Stock Exchange: Disciplined Entry and Exit Points

The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • Highlight several technical trading methods, including current ideas;
  • Feature advice from top traders and writers; an d,
  • Provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some earnings season ideas, please join in!

Review

Our previous Stock Exchange considered whether the bull market was slowing. If you missed it, a glance at your news will show that the key points remain relevant.

This Week – Using Discipline When Entering and Exiting Trades

To frame this week’s discussion, here is quote about using stops to exit your trades from a recent edition of Charles Kirk’s, The Kirk Report:

“I do not adjust my stops after they are set, especially not on the fly based on some outside risk event… I don’t like that kind of approach because it introduces a discretionary element into your risk management… At the end of the day, it isn’t up to me to decide whether the market is wrong or right. After all, the market is always right. The stop is there to protect my capital when the position is wrong.”

For some additional perspective on trading strategies, Valeriy Zakamulin adds a little order to the chaos in the field of market timing with moving averages in this article from Alpha Architect:

Trend-Following with Valeriy Zakamulin: Anatomy of Trading Rules

Further still, Alpha Architect provides more insightful information in this article:

Volatility Premium, Covered Call Selling, and Knowing What You Own

Specifically, the article defines the concept of “volatility premium” and then goes on to describe several ways to capture that premium when you enter your trades.

Expert Picks from the Models

This week’s Stock Exchange is being edited by our frequent guest: Blue Harbinger (also known as Mark D. Hines). Blue Harbinger is a source for independent investment ideas focused on value and income opportunities.

Homes: This week I like Franklin Resources (BEN). This stock’s dip over the last month is the sort of set up I like to see. From the chart below you can see BEN is below its 50-day moving average, and just above its 200-day moving average. It’s also received support at $42 twice now, and the price has moved up this week. With limited downside and plenty of upside potential, I hope I’ve brought the humans a solid pick.

Blue Harbinger: BEN is an interesting business Holmes. It’s largely an active asset manager targeting mainly retail investors, as well as some institutions. Asset managers make money based on the amount of assets under management (“AUM”) they have (i.e. their fees are often a percent of AUM). So when the market goes up, BEN’s revenues go up. The trouble with Franklin Resources is that there is this huge and continuing wave of assets moving away from active funds and into passive funds, this is NOT good for BEN.

Holmes: That a nice story about Franklin Resources, Blue Harbinger. But my style is dip-buying mean reversion, my average holding period is six weeks, I exit when my price target is achieved, and I control risks based on macro factors and stops.

BH: Well Franklin Resources delivered slightly disappointing earnings on July 28th, and that’s why the shares have sold off. The company’s AUM was up $2.8 billion during the quarter. Specifically, AUM was up $10.1 billion due to net market change, but then lost $7.3 billion in net outflows—you know, investors moving their money elsewhere. Holmes, have you considered a nice passive manager, like BlackRock (BLK)?… their assets under management will continue to benefit from investors moving to low-cost passive funds like the iShares they offer.

Holmes: I could counter your argument by pointing out active managers (including Franklin Resources) have been increasingly beating their benchmarks this year, and also that the retail mutual funds business has an enormous contingent of relationship-driven clients that will never go to the cold, bare bones, solutions offered by BlackRock. But instead, I’ll just remind you that my edge is based on quantifiable mean-reversion and dip-buying, and I’ll stick to that. How about you RoadRunner, what do you like this week?

RoadRunner: My most recent pick is RH (formerly Restoration Hardware) (RH). I look for stocks that are at the bottom of a rising trading channel, and if you look at the chart below you can see why I like RH. It’s been in a steady rising channel for months and may easily rise over $75 soon. I get in at opportune times, but only hold my position for so long—usually about four weeks.

Blue Harbinger: RoadRunner, might I remind you that you have picked RH in the past, on both July 28th and on May 19th. Is there any particular reason you keep bringing RH to our attention?

RR: Well aside from the reasons I just told you (it’s at the bottom of a rising channel, and it looks good for the next four weeks) my quantitative system has a profitable track record of getting in and out of these names at the right time.

BH: Ok RoadRunner, then I’m just going to remind you of some of the things I pointed out last time you recommended. First, I don’t like RH. It’s a luxury home furnishings company that just completed an extraordinarily aggressive share buyback program. Specifically, they bought back nearly 50% of the shares outstanding in less than six months, and that drove the price to more than double, and it caused the price-to-earnings ratio to also increase dramatically.

The company’s actions just seem very aggressive to me, especially considering they used some expensive debt to buy back the shares. And the market also believes there’s something odd going on here considering short interest is still over 50%! I just feel like this company could tank under even the slightest recession.

RR: Feelings are important, but not when it comes to my disciplined and repeatable process. RH is attractive. Anyway, how about you Felix—what have you got?

Felix: I like Yelp (YELP). This stock has some powerful momentum on its side.

BH: Interesting pick, Felix. It’s nice to see you finally bring an idea to the table after you had nothing for us last week.

Felix: Unlike you humans, I don’t get frustrated and try to force things when the opportunities simply aren’t there. On average, I hold my positions for 66 weeks. I’ll exit when my price target is achieved, and I use stops to manage risks.

BH: Yelp is interesting because revenues are growing rapidly, but so too are SG&A expenses. Your 66 week average holding period seems a little long compared to the rest of the gang, but I suppose that will give Yelp time to keep growing its business.

Yelp is basically an online platform to help people find highly regarded local businesses. It’s got a huge addressable market, so if it keeps growing revenues, and it finds a way to control costs (eventually it won’t have to spend so heavily on SG&A expenses), Yelp could turn into a highly profitable cash cow.

Felix: That’s an interesting story. However, I’m just here to pick winners.

BH: That’s why we like you Felix. Do you have an updated rankings list for us?

Felix: Yep. Here you go…

Conclusion

The trading process can often appear chaotic, especially if you are a newcomer to the field. However, there are methods behind the madness in determining when to enter and exit positions. For example, there are disciplined quantitative processes behind the selections of Felix, RoadRunner and Holmes (as well as Athena and Oscar). Further still, there are disciplined risk controls and exit methodologies in place. And having a disciplined process for entry and exit points is often what separates the most successful traders from the rest of the pack.

Stock Exchange Character Guide

Background on the Stock Exchange

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out http://dashofinsight.com/background-stock-exchange/  for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!

Jackson Hole Question: How Fast Will the Fed Unwind Its Balance Sheet?

Financial media, Fed watchers, and the punditry pay special attention to the Kansas City’s Fed’s annual conference at Jackson Hole. It is a forum that draws top speakers, innovative ideas, and a sense of the possible policy changes. I expect that a key question will be the reduction of the Fed’s $4.5 trillion balance sheet – how much, and how fast?

Because many market participants attribute the increase in asset prices to liquidity generated by the QE programs, markets are sensitive to any change. Even the contemplation of a reduction in QE caused the “taper tantrum” market reaction. Later decisions ending QE programs did not have the same effect. What about now?

I have frequently written that the punditry under-estimated the effect of a stronger economy and growing earnings, and over-estimated the QE effect. Commentary has more to do with a simple, persuasive theme than disciplined economic analysis.

A Costly Misperception

Investors pay too much attention to the Fed, and not enough to expected earnings and inflation.

Two months ago, I explained why the Fed plan to allow holdings to expire without replacing them would have a small impact. The key factor is that this is not a two-party market, but one with depth far greater than the securities offered. The problem with my explanation is that it requires a basic economic understanding of economics. It does not reach those who are proud that they never took Econ 101.

We are already seeing scary articles on the effects of the unwind. (Almost always ends in recession, based on six cases. This is an author on a mission!) This analysis, suggesting an increase in ten-year yield of 12.5 bps per year, is much closer to the truth.

Since I am trying to help investors, I seek the most persuasive presentation of truth. Instead of relying on basic economic theory, let us try a completely different approach.

A Natural Experiment

Suppose that a single owner held 60% of an asset and wanted to liquidate the position in a year. There is a right way, and a wrong way to accomplish this. It is the question faced by the Federal government when it wanted to conclude its ownership position in the stock of General Motors (GM). Here are the key events:

ProPublica tracked each investment in the bailout, as well as each repayment. It is a complete timeline.

In 2008, after the bailout, the US owned 60% of GM. The Treasury reported the Bush Administration plan, the Obama Administration support, and the final bailout size.

In 2013 the Treasury sold 70 million shares and announces a plan to sell the remaining 31 million shares. It announced a plan for a gradual sale via outside brokers.

On a quarterly basis, the Treasury plans to disclose how many share of GM stock it has sold and will report monthly its proceeds from the sale.

In December, the Treasury sold 200 million shares of its GM stock to the Detroit automaker for $5.5 billion, or $27.50 a share.

In order to prevent hedge funds and other investors from taking advantage, the Treasury doesn’t make the trading plan public.

The plan places limits on how much stock can be sold at any given time and at what prices. Government officials also can provide the banks with direction on when they should sell additional shares.

Last month, the Treasury named Citigroup Inc. and JPMorgan Chase & Co. to manage the sale.

The banks will get a 1 cent per share commission — or $3 million — for the sale of the entire stake.

The Treasury has said it “intends to sell its shares into the market in an orderly fashion and fully exit its remaining GM investment within the next 12-15 months, subject to market conditions.”

The government needs to get $72 per share for its remaining shares to break even on its $49.5 billion GM bailout. It initially held a 61 percent stake before selling about half of its shares in GM’s November 2010 IPO at $33 a share.

At current prices, the Treasury would lose more than $12 billion on its GM bailout.

 

When the plan was finally completed, the big story for most was the net loss on the “investment.” These articles included a lot of controversy, including opinions that the Government should hold on for a better price. Few evaluated the economic effects of stabilizing the company.

But my mission is neither to justify nor to evaluate the policy. I am using it as an example of how to exit a large position. How well did the plan work? Let’s look at GM stock prices during 2013 with Ford as a comparison.

The 2013 period is the key comparison. The prior period is presented to show the typically tight correlation between the stocks. It would be difficult to argue that the stock price suffered from the government sale of 60% of the company.

Policy Implications

The Fed should not feel bound to procedures designed for prior and dissimilar conditions. The public announcement of each QE trade helped to create a mythology that affected markets. They seem not to understand this. The Fed’s objective should be to minimize the footprint of the trades – the implementation of a policy which has consensus support.

Investor Implications

The answer to our headline question is that we should not care about the balance sheet unwind. This policy change will not – ultimately – be important for markets. The size is small relative to the overall market. Most pundits could not even tell you the daily volume in Treasuries, nor could they draw a supply and demand curve. It is a good example of where even a small amount of economic education can provide a big market advantage. And also where pseudo-experts can create fear.

 

 

 

The ETF Effect – and the Opportunity it Presents for Investors

There is a repeating dynamic in US equity markets. It represents an opportunity for investors.

  • News breaks – authenticity not required.
  • The information is parsed based upon simplistic memes, general ideas which have worked in recent trading.
  • The fastest algorithms jump on the trade, using the ETFs that fit the story. (The Seattle Times describes this, citing Josh Brown, who frequently makes this point on CNBC).
  • Financial media sources interpret the move, usually repeating the popular concept.
  • Some traders and investors “chase” the action.
  • The algo traders flatten positions, booking a profit, and move on.

Meanwhile – inside the ETF – each member is bought or sold, whether or not it fits the current story!

An Example

A current theme, based upon the success of Amazon (AMZN), is that “retail is dead.” The retail SPDR (XRT) shows how this has played out over recent weeks.

The emphasis on ETF trading takes the simple theme and applies it to all companies in the ETF – whether or not that is appropriate.

Here are two companies where ETFs hold 8-10% of the stock – Williams Sonoma (WSM) and Guess (GES). Here are the F.A.S.T. Graph summaries for each.

 

WSM has a nice dividend, no debt, and a reasonable multiple. It also has an anti-AMZN online and value component as part of the business. It is not just like the other retail ETF members – even if one gives credence to the basic theme.

GES is rather expensive on a PEG ratio, but it does have a great dividend and almost no debt. It is easy to see why some would find it attractive, and unlike other retailers.

Investment Implications

Any stock’s return is a combination of the overall market, the sector, and the company’s results. For investors who analyze the fundamentals of the company, exclusively trading ETFs misses out on an important potential source of edge.

The examples cited above both beat earnings estimates today and will probably have nice gains tomorrow. It can pay handsomely to focus on individual companies rather than (or in addition to) broader sector or market themes.

Market participants, especially those needing to react immediately, often over-simplify. This is an opportunity for investors with a longer time horizon.