Plan for the Impending Rally, Part 2

The market has given conflicting signals over the past several weeks. October 16th, the market logged a Follow-Through Day which often indicates a change in market trend. As IBD is fond of saying, “no market uptrend has ever started without a follow through day, but not every follow through day means a new bull market”. How should an investor reconcile what on the surface seems like contradictory advice? In part one of “Plan for the Impending Rally”, I said that investors need a system that at a minimum answers these four questions:

1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble

Before we go any further I just want to point out that during the week of October 22nd the market suffered two straight days of heavy volume losses coupled with a traumatic Friday start when the market opened with limit down curbs in place. The poor daily and weekly action negates the follow-through day mentioned above. Today, October 28th, the market logged yet another follow through day on decent volume and big price gains.

Now that the market direction may have changed, where do we go from here? The market is clearly whipsawing creating a dangerous environment. The media is filled with pundits calling this an opportunity of a life time and value investors have started to come into the market lead by Warren Buffet. Tread lightly.

As I mentioned in my prior posting, if you are a long term mutual fund investor with a 10+ year time frame keep putting money to work and double up if possible. In 20 years you will glad you did.

What should you do if you have a more speculative outlook? First review the four main points above and begin constructing an appropriate system so you can effectively invest in this challenging market environment which could last for years. There are literally thousand of stock market systems out there but keep in mind you must find one that matches your market outlook and personal psychology. Be realistic and know that it will take several years to master a given system so in the meantime how should you operate in today’s’ market?

Here is a game plan to consider. The plan allows you to spot a potential market turning point, identify new leadership, pick strong stocks and effectively manage your money.

1. Look for the market to log follow through day. This indicates a potential change in market direction and could potentially signal the long anticipated bottom. This event occurred today.
2. Now that the market has followed through, look for stocks making new highs while preferably breaking out of new bases. Ideally you would find several stocks form the same industry group moving in tandem to new highs. This is an excellent way to confirm market sector leadership.
3. The bear market has damaged just about every stock, so even though a follow through occurred not many stocks may fit the parameters mentioned above. You must exercise patience and resist the urge to jump in because you will miss big gains. We are in a nasty correction and you must exercise skepticism above all else and make the market prove itself before you risk your hard earned money.
4. Once you have found a stock that meets your selection criteria, make a small initial purchase as close to the proper buy point as possible. The initial purchase should be only a very small amount of your total portfolio. My last initial buy used only 2.5% of my total portfolio, but I risked even less. More on that below.
5. Put a stop in place when you make you initial buy. I normally put my stop loss at 5% below my first purchase price but you could go as far as a 10% stop. My experience is that once a stock begins to show a loss it will eventually hit my stop so I try to get out as cheaply as possible.
6. Stops limit what you actually risk in the market. For instance if you purchase $5,000 worth of stock with a 5% stop you aren’t wagering that total amount but just $250 which on a $100,000 portfolio equals just .025%. Think about this the next time you see the whole market swoon 10%.
7. If the initial buy shows a profit, add more as the stock gains 2-2.5% from your last purchase price. Make three buys of even amounts and be sure you do not buy any further than 5% past a proper buy point.
8. If your stock increases enough to make three buys make sure you have stop in place to protect that whole position. Again I prefer a 5% stop for a complete position.
9. If the first position is a winner look for a second stock to buy. The market has shown strength so now repeat steps 4-7 but it is safe to increase the amount of capital that you use from 2.5 of your total portfolio to 4% when making the next purchase. Don’t forget the stop!
10. If your first position is stopped out take it as a danger signal. The market is not working for you. Consider sitting on the sidelines but if you are compelled to make another stock purchase repeat steps 4-7 but this time only use 1.5% of your portfolio take make that first buy and don’t forget the stop!
11. If you buy three stocks and you stop out on all three take three weeks off before making any more buys. Use the time to evaluate the overall market condition because three strikes is the market’s way of telling you something is wrong. This is by far that hardest thing that I have to force myself to do because I have a psychological weakness that I believe the market will increase. I have put this rule in place to protect me from myself.

In closing the market has followed through indicating a potential change of trend. Use a sound set of trading principals like the ones outlined above of search for one that fits your own personal style. Above all, exercise caution and use stops to protect yourself in a dangerous market.

Plan for the Impending Rally - Part 1

This past week saw historic market losses; in fact it was the worst week ever for the stock exchange. The cover of Time Magazine shows a soup line from the 1930’s and questions if we are heading for another depression. Many popular commentators now openly use the term “Great Depression 2” as a real possibility if the markets cannot be righted. For the first time in my life, excluding 9/11, there is genuine almost primal fear in the country. Yet history shows us that these times may be the best to start putting money back to work in the market. In order to fully capitalize on this opportunity you must have a game plan to take advantage of the impending rally.

John Boik discusses many market crashes and the ensuing market rallies in his book How Legendary Traders Made Millions. Each market crash such as 1929, 1962, 1973, 1987 and 1998 saw significant market rallies that bagged gains of 50%, 100% or more in the subsequent recovery. No matter how bad the market gets, it will always make a rally attempt.

This does not mean that the market bottoms, rallies, and then goes straight up. The 1974 recovery saw the market bottom in the fall of that year, rally for 5 weeks then roll back over undercutting the prior lows. The market then got itself back together in the beginning of 1975 before it started its big run. Monday saw the US exchanges rocket over 11% in one day. Many people may take this as a signal that we have bottomed, but historically big one day percentage gains often happen during a Bear market so caution is still advised.

Who knows how the market will recover from the 2008 crash, but there are three distinct rally scenarios that you must be ready for.

1. The markets will rally and logged a quick gain of 20%+ since stocks have been beaten down so much and so quickly by panic selling.
2. The markets will put together a suspect rally that last for several weeks which is just long enough to get people to start buying again before it rolls over and heads lower.
3. The market will rally but trend sideways for several months in order to heal itself before heading higher or potentially lower based on world events.

How should investors approach the three scenarios? In general, there are two classes of investors, the first group is long term mutual fund holders and the second group is short term traders who invest in individual securities. Each should approach the market differently.

If you are a long term mutual fund holder who makes monthly contributions towards your retirement and you have a 10-20 year horizon then stay on track and resist the urge to stop putting money into the market because of scary headlines. The markets will certainly be higher 20 years from now and you will be well rewarded.

For those of you who want to invest in individual stocks your job is much harder but it does offer greater rewards. To maximize your gains you must have a game plan and a system to capitalize on the impending rally while protecting yourself from a potential market head-fake. Your system and game plan should include the following:

1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble

Monday’s big gain offers hope that the worst is behind us and that we may be at dawn of a new golden Bull market. The only way that we will know for certain is if market prices continue to rise. Caution is the way now; make sure that you have a plan and a system that can help you navigate these historic but dangerous times. If you do not have a system, I strongly suggest that you visit Investors Business Daily and get a free two week subscription to this great publication.

Definition

Given the current market conditions, I think it is appropriate to define and explain the namesake of this blog. The term “Ever-Liquid Account” was a phrase coined in Gerald Loeb’s book the “Battle for Investment Survival”. For those of you not familiar with Loeb, he was a legendary trader who got his start the early 1920’s and made a fortune in the stock market over a long and fabled career. The “Ever-Liquid Account” is essentially a money management and strategy for trading stocks.

Loeb suggests the following:

1. A major component of stock market success is predicated on the ability to stay completely in cash until the right market opportunity appears.
2. When an upward market trend is established, buy liquid market leaders or those stocks with the potential to become market leaders.
3. The method favors concentrated purchases and eschews diversification since the investor must have strong convictions about both the positions established along with the general trend of the market. An investor may hold up to four carefully chosen stocks.
4. This style of investing lends itself to pyramiding. This means that when a new position is established the entire stake is not bought at once. Rather, a small pilot purchase is advised and if this initial buy shows a profit then more can be bought as the price advances. The initial buy may be 1/3 to ½ of the full position. Subsequent buys may be made in additional thirds until the position is rounded out.
5. If the first full purchase shows a profit then a second position can be established in a new stock using the method above.
6. If the original purchase shows a loss it should be closed out. The stop may be anywhere from 3%-10% below the first purchase price. If a compelling new stock is found after this first loss, a new position can be started albeit with a smaller amount.
7. A limited amount of capital deployed in concentrated positions will allow the shrewd investor to outperform the market. In certain circumstances 20-25% of one’s capital may be invested in individual positions but this is the exception rather that the rule unless a compelling market event appears.

This style of investing is not easy and requires extreme patience and discipline. The main advantage of this system is that it keeps one out of weak markets by taking small losses on pilot purchases and additional funds are only deployed as prices appreciate during an uptrend.

Principles Defined

There are ten principles of investing that I believe if properly employed will put one on the road to the wealth that one seeks, or at the very minimum, allow the individual investor to consistently beat the market. The trick is to firmly believe in these time tested principles, work on them daily, and finally obey them no matter what. It is the final clause that gets most people. It is all too easy to make excuses in the market for a given situation and rationalize a decision that almost always ends in tears. The ability to stick by one’s guiding principles is what separates the winning investor for all others. I believe the path to success in the market is based on the following:


1. Investing is a business
2. Always obey the Golden Rule
3. Have a system
4. Implement a money management plan for your trades and your portfolio
5. Learn to use charts
6. Start with a small amount of money while learning
7. Keep a trading log
8. Measure success in terms of years and not days and weeks
9. Concentrate, do not diversify
10. Don’t buy on tips alone

These tenets will serve as the basis of this blog and it is my goal to explore at least one a week. The curious reader may ask on what foundation are these principles based. I will be upfront and confess that these ideas are not my own but rather they are founded on the habits and thoughts of great speculators which span from over 100 years ago to the present. The real secret is that they hide in front of us.

There is one final principle which I purposely omitted. This last precept is in fact the real key to your ultimate success in the market and personal happiness in life. I have searched for it all of these years and I have still not achieved it and never thought I would have found it in this endeavor, but I believe it is within all of our grasps. I will share more as this blog unfolds and I promise I am not recruiting for a cult.

My wish is that you will visit often as I discuss these principles. They are truly what separate the winning speculator from the losing, but hopeful, investor.

Introduction

The secret of investing success hides in front of each us. The purpose of this blog is to share the habits that can lead to the financial success that we all desire. This site is specifically designed for aspiring investors who may have invested for a year or a dozen years. There are 10 core habits that I believe, if followed and worked on daily, can help you reach your goal. I will be upfront and state that this success for most of us will not occur overnight but rather it will take us years to achieve. My goal each week is to publish at least one article on a given habit interspersed with market commentary, stock analysis and notes on some of my other passions including food, music, tennis and my family. I hope that you will enjoy this site and visit often.