Michael Covel: News & Info.

‘SmartMoney Comparison’ from reader:

“I just wanted to send you a quick note thanking you for writing such an insightful and helpful book. I purchased the expanded edition of Trend Following on Tuesday and finished it Saturday. Today, however, I found myself reading a copy of SmartMoney and much to my surprise, I was mentally critiquing the columnist’s recommendations based upon the trend following philosophy I had just read about! The columnist was talking about his recent efforts to cleanup his portfolio, including trimming winners, adding to laggards, eliminating stocks that no longer met the original criteria for the initial purchase, and, he even stated that he could not remember why he had purchased some of the stocks! Finally, he stated that some of the stocks would be held for 10 years because that is what he told his readers he would do. I couldn’t help but think “gee, what if the stocks are in a downtrend for the last five years? The drawdown is going to hurt!” In short, everything he was saying was 180 degrees off from the philosophy you discuss in your book. Unfortunately for SmartMoney, I have to cancel my subscription because the advice no longer seems to make much sense! Now I need to find something else to read. Finally, I want to thank you for answering a question I have had for the last several months…when to sell my shares in JCPenney. Purchased five years ago at $11.65/share, they are now trading over $65 and I have been thinking about taking the profits off the table. Now I know to take my profits when the trend reverses, and to be prepared to take advantage of the downtrend too. Thanks again for a great book. Best Regards, Steve H.”

The Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts Amherst (mouthful eh?) offers an interesting piece of research on trend following trading (PDF). Don’t let perceptions that some of the material is “too” complex deter you. As always in academic works, you are trying to find nuggets of useful information buried in verbose writing!

Jeremy Siegel, Ph.D., the famed professor, recently composed this piece for Yahoo Finance (PDF). Siegel is a very smart man, but his view of the markets is polar opposite to that of a trend follower. I think the real distinction is the trader v. investor mentality. Legg Mason makes the strong case for the “trader” mentality here (PDF).

Feedback from Chuck Cain about numbers we can believe in:

“Michael: What do fundamental analysts analyze? It doesn’t make sense to base an analysis on data containing errors. Example? H&R Block’s error in allowance for income taxes was funny, but seriously, think about all the ‘restatements’ that I’m sure you’ve seen, some restating several years at a time. It doesn’t make sense to base an analysis on numbers which are estimates. Numbers that are ‘reserves’ are estimates, by definition. Example? Banks can set earnings in quite a wide range by changing this period’s addition to ‘reserves for loan losses’. Yes, I’ve spent a lot of years working inside banks. You wouldn’t believe what gets done to this poor number when the trial balance bottom line doesn’t look good. The IRS won’t let banks use this number; the IRS requires actual loan losses, instead. It doesn’t make sense to base an analysis on numbers which are made up. Example? Worldcom, Enron, enough said. It doesn’t make sense to base an analysis on numbers which have a high margin of error. Example? Most government statistics. Think about all the ‘revisions’ that I’m sure you’ve seen in the financial press. I have a friend who used to work with this kind of information inside the Federal Reserve. Some of his work went to Chairman Greenspan, who may understand error ranges, but how many other people who read these things in press releases really understand the confidence level? How useful would it be for a friend to give you a phone number for a dream date without telling you that he’s only confident that the area code is correct. How do fundamental analysts know which numbers are wrong, are estimates, have large error margins, or are completely bogus? What is fundamental analysis worth if these numbers aren’t screened out? If they are screened out, what’s left?”
Chuck Cain

What’s left that we can believe in as true? The market price. Thanks Chuck, great piece!

A very good web resource outling a wide array of Behavioural Finance resources can be found here. Yes, the list is long winded and in some instances very academic, but there are some great pieces of information there. Go spend some time exploring.

I received feedback from a reader looking to sell his trend following system. He described it:

“[My system] is a trend following system. It promises a systematic methodology for assessing trend or relative strength of an individual trading vehicle. As with all band or channel systems, when the prices do not show trend, they will remain within the band. When prices break though the band, it can be taken as a signal to either buy or sell.”

Perhaps there is more, but where is the bet size discussion? Isn’t that the most critical aspect? Where is the money management?

I have an article about “Confusing Concepts” in the May 06 issue of Stocks, Futures and Options Magazine.

Feedback today:

“Michael, I’m writing to you for advice. I got myself in a jam and don’t know what to do. I recently got long an equity called Rambus. I built five units (10 Leap contracts) over a price from 36 to 38.5. The stock ran up to the mid to upper 40’s and within a few weeks I was up around $6k. The company issued earnings last Wednesday after the market closed. The earnings were ok, nothing bad, nothing spectacular. The stock traded off a point or two, no big deal, normal volatility. However, the company is awaiting a verdict on a patent infringement case. Thursday afternoon, rumors were being spread that the verdict was released and it was negative for Rambus. The stock sold off roughly 15 points to hit a low of $29, but closed the day in the high 30s (around 38.5). While all of this was happening, I’m on the golf course playing golf with my dad and two brother-in laws. I had one contract at Ameritrade that got sold for a nominal loss, because I had a trade trigger in place. However the other nine contracts housed at my Fidelity account did not have trade triggers so I still have them. I basically lost $5,400 in one day (all gains) and still have nine contracts with a small profit of $500. Hence the subject title … easy come easy go. Since this event, the stock has been trading above my exit signal. My question. Technically I should be out of those nine positions, but because I didn’t have the trade triggers in I’m still long. Can I ignore the event because the price is back above my exit price? What would a trend follower do? A verdict is due out soon on this case. Many think the verdict will be positive for the company, however, if it is not, the market has given a clear indication that Rambus will be thrown under the bus. I sense you like to avoid answering questions like this, but I thought this was an interesting situation and maybe you can use it for educational purposes. Obviously I would not hold you to any guidance you provide. Best regards, Vinnie”

Some quick thoughts:

1. You are asking me for fundamental opinions to some degree. I don’t have them.
2. You need to focus on a portfolio perspective so one market or stock is not the be all and end all.
3. Follow the price. That’s all you can do.
4. You need to have precise rules to follow the price. If the rules are not followed, for whatever reason, no one can offer you after the fact “proper” advice.

Consider from the Wall Street Journal:

“At issue are the ways some Wall Street firms allegedly profited by inflating the prices paid by individual investors for stocks after IPOs were launched, exacerbating losses when the bubble burst. The alleged misconduct includes “laddering,” or steering more shares of hot IPOs to investors who signaled plans to buy more shares at higher prices after trading began. This had the effect of increasing their first-day price gains while worsening losses of investors who bought later in the open market. Plaintiffs’ lawyers have estimated investors lost a total of as much as $55 billion from the alleged misconduct related to the IPOs, but say recoveries will likely be well short of that amount. Plaintiffs’ lawyers could get up to one-third of the $1 billion guarantee — if that is the only amount recovered. Requests for compensation from the ultimate recoveries need court approval.”

If illegal activity took place than damages are due. But given the fact that only pennies on the dollar will be recovered, is there a better way to handle it next time? Yes, consider:

1. Don’t use brokers for stock tips.
2. If you are long ’some’ stock and it is headed to the moon, know your exit plan. For example, GOOG and CME might be great trends now, but you need an exit plan.

Don’t want to do this? Then get ready for the next fleecing sure to come at some future time! And remember, there was for the vast majority of internet stocks…time to exit. The time to exit is always clear if you are following the “price”, but fuzzy if you are following “fundamentals”.

A reader emailed me an article (PDF) tonight titled “Busting Baseball Myths: Scientist Throws Big Curveballs”. It quickly reminded me of prior posts closely related:

1. Gerd Gigerenzer: Make Decisions Fast (Includes Video).

2. Simple Heuristics That Make Us Smart.

Not sure how this all relates to trading? It does. Give it some time to marinate.