DENNIS GARTMAN'S NOT-SO-SIMPLE RULES OF TRADING

DENNIS GARTMAN'S NOT-SO-SIMPLE RULES OF TRADING

1. Never, Ever, Ever, Under Any Circumstance, Add to a Losing Position... not ever, not never! Adding to losing positions is trading's carcinogen; it is trading's driving while intoxicated. It will lead to ruin. Count on it!

2. Trade Like a Wizened Mercenary Soldier: We must fight on the winning side, not on the side we may believe to be correct economically.

3. Mental Capital Trumps Real Capital: Capital comes in two types, mental and real, and the former is far more valuable than the latter. Holding losing positions costs measurable real capital, but it costs immeasurable mental capital.

4. This Is Not a Business of Buying Low and Selling High; it is, however, a business of buying high and selling higher. Strength tends to beget strength, and weakness, weakness.

5. In Bull Markets One Can Only Be Long or Neutral, and in bear markets, one can only be short or neutral. This may seem self-evident; few understand it however, and fewer still embrace it.

6. "Markets Can Remain Illogical Far Longer Than You or I Can Remain Solvent." These are Keynes' words, and illogic does often reign, despite what the academics would have us believe.

7. Buy Markets That Show the Greatest Strength; Sell Markets That Show the Greatest Weakness: Metaphorically, when bearish we need to throw rocks into the wettest paper sacks, for they break most easily. When bullish we need to sail the strongest winds, for they carry the farthest.

8. Think Like a Fundamentalist; Trade Like a Simple Technician: The fundamentals may drive a market and we need to understand them, but if the chart is not bullish, why be bullish? Be bullish when the technicals and fundamentals, as you understand them, run in tandem.

9. Trading Runs in Cycles, Some Good, Most Bad: Trade large and aggressively when trading well; trade small and ever smaller when trading poorly. In "good times," even errors turn to profits; in "bad times," the most well-researched trade will go awry. This is the nature of trading; accept it and move on.

10. Keep Your Technical Systems Simple: Complicated systems breed confusion; simplicity breeds elegance. The great traders we've known have the simplest methods of trading. There is a correlation here!

11. In Trading/Investing, An Understanding of Mass Psychology Is Often More Important Than an Understanding of Economics: Simply put, "When they are cryin', you should be buyin'! And when they are yellin', you should be sellin'!"

12. Bear Market Corrections Are More Violent and Far Swifter Than Bull Market Corrections: Why they are is still a mystery to us, but they are; we accept it as fact and we move on.

13. There Is Never Just One Cockroach: The lesson of bad news on most stocks is that more shall follow... usually hard upon and always with detrimental effect upon price, until such time as panic prevails and the weakest hands finally exit their positions.

14. Be Patient with Winning Trades; Be Enormously Impatient with Losing Trades: The older we get, the more small losses we take each year... and our profits grow accordingly.

15. Do More of That Which Is Working and Less of That Which Is Not: This works in life as well as trading. Do the things that have been proven of merit. Add to winning trades; cut back or eliminate losing ones. If there is a "secret" to trading (and of life), this is it.

16. All Rules Are Meant To Be Broken.... but only very, very infrequently. Genius comes in knowing how truly infrequently one can do so and still prosper.

Forsythe - Schwab Equity Ratings

GREG FORSYTHE HAS never bought a lottery ticket, at the store or in the stock market. And that points to a key element in the successful Schwab Equity Ratings system. "I won't play any game seriously that I don't have a forecast advantage in," says Forsythe, the creator and director of the team behind the quantitative stock-selection method, which has fueled the discount broker's long-term success in Barron's rankings of brokers' top stock picks ("Who's the World Champ?" Sept. 25). Since 2003, the model portfolios of Charles Schwab (SCHW1) have dominated the long-term rankings compiled by Zacks Investment Research, which compares the focus lists of about a dozen major Wall Street brokerages. Schwab has been first in either the three- or five-year period in each ranking, except one, when it finished second over three years. Wall Street's army of sell-side analysts, who create the more traditional focus lists, are good at picking great companies, but aren't necessarily consistent at picking great stocks over time, says Forsythe, who works in Chicago. In its quest for stocks with sustainable high earnings growth, the Street focuses on profits. "The payoff from accurate earnings forecasting is extremely high," he says, but the accuracy is typically too low to pay off. Just 15% of quarterly EPS forecasts are within 1% of actual reported EPS, according to a Schwab study. In traditional analysis, there also seems to be an under-appreciation of the forces of creative destruction. "Analysts study the company, the industry, the management and forecast earnings," he says. The implicit assumption is "if I find a great company, I'll find a great stock....But if a company is great today, it doesn't necessarily mean it's going to be great in the future, and that's where this fails," Forsythe continues." Great companies get big and hard to operate; saturate their markets. Success attracts competition." Because analysts and investors usually extrapolate success far into the future, the great companies of today tend to be overvalued, he maintains. "You have got to look at the expectations imbedded in the stock price. You can get the fundamentals right, but you may not get the stock right." The issue isn't which stocks have the strongest fundamentals, but which stocks are offered at prices that don't reflect their actual chance of success. There are strong parallels, he adds, between the Schwab Equity Ratings system (SER) and Sabermetrics, a statistical approach to evaluating baseball players and strategies described in Michael M. Lewis' book Moneyball. In a way, the typical focus list is comparable to the collected wisdom of baseball managers and scouts looking at batting averages and runs batted in. While SER's statistical analysis of less widely followed company financial data, like the relationship between income and cash flow and 17 other factors, is similar to Sabermetrics' emphasis on factors like on-base percentage. Making the Grade: The Schwab Equity Rating system ranks 3,200 stocks weekly on 18 factors the firm says are correlated with future returns. Forsythe points to a study his team did of Wall Street earnings projections and stock recommendations, as compiled by Zacks. From 1995 through 2004, the stocks with the lowest earnings- growth forecasts and worst ratings beat those with the highest. Street analysts are capable, says Forsythe, but it's a "perverse" capability. "You are better off doing the opposite of what they do. I am not saying these aren't smart people. My explanation is a misplaced research focus," he says. He also maintains that investors and analysts are too focused on the payoff. Discovering the biotech firm that finds the cure for cancer would produce a high reward, but the probability of hitting the big one is very low, says Forsythe, who notes: "The biotech industry has destroyed about 60% of the capital that's ever been put to work in the industry." The payoff from a few winners has been swamped by losses from the many failures. Profit estimates aren't part of the SER model — a "very big distinction" between it and the conventional Street approach and even other quantitative methods, many of which employ analysts' forecasts. (Directional changes in consensus earnings forecasts, however, are used in SER.) What the Schwab method looks for is "surprise," which can be defined a lot more broadly than earnings. Indeed, nothing is more highly correlated with stock returns than knowing which companies are going to report the most positive and most negative earnings surprises one year from now, says Forsythe. If Google, a current market favorite, meets its expected growth rate of 40% a year, its stock isn't going to go up 40% annually, he argues, but rather 10%-15% because the 40% assumption is already in the price. It's more important to know not what Google is going to make next year, but whether it earns more or less than what people think it will, he says. (By the way, Google is rated C, or Hold, by SER, whose highest rating is A.) "How do you search for factors correlated with surprise?" asks Forsythe, who comes to the investment world with an unlikely background. He was trained as an industrial process engineer at Purdue and worked at Union Carbide before obtaining an MBA at night from the University of Chicago. "My father-in-law introduced me to stocks. I noticed one stock worked, one didn't. It was too random and that's when the engineer in me kicked in," says Forsythe. "I wanted to become a better investor." Free cash flow (net income plus depreciation and minus capital expenditures and dividends) is "very, very important," the biggest single driver behind the SER ratings, compiled from the 18 factors. These are weighted differently and grouped among four categories: fundamentals — the most important component at 50% of the grade — valuation and momentum, each 20%, and risk, 10%. The Schwab Equity Rating model ranks 3,200 companies weekly on each factor and against one another. Letter grades are then assigned to each stock. Credibility Gap: A study of stock performance from 1995 through 2004 showed that shares top-rated by Wall Street analysts underperformed those that were out of favor and had low earnings-per-share growth estimates. SER focuses on the quarterly cash flow statement, which many analysts neglect because they "obsess" on earnings, Forsythe says. "What people ignore is less likely to be built into expectations, that's why we spend so much time with that statement," he offers. Among other things, SER compares inventories to sales, that is, a balance-sheet account to an income account. Traditional analysis loves high profit margins and strong returns on equity, but Forsythe says the former has zero correlation to stock returns and the latter just "some value." In fact, "the ratio of free cash flow to equity gives you more insight into future stock returns," he says. SER also compares rates of change: How fast are sales growing versus assets, inventories and receivables, for example? If sales rise 15% annually while assets grow 10%, it means the company is improving asset utilization and becoming more efficient. These are "excellent indicators of returns and surprises," he says. Another important element is cash. "We've found that generally [stocks of] companies that have a lot of cash, relative to their market value, perform well." Some argue that a high cash level means that management doesn't know what to do with it, "but that's not what the data tell us," Forsythe says. Why? Well, unless it's an IPO, "if you have a lot of cash you've probably been earning it...and that's a good thing." But the greater the capital expenditures to asset ratios, the lower the subsequent stock returns, according to SER. It could be managers often make bad capital investments, or it also could be that capital-intensive businesses generate lower returns in the long run. But, in Forsythe's view, the history is "very, very convincing" that the higher the capex rate, the lower the rate of return over time. Stock buybacks (netted against issuance) are one more SER factor and historically a signal that the company feels the stock is undervalued. "However, these days, everyone is buying back stock and that can't be good, so our model will have to evolve," Forsythe adds. Short-selling is an element that the Schwab system also considers; one that Forsythe refers to as the "smart money," whereas "dumb money historically has been the analysts' recommendations. We've found short sellers are somebody you want to watch." He looks at both the level and direction of short sales. Are the number of short sales rising or are the shorts covering? "We've found that is predictive of future returns," he adds. Among the major factors, momentum has a shorter time horizon. Here, SER looks at things like the direction of analyst ratings and profit forecasts, as well as price momentum. Stocks' past changes don't predict future price changes at the tick level but, long term, price change does tend to continue. "If investors are buying a stock, driving up its price, that's saying that expectations on that company are improving and they tend to move in trends that we can pick up." The last component is risk, which covers the market capitalization and stability of things like revenues. "Measurements here tend to get us in less volatile stocks, which most investors prefer," Forsythe says. No system is perfect, of course. As Forsythe readily acknowledges, "not every A outperforms, not every F underperforms," which is why Schwab's equity model includes 100 stocks. Additionally, there are aberrations that distort performance, like the classic biotech IPO that hits it big. Most times, such companies will be rated Fs after they go public. "One is going to hit. The nice thing is if you are right 99 times and wrong once, you are right on average." The Schwab Equity Ratings system encounters limitations when everyone in the market is thinking one way, such as at the end of a deeply bearish period or frenzied bull market. In late 2002 to early 2003, when the market embraced risk and poor-quality stocks, the Fs outpaced the As and Bs. But, eventually, people began paying attention to quality. While there are a few things in the model no one else probably looks at, "the combination is the unique thing. It's not magic," he says. In his childhood, Forsythe's pals called him: "Hey, Foresight." The success of Schwab's model portfolio over a half-decade seems to justify the nickname.

Method to the Madness: Alpha Chasing Beta

Method to the Madness: Alpha Chasing Beta

A reader asks: "What is your investment strategy based on? Do you have a specific model?"

Fair question: Here's the short answer:

My investment strategy is a "Macro-Vector" approach.

Its based on the belief that markets are neither random nor predictable, but rather, follow trends, which often respond to different combinations of factors in a way that may occassionally be predictible over the short term.

Essentially, markets -- all markets -- only do 2 things: They Trend, and they Reverse. Most Macro models are designed to get you on the right on the right side of a trend, and keep to keep you there, and as far as that is concerned, mine is no different.

Where I diverge from most Trend traders is the process of determining when markets reverse. My framework uses 5 key elements -- Sentiment, Market Internals (Technicals), Monetary Policy (Macro-Economics), Valuation and Cycles -- to determine the potential of a market reversal at any given moment.

Note that each of these 5 elements works on different time horizons, and they are presented from the shortest term (Sentiment, and then Internals) to the longest (Valuation and then Cycles).

Even within a well defined Trend, these 5 elements help determine what the relative risk versus reward of the equity markets are, and assesses the most advantageous investment posture -- Long, Neutral, or Short.

~ ~ ~ “There are very few markets (betas) or managers’ performance numbers (alphas) that are not dominated by changes in the macro picture. That is because almost all pricing reflects expected future conditions, so prices change as a function of changing expectations.”

-Ray Dalio, founder of Bridgewater Associates, which manages $120 billion in institutional assets.

I believe my approach is very different -- and a bit of a throwback -- than what seems to have become the dominant investing approach over the past few years: The undue emphasis of Alpha over Beta.

What does Alpha over Beta mean?

It's a bit of a tongue in cheek phrase, but follow it to its conclusion: The recent surge is hedge funds assets is the result of investors “chasing Alpha.” Money has been flowing to managers who have shown the ability to eke out a profit arbitraging away some of the inefficiencies in the market.

Over the past decade, the move to chase Alpha -- rather than Beta -- was perceived as the less risky, smarter strategy. But for obvious reasons, it couldn't last forever. The underperformance of the alternative investment community shows the net result: With over 8,000 hedge funds, alot the Alpha opportunities have been wrung out. Many of the inefficiencies which were the basis for the strategies hedge funds have been pursuing (Alpha) have run dry.

The great irony is that a decade ago, Alpha was actually a function of Beta. The great hedge fund managers, -- from Robertson to Soros to Druckenmiller on down -- were Alpha males engaging in Beta trading. They made big, bold bets on macro events: Currency, Rates, Commodities, Indices, Sectors, Stocks. They hardly engaged in the genteel strategy of ekeing out a percent a month or so. Instead, these swashbucklers developed the tools and skills to read the macro enviroment. The good ones were successful, the great ones, wildly so.

And then the meteor came. Like the Dinosaurs before them, the Beta players got pushed aside. A combination of smaller faster mammals -- new managers offering reduced risk -- and the dot com bubble did what the Bank of England couldn’t: They ended the reign of the Dinosuars.

The environment today presents a fascinating void, a place in the food chain for those who know that for most of investing history, Alpha has been a function of Beta. That’s the spot where large gains can be had.

That’s where I want to be . . .

What Do You Know?

in Apprenticed Investor

"Remember the wisdom of Lao Tzu: "He who knows others is wise. He who knows himself is enlightened." What do you know?"
-Paul Farrell

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This seems to be Paull Farrell appreciation week at the Big Picture. I sense his frustration levels are increasing as he continues to rail against some of the absurdities of Wall Street.

Paul, you better watch out or you may become victim of the Cassandra Syndrome.

His latest column I wanted to reference exhorts investors to avoid the guru trap and steer clear of forecasts. Indirectly, he really suggests that individuals must take responsibility for their own investments. Incidentally, I addressed an aspect of each of these three concepts in 3 different Apprenticed Investor columns: The Folly of Forecasting, Lose the News, and Your Fault, Dear Reader.

Here's an excerpt:

"The best investing advice is simple, timeless, paradoxical -- and often ignored. Yes, ignored, because so many investors cannot make decisions. Lacking self-confidence, they rely on the random flow of breaking news. That overwhelming rush of new information, all of it short-term, drowns out the investment advice to which we should be adhering. Those timeless principles demand that we ignore breaking news and take personal responsibility, a very scary idea for investors who have lost their self-confidence.

This message has been summarized by the Chinese master Lao Tzu: "Those who know do not speak, those who speak do not know." He offered this investment advice three thousand years ago in the Tao Te Ching. Test it on any guru: Gross, Siegel, Bogle, Cramer, Bernanke, Paulson, and yes, even me. Of course, if investors took Lao Tzu's advice, Wall Street would be out of business. You'd be in command!"

Its more than the being misled by the news flow; Understand that much of what is said is merely people "talking their books." Not purposely misleading -- but that is the ultimate result.

Regardless, Farrell spoke with Paul Merriman, and identified 5 issues investors need to think about when considering forecasts and pundits and their own knowledge of "the facts" :

1. Stuff you know, that actually is true

Investors are historians not futurists. We're overloaded. Even with the best data available, like our fund profiles, you're dealing with 10,000 funds, each with 100 bits of data that's actually old news, usually at least 3-6 months old. So you oscillate between a false sense of being well-informed, and insecurity about the truth.

2. Stuff you think you know, but is wrong

Economists, securities analysts and cable's talking heads know our brains prefer positive upbeat news. Eternal optimists, they speak the good news. You know you don't know the future, so you turn to the media and press for hints, thinking maybe if you just listen to CNBC long enough, or read one more newspaper, or research one more fund, you'll figure out tomorrow. The blind are leading the blind. Your mind is rationalizing a bad idea.

3. Stuff you know you don't know, but obsess about

Every day the media talks endlessly with hundreds of market gurus, economists, CEOs. You get all the contradictions, oxymorons, dilemmas, paradoxes, a daily torrent of conflicting data about tomorrow's unknowns and unpredictables. So you obsess anxiously, trying to figure out what you can never really know until after the fact.

4. Stuff you know to be true, but deny

Our minds are masters at denying the truth, even when it's staring us in the face. In hindsight any damn fool could have predicted the dot-com collapse. But greed drove us and we denied P/E ratios mattered. You're fortunate if 25% of what you know is true. But the fact is, even when you feel you're right, you might still be dead wrong, unable to let go of even a bad idea.

5. All the stuff you don't know that you don't know

Stuff you don't see until after the fact, when it's too late! Unknowns that unpredictably crash markets: Natural disasters, deficit collapses, homeland terrorist attacks, nuclear war.

Regardless of our gaps in knowledge, the best advice remains to recognize you are on your own. "Folks, the toughest decision any investor must make is to act responsibly. But you'll never mature if you don't stop following the "experts" and take full responsibility. It's your money, your retirement, and in the end, you, not the gurus you listen to, are stuck with the gains or losses."

As one who is in the Pundit class, I've hoped to be the exception to the rule.

The Folly of Forecasting

Apprenticed Investor: The Folly of Forecasting
By Barry Ritholtz
RealMoney.com Contributor
6/7/2005 1:05 PM EDT
URL: http://www.thestreet.com/comment/barryritholtz/10226887.html

As a chartered member of the chattering class, I am all too familiar with the "perils of predictions." Anyone who works in the financial field and speaks to the press eventually gets tagged for a market forecast gone awry. It's an occupational hazard. Unfortunately, investors all too often give these "predictions" in print or on TV far more weight than they should. It's very easy for a confident-sounding analyst, fund manager or professor to say something on TV that can throw off the best laid plans of investors. I wish an SEC-mandated disclosure accompanied all pundit forecasts: "The undersigned states that he has no idea what's going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation." Don't hold your breath waiting for that to happen. The bottom line is that I've yet to find anyone who can accurately and consistently forecast the market behavior with any degree of accuracy, beyond short-term trend following. That inconvenient factoid never seems to dissuade the prophets -- or the press -- from their fortune-telling ways. There are a few things that investors should keep in mind when encountering these speculations. Whenever you find yourself reading (or watching) someone who tells you where a stock or the markets are going, consider these factors:

No one truly knows what tomorrow will bring. Nobody. Any and all forecasts are, at best, educated guesses.

All prognostications are instantly stale, subject to further revision. Conditions change, new data are released, events unfold. Yesterday's prediction can be undone by tomorrow's press release.

In order to "become right," some investors will stand by their predictions despite a stock or the market going the opposite way, hoping to be proven correct. Ned Davis called this the curse of "being right rather than making money."

There are only two kinds of predictions that have some value to investors: One is probability-based, and the other is risk-based. As long as you apply the same rules -- no one knows the future, they are subject to revision and should not be taken as gospel -- then these are sometimes worth considering.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. They are of this variety: In the past, when X, Y and Z all happened together, then we expect that A is most likely, then B is possible, while C is the least likely.

That doesn't mean A will happen or C cannot -- only that there's a specific probability of these events occurring out of the millions of ways the future might unfold. Whether any particular scenario plays out is determined by how the countless variables interact over time.

Looking at the future in terms of various probabilities is a productive way to position assets and manage risk. Why? If your expectations for the future recognize that this is but one possible outcome, then you are more likely to consider and plan for other contingencies. It builds in an expectation that other scenarios can and will occur.

For example, one signal I use is to determine when to sell (the subject of a future column) is after a long uptrend is broken. It's not that stocks cannot go higher after breaking their trend line -- they sometimes do. However, most of the time this happens it signals a significant change in institutional behavior towards the stock. Typically, it reflects a shift from fund accumulation to distribution.

For those people who have been enjoying the ride in Google (GOOG:Nasdaq) -- especially the near vertical move since April -- this is a high probability strategy. Once that trend line gets broken, say adios muchachos, take your profits and move along.

Again, a trend break is not a guarantee that the upside is finished, but it's a fairly good probability assessment.

The second type of good prediction is the risk-based discussion. These forecasts care less about price targets -- instead, they are an assessment of danger. In other words, to buyers of stocks under the present conditions, when this, that and the other are happening, you are taking on more (or less risk) than is typical. Saying the markets contain more or less risk at given times is a very different statement than: "I think the Dow is going to go to X."

I engaged in a combination of broader market-based probability this week in Smart Money, along with future risk assessment. Given the change in character the market displayed since the April lows, I noted the high probability of a substantial rally in the second half of the year. My basis for this was part technical -- the market regaining its prior trading range -- and part anecdotal (all the hedge fund cash on the sidelines). This created a high probability of a move similar to what we saw over the summer of 2003.

But I also included a risk-based assessment based upon the age of this bull move, along with the decaying macroeconomic environment; in tandem, they set up an increasing risk environment as the year progresses. That's how a top can form, and that presents an increased risk of a market correction or even collapse.

When you stop to consider all of the unforeseen actions that might occur between now and then, however, it becomes pretty apparent that all forecasting is at best a low probability activity.

Chaos Theory

Why are the markets so difficult to predict? To borrow a phrase from the physicists, the market demonstrates "unstable aperiodic behavior in deterministic nonlinear dynamism."

This behavior is better known as Chaos Theory.

What does that mean in English? The market is called "aperiodic" because it never repeats itself precisely the same way. Weather is also aperiodic -- it may be colder in the winter than in the summer, so there is a degree of cyclicality. But the day-to-day changes are never exactly the same year after year. The same dynamic applies to the markets: There are similarities from one era to another, but it's never identical. In Mark Twain's words, "History doesn't repeat, but it rhymes."

The markets also act with a surprising degree of instability. Small forces can create disproportionately large reactions. A surprising economic report, an off-the-cuff comment by a Fed official, a small change in earnings by any one of 1,000 companies; any one of these data points can roil the market. That behavior does not occur in what the scientists call "stable" systems.

Given the complexity of both the capital markets and the physical universe, we shouldn't be that surprised that Chaos Theory is so applicable to the financial markets.

Considering how little we know about the totality of market conditions -- and how incredibly intricate and complex the system is -- it's no surprise that pundit predictions are so frequently poor.

Are Social Security Benefits Taxable?

IRS TAX TIP 2006-30

How much, if any, of your Social Security benefits are taxable depends on your total income and marital status. Generally, if Social Security benefits were your only income, your benefits are not taxable and you probably do not need to file a federal income tax return

If you received income from other sources, your benefits will not be taxed unless your modified adjusted gross income is more than the base amount for your filing status. Your taxable benefits and modified adjusted gross income are figured in a worksheet in the Form 1040A or Form 1040 Instruction Booklet.

Before you go to the instruction book, do the following quick computation to determine whether some of your benefits may be taxable:

• First, add one–half of the total Social Security you received to all your other income, including any tax exempt interest and other exclusions from income.
• Then, compare this total to the base amount for your filing status.

The 2005 base amounts are:

• $32,000 for married couples filing jointly
• $25,000 for single, head of household, qualifying widow/widower with a dependent child or married individuals filing separately who did not live with their spouses at any time during the year
• $0 for married persons filing separately who lived together during the year

For additional information on the taxability of Social Security benefits, see IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits. Publication 915 is available on the IRS Web site at IRS.gov or by calling 1-800-TAX-FORM (1-800-829-3676).