Chapter 11
Equities
Throughout this book, I have presented numerous methods and strategies designed to decode the market puzzle. My experience suggests that these techniques can be applied to all markets equally well. Whether your specific interest lies in the area of cash currency, commodity, fixed income, or stock trading, the applications and the results should be comparable. Because of the variations in market composition, however, composite indexes may vary from one market to another. In this chapter, I intend to highlight various trading strategies I have created and have applied to both individual stocks and the stock market.
New Issues—Initial Public Offerings
For many years, I have observed a similar trading pattern for most newly issued stocks. I have been particularly sensitive to the trading activity of these new issues because I was in charge of trading these stocks when I first entered the investment business over 23 years ago. Although nothing in the investment business is for certain, and most techniques, following a period during which they work exceptionally well, undergo a period of erosion and disinterest, this method seems to have successfully withstood the rigors of various market environments and of time. Whether the climate for public offerings is hot or cold, this technique on balance seems to work, although the degree of success seems to be influenced somewhat by the overall market.
Typically, once a new issue begins to trade, I look for the following characteristics regardless of the price at which the public offering is completed. Often, price will either advance or at least move sideways for a few days. The reason for this price movement is that the selling syndicate that initially offered the shares to the public for sale supports the price of the stock for a period of time. If the original offering is priced conservatively, the syndicate's price support activity is not as critical. However, if the underwriter attempts to raise the maximum amount for the selling company, it may stretch the market to the point where prospective buyers believe it to be too expensive; price then declines. In any case, the syndicate usually is able to muster enough buying to support the offering price. In fact, I have heard of some instances in which the underwriter has insured the absence of supply by failing to compensate its brokers with commissions when their clients “flipped” a new issue—bought the offering and immediately liquidated once trading began, which forced the syndicate to buy it at the syndicate bid.
Whether the stock's price remains above the public market offering price or not, there is a tendency for price to retreat or move sideways for two to four weeks after the first two to three days of trading. Then, at about the time when most of the people originally interested in the offering become distracted, a new, more subdued surge in buying generally appears. To fine-tune the arrival of this secondary interest, I often review specific items regarding the offering. I make an effort to obtain information regarding the size of the public offering, the name of the underwriter(s), the size of the selling syndicate, the number of market makers in the stock if on National Association of Securities Dealers Automated Quotations (NASDAQ), the amount of stock the underwriter's) will place with investors, the volume and dollar-weighted volume for each day since the offering, and so on. This is not to say that the price activity will not conform to the one I anticipated if these items are lacking; rather, I use these criteria to market-time entries, as well as to reinforce my expectations.
Once I have information regarding the number of shares offered for sale, I attempt to learn how much stock the underwriter has placed in the hands of buyers. Underwriters often attempt to place the stock in strong hands—in other words, with buyers who are prepared to hold the stock for a period of time rather them liquidate once trading begins. They accomplish this by denying commissions to the broker if the stock is flipped (sold immediately) at a loss. Generally, the underwriter is obligated to support the stock at the offering price level for a period of time, and may not want to increase its inventory. Consequently, I make the assumption that the stock held by the underwriters and their customers should not be a factor in the market for a period of time. Next, I calculate the balance of stock offered by the other syndicate members. With that figure in mind, I observe the trading volume for the ensuing days. As a rule of thumb, once the syndicate members' stock has been turned over two times, the upside move should resume.
Other items, such as the price of the stock and the exchange on which it will be listed, are incidental factors that should also be considered. Many institutions are precluded from buying a stock that does not appear on an approved list. Frequently, a stock cannot be included on the approved list if it is not priced above $10. Most reputable new issues are traded on NASDAQ, with a few exceptions that qualify for the listed exchanges. Margin requirements associated with these exchanges are important considerations as well.
Other factors, such as the lifting of the “quiet period” and the removal of major restrictions, often revitalize interest in the stock. Furthermore, a primary consideration is the subject of supply. As mentioned in Chapter 1, many investors who own a stock at a loss will sell once they break even. In the case of a recent new issue, there is no supply because there are no buyers with a loss.
The various factors I review when I consider a new issue should not be confused with the basic tendency inherent in stocks offered in the new issue aftermarket. A noticeable pattern to advance appears three to five weeks after the offering. I suggest that, in order to be alerted to potential trading candidates, you subscribe to a chart service such as O'Neill's Daily Graphs, which monitors the daily price history of many of these stocks just after public trading begins to follow this price behavior.
Buy-Outs
I have been in the investment business for a long enough time to witness all the fads and market concepts that are imaginable. The era of corporate takeovers was a thrill for me. Fortunately, the supply–demand models I had created were installed and were being successfully used prior to the advent of this period. Initially, my work would alert me to those situations in which aggressive buying was taking place. Most technicians are parasites and require no fundamental justification for their market activities, so I assumed that positive fundamental developments had precipitated this demand. I was soon to learn that a pattern had developed that correctly predicted pending buy-outs. At last count, between 1978 and 1982, more than 32 acquisitions were correctly forecast. I even had the gall to notify corporate presidents and announce that their companies were being acquired. In fact, I was described by one journalist as the “grim reaper.” The techniques are described in Chapters 5 and 7, which discuss accumulation/distribution and Sequential© respectively. Both methods combined were sufficiently sensitive to identify these opportunities. In this chapter, my goal is to share information I acquired from experience to further validate acquisition candidates.
Having played basketball, I was never satisfied with the easy lay-up. When I was put in a lay-up situation, I often passed the ball or made an effort to score with a more difficult shot. The same strategy applied to inside information and potential buy-outs. Not only did I prefer to make the process a challenge but I also was confident that by the time pending rumors of buy-outs were widespread and nothing was announced formally, the rumors were more than likely bogus. I tried to explain this to others, but they were unwilling to listen. I did much research to convince them with logic and with examples.
In the early 1970s, there were occasional buy-out rumors. Most legitimate instances demonstrated a similar pattern. I noticed that a surge in price volume was followed by a respite period of typically just over six months. I came to respect this pattern; under the tax laws at that time, long-term capital gains required a holding period of six months. Furthermore, the governmental agencies were not actively involved in prosecuting traders for insider activity. Consequently, I was always aware of rumors from reliable sources and I advised others that, typically, the official announcement was more than likely forthcoming much later because the insiders were probably still in the process of accumulating stock personally—even though I never capitalized on this fact myself. At the same time, the acquiring company was careful not to accumulate more than the maximum allowable percentage of the shares outstanding before the government required a formal acquisition announcement.
After the tax law was changed to abolish the six-month holding period requirement, other factors that served to confirm rumors of a buy-out were tested and were applied successfully. My belief was that once the rumors were received by the lowest common trading denominator—the public—and still nothing was formally released, more than likely they were nothing more than rumors. To prove this fact to others, I conducted the following exercise. First, I researched and confirmed the total shares outstanding. Next, I multiplied the number of shares outstanding by 5 percent to arrive at a benchmark. In turn, I multiplied this figure by a factor of 5. Because the Securities and Exchange Commission (SEC) requires any shareholder accumulating in excess of 5 percent of a company to divulge this information, I assumed that for every share a potential buyer accumulated, four shares were being bought by others. Were a rumor proven to be fact, then the critical 5 percent ownership would most likely be completed by the time 25 percent of the shares outstanding had been traded. This particular filter process served me well in convincing others to avoid disasters.
Another important observation I have made throughout the years relates to the price activity displayed by a stock which has been “put into acquisition play” by the release of a statement from the acquiring company. Specifically, once the announcement is made and it is a cash—as opposed to a stock—purchase offer and the price of the shares immediately trade at or above the acquisition price, generally either a higher price is bid by the suitor, additional buyers appear, or, in any event, the deal is easily expected to be consummated.
New Listing on Exchange
Once a stock is listed on an exchange or added to an index, the potential for additional interest is enhanced considerably. Index funds are required to include in their portfolios all components in various indexes, and margin requirements are often more attractive once exchange listing is accomplished. For these reasons, the potential audience is often increased significantly. It is not uncommon to witness a price advance even prior to listing, in anticipation of this tendency. Furthermore, many committees of large investment companies restrict investment to only listed stocks—and then only stocks priced in excess of $10. Because of the criteria required for listing approval, these large investors use the listing process and the active requirements to remain listed as additional safeguards to ensure that they are investing prudently. The reverse of this phenomenon occurs when a stock is delisted. Heavy liquidation of delisted stocks, together with the prospects of the company itself failing, are legitimate concerns that are to be respected and expected.
I noticed the same tendency back in the early 1970s, when exchange-listed stock calls were first introduced. It was almost a foregone conclusion that as soon as a call was listed, the underlying security would advance. This pattern was dominant for an extended period of time until the exchange-listed puts were introduced and prices for the underlying stock declined for a short period of time. Unfortunately, this tendency was short-lived. In any case, I remain vigilant to observe the vagaries associated with the introduction of any new product in order to identify any inclination for the pattern to repeat itself.
New Highs–New Lows
Newcomers to a race track can always be expected to bet on the long shots. Typically, those bets have odds over 50-to-1 and almost never win. The smart money—the sophisticated gamblers—conduct their research and bet their money prudently and realistically; any expectations of a long-shot winner are left to inexperienced gamblers. A long shot does occasionally win, amid as many bells and whistles as a big slot machine winner will hear in Las Vegas, but that outcome is the exception. The same concept applies to the stock market. Invariably, inexperienced traders like to focus on yesterday's market winners. History has proven that it is the exception indeed for a strong stock or industry performer in one bull market to repeat its preeminence in a succeeding bull move. Generally, once it has become a fallen angel, it takes a number of market cycles to recover and lead once again. Unsophisticated traders (and some experienced traders) ignore this fact and often become trapped in these losing propositions.
Common sense dictates that, as price declines more and more, owners of a stock incur losses. For the stock to rally significantly to new highs, all the supply created by premature buyers on the way down must be overcome. How many times have you entered a trade only to see price move immediately against you, and then said to yourself that once you break even you will liquidate? Either these buyers must hold their stock positions and not liquidate, or their supply must be absorbed before price can advance. If a stock is making a series of new highs in price, there are no unhappy buyers with losses. Thus, the expectation of liquidation once the trader breaks even is gone. Conceptually, the argument of overhead supply does not exist. My experience of being a stock scavenger was short-lived, once I viewed the prospects in the context of overhead supply. My research proved that stocks making new highs during an overall flat market were candidates for purchase because they were able to defy the laws of gravity displayed by the market indexes. In fact, generally, they were leaders in the market during any period of strength. Conversely, during a sideways market prior to decline, those stocks recording new lows were the leaders on the downside in any market selloff.
Many years ago, I took my research regarding 52-week new highs–new lows and applied a technique that assigned a stock's relative position versus its 52-week high or low. For example, instead of just relying on the list of new highs-new lows as they appeared in the newspaper, I wanted to know precisely how close a given stock, presently at neither a new high nor a new low, was to recording one. Often, the proximity of a stock to recording a new high or a new low is camouflaged. An index I created, the TD New High/Low Index, provided me with a benchmark whereby I could confirm expectations of price breakouts either upside or downside. The index is constructed by dividing the 52-week price movement of a stock by 10, and then ranking the stock on that particular day. If, for example, price records a close today within 10 percent of its 52-week high, then a rating of 10 is assigned to the stock. Conversely, if price records a close less than 90 percent of its 52-week high, then a rating of 1 is assigned to the stock. If the price closes 50 percent less than its 52-week high, then a rating of 5 is assigned to the stock. Next, I calculate a cumulative value and plot this index beneath the price action of a market index to validate price moves and trends and to determine the durability and substance of a trend. This method of evaluating the relative price close versus the price range of the previous year and then calculating a composite index (TD New High/Low Index) to validate overall market moves is a valuable contribution to the library of market indicators. Once again, a basic, widely accepted indicator—new high–new low—is enhanced to create a more complete market indicator. All it took was a little imagination and some creativity.
The other indicators described below are designed to improve on those commonly used by most stock traders. I believe the enhancements I have introduced, as well as the integration of the various approaches into a composite, yield benefits that greatly improve the potential of trading success.
Turbo-Charged Indicators
As is apparent throughout the book, many of the ideas I have presented are improvements on the techniques employed by most traders. My personality is such that I have never been content to accept what everyone else does. I want explanations and logic to substantiate what I do. In most instances, my research confirmed that the widely followed construction and the interpretation of indicators had some validity, but I wanted to exploit them further and make them more effective and valuable with my adaptations. I was comfortable and confident knowing that no one else would be using anything similar unless I shared these indicators with them.
Advance-Decline
Most traders are familiar with advance-decline models. Conventional methods usually run a cumulative index of net advances–declines plotted daily below a particular market index. For over 20 years, I calculated a 5-day average by summing the net advances-declines and then dividing by 5.1 also calculated a 13-day average by summing the net advances-declines and then dividing by 13. I established overbought/oversold boundaries for these averages and compared them to a series of other relationships (described below) to arrive at ideal buy or sell opportunities. Generally, I would expect to see the 5-day figure exceed ±450 on the same day that the 13-day figure exceeds ±250.
I perform similar calculations of 5- and 13-day averages for the Dow Jones Industrial Average 30 components. Generally, readings of ±14.0 and ±5.0 for the same-day readings for both the 5-day and the 13-day averages coincide with turning points.
Next, I divide the total advances by the total declines for each day. I sum these values and average them for 5 days and for 13 days. The 5-day figure would have to exceed 1.95, and the 13-day calculation would have to exceed 1.70 on the same day. Conversely, the 5-day figure would have to be below .65 and the 13-day calculation below .95. In turn, these levels would be incorporated into the master model to identify ideal buy and sell entry points.
The next comparison in my overbought/oversold matrix is the ratio of advancing issues/total issues traded. On a 5-day and a 13-day basis, for an ideal oversold reading, I like to see the 5-day below 30 and the 13-day below 35. Conversely, for an ideal overbought reading, I like to see the 5-day above 50 and the 13-day above 45. Integrated into the model constructed by determining ideal overbought/oversold bands for the other indicators, this measure confirms high-risk and low-risk buy and sell zones.
Most people are familiar with the trend index (TRIN) developed by Richard Arms and found on most quotation terminals. This index divides the ratio of advancing to declining issues by the ratio of upside volume to downside volume. I recommend averaging these daily values over 5-day and 13-day periods. If the 5-day value is above 1.35 and the 13-day value is above 1.20, or the 5-day value is below .75 and the 13-day value is below .85 on the same day, and the other relationships in the model confirm, low-risk entry levels can be established.
The last component of the market model is a ratio of the current day's Dow Jones Industrials Close divided by the close of the Dow Jones Industrials Close 55 trading days before. If the ratio is below .89 or above 1.13, usually turning points are identified. Used in conjunction with the other indicators described above, a package of indicators with a respectable track record history is created.
I created this overbought/oversold matrix over 20 years ago. I entered the statistics myself dally. Today, computers simplify this task markedly. I present below a sample of the statistics I accumulate daily.
Date
Total Issues Traded
Advance (Adv)
Decline (Dec)
Net 5-Day 13-Day
Advance
Total
5-Day 13-Day
Advance
Decline
5-Day 13-Day
Net DJIA 5-Day 13-Day
TRIN 5-Day 13-Day
DJIA High Low Close
Momentum Close Today
Close 89 Days Ago