Choosing a Trading Set

Whatever you do, you have to think about that one single most important paradigm of life and trading: “Can I Live to Fight Another Day?”  After all, survival is for the fittest!

In the wake of the financial crisis I developed the following “trading code of conduct” derived from the lessons learnt.  I am advocating using this code of conduct for finding and updating a Trading-set.

The trading code of conduct is very straightforward.

• This is not a “Game!” I am doing it to gain independence and to build wealth over time!

• My assets should always work for me. If an asset does not pay me to hold to it, then I don’t need it.

• Judge fundamentally, and trade technically. After all, it is all about people and the writings were on the wall and before the financial crisis I saw them a year earlier.

• If there is doubt, then Cash is King and for as long as the doubt persists!

In addition, it became clear, that I still practiced some of the stuff I cautioned friends and family and lectured them about, such,

• Judge and act using your own judgment, not according to anyone’s advice

• ETF’s are good for “playing the market” but for assets, you need actual companies, with assets themselves

• Never, ever, fall in love with a company. They will equally fail you, regardless of how much you love them – GE did it for me during the crisis

• Do not buy on impulse, watch the stock for a while for a good technical buy point, and then continue to watch it after the buy for a sell or an add.

Based on that, I developed a simple selection criteria:

• Find a sector/index you fundamentally think should outperform, and convince yourself it is good to be in that sector.

• Find the players in that sector/index and select the best component you can find based on the decision criteria (below)

For instance, after the financial crisis, there was the Swine Flu scare, and I decided that “Death” and “Health” are good sectors. So I bought into these sectors.

The decision criteria is simple. Look at the company market action overview (your brokers site or any reasonable financial website will do, double check if in doubt). There you need to look for:

• Market Cap/Valuation – avoid smaller companies

• Yield – above 10 Year US Treasuries is a strict rule.

• Average volume – you need liquid assets, after all that is why we trade stocks

• Average stock price – above $10 should be a cardinal rule.

If it fails any of the above, then there are plenty of fish in the ocean. Move on!

• Look at the company profile and management, again, any reasonable source would do.

• Is the management diversified?

• Are they overcompensated?

• Do they look like a club or a clan?

• Any red flags on the governance structure?

• Are they new to the company or the sector?

• Who are the competitors, and are there others that look better per above?

Again, if it fails any of the above, then cash is king. Move on!

Check the company financial statistics:

• What is the book value? Enterprise value? Loan to equity ratio?

• What about cashflow? Revenue? Earnings growth?

• Are the returns on investment/equity reasonable? How do they compare to peers?

• Is the yield historically high, and is there a reason for that?

• What is the payout ratio, and how is the company covering the dividend payouts?

• Is there a pattern of stock issuing or borrowing around payout time?

• It is worth visiting the filings pages to check earnings reports and yearly statements at this point, especially if more than one candidate of the same sector is being considered.

Bottom line, if unsatisfied, don’t look into satisfying yourself by talking yourself into the purchase, having someone else talk you into it, or kicking yourself for not doing it. You have to remind yourself that there is plenty of decent and readily available companies on the market.

On this point, to find stocks, I check, and periodically recheck:

• Index components (DJIA, COMP, etc.)

• ETF components (XLF, XLE, etc.)

• Peer groups for one of the “highly recommended” companies

• Newsletters etc.

But I always do the exhaustive homework. You see, if you limit yourself to what you know, you are bound to cut corners because you end up being stuck with the “best available” rather than the best.

If a company passes the above, it is added to the trading list, and technical analysis starts to see when to buy.  Here, I look at:

• 7-period Daily 3-EMA (to start with, can use different period if necessary)

• You need to have the EMA’s in right order, with the faster above the slower to be convinced that it is moving in the right direction for a buy (as explained in the Price and Averages post in the Analytics section)

• When was the last “mean-reversion” and how far above or below the EMA’s is the current stock price

Here, there is no hurry. If it is way above EMA’s wait for mean-reversion to happen. If it is well below, then wait till it is moving above. After all, you are going to hold it possibly for months and years, what’s an extra month. If you miss the opportunity, find another one! You know how to do that, don’t you?

Finally,

• Check the Weekly 3-EMA for at least 4-5 years (to cover pre-financial crisis). Here you want to make sure that there is nothing fundamentally wrong, as in something that has been trending downwards for months and years.

• On Balance Volume: I like to see an uptrend, and it is here that I become more interested in support and resistance than I do with the price charts.

• Money Flow; same as OBV.

The bottom line here is that you need to the counter-intuitive, which is to buy on the way up and to sell on the way down. I no longer average down or take profits on the way up.

This takes us to something important that I started practicing strictly:

• I buy and sell percentages of portfolio (translated into dollar amount or number of shares).

• I do not want my held-portfolio to have more than 10-15 issues (15 if there are doubles, like buying VZ and T while deciding which one to keep).

• No point of holding less than 5% of portfolio in any single issue, and no need to hold more than 15% in any single issue.

• I normally nipple while buying but sell in one shot.

• I always keep in mind the opportunity cost, so if a yield drops below 10Yr UST or if they cut dividend, then they are normally gone at earliest possible time (same day usually).

• I no longer over trade. If a holding starts trending down, I don’t sell until it breaks the weekly 3-EMA, possibly with a different periodicity than what I used to buy, even though this means losing part of the profits. I need to be sure that the pullback is not due to the healthy and normal mean-reversion before actually selling a holding.

• If the market is going down, I don’t buy, as most stocks are highly correlated with the market.

 This more or less completes the essence or the conceptual series on trading.

Trading Lessons Learned.

“Live to fight another day” or survival is the keyword in trading the financial markets, be it stocks, futures, or currencies.

In systemic failure situations, or systematic failure as some call it, survival is the only thing that counts. After all, knowledge of what is impending does not always save you! It is those who survive systemic failures that benefit the most. But can you? What would you do? Is it cash and deposits? Or is it commodities? Or equities? How about foreign investments?

Up to 1991, I had all my retirement money in GIC’s. For those who do not know, these are Guaranteed Income Certificates. Now, as it happened then, and is still happening now, people market them as Guaranteed Investment Certificates. Where is the SEC? If you know the answer, let me know, since I lost more than a third of my retirement money when Mutual Benefit Life collapsed in 1991. Not to mention that this money was frozen for a period of years, before I was able to get the remaining portion. As the name suggests, I thought it was “guaranteed.” It turns out that the income is what is guaranteed but the principal was not. When the systemic failure caused by the real-estate bubble of the early 90′s happened, MBL collapsed, in what is now referred to as the Savings and Loans Crisis. MBL was not an S&L, but like most companies seeking cash, they were heavily vested in real-estate, commercial in particular. When the bubble burst, there were no guarantees. If you had assets (equities and bonds) then you got it back, but if you are trying to grow a guaranteed nest egg, then it smashed in your face.

Lesson learned: “There are no guarantees in life,” also stated as “The biggest risk you can take is not taking a risk!” As old as this last quote has been circulating, sometimes you have to be burnt to understand it.

Investing in equities, rather than the “guaranteed” was the lesson I got out of the early 1990 Savings & Loans collapse. But these once in a century systemic events seem to have become frequent.

In 1997, we had the Asian Flu, as it was referred to, when complete Asian economies collapsed. For instance, just check out the the Indonesian Rupee current exchange rate and compare it to what it was before. It took some of these countries more than a decade to even start speaking of recovery. I did well through that, since most of my holdings were technology. 1998 was the Russian Ruble Crisis. Again, this affected the financial system and again, this actually was an opportunity to load on some JPM. So, I also did fine. Of course, I did not really experience adverse effects due to these events, as I was then mainly a technology investor. I did not have that much exposure to banks or financial institutions, so I escaped unharmed.  After all, this systemic failure was contained.

So is technology the answer? Well, unfortunately that was not a lesson, and in any case it was not true.

After 1998 and well into 2000, the Internet Bubble started. Now, I was truly in the midst of that, by virtue of employment, and by virtue of residence. I lived in Silicon Valley at the time.

Banks, loans and real-estate were going crazy. Literally, I was at the Nordstrom Department Store in Palo Alto, California buying something for my wife, and the guy next to me was telling his female companion who was exclaiming about the price of some Gucci bag: “don’t worry it’s only 10 stock options!”

I knew the world would collapse, just I did not know when! So, I told my friends who are heavy on stock options, to sell. Believe or not, nobody budged, not even to sell enough to buy what is important to them, be it a house or a car or something they desire. Everybody was of the opinion that CSCO will be a trillion dollar company (it did hit $600B and became the most valuable company on earth for a short while). Everybody was of the opinion that Sun Microsystems would double again, and then again. We were supposed to be sitting home as “bricks and mortar” stores collapse around us because we would eat, drink, and live the internet. This was the common wisdom.

When the NASDAQ hit 4800, I became confident that the world is going to end. I fortified my portfolio, and designed it to withstand a NASDAQ 2400. Everybody thought I was crazy. Of course, their belief was reinforced when the NASDAQ (in no time) hit almost 5200.

When the collapse came, I did lose money! Big time! How come and I have already protected my portfolio? Well it was designed to withstand 2400, the NASDAQ dropped to 1600, 1/3 less than my worst case scenario, the one people were laughing at. Further, the schema I developed was based on selling winners which moved well above the mean-reversion, keeping losers who are below their mean-reversion, and hedging everything, so that I can go on margin if I wanted, using “Flagship Holdings” such as AT&T (the old one) and the Gap Stores. The last mistake I made was to rely on “discount brokers” and we shall keep the names secret to protect the guilty.

Guess what, margin calls (which I could have covered) were reported by regular mail, and arrived after the liquidation happened. The cheap broker did not bother send an e-mail or make a phone call. The flagship holding collapsed, actually before the “gambling” positions. Reason being, this was a systemic failure. Those people who would have normally bought at Nordstrom or Banana Republic using “option credit” were no longer millionaires, and they could not afford to stay in their own homes which banks happily financed using stock options. And (almost) “ALL” internet companies collapsed, at least price-wise if not actually declaring bankruptcy. Who would buy Gucci with “option money?”

Lessons learned: when a systemic failure happens, there are no good or bad holdings. Things will spill over from technology into retail, banking and whatever else. People will overreact, so there will be no oversold losers that are worth hanging on, wrongly believing that they already took the beating (mean reversion or whatever). There is no safe haven. Even commodities collapsed at that point.

April 2001 was the lowest point in that period, just to be followed by additional lows in the wake of September 11, and then in the run-up to the 2003 US invasion of Iraq.

In the aftermath of the Internet Bubble, if you had your money in Bonds or cash, you would have fared well.  So, is that also a lesson?  Let us look at the next story, and then you judge by yourself.

Here we are talking about stuff that all of us, young and old, experienced in recent memory.  It was the “Sub-prime Crisis of summer 2007.”  I remember that I was sitting in a hotel in Massachusetts, where my older son was attending school, in early September 2007, and running my technical analysis.  I noted that during the summer, and well before oil hit $150, there was a rotation out of commodity ETF’s into “other stuff” that I could not discern  (look at DBC and IGE).  I called my broker in California and told him to sell everything.  I gave him a hard time for not telling me about the rotation when it happened.  I also gave a lecture about how the Sub-prime crisis will eventually affect banking and purchase power, which will cause money supply crunch due to banks holding credit, followed by demand destruction due to consumers feeling poorer because they cannot borrow overall and inability to refinance or borrow on a second mortgage due to the sub-prime issue.  I then lectured about how this sounds like a systemic failure waiting to happen possibly the Western version of Asia 1997 and Russia 1998.

Perfect insight isn’t it?  I wish I had a voice recorder then!

Guess what, my children’s brokerage accounts are managed by my financial advisor, and I manage my own account.  So for 6 months between September 2007 and March 2008 I was moving my portfolio between different 1-3month CD’s, at a max of $100k each, and with a diminishing return that started in excess of 4% and in a few months dropped to below 3% annualized. Meantime, the children accounts where doing just fine, thank you, and making good profit.

Greed always wins.  Here I am a few months from selling all, and I am badly lagging market, and none of my prophecies materialized. So, I jumped back in the market.  On September 15, 2008 Lehman Brothers collapsed. I was up, I believe around 10-15% on my portfolio.  Everybody knew it was big, but the market did not react then as violently as it should have.

On October 1^st, 2008, the games began.  I was still up a couple of percentage points, yet by end of next week, I was down almost 40%.

Now, with all that knowledge and market tracking, shouldn’t I have sold on October 1^st or 2^nd? Yes I should have, but here is the new lesson from 2008 that was not true in 2001:  Cash was not a safe-haven! This was Mutual Benefit Life and the Savings and Loans Crisis magnified many times over.  I actually believe that the damage of the 2008 Financial Crisis is much bigger than anyone has declared, and most probably it will be historians who will one day tell us the truth.

Why did I not  sell, well it was the MBL lesson learned.  You see, if you have assets with a broker, and the broker collapses, then you can withdraw your assets under management regardless of the legal status of the broker as soon as practically doable (at least theoretically, as MF-Global collapse showed the opposite).  Usually a few days, enough for the dust to settle, rather than the multi-year wait I had to suffer through with MBL.  On the other hand, if you have deposits with a broker, as in proceeds from sales in this case, then you are one of the most-junior, unsecured lender, with preference only to broker’s common and preferred stock holders!

So here is the dilemma, everybody, including the top tier investment bank where my account was, were rumored to fail.  Actually, a few hundred banks, including Merrill Lynch the biggest broker on earth at the time, did collapse or have to be taken over by someone else. If it was not for foreign investment, prior to October 1^st, and Fed intervention afterwards, and Buffet’s investments, many of the top tier banks would have failed.  Morgan Stanley, Goldman Sachs, Bank of America, Bank of New York, all were teetering on collapse.  At that time, assets, regardless of how depressed, were your best bet!  To tell you how bad it got, overnight LIBOR rate spiked to double digits; that is, banks stopped lending one another  because they ceased to trust each other. Banks were tracking their wire-transfers to assure that they did not go through a collapsed bank, and yes, money was caught at some of the collapsed banks.

In short, you could not have sold and risked losing everything, rather than just losing a percentage. I could not take that chance.  After all, you always need to “live to fight another day!”

So, a second, and newer lesson, when the collapse is systemic, not even full knowledge, nor cash will save you! As a matter of fact, the world could just freeze, either actually, like September 11, 2001, or logically, like early October 2008.

You see, (in retrospect) it was clear from technical analysis. Just look at the charts for the era and you will see that we have moved under the (reversed) moving averages both for daily and weekly since summer of 2007. This is why I sold to start with. Initially, I kicked myself for jumping back into the market, but on another thought, imagine if I had stayed in cash (other than CD’s less than $100k and insured by the government) in one of the hundreds of collapsed banks?  I would have gotten broke, even though I would have seen it and acted on it correctly.

The 2008 Financial Crisis was a Systemic Failure. It was different, save 1929.

Funnily, the next one, which will inevitably happen one day, will have an aspect that is different that we may understand afterwards and plan for after the fact.