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Picking The Bottom

Thursday, March 15, 2007 | Chris Rowe

I got more positive feedback than ever before on last Thursday's article ("These Simple Market Indicators Clarify this Market ".)  Now I'm getting even more kudos from people who acted based on my simple analysis of the probability of the intermediate-term direction of the market (since the market turned back to the downside.)

This I find somewhat troubling.  You see, most investors said that I was right about what I said last week because they see the market moving lower again.  But the truth is that even if the market moved higher, I would still have been right. 

Decision Vs. Outcome:  In the article, I said that the name of the game is to be right 7 out of 10 times.  The stock market isn't about perfection. It's a game of probability.  So all that you want to do is be right more than you are wrong about your forecasts. The most successful investors only take bets that they know are in their favor.  If you can't confidently say that in nearly every move that you make in the stock market, you know that the probabilities are in your favor, then you need to read more and trade less.

This bring me to the first question that I received from a reader...

QUESTION:

You gave us these great indicators, but then near the end you say, "We have to take all of what we can gather, and then go with our gut."  I don't get it.  Why go with your gut when you have these great indicators?

ANSWER:

My decision-making process has two parts. 

The first is "forecasting" which is done by screening my potential positions by using several indicators. The second is when I gather all of my facts and then pass the analysis to the place where the final decision is made - my gut.  Here's how and why it works...

Screening:  In last Thursday's article I gave you a few of the most common and simple indicators, and there are obviously so many more out there.  But the truth is that not one of the indicators that I mentioned is hard to learn and understand if you only spend a little bit of time learning about them one by one.  It's quite easy as long as you don't move on to the next one until you have a full understanding of the one that you are studying.  If you can't decide which to study first, then just pick the one that intrigues you the most so that your interest and your focus stay at high levels.

Indicators:  Last week, the indicators that I wrote about were
the breadth of the market, the chart pattern, the price volume relationship, the moving averages, and so on.  There are no "perfect" stock market indicators.  The reason that I showed you several different indicators last week was that it's always important to use indicators that differ from each other (instead of using similar indicators.)  You will increase your odds of success each time you apply a different indicator to your analysis that confirms the other indicator's signal (bullish, bearish or neutral.)

The fact of the matter is that stock market indicators are only slightly useful if not used in conjunction with one another.  You probably only have a 50-60-70% rate of accuracy with any one indicator alone, but by only entering positions where at least four or five indicators are in agreement, you may increase your rate of accuracy to 70-85%.  And if you're right 85% of the time, and if you understand your own emotions enough to manage losses properly, then you can be a top notch trader. 

The only thing that stands between most individual investors and successful trading is intimidation of learning about stock analysis and actually spending some time to learn.  But take it from me, you don't have to be a rocket scientist.  Just stick to the rules and control your emotions, which means that you understand that the outcome of your trade has zero to do with whether or not you took the right action.  It's all about increasing your odds of success before entering the trade.  Nothing that happens after you hit the "submit transaction" button has to do with whether you are right or wrong.

If you flip a coin 10 times, and it lands on tails every time, that doesn't change the fact that there was a 50% chance of either outcome, and it doesn't change the odds of the next coin toss. 

In that same vein, if you know how to control your emotions, and you know that if you increase your odds of success to the highest level that you possibly can, then you don't even consider the outcome of the trade. 

You also have to admit when you make a mistake, and that mistake is almost always made before the trade was even opened.  (Sometimes you make the mistake when you exit the trade by exiting at the wrong time, but that also relates to something that should have happened before you even entered the trade.  This is because you should have a plan on how or when to exit the trade before even going into something based on the different possible scenarios of what may happen once you are in the position.

The reason that I leave it up to my gut in the end relates to everything that I just wrote.  Your gut won't always be right, but you have to listen to it because it will tell you if you are confident.  You have to listen to your gut, and if your gut feels good enough to make the trade, then do it.  I mean that if you understand the rules well enough, then you will feel confident with each move that you make. 

If you play with a rule-book that is right 7 out of 10 times, then you are making the correct decision 10 out of 10 times, even though you will only be successful 7 out of those 10 times.


QUESTION:

As usual, Chris, your article was very educational. In all your articles, when you speak about the extra money that could be generated from options (from a seller's perspective,) there is one thing I'm not sure I understand. When we write/sell options, are we sure to sell them all?  How long could it take to sell the options in question?  That could maybe be a subject or part of a future article.

ANSWER:

You will be able to sell any option as long as it isn't so far "out of the money" that the option has no value (has no bid.)  But just like stocks traded on the New York Stock Exchange, options (which are also exchange traded) have prices that are maintained by a specialist.  The difference is that when you sell an option, you are essentially creating a contract and selling it.  You are making a commitment to do something, and once someone pays you for that commitment, you are obligated to fulfill that obligation.  So unlike stocks where there is a limited share amount to go around (shares outstanding,) an option is created when you decide to sell it as an opening transaction in order to receive a payment.

The specialist's job is make sure that there is always a bid and an asking price for an option (unless it is too far out of the money.)  So the answer is yes, as long as the option doesn't have a bid of zero, which would be based on the value of the stock and the time left before expiration, then you will be able to sell it quickly.  But just as you are pretty much guaranteed to be able to sell a stock, there is the possibility of the security going to zero, in which case you can't sell it.


QUESTION:

How do I adjust 401k mutual funds using this information?  Should I jump into income funds if things start to decline?  Thanks.  Gerald J.

ANSWER:

I personally wouldn't trade my 401k mutual funds.  You are probably better off just leaving them for the long haul growth.  One thing that you may consider, and this is if you have a self-directed 401k, is relative strength investing. 

Relative Strength Investing: This should only be done with no-load funds that charge nothing for the purchase or redemption fee for holding periods of at least 90 days.  What you want to do every 91 days or so is gather mutual fund data from Barron's Dow Jones Business and Financial Weekly or somewhere else that you may prefer.  You may consider looking at funds that have volatility no greater than that of the S&P500.  Try to gather data of at least a few hundred Mutual Funds each quarter and then isolate the top 10 percent based on last quarter's performance. 

Very Important: What you want to do is to diversify these mutual funds, so you may consider being invested in at least three mutual funds.  Diversification significantly reduces risk, but you don't have to go crazy with over-diversifying.

No matter how many mutual funds you decide to own each quarter, you should choose from the top 5th-10th percentile in terms of last quarter's performance.  I know that this may go against conventional thinking ("Past performance is no guarantee of future results,") but several studies show that by re-balancing your portfolio regularly to own the top performers of the last time period (monthly or quarterly,) you increase the probability of having a significantly higher return over time (approximately 13.5%-14% vs. the S&P500's 10%-11%, depending on the time period.)

This makes more sense to me than jumping into income funds when the stock market looks weak because you are essentially trying to time the market in that case.  You don't want to do that, as nobody in history has consistantly timed the direction of the market.  It's a sucker's bet. 

With relative strength investing, you are investing in a proven strategy that outperforms the general markets.  So if the market declines by 20%, your portfolio may only decline 10-15% and so on.


QUESTION:

It seems that the Institutions lead the market, which makes sense.  How does the lagging small investor endeavour to even stay close to them?  When you explain the charts so well, it looks as if they are all moving in unison and know something we don't; maybe they do. There's a lot of momentum on those charts; has the horse stopped and the cart (us) still moving? Thanks for your insight.

ANSWER:

The short answer is to sign up for one of our products.  LOL!  The answer is that you have to keep things in perspective.  I know that you will think that I'm stating the obvious here, but sometimes that's necessary...  Institutions don't always get some magical inside information or insight.  It isn't that they know that the market is about to tank and get out at the top.  The point is that the institutions are the market movement. 

You can stay ahead by taking two simple steps:

Step 1) Accept that you will almost never call a top or a bottom.  The institutions will tell you when the top or bottom is here.  How will they tell you?  You'll see what happens to the stock market based on their actions. 

Step 2) Just follow their lead.  I promise you that you have an advantage by being "the little guy".  You can sell or buy without moving the market.

When the market sells off like it currently is, you see "legs" down (usually more than one.) Those legs are created by the institutional selling.  They know that when they sell stock, it is easy to see.  So they dump a ton of stock very quickly, and then they pause.  Check out the chart below.  On February 27 and throughout the following week we saw the first leg down; on Tuesday, we saw a second leg down (both of which are circled in red.)  This is similar to what we saw in May of 2006 when the market corrected.




When you see that first leg down, you know that institutions are dumping stock.  Now how did I know that there would likely be another leg down?  Magic!  No, the point is that institutions can't sell too much stock at once or they will push prices down too fast.  They have so much stock that they have to dump partial positions and wait to see if the market comes back up for a better price to start selling. 

That's the whole point in last week's article when I wrote about the long-term channel.  That's why you have to understand that the market moving lower is a result, or the process of their selling, not something that happened after they got out at the top.  The institutions don't make the waves.  They ARE the waves.

This brings me to the next question...


QUESTION:

Super. I hope that Chris will keep us updated on these signals, as I find it hard to keep up with them myself.  Being mostly out of the market, I would appreciate the signal to start buying.

ANSWER:

Check out the chart below.



You can see the huge volume circled in blue.  Now do I think that there's more selling to go?  I don't try to make that prediction.  I will know when the sellers turned into buyers when I see a selling climax.  How will you identify the selling climax?  You typically see two things happen. 

1)
You usually see at least a double bottom (where levels previously bounced off of are tested a second time, circled in blue) and if you see more than one bounce off of that "support level", then that support level is considered to be that much stronger (and more likely to be the bottom.)  When these "bottoms" are being created, there is also resistance created (blue line and green circle.)  I don't think that the market is clearly back in bull mode until I see that resistance broken.

2) You see above average volume (blue circles at the bottom.)  When you see above average volume, that means that institutions are moving, and the stronger side wins (bulls or bears.) 

So when you see a selling climax, you see high volume at the point where the market bounces, and you find yourself asking whether or not that was the bottom.  Once you have that first clue, the next question is whether or not the market will break the past resistance level or turn back around to the downside. 

Only after you see that resistance was broken (showing that the past sellers at that level are no longer interested in selling,) will you know that the bulls are back in the driver's seat.

Okay folks, last question...  I had to post this one...

QUESTION: 

Masterful presentation!  Maybe I'm just too old, but what does LOL mean? 

ANSWER:

LOL!  That means "Laughing Out Loud" which is another way of saying "ha-ha-ha-ha."   But in this publication, I'm not allowed to tell you what "LMFAO" means; you can ask around or consider it a funny riddle.

More questions?  Click the link below!

Until next week...
chris row signature
Chris Rowe
Chief Investment Officer
Technical Analysis Millionaire
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