Commentary Thursday Morning

[HenryTo]

Just wanted to let you all know that tomorrow morning's commentary will be provided by dear Mr. Bill R. aka nodoodahs who had previously already provided a commentary re: picking stocks.

In his latest commentary, he will providing an analysis on the equity put/call ratio and its usability in predicting the stock market on a going-forward basis. Readers who are totally unfamilar re: regression analysis may want to read up on it beforehand.

Thank you Bill for providing us your insightful analysis!

Best regards,

Henry

[nodoodahs]

[nodoodahs]

Before I started investing in individual stocks, I put in writing some guidelines, which I highly recommend. Putting YOUR guidelines in writing is what I recommend, not necessarily MY guidelines. Here's item 3.

3.When to sell
(a) No longer a good business
1) Changes in management, direction, or macro variables impacting company
2) Dramatic declines in earnings
3) Dramatic increases in debt level
4) Switches from positive cash flow to cash burn
(b) Price appreciation too high
1) If PE becomes >15, put on a watch list
2) If PE becomes >20, think about selling
3) If PE gets consistently over 25 it’s time to go

Having given it some thought since originally writing it down, I think that perhaps rather than an outright sell on condition 3.(a) or 3.(b), a strategy of putting fairly aggressive stops under the appreciated price might allow for the stock to rise further (if the market continues to misprice the issue) and I could reap more gains than if I sold outright.

Hypothetically, if the stock is purchased at 10 PE and becomes "hot" - rising to 25 PE over a year or so - I have no guarantee that the broader market will see it my way. I could sell outright, but what if the stock valuation went even more outrageous before it fell? I potentially miss out on that irrational (IMO) run up. If I simply allow it to rise but start putting increasingly aggressive stops underneath it I could lock in some gains.

Take the other hypothetical, that I see warning signs in the company's financials. Often it takes years for them to be noticed by the general public and be reflected in the stock price, although they almost always eventually are. The strategy of aggressive stops might be better than an outright sell for maximizing total return.

It all depends on your ability to sleep at night while holding a stock you think is overvalued or is not a good company.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[fh1951]

Just read the very detailed framework that you use for making informed decisions when buying low PE stocks that you so kindly provided back on June 23. Do you have similar analytical criteria for selling that you would be willing to share?

[nodoodahs]

I was asked two questions from a reader via email, which I’ll share the answers for.

1. What is my forecast for the price of oil by Dec 2005?
2. Where can one find my stock picks?

Ouch. I don’t have a forecast model for spot oil prices. I do have some thoughts regarding how oil prices are set, and some charts, etc., that I shared with the Longwaves/Safehaven email group in a series of emails. I also posted on this board some thoughts. A synopsis:

Adjusted (for monetary inflation not CPI) oil prices have been getting cheaper over the last 20 years. This has led to a lack of investment in exploration and extraction, causing the real term price to rise over the last 3 years or so as this has now caught up to us. I expect that as the adjusted price rises, investment will slowly increase, until the adjusted price drops again. This makes me bullish on commodities stocks like oil explorers, rig and service companies, and to some extent, shippers.

The relationship between year over year change in world production and year over year change in adjusted oil price, for the last 20 years, has been a lock step movement. What happened in 2002 was not a freak event, it was to be expected. When the adjusted price falls (rises), then the production falls (rises) soon after. Traditional economics would say that depressed supply would increase the price, but that is not what happens here. My possible explanation: over the short term, the low (adjusted for inflation) price (caused by whatever, perceptions of “all is well” or a “global economic slowdown”) causes the decrease in production, as producers idle capacity rather than waste money pumping oil at a loss.

The price mechanism is complex. This is how I conceptualize it. Daily, the traders make calculations based on their view of the situation. Obviously this view can change every day, be there a hurricane in the gulf, war on the horizon, political instability, etc. The sum of many of these transactions makes the spot price. If the collective view of the trading market gets more optimistic, prices fall, and vice versa. This is the short term. Think of it as a teenager high on ecstasy, dancing in a circle and waving a tiny little glow stick. The short term price, if it persists at a higher or lower level than it had been, sends a signal to the producers that production needs to increase or decrease. This is where price drives production. Producers alter their production, until either the change in production, supply, or stock levels finally "clicks" with the daily traders, and shifts their mindset. Think of it as giving that dancing teenager a nudge. This is the medium to long term - medium term is where price drives supply, long term is where stocks, supply, and demand shift the mindset of the traders, who set prices daily. In the very long term, the price is always increasing because monetary supply increases drive prices up. Think of money supply growth as tilting the floor that the teenager dances on.

Given the recent climb in adjusted oil prices and the demand and supply side moves talked about here http://www.marketthoughts.com/forum/viewtopic.php?t=560 , I think oil is going to go up very nicely over the next several years, possibly a decade. But that doesn’t mean it’ll go straight up, there will be drawbacks, corrections, etc.

At first I thought, geez, I don't want to have my portfolio on the board! But I realize I have left bread crumbs about my portfolio all over the board for a while now. I feel kinda weird about posting it. I've got some stocks, some funds, some real estate. I usually do a bunch of research right after earnings season ends and buy several stocks at a time, the other stuff is mostly older, and my wife and I both have to agree before we pull the trigger. I probably need to be more of a trader and wait for good dips or whatever, buy a little at a time, but I usually just buy a bunch as soon as I’m convinced it’s a bargain. Funny, there are two or three I could have bought at sizable discounts if I had only waited, and a couple of others that, had I waited, I would have paid more. I’ll list the last thirteen stocks I have purchased along with price, today’s close, and date bought.

Ticker Company Price Close Bought
AGU AGRIUM INC. 19.68 23.04 21-Jun-05
CVX CHEVRON CORP 53.58 58.94 20-Apr-05
RE EVEREST RE GRP LT 82.36 97.47 27-Apr-05
IMKTA INGLES MARKETS IN 13.44 15.56 22-Jun-05
KFS KINGSWAY FINANCIA 15.92 17.60 27-Apr-05
VLCCF KNIGHTSBRIDGE TNK 43.89 42.10 27-Apr-05
MGA MAGNA INTL CL A 62.70 75.56 20-Apr-05
NEU NEWMARKET CORP 15.42 16.90 27-Apr-05
NXG NORTHGATE MINERAL 1.06 1.14 3-May-05
NUE NUCOR CP 53.50 56.20 20-Apr-05
OSG OVERSEAS SHIPHDLG 58.50 61.83 27-Apr-05
PKX POSCO 46.90 49.80 20-Apr-05
PCU SOUTHERN PERU COP 51.65 51.80 3-May-05

As you can see if you look at their charts, some of them have been quite bumpy rides, and if I used a stop (I generally don’t), I would have been kicked out. Others have been rather pleasant. Just because they’ve done well as a group so far doesn’t mean they’ll do well in the future or that you should buy them – do your own research and due diligence, this is not advice or a solicitation to purchase, I’m just an amateur investor sharing what he has purchased recently. While I intend to hold them for the long term, I may sell them, or buy others, without posting to the board. I have no intention of keeping a running log of transactions on the net, but I will probably talk about stocks I like and dislike.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[nodoodahs]

Astro, Prof, thanks for your comments!

Right now with earnings season almost over, first order of business is screening for value long positions. Then I will be back to market models.

I only have data for EPCR to 1997 and Henry got that for me, before I was working with a more limited set to 2002. So I can't backtest as far as I'd like. I want to check if the regression output is similar for the different markets, to the output for the combined market. Then I'll try to develop a strategy and backtest the alpha, then forward test, then if all is well, go "live" with a portion of my investing money.

Studies of gamblers (and market timing is speculation not investing) show that the successful ones, be they horse track handicappers or poker players, adjust the size of the bet according to their perception of the odds. I can definitely imagine that when the model was inconclusive I would bet zero, and then ratchet it up according to the likely outcome.

I haven't verified today's output, the analysis for the presentation was completed Monday with data ending about a week before. I have been busy at the regular job and looking forward to earnings.

Mostly I have worked with the S&P 500 as my representation of "the market." Definitely I plan on expanding the analysis, but my bias is to go larger, not smaller, i.e. the NYSE composite rather than the Nasdaq. I think if I went smaller, I would want to use the EPCR for that index rather than the total EPCR.

Possibly the same principle applies to all sentiment indicators, in that they are heavily influenced by recent events. However, one key to the EPCR is that large numbers of buyers are wrong, that is, their purchases expire worthless, and they have put money on the table. Perhaps that would make a difference with AAII, MarketVane, and Investor's Intelligence? I don't know, I am not as familiar with them as I am with EPCR.

I'll keep posting.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[professor_56]

Bill,
I also greatly appreciate the quant analysis, having taken Multiple Regression Analysis and several other arcane statistical courses in graduate school 35 years ago. It's all just a dim memory at this point, but you've inspired me to delve into Excel, which I don't even have currently. If I applied your regression equation correctly, the S&P prediction for the next month is down approximately 1%.
Have you checked out other indexes, e.g. the NDX? Do you think the same principles apply to other sentiment measures, e.g. the AAII, MarketVane, & Investor's Intelligence surveys?
Welcome, Astro2
I am also interested in a fruitful trading strategy, as I'm sure most of us are.
Thanks again.
professor_56(Bill O.)

[astro2]

Bill,

Your great analysis using the equity put-to-call ratio inspired me to post to this board for the first time! This kind of work is probably not to everyone's taste, but having a science background I appreciated the quantative nature.

Do you have any plans to test a detailed trading strategy ?
It seems to me to improve results you'd only want to trade when the predicted next month’s outperformance was a relatively large move positive or negative - eg. avoiding the central -5% to +5% region.

THanks again for the analysis