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CHAPTER 1
Be Prepared
Trading stocks is 100 percent mental. Trading means the buying and selling of one or multiple stocks to take advantage of price fluctuations, rather than just holding on to the stocks indefinitely. Success as a trader is a difficult achievement; it has never been easy. Added to this, the 2008 financial crisis brought to the market a new age of volatility, as well as new thinking and new approaches in trading. If you do not know what you are doing, trading will now be even harder.
Markets consist of a multitude of investors from individuals to institutions, each with their own investment agenda. In aggregate, investors’ emotions of greed, fear, hope, and despair dictate market fluctuations and directional movements. Similarly, the psychological state of a trader may affect his trading results because his emotions influence his decision making. To outperform the market and to succeed in trading, a trader needs to take charge of his emotions. To start off, he requires a patient and confident mind. If a trader is confused about what he is doing, the probable win ratio is zero and he might as well give up trading. The mind is mischievous and it often is the primary cause of failures. The market is always creating noises and if a trader fails to control his inner noises, how can he listen to what the market is trying to tell him?
In Figure 1.1, the Hang Seng Index showed that the market was in an optimistic mood for about 55 months from April 2005 to its exuberant high in October 2007. Fear began to take over in November 2007, and the market finally cracked in January 2008. The financial crisis struck across the globe, creating panic among investors. The collapse of confidence lasted about 13 months until the U.S. government began to announce concerted efforts to calm investors. Hope returned to the market with the announcements of the government’s financial stimulus packages.
After approximately eight months, the buoyancy of the market slowed down and investors seemed to return to an anxious mood. Notice that the volatility of the market, shown by the wide monthly range, was greater toward the end of the greed and fear states of the market. The top window shows that the momentum oscillator stayed in the oversold zone for 12 months during the state of fear. During the optimism state, the momentum oscillator stayed continually above the oversold line and rose steadily to the overbought zone, supported by increasing volume.
The market is always dynamic. It is oblivious to your wins or losses. But too many traders blame the market for their failures. They do not consider for a moment that their failures are caused by a lack of preparation and irrational emotions. Whatever the cause, the best solution is just to move on to the next trade with a clear mind and in good spirits. A good trader should not dwell on the past. A trader’s ego is his greatest hindrance to being successful. The best approach is to turn emotion into a positive tool. Whenever any negative emotions stir in him, a trader should take it as a wake-up call. He should not allow such emotion to blur his judgment and derail his trading plan. The most common fault in trading is overthinking—dwelling on the past and not keeping to the trading plan. Besides thinking too much, a trader may believe he is always correct and will refuse to accept the reality of the market. Thus, he should make extra effort to understand more of himself and his emotion, so that he will trade better and feel better.
FUNDAMENTAL AND TECHNICAL ANALYSIS
When a stock price is compared to its intrinsic value, it is termed as “fundamental analysis.” When the stock price is looked at from the angle of supply and demand, it is known as “technical analysis.” Each method of analysis is just as useful and important as the other, and both methods should be used in combination when reading the market and selecting stocks. However, it must be remembered that all analysis serves as a means to estimate the value of stocks.
Fundamentals refer to the financial information reported by the listed companies, which is always historical. A fundamental analyst calculates the stock’s future worth based on the company’s past reports, and projects its value and relative earnings. Fundamental analysts study the change in profitability of the corporation relative to its revenue trend, costs, and expenses, which will include an analysis of its business competition, its capitalization, and the strength of its business sectors. Fundamental analysts should be aware of the potential risk of change between the company’s latest report and its current situation. It takes generally at least three months from the cutoff date of the financial statements to have the audited results published. During that period, many things can happen and, as a result, the published results may not reflect the current state of the company’s financial position. Nonetheless, one would be foolish to ignore all fundamental analysis.
Fundamentals are more determinable and deliver fewer surprise punches. After studying companies with consistent earnings and growth, it should be possible to forecast these companies’ earnings per share (EPS) and the likely range of their revenue and earnings growth. It might also be possible to estimate the return on equity and the dividend payout ratio based on each company’s dividend policy. However, it would be difficult to do so for companies with volatile levels of revenue and earnings. Investors look for steady growth in both earnings and dividend payout over time. This does not mean the investment dividend has to increase each year. The dividend payout ratio is an important sign. If the dividend payout ratio starts to make a series of declines, business may be turning negative and it should trigger an alert to reassess the investment.
Fundamental analysis is more likely to be based on a uniform standard, which makes it easier for investors to understand the results. Fundamental and technical analyses are not alike, but there is a growing trend to combine both forms of valuation. In fundamental analysis, the P/E ratio is the indicator most often used. It indicates the multiples of earnings represented in the current price. However, the indicator has a major flaw; it tends to distort if and when the current information and the cycles of an industry have changed since the latest earnings report. In spite of this, the P/E ratio has remained a popular and decisive indicator used by many analysts for valuing stocks. Other ratios are important as well, including dividend yield and price to book value.
Investors have a tendency to overvalue stocks by pushing their prices to extreme levels, especially when such stocks are in hot demand for one reason or another. In such instances, P/E ratios can be used as a comparative guide of the stock’s value against other similar stocks in its industry, and when the P/E ratios are well above a specific level, the ratio can be used to eliminate such stocks. Also, P/E ratios make it practical and easy to search for stocks trading at a bargain price. Sometimes, stocks may have extraordinarily low P/E ratios because they may be priced too conservatively and the potential for profit is limited. Other times, very low P/E stocks should be avoided, as there may be certain undisclosed reasons why they are being shunned by knowledgeable investors. A more sensible way, perhaps, is to tread the middle path, picking mid-range P/E stocks using the P/E of the Hang Seng Index or relative sector index as a benchmark. There is no single answer in the market. Additional analysis could include relative studies of the stock’s dividend yield (see Figure 1.2) and business outlook and its market capitalization among the stocks in the same industry.
In Figure 1.3, the highs of the Index are marked H1, H2, H3, H4, H5, H6, and H7; and the lows are marked L1, L2, L3, and L4. For the past 16 years, the Index’s P/E ratios have risen seven times to the approximate multiple of 20, four of which occasions (H1, H2, H3, and H6) caused major declines. H4 and H7 tops have produced smaller corrections compared with other tops. The Index managed to hold on to its levels though the P/E ratios in both cases are in the proximity of 20; these were the only incidents that did not result in a major decline. Note that for the same period, the P/E ratio lows, falling below a multiple of 10, offered excellent bargains at L2 and L4.
Technical analysis, on the other hand, is the study of directional movement of prices using charts. A technical analyst looks at a stock’s current price movements during the trading period, regardless of its fundamental value. Whether a stock is expensive or cheap relative to its fundamental value is immaterial. The only thing that matters is the price directional movement and where it might move in the future. The arguments are based on two criteria: that all known fundamental information is reflected in the price, and all changes in emotion and sentiment are shown in the relative action of price and volume. No matter what the stock is worth, it takes only buying and selling to move prices, without which no trade will ever be profitable. A technical analyst does not question why the stock price has moved, but how. His only concern is whether the present state of the stock price will be short-lived or will continue for his trading time frame. His challenge is to anticipate the next direction of the stock price and to time his decisions to either buy or sell based on the correlation of price and volume information, price patterns, and technical indicators.
Basically, a technical analyst looks at the market price action and its relative price patterns to determine whether there is a probable trend to trade. The most important point in attempting to read the market is to have an open-minded approach. It is disastrous to have a prejudicial frame of mind in reading the market. If a trader is biased, looking to fulfill his ego, he can easily get a distorted view of the market. He may be telling himself that he already knows what direction the market will go in, while the truth is he merely wishes it to go in that direction.
In summing up, it will be readily apparent that technical and fundamental analyses serve different purposes and the best strategy is to apply the technique that is most helpful in making the trade. Each approach can be used to complement the other. A long-term investor will more likely be focusing on fundamental information, while a short-term investor will concentrate on technical analysis. In a broader sense, fundamental and technical techniques are all about valuation of a company and its stock.
It may be of interest to note that there are software programs that combine fundamental and technical analysis into a hybrid trading methodology. Investors can use fundamental analysis to screen a universe of securities and identify stocks with good fundamentals and growth potential. They can then use technical analysis to determine the timing to purchase shares, such as near oversold levels, or after a retracement of prices of a certain percentage from the peak of a rally. In this book, we show another approach where financial astrology is used instead of using fundamental analysis to screen shares. The shares selected on this basis have greatly outperformed the shares selected on the more conventional basis, although it must be said that more comprehensive research is needed to establish that the superior performance holds true under a greater variety of market conditions.
The book presents readers with a broad range of technical and financial astrology indicators that have been found to be effective in gauging market trends and approaching change in trends. The wide range may appear somewhat overwhelming at first. The intention is not for users to adopt all of these indicators, but, after a thorough review, to choose only those that suit their style of trading and which they themselves find most useful. In particular, we hope traders will also find that integrating some select technical indicators with financial astro indicators can boost their results. Whatever the approach, it is imperative not to overanalyze the market. As Mark Douglas pointed out in Trading in the Zone (2001), “I know it may sound strange to many readers, but there is an inverse relationship between analysis and trading results. More analysis or being able to make distinctions in the market’s behavior will not produce better trading results.” We have found this to be true as well, and readers would be well advised to take the time necessary to develop a simple yet powerful trading methodology of their own that does not involve overly extensive analysis.
Another common habit besides overanalyzing the market is the repeated use of the same type of information, whether intentionally or unintentionally, particularly in applying multiple oscillators, so that the result of each oscillator reveals the same type of information. Having one oscillator to confirm another oscillator will not serve the purpose if the calculation of the oscillators is derived from the same information. At all co...
