull market willbe argued for years, but one thing is certain: Our bond market buy signalwas there at the precise low! Investors knowing this could have bought allthe stocks they wanted and made a killing while others were being killed.
Things went well for stockholders until 1990, which is just about thetime we would expect the market decline based on our decennial pattern.After  all,  what  are  zero  years  for?  They  are  for  declines.  That’s  nice  toknow, but it’s even nicer to know when to buy. Using our bond market buysignal for the stock market, an investor would have noticed bonds had beenbelow the volatility stop until the week ending November 9, 1990, a scantfour weeks after the stock market had bottomed and very close to the lowitself (see Figure 4.11). Stock prices had not yet begun to advance. Investors
Figure 4.11 Volatility Stop, Bonds 1990–1992
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who purchased at these levels were quickly rewarded as yet one more up legcame into play. Starting to see how all this works?
All was well and good until 1994, when stocks began to stagnate, os-cillating back and forth, up and down—seemingly directionless (see Figure4.12).  No  longer  was  it  a  one-way  path  to  instant  stock  market  wealth.The bear was again on the prowl. Investors were frightened and wonderingwhether  another  crash  like  that  of  1987  was  ahead  of  them.  Would  thismiserable “go noplace” market get healthy, or would it hit the skids?
On December 23, 1994, stocks had rallied for a brief three weeks, butthere had been many similar rallies such as this in the past that had onlyled to further market declines. This time something was different, though:The  weekly  closing  price  of  Treasury  bonds  had  exceeded  the  volatilitystop. A buy signal was given and investors were told interest rates wouldmost likely go lower and stock prices higher.
It is interesting to note that this particular buy signal, which came rightat the start of a year ending with a ﬁve, produced the most rapid up move-
Figure 4.12 Volatility Stop, Bonds 1993–1996
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ment of the 1982–1999 bull market. It was clearly evidenced as a bull mar-ket buy point by our bond market trend change signal.
The “tech wreck” that came to the marketplace during the middle of2000 saw value cut beyond anyone’s expectation. Stocks that been sellingfor  over  $100  a  share  went  to  $80,  then  $50,  then  $30,  and  then  belowanybody’s wildest predictions, dropping to $10 and in some instances $5 ashare. While 1987 was a big crash, it was over within one month. Compa-nies came back for better and brighter days. But that was not the case inthe crash of 2000. Not only did the stocks not come back, but in my judg-ment (as you’ll read when I discuss individual stocks) most of these neverwill come back, or at least not for the next 6 to 12 years.
As  you  may  have  noticed,  from  1982  all  the  way  to  2001,  each  andevery signiﬁcant buy point was preceded or indicated by our simple bondmarket/volatility stop penetration. Let me remind you there’s no magic tothis  approach.  The  precise  value  of  the  volatility  stop  is  not  what  makesthis work. What makes this work is the fact that we have an objective wayof determining when the bond market has most likely hit bottom. That’simportant because bottoms in the bond market mean you are at, or verynear, bottoms in the stock market.
The relationship between stocks and bonds is a fundamental consider-ation  to  the  marketplace.  It  is  not  some  mumbo-jumbo  technical  linedrawn from point to point, some unproven charting technique or junk sci-ence  approach  to  forecasting  the  markets.  We  are  talking  about  whatmoves the economy: interest rates. They move the economy. Charts don’tmove  the  economy;  conditions  move  the  economy,  and  conditions  movethe  stock  market.  I  know  of  no  simple  and  better  way  of  measuring  thisthan the volatility index approach.
The ﬁnal chart, Figure 4.13, shows the results of this same simple indi-cator during the tough sledding of 1999–2002. There were only two buysignals,  the  ﬁrst  on  August  24,  2001,  a  scant  four  weeks  from  the  year’slow. In 2002 the buy signal came in the week ending June 21, ﬁve weeksbefore the low of the year.
LOOKING AHEAD
There will be bear markets and bull markets in the coming good years. Itis  our  objective  to  determine  when  the  tide  has  turned,  when  the  buypoints are at hand, when the slides are over. We now have two excellent
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Figure 4.13 Volatility Stop, Bonds 1999–2002
fundamental indicators to help us. One is the value or yield on the DowJones Industrial Average, the other the trend direction of interest rates andthe bond market. We can couple this with investor sentiment, using oddlot short sales and investment advisers along with mutual fund activity forour major timing tools.
If I had to choose just one of these tools it would be the bond marketbecause it is precise, readily available, and simple to follow. Seldom in his-tory have bonds rallied without an ensuing up leg in stock prices.
There  is  an  old  adage  on  Wall  Street  that  says,  “The  trend  is  yourfriend,” and that is true, “at least until the end.” The problem is identify-ing when the beginning and end occur. Now you know the conditions seenat the end of most bear market slides. Accordingly, it is my wish that yougo forth and prosper, keeping your eyes peeled to these invaluable indica-tors. I expect they will call buy points in 2003 and 2005 and speak ratherloudly  once  more  when  the  four-year  phenomenon  gives  us  yet  anotherbuying opportunity in 2006. Indeed, whenever stocks have been in a bear
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GOING BUGGY OVER GOLD: BREAKING THE GOLDEN RULE
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market, pay attention to the bond market. A signiﬁcant change in directionthere is the key you are looking for.
GOING BUGGY OVER GOLD: BREAKING THE GOLDEN RULE
The  golden  rule  of  life  is  not  the  same  as  the  golden  rule  of  the  market-place. For years investors, advisers, and ﬁnancial authors have proclaimeda  relationship  between  gold  and  the  stock  market.  One  of  my  favoritequestions  to  ask  at  trading  seminars  is  simply  this:  “If  the  stock  marketcrashes, what will happen to the price of gold?”
The  investor  response  is  unanimous.  “Gold  will  rally!”  the  crowd
roars back.
“Oh,” I ask, “is that so? But what about the crash of 2000? What didgold  do  then?”  I  see  furtive  glances  around  the  room.  I’ve  got  themtrapped. Chart books open, mouths drop, bodies squirm . . . then the real-ization sets in. Gold declined in the crash of 2000. (See Figure 4.14.)
Figure 4.14 Nasdaq Crash versus Gold, 2000
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I then ask about the crash of 1987. What did gold do then? As you cansee from Figure 4.15, gold went sideways during the crash of 1987. It iswith irony that I point out that the largest rally in gold of that year cameafter  the  crash  was  over,  in  December  1987,  long  after  the  bottom  hadbeen put in.
The  next  step  is  to  take  the  seminar  attendees  back  to  the  crash  of1929, so they can see for themselves what happened back then. They ex-pect to see a substantial rally in the price of gold. But they don’t see it, be-cause  it  didn’t  happen.  Gold  has  never  had  a  substantial  rally  during  astock market crash!
Isn’t that interesting? It’s been an old wives’ tale, a tall tale at that, this
supposed relationship between gold and the stock market.
If you are a gold bug, be a gold bug for the right reason. Depressionsdon’t make gold go higher. There are only two considerations that causegold to rally, in my book: The ﬁrst is inﬂation; the second is what the com-mercial users and producers of gold are doing. Seldom has a major market
Figure 4.15 Crash of 1987 versus Gold
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rally  in  gold  taken  place  without  the  commercial  interests  ﬁrst  becomingheavy buyers of this precious metal.
Even a cursory glance at charts or study of history shows that gold ral-lies the most during times of inﬂation, not times of depression. Stock mar-ket  crashes  are  depressing  not  only  to  investors  but  also  to  the  entireeconomy. Even to gold bugs. Indeed, there’s a time to sow and a time toreap. When it comes to the gold market, it, too, has its natural cycle, whichis a product of commercial demand and inﬂationary pressures. That’s whatto look for here. Now you know my golden rule for the gold market. It isnot that he who has the gold gets to rule; it is that he who has the smartsgets to buy gold at the right time.
Figure  4.16  shows  the  tremendous  impact  the  commercials  have  onthis market. What you are seeing here is an index that measures the per-centage  of  net  longs  the  commercials  have  positioned  themselves  with.This is an actual measure of what they’re doing with their money. Most
Figure 4.16 Commercials versus Gold
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often, when they become aggressively long—that is, they have a high read-ing of net long positions—the gold market rallies. Note their large sellingin the fall of 1999 and subsequent crash, or their buying in early 2001 andlater a rally.
By the same token, when they are aggressively short or have not beendoing much buying (that’s indicated by low reading in the index), gold hasshown a distinct propensity to decline.
If the gold bug camp would pay attention to what the commercials aredoing they themselves would have a much better idea of when to get in andout  of  this  market.  It  is  unfathomable  for  me  that  anyone  would  thinkthere could ever be a signiﬁcant market rally in gold without the commer-cials ﬁrst assuming heavy long positions. So, if gold is your thing, followthe commercials; don’t follow the pipe dreams or any emotional reactionsof would-be market gurus. All they have invested are postage stamps andwords, while the commercials, who are in the business of using or produc-ing the precious metal, have plunked down millions of dollars.
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THE NEXT MOVE UP: WHY ITWILL BE SO SPECTACULAR
It is better to learn to say no than to learn Latin.
Stock markets do many different things for many different reasons, but be-hind  every  market  move  there’s  a  common  element:  human  emotions,which are motivated by greed and fear.
I think it is important for us to look at the current investment climateto see whether it can help us ascertain how the future might unfold. If wecan get even a glimpse, be it ever so small, of what will next drive stockprices up, and down, we will have in part beaten the game—in part madeourselves smarter than and placed ourselves ahead of the rest of the invest-ment crowd.
I  have  given  this  a  good  deal  of  thought,  studied  markets  from  thepast, and talked with fund managers and investment experts whom I