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CHAPTER 1
Stock Indexes and Sectors
For those picking up this book who have little to no experience in the markets, I'll start off by welcoming you to the world of trading and investing. One of the greatest achievements for the human mind and psyche is to identify a business opportunity and then profit by taking decisive action.
Let me start off by addressing the newcomer or novice investor. I am not going to scare you away with heavy technical stuff, at least not now because that will come later. For the advanced trader, there are quite a few golden nuggets of trading concepts packed in these pages.
I want to share with you a story about my next-door neighbors' experience. These are awesome people. The husband is retired; the wife works as a travel agent in a North Shore suburb of Chicago. As the world was facing the financial crisis back in early 2009, the wife came over to our yard while I was surveying the garden. She knew that I worked in the financial markets, but had no idea exactly what I did. In the past, she had seen me on CNBC commenting on gold or crude oil and wanted my opinion on what to do. She had a feeling that stocks were too cheap and that there might be something she should get in on. She was right; stocks were cheap in March and April 2009.
She explained that they hadn't invested in stocks since the tech wreck of 2000, but they had some money and wanted some advice. I had her come over the next week for a lesson. All we did was go over some companies and get her online to open a self-directed trading account. The online trading company at the time was Thinkorswim. Some of the stocks we started her off with were General Electric (GE), Starbucks (SBUX), and Bank of America (BAC), and then later she asked me about other names like McDonald's (MCD). I talked and she listened, and more importantly, took decisive action. I found it amusing when making comments like āhere is where your stop should go.ā It was like I had just said something in a foreign language. But she learned. I am not saying she experienced enough success to start her own hedge fund, but she did experience success.
I wanted to start the book off with this story to show the beginner that good things can and do happen, but it takes the human mind and psyche's ability to identify an opportunity and then take decisive action.
Technology in the new millennium has given all of us a more equal playing field as far as pricing in regards to the cost of doing business, direct access to the markets by means of the Internet, and transparency by means of order execution platforms.
Many individuals exclude themselves from the markets for one reason or another. As it has been said, I believe more people plan for a family holiday than they do for their investments or financial futures. Perhaps others have a profound fear of loss and shy from making effective reasoning rationale.
Yet this is a business where it takes money to make money. There is no question about that. One has to be able to afford to lose once in a while and not let that hinder one's ability to make better educated and therefore more reasonable actions in the markets. My goal in this book is to help you to learn how to structure a formulated perspective in order to overcome all disputes that often lead to poor judgments or inaction.
Remember, the reason you are looking to trade is simple: to make money. Never forget this. Friedrich Nietzsche, the German philosopher, stated long ago, āThe most fundamental form of human stupidity is forgetting what we were trying to do in the first place.ā Never forget that this is the bottom line, to make money. Yet many do, mostly as fear, doubt, and greed interfere with rational thinking.
In order to give you the edge, I want to take a comprehensive look at how we can use the information in this book and apply it to real-time trading. There are obviously volumes of different material we can look at, like macroeconomic effects and the business cycle. Or microeconomic events like earnings and other situations that will impact a stock or a sector and the overall market's performance. Quite frankly, we will most likely cover many of those subjects in this book.
My goal was to put together a sophisticated yet simplistic book in such an organized manner that any trader would be able to walk through the steps contained in these pages, which combine the most relevant tools we have at our disposal, to make better, lower-risk, and more profitable trades as a direct result of better educated investment decisions. I have what I consider some simple tools in a technically oriented and complex time.
In order of importance, here is my ideal checklist of noncorrelated, yet corroborating tools to use:
- Sector analysis
- Seasonal trend analysis
- Contrarian indicators
- Price patterns
- Momentum indicators
- Volume studies
- Breadth indicators
- Moving average tools
- Support and resistance
You can use fundamental analysis (study of current events), or you can take a pure technician's approach to studying the markets. I believe a trader needs to do both. The issue with fundamental analysis is that you need to receive information from the media and third parties, which can be unreliable. You can also look at the company's balance sheet, like the price-to-earnings growth rate (PEG) and the earnings per share (EPS) over multiple quarters. Most of this information is listed on your brokerage firm's trading platforms; if not, Yahoo! Finance works wonders.
The really fundamental question for traders and investors is not to seek answers to the questions of fact or finance, but rather the really deep question to seek an answer to is: What is value? What gives a stock value? When Netflix was at 304.79 back on July 13, 2011, many perceived this stock to be a good value, especially if one was long from a lower level. Fundamental news was released that they were going to charge more for their services, and that is what created a higher opening. We called it a āgapā higher open. The fundamental facts were released, and investors measured the mathematics of future earnings, but the real question that begged to be answered was: Is this stock at this point in time a good value or overvalued? As it turns out, the stock was more than overvalued, as it cratered to a low of 62.37 by November 30, just shy of four and a half months.
Were there ways to uncover the truth of whether this market was at a good or overvalued price over 300 per share? And, if so, were there avenues one could employ to take advantage of it? To be certain, there is a reasonable approach to investing that is unbiased, factual, and incorporates mathematic formulas, but best of all, uses what we all have at our disposal. It is the information provided to us in the form of prices such as the market's or stock's high, low, close, and opening levels, as well as the amount of volume traded and the volume detected in both the up and down directions. The information is what we can find in what is called technical analysis.
Technical analysis shows us what the market is or has done. Certain tools, based on past performance, give us a clue what might happen but not what will absolutely happen.
However, there are several indicators and methods we can use to effectively help us in formulating a market opinion that can improve our chances for success. There are hundreds of methods for picking stocks to buy. The key is to know when to fold. I am talking about an exit strategy. Most individual traders have a hard time taking a loss, mainly because they believe the company's stock price will turn back in their favor. More importantly, most traders don't know when to take a profit either. Thus, the phrase ācut your losses and let your winners rideā might not be a complete truth. While it is important to cut losers, it is also just as important to establish profitable exit levels. This concept of setting an exit plan is imperative for overall success in trading. A pretty good analogy on this point can be summed up by a friend of mine, who once asked, āWhen flying a plane, what's more importantātake-off or landing?ā That's a profound question, as they are both important, but once you are in the airājust like once you are in a tradeālanding is like your exit strategy. You need to have a profit objective in order to land the investment plane safely. That is why the subject on profit objectives will be covered in this book.
STOCK-PICKING QUANDARY
Picking stocks from a large universe can be overwhelming. So let's look at what I consider a systematic approach for picking stocks to trade. Rarely does one look at one method in what I call the top-down approach. Let's look at the Standard & Poor's (S&P) 500. It is compiled of 10 sectors. Jeffrey Hirsch, my co-editor in the Commodity Trader's Almanac, along with his father Yale, put together a seasonal guide from a study done long ago by Merrill Lynch. Yet I believe most traders are not aware of this, or at the least, it is most often ignored.
Many of the reasons we see seasonal strength or weakness in markets are very logical. We will we cover many of these reasons when we delve into seasonal analysis in the next chapter.
Many individual retail investors and traders start off their careers by looking at stocks that are brought to their attention by either the company they work for or by some means of communication, either in an e-mail or the news mediaāprint, online, cable TV, and so onāor, the best way of all, a hot tip from a family member or friend.
Others who are invested in the stock market indirectly, either in a 401(k) or through mutual funds, rely on the professionals who run those funds. The fund manager's sole responsibility is to beat the benchmark, what is considered the S&P 500 Index. Here is the listing of these sectors:
1. Consumer Discretionary
2. Consumer Staples
3. Energy
4. Financials
5. Health Care
6. Industrials
7. Materials
8. Technology
9. Telecom Services
10. Utilities
The iShares U.S. sector and exchange-traded fund symbols are:
1. Technology (IYW)
2. Consumer Goods (IYK)
3. Consumer Services (IYC)
4. Energy (IYE)
5. Health Care (IYH)
6. Financial (IYF)
7. Industrial (IYJ)
8. Basic Materials (IYM)
9. Utilities (IDU)
10. Telecommunications (IYZ)
Next, there are the subsectors and then the stocks listed in those subsectors we can look at for investing and trading opportunities.
First, let's examine the Energy sector as a whole, not the actual commodities like Brent Crude Oil or West Texas Intermediate. I will cover these, including natural gas, in the next chapter.
We can break down t...
