Successful Speculation 0448021005

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$1.95 G&D 2100

How to Outfox the Bull and the Bears and Make Maximum Wail Street Profits Formerly Plan Your Way to Wa

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Digitized by the Internet Archive in 2019 with funding from Kahle/Austin Foundation

https://archive.org/details/successfulspeculOOOOshel

to Michael II. Sheldon Formerly Plan Your Way To Wall Street Profit

GROSSET & DUNLAP -

A NATIONAL GENERAL COMPANY

Publishers

New York

FORMERLY PLAN YOUR WAY TO WALL STREET PROFIT COPYRIGHT ©

1969

BY MICHAEL U. SHELDON

ALL RIGHTS RESERVED

PUBLISHED SIMULTANEOUSLY IN CANADA LIBRARY OF CONGRESS CATALOG CARD NUMBER: PAPERBACK EDITION, AUGUST isbn:

77-75326

1971

0-448-02100-5

PRINTED IN THE UNITED STATES OF AMERICA

To Eileen

CONTENTS

PART I

BASIC CONCEPTS

CHAPTER

1

CHAPTER 2 CHAPTER 3 CHAPTER

4

CHAPTER 5 CHAPTER 6 CHAPTER 7 CHAPTER 8 CHAPTER 9 CHAPTER

10

CHAPTER

11

PART II

The Fundamentalist The Technical Analyst Tips and Recommendations Timing The Small, Early Foss The Market Anticipates the Future Contrary Behavior The Primary Trend The Secondary Correction Charles Dow and the Dow-Jones Averages Basic Principles: A Reiteration

3 8

13 16 19 22

25 31 41 45 53

CHART FORMATIONS

CHAPTER

12

CHAPTER

13 14 15 16 17 18 19

CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

20 21 22

The Chart The Rectangle The Triangle Head-and-Shoulders Patterns Double/Triple Bottoms and Tops Other Chart Patterns Gaps Reversals and Climaxes Resistance and Support Trend Lines The Moving Average

59 62 65 70 73 75 79 82 85 90 94

chapter chapter chapter chapter chapter

PART III

23 24 25 26 27

The Stop Order Volume Point-and-Figure Charting Momentum and Relative Strength Charting: A Reiteration

97 100 111 120 122

MARKET INDICATORS

chapter

28

Indicators

131

chapter

29 30 31 32 33 34 35 36

Indicators Based on Stock Prices Market Breadth Earnings and Dividends The Short Sale Money and Bonds The Calendar Weak and Strong Markets Supplementary Technical Tools: A Reiteration

135 141 146 150 157 163 168

chapter chapter chapter chapter chapter chapter chapter

PART IV chapter chapter chapter chapter chapter

174

THE RIGHT STOCKS AT THE RIGHT TIME 37 38

The Speculator’s Portfolio Buying on Margin

181 187

39 40 41

Stock Classifications Types of Stocks The Right Stocks: Conclusion

190 194 203

’

SkgcssM SmUn

Part One

BASIC CONCEPTS

H *

Chapter 1

THE FUNDAMENTALIST

My wife commented the other day that anyone could soon become a millionaire in the stock market if he did precisely the opposite of our old friend, Manuel Petty. That fellow’s knack for losing money is typical of many of the millions of small investors who aim to profit in the future of our economy. Manuel came to believe there was money to be made in Wall Street. His friends’ glowing reports set him to reading the financial pages. He sought a better way of investing the $10,000 he had accumulated through effort and sacrifice than leaving it in the savings bank where it yielded about $33 a month. He was also beset by deductions for taxes and social security and the havoc caused by inflation: the dollar saved in 1948 was worth only 80 cents ten years later, and by 1968 it had dropped in value to 63 cents. What with the prospective rewards of a good return and the simplicity of investment, he became attracted to common stocks, particularly in view of the constant economic growth of the nation and the steady rise in the stock market. These sentiments were quite normal; in 1945 only 5 million Americans owned publicly held stocks. By 1955 there were 12 mil¬ lion, and by 1968 the number had mushroomed beyond 25 million.

3

Successful Speculation The increase was nurtured by the rise of the Dow-Jones Average from 1940 to 1968, where a $10,000 investment would have grown to approximately $72,000. Manuel’s conversations and financial exposure gave him a superficial

understanding

of

business

failure,

Gross

National

Product, sales, employment, inventories, and the economy. Mr. Petty, you see, is a fundamentalist—a long-term investor who seeks safety, willing to bypass “risky” stocks. He seeks a regular return from dividends and appreciation consistent with the growth of the economy. He tends to hold his stocks patiently anywhere from three to eight years. A cautious man, Manuel tried to learn all about the company whose stock he considered buying. Aware that general business conditions affect various industries differently, he laid great atten¬ tion on a firm’s earnings, dividends, and the number of years it had consistently paid them. He explored its management, book value, reputation, liquid assets, and rate of growth. But the difficulty in securing accurate, current data made him rely on his broker’s recommendations. Manuel Petty was not fully aware that by the time the facts reached him they were out of date. When the newspapers, for example, published a report that Nuclear Radio was launching a new product, it was logical for him to conclude the stock would rise. In the next few weeks, however, he watched it drop 6 points. (Professionals who knew of the product and bought the stock weeks and months earlier were able to sell to Manuel at the peak when the news was announced.) The market is not concerned with ancient history. The current price of a stock reflects every bit of news and all opinions. Vital matters that effect the ups and downs of a stock never appear in the papers—at least, not until the move has been made. By then it is too late for Manuel to reap the full benefits. In appraising the kaleidoscopic elements that go into a stock’s price, Manuel bogged down in a mountain of statistics. His attention 4

THE FUNDAMENTALIST was so focussed on learning the reasons for a dividend increase or details on a new product, trends of earnings, and management prob¬ lems that he lost perspective and objectivity. He could look at two different brokers’ reports on the same company and reach diametri¬ cally opposite interpretations: one broker believed the stock should be sold because its sales, profits, and dividends had fallen, while the other broker recommended buying because of a promising future and the fact that the stock was oversold and overdepressed. Manuel was often confused by the seemingly illogical behavior of the market. He observed that the Averages and individual stocks often dropped on no provocation, and on other occasions a price rise accompanied adverse news. He was little aware that the psy¬ chology of the public could exert a potent, volatile influence, and his only consolation was that market prices would eventually adjust. His problems mounted all the more after he had bought a stock. I remember when he acquired a “bargain-priced” XYZ at $10 a share. A few weeks later the papers were full of critical reports of mismanagement, but he shut them out of his mind. He told himself he had done the right thing and, in typical fashion with a head-inthe-sand attitude, he ignored the unfavorable news. When XYZ dropped to 914, to 9, to 814, he blamed the decline on the stupid public’s inability to recognize a good stock, on the machinations of Wall Street, and on everything but his error in buying. Undaunted though, he bought another 100 shares at 814 to “average down” his price. When the stock dropped to 714 his ra¬ tionalizations became more severe. “I can’t sell now,” he moaned. “I can’t afford that huge loss.” But what hurt more than the money was the blow to his pride. He finally convinced himself it was only a “paper loss.” Only when XYZ plummetted to 6 did he liquidate. . . . Two days later it slowly started reversing its trend and within six months had returned to the 10 level. Curiously, Manuel’s plight was worse when his stocks started advancing. He had bought PQ at 40 and happily watched it bounce to 43 and then to 46. His brow furrowed as he soliloquized, “If I 5

Successful Speculation sell now my profits will be almost $600. But maybe I should wait. It may go to 48 or 5 0—or perhaps 46 is as high as it will go. What shall I do? If I hold, it may return to 40 or even lower.” His anxiety grew as he nervously pondered whether to take the 6-point profit or to wait for a larger gain. One can develop the odious habit of breathing, eating, and liv¬ ing the stock market, of devouring the ticker tape, of quaking when the broker telephones. Manuel was also plagued by the fear he would buy on the eve of a steep bear market or economic recession. His goal, rightfully, was to buy blue chips and growth stocks at the start of a new bull market for a substantial gain during the succeeding prosperous years. But, unfortunately, he always increased his holdings near the peak of a bull trend. Then, as his stocks tumbled unmercifully, he remained hopeful an upward reversal would recover his losses. In a sense, he was trying to tell the market what to do. Later, in the bear trend, he couldn’t resist the “bargains”—and before long, at the very bottom, he abandoned all his holdings. That was Manuel’s experience in 1962. It was a year in which the market Averages started and ended at about the same level, but within a three-month period in mid¬ year a severe 185-point decline battered prices by more than 25%. Many stocks encountered no net change for the year. Some had a sharp rise: for example, Briggs and Stratton rose 43% and Delta advanced 82%. But the sharp market drop stimulated Manuel to sell the five “good” stocks he owned: Automatic Canteen, Bur¬ roughs, Chris-Craft, Kayser Roth, and Champion Paper. He did so near their lows, thereby incurring a 50% loss on his investment. If he had held on patiently, he could have recovered completely. Although many small investors can proudly point to a series of annual gains, most of them are eventually guilty of the cardinal sin. They will increase their holdings late in a bull market and hold on during the ensuing primary bear decline (and will make new pur6

THE FUNDAMENTALIST chases on the way down). Then they will liquidate at the bottom and, much later, they will recover their courage in time to buy again near the next bull peak. Their profits and most of their capi¬ tal must surely evaporate. Manuel, like most fundamentalists, was unable to judge the mood of the public or its degree of confidence. He committed their mistakes: he was emotional, exercised bad timing, displayed needless concern with detailed economic statistics, and abhorred taking a small and early loss. Your success hinges on avoiding the errors of the fundamentalist and recognizing why he loses.

Technical analysis enables the investor or speculator to enhance his financial status by understanding the market and correctly fore¬ casting its future trend.

7

Chapter 2

THE TECHNICAL ANALYST

You must not imagine that technical analysis is a system for “beat¬ ing the market.” No method that involves predicting the whims, motivations, and behavior of the public can be scientifically perfect. When man is able to foretell the market’s precise future, there would be no need for investors or speculators. The disparity of opinion makes for buyers and sellers; prices will fluctuate as long as individuals believe their evaluations are superior to their neigh¬ bor’s. The glamour and mystery of Wall Street lures many persons, and there is no more misleading bait than that it can be a get-richquick game. One rarely gets something for nothing; wealth doesn’t come easily or in one tremendous spurt. Hardly ever does a man wander into the market and quickly treble his investment—and in that infrequent instance he usually loses everything soon thereafter. Luck is transitory and insidious, and the risks are insurmountable without knowledge and intelligent application; therefore, most spec¬ ulators do not fare too well. Many are raw amateurs, lacking the 8

THE TECHNICAL ANALYST required experience, the right temperament, or the willingness to benefit from their mistakes. The speculator, by definition, is a man who reflects and observes. He must be able to reason, to analyze men, and to capture the mood and pulse of the public. During the learning process he must mini¬ mize his risks and losses by making very few transactions. Later, he must learn to live through victories as well as failures. The technician is not, and cannot afford to be, a gambler. The gambler is intent on the fast dollar, on becoming a millionaire over¬ night. Usually, motivated by greed and ignorant of basic market information, he operates on tips, buying what his friends buy. He often trades in penny stocks, failing to comprehend a low price does not make a stock cheap; many expensive stocks are “cheaper” and better valued. It is regrettable that the terms “speculating” and “gambling” are so often confused and used interchangeably. The speculator’s goal of profits from appreciation is also differ¬ ent from that of many investors who seek dividends and income. The speculator understands that a higher risk warrants a higher profit and is willing to buy some stocks that are not of high quality because of the opportunity for the greater rewards. And yet, the difference in the two groups is not so great. Is there an investor who disdains a profit? And is there not speculative risk in every investment? The causes of,failure in the market won’t be crystallized in our minds unless we face up to them, unless we think. We tend to absorb popular opinions and prevalent propaganda. We are guilty of wishful thinking, poor judgment, superstitition, and gullibility. On experiencing an unprofitable transaction, we rationalize, “It could happen to anyone.” We must not blame it on bad luck, nor can we afford to be creatures of habit who repeat the same mistakes. Some speculators do very well when they buy or sell “on paper.” But when they invest hard-earned money they are influ¬ enced by their emotions, by rumors, or by conflicting reports. (For 9

Successful Speculation this reason, many brokers, who may be excellent advisors, engage in personally disappointing transactions.) When you purchase a stock, you must think clearly and un¬ emotionally. You must not be disturbed by rumors. Try to over¬ come your hunches, your intuitive and personal feelings of bullish¬ ness or bearishness. It is only human for a bull to want to see bullish signs and for a bear to read gloom in the market, but an obstinate and inflexible attitude may be very costly. If you failed to buy a certain stock when it was low, it may be better to buy at the cur¬ rent higher level than to wait for it to drop, for you may watch it climb to unprecedented heights. Concentrate on the larger picture instead of being disturbed by the 2 and 3 points you missed.

Generally, once you have decided on your course of action, adhere to it. Before you make a purchase,, set a tentative goal; de¬ cide on the price you are willing to pay and the probable level at which you may sell. Maintain your point of view as long as there is no sudden, unexpected change in the technicals. If your stock has advanced and the market appears about to erode, accept your profit. But if you start to suspect that the market is about to tumble, do not make a complete about-face in your market position; it would be wrong to liquidate your entire portfolio of long holdings and put your total capital in short positions. Markets almost never end that abruptly. The better procedure is to make the change gradually. Besides, the danger in such an extreme course of action is that if you prove to be wrong, you may decide to cover your shorts and buy long again—and your confidence would be annihi¬ lated if you then were wrong once more. You must be able to win without undue glee and to lose with¬ out a spasm of nervous depression. This concept of avoiding the extremes of panic and overoptimism is related to a basic principle of the successful speculator. He trains himself to suppress two normal reactions: 1. When your stock advances, it is natural for you to fear a decline will set in to wipe out your profits. Fright provokes a ten10

THE TECHNICAL ANALYST dency to sell too soon. Instead of fearing a decline, you must hope —hope that the stock will advance further. 2. When your stock declines, it is natural for you to hope that the worst is over and that prices will soon recover. The tendency to hold too long during a decline stems from hope. Instead of hop¬ ing for a recovery, you must fear—fear that the stock will drop lower. Your profits will multiply if you can learn to contradict the normal tendency: you must be afraid of a declining stock or market when others are hoping the worst is over, just as you must hope that prices will continue rising when others grab their profits in the fear that the rise has terminated. Greed is another pitfall. Greediness can disguise the inherent dangers in a situation. It causes overspeculation, compelling a man to invest more capital than he should. He forgets that there are new opportunities every day and that the market neither climbs nor falls forever. You should never be rushed into buying or selling. It is also a good personal policy to sell a stock at a profit if you wish to obtain something special, such as a new car, a fur coat for your wife, or a trip to Europe. On such occasions you should sell the stock on the way up even if you are convinced it will rise higher. It’s a luxurious feeling to obtain a particular luxury on someone else’s money. If you greedily wait for a larger gain, it may never come and you may end up with a loss—and without the once-in-a-lif etime, vacation. Another good idea is to get away from the market every once in a while, to look at it dispassionately. You may be unsure of the future, in which case the advice of William D. Gann can be fol¬ lowed: “When in doubt, get out, and don’t get in when in doubt.” When you are out of it, you will often be able to see what is really happening. The most independent, self-assured, and relaxed indi¬ vidual is the one who has banked his profits. Somewhat the opposite of greed is the virtue of patience. Time is part of the speculative process; the economic cycle moves slowly, 11

Successful Speculation making it different from roulette or horse racing where the results are known instantly. Buying a stock may require months of waiting for the right opportunity, and patience is needed to dominate the suspense and trepidation that arise concerning the future. The best policy is often one of inaction. It’s not easy to learn that great profits are frequently acquired from sitting tight. Many times an extra dose of patience will do more for the purse than the keenest intelligence or the best charts in the world. Most speculators would make more—or lose less—if they reduced their trading. By avoiding hasty or premature decisions, the patient technician will magnify his gains and, also, escape burdensome broker’s commis¬ sions and taxes. The art of technical analysis requires common sense, patience, experience, and courage. With study, you will develop the ability to analyze past price movements and thus gain an insight into the future. You will learn which stocks and industries to buy, and you will gain proficiency in market timing. A mastery of the two ele¬ ments of what (to buy or sell) and when (to act) is the technician’s goal. He places small emphasis on dividends, governmental activi¬ ties, growth prospects, or earnings. Instead, he concentrates on what is happening in the market—how the Averages are moving, the volume trend, the short interest, and how specific stocks are fluctuating. He bases his purchases and sales on past happenings and what is reflected in current prices. By taking advantage of the interplay of supply and demand and the changing trends of the market, you will avoid the errors of the little man and emulate the skill and success of the professional. It is the human being, not the gyrations of the market, that governs profits or losses.

12

Chapter 3 TIPS AND RECOMMENDATIONS

Rumors, tips, and recommendations by brokers, advisory services, and market letters are popular because most people can’t—or won’t —think for themselves. Much of the public, insufficiently alert to the intricacies of the market, believes what it is told, particularly if the source is deemed an authoritative one. Predicting the course of the market, however, is a rare talent. There has never been anyone who came close to having a perfect record. At any instant the opinions of the pseudo experts will be divided into three large and distinct groups: the bulls, the bears, and the neutrals who foretell a period of consolidation. The more proficient the expert, the less absolute and more cognizant of the variables he will be. The man who claims infallibility or even that his recommended stock is a “sure thing” is untrustworthy. Unfortunately, brokers, polished and convincing salesmen that they are, possess no crystal balls. Many operate on the law of ave¬ rages, constantly broadcasting their successful predictions but con¬ veniently forgetting their failures. Instead of investing their per¬ sonal capital to earn a livelihood, their income is derived from commissions. The public, inherently bullish, tends to believe the good things 13

Successful Speculation it wants to hear. It dismisses bad news, even when it emanates from experts. As a result, brokers tend to emphasize favorable news and reports so that their customers will afford them commissions. When the brokerage house is utterly convinced a stock or the market is bearish, it frequently issues a confidential analysis only to its mem¬ bers or elite customers; the small investor is almost never given a severely adverse forecast. Success does not come from following recommendations blind¬ ly. You must question the opinion, doubt it, and ask yourself, “Why is this not true?” The facts can usually be accepted or easily con¬ firmed, but it is the conclusion that must be questioned. That XYZ is going to split 3 for 1 can be authentic, but it does not follow that its price will automatically advance. Nor should you accept the news of a pending announcement of an increase in earnings as tantamount to a rise in the stock’s price. It has been demonstrated time and again that the man who operates on tips must eventually fail. He may acquire some good holdings but in the long run the “rumor mill” proves unfruitful. An even worse fate occurs when he buys a stock that someone, especially a stranger, is eager to sell him. Countless investors have been fleeced by high-pressure salesmen, easy-money market let¬ ters, and “cat-and-dog” stocks. Further, the trusting soul becomes a victim of vanity when he accepts this kind of “inside” informa¬ tion and he invariably risks more money than he should. There will be occasions, however, when it is judicious to keep an open mind; stocks recommended by personal, respected friends should be investigated. When their advice is fundamentally valid, you can assess the market trend and the specific situation through technical analysis and decide on the course to take. If you make such a purchase, do not rely on your friend to inform you when to sell. Your gains may be short-lived. You must determine for yourself when the upward trend has ceased and when to get out. Also bear in mind that even a company official—who is fre¬ quently a poor judge of the market—cannot foresee the technical 14

TIPS AND RECOMMENDATIONS strength or unfavorability of his own firm more than a few months ahead. He is likely to be a perennial optimist and therefore too bullish about the stock of his company. An increase in competi¬ tion, a change in the advertising policy, a dip in new contracts, or an unpredicted strike affect earnings and the stock’s price. This is the reason so many high officers, recognizing that their inside information may prove untrustworthy, are loath to recommend their stocks to friends. And they, too, suffer losses in a general market downturn. In fact, it is prudent policy never to advise your friends on what to buy or sell, nor even to discuss your holdings with them.

15

Chapter 4 TIMING

A basic tenet of the technician is that a stock is only worth what it currently sells for. Unlike the fundamentalist who requires facts and statistics to determine his purchases, the speculator is primarily concerned with the market’s action and how certain stocks are behaving. His charts and indicators reduce the day-by-day move¬ ments to comprehensible projections and tell him how to act. His decisions are largely based on the age-old principle of supply and demand: when the sum total of all the myriad influences on a stock or the stock market result in an excess of demand (a desire to buy) prices will rise; when there is an excess of supply (more sellers than buyers) prices will fall. The technician’s chart will not disclose the underlying reasons for some stocks going up and some going down. He does not care about the reasons. He contends, instead, that the past movement of the stock or the market foretells future behavior. Profits come from knowing when to buy and not with why one should buy. The key lies in detecting buying and selling pressures—in timing one’s transactions to the trend. Timing can magnify profits and minimize losses. It enables you to avoid the miserable experience of proving the saying, “A good stock bought at the wrong time can be a bad stock for a long time.” 16

TIMING

Suppose you had bought Texas Instruments in January 1958 at 22 and retained it until mid-1960 when it reached 205. Would you have sold at this peak, attaining a 930% appreciation in thirty months? Or would you have sold on the way down at 190? Or even at 150 in the fall of 1960? Or would you have stubbornly held until late 1962 when it had slumped to 40? Conversely, the magnitude of timing becomes evident if you unfortunately bought at the 205 peak and retained the stock during the full decline. Only one-fifth of your capital would have re¬ mained! Many investors find little comfort in reading that the economy is in a glorious bull trend. Their equities may have a washed-out 1930 look. Notwithstanding the fervor of good times and a bound¬ ing market, there are always lagging and depressed issues. From 1957 to 1966, for example, the Dow-Jones Industrial Average rose from 420 to 995, but about one-fourth of all Big Board listings were still below their highs of 1957. Here are some well-known stocks, shown with the highs they reached in 1961 and their levels on January 1, 1966: 1961 high 46 83 75 20 45 74 35 20 23

1/66 price

Stock

1 1 16 10 5 1 1 13 4 6 4

American Photocopy Anken Chemical Brunswick Corp. California Financial Great Western Finance Helene Curtis Lionel Corp. Servel United Whelan

These stocks nosedived to about one-fourth or less of their ear¬ lier levels amid a giant bull trend, confirming that a market rise is no guarantee your holdings will necessarily gain. Beyond this, while the Averages multiplied about 4 times from 1946 to 1965, many life insurance stocks multiplied 20 times. 17

Successful Speculation The same principle was demonstrated in 1968, a year in which the Dow-Jones Industrial Average, as well as the rate of inflation, rose by about 4%. However, there were about fifty stocks on the Big Board that more than doubled in price: the largest gainers were Duplan (301%), Bath Industries (257%), and Minnesota Enter¬ prises (235%). Although three out of four stocks advanced for the year, the disasters included Automatic Sprinkler, Fansteel, Eastern Air Lines, and Freeport Sulphur, with declines ranging from 39 to 62%. Technical analysis will enable you to be in the right stocks at the right time. By utilizing market and stock trends, profits can be scored in bullish stocks and in boom days, and you’ll know to unload when the dark clouds loom on the horizon. Litton, because of its volatility and splendid record, demon¬ strates what good timing can do. LIT sold at $12 in early 1958. A $1,000 investment would have given you 83 shares. If you had held for five years, you could have sold at $84 a share, for a profit of $5,972. (Taxes, commissions, and dividends are being ignored.) Now see what could have happened with one extra perfectly timed sale and one repurchase during this same five-year period. If you sold your 83 shares in December 1961, your capital would have grown to $6,391. By mid-1962 the stock had fallen to $37, and you could have rebought 172 shares for $6,391. Upon liqui¬ dating these shares in 1963 at $84, as above, your profit would have been $13,448. The one additional sale and repurchase on your $1,000 would have produced an extra profit of $7,476—a total profit of $13,448 instead of $5,972.

18

Chapter 5 THE SMALL EARLY LOSS

Human nature can be peculiarly illogical. Manuel Petty always expressed great regret when he sold a stock and it thereupon climbed another 5 points. Any elation he may have experienced about the profit he made was subordinate to his chagrin in missing those 5 extra points. Many brokers, for this reason, do not display a bearish attitude even when they believe the market is due for a decline. Their customers will forgive them for that, but they never seem to forget the broker who suggests selling a stock that sub¬ sequently rises. Selling at the top was satisfying to Mr. Petty because it bol¬ stered his ego. His pride and self-esteem were actually more im¬ portant than profits or losses. He was always tempted to take a small profit, and he usually avoided taking a loss. Associating an unsuccessful transaction with loss of dignity, he tended to hold on in the hope that there would be a turnaround in prices. The technician, however, comprehends that it is not embar¬ rassing or self-deprecating to take a loss. It is vanity that blinds and prevents men from admitting they erred. There’s nothing de¬ grading in not winning every time; it happens to champions in every field. Success should be measured by one’s batting average —by the overall net profit or loss. 19

Successful Speculation If Mr. A enters six transactions and loses $1,000 on each of four of them and makes $3,000 on each of the other two, he shows a $2,000 profit. His result is no different from Mr. B’s, who makes $2,000 on a single transaction, or Mr. C’s, who in ten transactions loses $200 on each of nine of them and make $3,800 on the tenth. The opposite circumstance exists if a man obtains a $100 profit on each of nine transactions and loses $2,000 on the tenth; the one loss more than wipes out the nine small gains. Only the final result is important. Minor mishaps must be accepted speedily before they become painful. If it will help your morale any, regard your sale of a declining equity as a swap or trade, whereby you are merely transferring your capital to a better stock. But Mr. Petty was like the gambler who wagers on an old plug horse on the theory that he was due to win because he hadn’t in the past. When Mr. Petty built a portfolio of diversified stocks, he sold the profitable ones and kept those that showed a paper loss. He intended to hold his losers until they came back to their old higher levels. (Sometimes this can take decades: the level of Averages in 1929 was not seen again until 1954.) He then bought new stocks and kept repeating the process. Every time he kept a falling stock, he persisted in betting on a loser; and he eventually was left with a “sack of rotten apples.” The fallacy in the old adage, “You never grow poor by taking a profit,” is that with your modest profit you are left with deterio¬ rating properties. This kind of activity also precludes the chance of staying with an outstanding stock for an extraordinary gain, one that will more than counterbalance all the small losses. It may seem plausible only to sell at a profit and to keep the disappoint¬ ments until they too are in the black, but the market doesn’t operate that way. Follow the prevailing trend. Watch your stock closely if it drops or if it rises a trifle and then declines. If it falls about 10% from its recent high, it often will be prudent to sell promptly at the small loss. You are best out of a bearish situation—and if you 20

THE SMALL, EARLY LOSS neglected to get out at 80, get out at 75 before it falls to 70. If you must sell one of your holdings, for whatever reason, choose the least favorable one or the one that declined severely in the last market reaction. The successful speculator amasses a huge profit be¬ cause he keeps his canital in active, rising stocks. He invests in those that start adva cing on higher volume, frequently when they rise above their recent highs. Unlike Manuel Petty’s hunt for bargain-priced equities, your search must be for stocks that have recently moved into high ground. They are apt to show the great¬ est profits. Here are six stocks, shown with their 1961 and 1966 prices: 1961 1. 2. 3.

Northwest Airlines RCA Xerox

4. 5. 6.

Cert-teed Products US Steel Reynolds Tobacco

8 19 33 60 90 87

1966 99 (adjusted) 46 (adjusted) 1 86 (adjusted) 13 38 35

Suppose you had bought 100 shares of each of these stocks in 1961. If you enjoy a quick profit, say 10%, the first three holdings could have promptly yielded you a fast $600. But if you held the last three, waiting for them to produce a profit, your $23,700 in¬ vestment in them would have shrunk to $8,600 by 1966. The policy of selling the profitable stocks and holding the weak ones would have resulted in an overall loss of $14,500. What if you had reversed the procedure? By liquidating the last three stocks as soon as they showed a 10% loss and retaining the first three profitable ones until 1966, your net profit would have been $24,700. (Note that these two opposite courses of action would have meant a differential of $39,200.) One of Wall Street’s most glamorous and influential speculators, Jesse L. Livermore, considered the ability to accept a small, early loss as the corner¬ stone of his success. 21

Chapter 6 THE MARKET ANTICIPATES THE FUTURE

Inexperienced marketeers tend to place too much weight on past performance. When General Motors reports higher earnings or an increased dividend, they rush out to buy the stock. When they read about the zooming market and immense company profits (and insiders, professionals, and even politicians may help stimulate the bullish sentiment), they load up. The wonderful news of larger profits, increased production, the end of a strike, or a pending stock split magnifies public participation in the market. They fail to recognize, however, that the news has already been discounted; the stock or the market may already have risen and may in fact start to decline on the promulgation of the news. Even if a company official, as your personal friend, were to tell you that a substantial increase in the dividend can soon be expected, the stock may drop when the news is announced pub¬ licly. Alert speculators will have completed their selling to the tardy amateurs; prices often peak out a day or two before the stockholder’s meeting. It is essential to understand that a stock’s price embraces the anticipation of future events. Everything but an act of God, as Charles Dow espoused, is discounted. All too often stocks will go 22

THE MARKET ANTICIPATES THE FUTURE down on good news and rise on bad; the facts, whether good or bad, are now out of the way. Any item of news usually affects the market (or a stock) only once. If the projected incident occurs after it has been discounted, prices will be little disturbed. But if the news has not been dis¬ counted, it will exert its effect when finally publicized. Sometimes an event is overdiscounted. If a 20% gain in earn¬ ings is expected in XYZ, the stock will advance sharply in antici¬ pation. But if the earnings statement, although excellent, only shows a 15% increase, the stock will probably fall. When a future event is not certain, the stock may move sidewise, up, or down, depend¬ ing on the preponderance of opinion and the number of shares in supply or demand. The more varied the opinion, the more volatile will be the stock’s fluctuations as the opinion changes. When certain growth stocks or equities with excessively high price/earnings ratios are widely touted, the shrewd speculator avoids them. He also tends to ignore stocks purchased by mutual funds once their purchases are publicized; higher price levels have already been reached with the dissemination of the news. Since the experts make their move before the news becomes public property, a stock that advances for no apparent reason offers a more bullish signal than when its advance is widely heralded. Similarly, a stock that falls on bad news is not as bearish as a stock that slips for no evident reason. One practical procedure is to watch a stock when good news is announced. If it continues to advance, it is technically favorable and the rise should persist. But if the stock fails to exceed its recent peak, no early rise to a new peak should be expected. (The con¬ verse would apply when bearish news is announced.) When a company president denies rumors of a possible merger or professes ignorance as to why his stock is booming, turn to the technicals. The experts may be accumulating and later, when the good news is confirmed, will distribute to an eager public at peak prices. The stock may then become overpriced and suffer a sharp 23

Successful Speculation correction, at which time it may be obtained at or near its original level. All of this is natural. The technical analyst must not act or react mechanically. Don’t try to simplify the future of the market or a stock automatically; you can be misled if you always judge the future by the past. Every day in the market is a brand-new day and a new set of conditions prevail. Each situation must be ap¬ praised independently. But you can be certain that when the news and public opinion are at an extreme pole a change will occur. Prices will be most bearish when the news is most bearish, and neither prices nor the news will be again so bearish. When you don’t remember the last time the market mood was so bullish, it is likely that it won’t be so favorable for some time to come. The market and some stocks will often move upward soon after bad news and move down after good news. Thus, the time to liquidate is when good news is made public, and the best time to buy an overdepressed stock is when the odious news is announced.

24

Chapter 7 CONTRARY BEHAVIOR

Every transaction involves a buyer, who believes prices will go up, and a seller, who believes prices will fall. At any instant there will tend to be more buyers or more sellers, and it is the action of the majority opinion that causes a stock or the market to ad¬ vance or decline. Professionals and insiders will often operate contrary to the majority, public opinion. They will buy stocks at depressed prices when no one wants them, accumulating when a frantic public sells. Later, they will sell them at skyscraper prices on an extravagant demand, distributing to an overoptimistic public that thinks rising prices and prosperity will continue indefinitely. These experts are applying the moss-covered, and only partially true, adage, “The public is always wrong.” Let it be made clear that the public is not always wrong. It cannot be; for the public, to a great extent, is the market. Its sup¬ port and confidence is essential to any prolonged market advance. Its disdain for the market and pessimism is the reason for any major decline in prices. Lurther, John Doe is far better informed and more sophisticated about the market than his father was. He shows a (paper) profit much of the time and engages in considerable buying well before 25

Successful Speculation the bull market tops out. He sells many stocks at a profit. In fact, the public is more often right than wrong. However, at critical stages the market has a peculiar knack for operating contrary to mass opinion. The public buys too high (at the wrong time) and sells too low (at the wrong time). Also, in¬ stead of attending to the present, he remembers the past and buys stocks that attained remarkable summits in the last bull trend. For¬ tunes have always been made by those technicians who could gauge the public’s sentiments. They know that John Doe is wrong at the critical turning points of the market, at the major peaks and troughs when the primary trend is changing. At every one of these major turning points there is always an almost unanimous opinion, an incorrect opinion, concerning the market’s future course. When “everyone” predicted the market would drop much lower toward the end of the 1962 bear market, alert speculators were buying heavily. In the next thirty months, the Averages rose 400 points. Then, in the spring of 1965, amid rampant good news and increased public buying, the technician who did his homework knew to liquidate near the 940 Dow-Jones peak, and to buy back six weeks later after a 100-point drop. Simi¬ larly, when the D-J Industrial Average skirted 1,000 points early in 1966, professionals were distributing to the public; the public did not envision that within six months prices would decline by 23%. It is only after a market peak or trough that the little man sees his error and realizes how terribly costly his ill-advised timing had been. Does this lack of wisdom and inexperience seem perplexing? Can the public be so ignorant of the ways of the market, so gov¬ erned by fear and greed? A partial answer is that John Doe is engaging in an unfamiliar activity, outside of his field. He rationalizes his sheeplike behavior on the grounds that his brokers and advisers know more than he does. In addition, the market is not democratic; John Doe, being slightly less intelligent and knowledgeable, is outsmarted by the 26

CONTRARY BEHAVIOR professional. The giant holder, silent while the crowd is talkative, is only willing to talk after he has achieved his position. Then he is pleased to have his position made known since it assists in mov¬ ing stocks in the desired direction. The successful speculator is not fooled by “talk”—reports, newspapers, market letters, brokers’ recommendations, or the urg¬ ing of crowds. His response to all of this is that they are decoys, if not purposely then innocently intended, to lead him astray. He may not know for sure what the experts and insiders are doing, but by identifying and acting contrary to the actions of the masses at the decisive stages he will come out well ahead. He also understands that while mass opinion is composed of millions of individuals, it is the number of dollars rather than the number of persons that in the long run control prices. The man or fund who possesses $1 million in a stock has as much voice and power as 5,000 men who aggregate an equal quantity of stock. A different aspect of contrariness is exhibited in the normal tendency to buy, sell, or place stop orders in round numbers—at 25, 40, 50, 75, 100, etc. People are inclined to think in rounded digits. Hence a rising stock will encounter resistance at round numbers; if you plan to sell, don’t wait for the stock to reach 20 or 50, but dispose of it at 19% or 4914. Conversely, since a declin¬ ing stock is likely to find support at 100 or 50, you should put your orders to buy at about 101 or 50!4. Acting normally, logically, at the high and low points of the market can be disastrous. Profits come from forsaking the herd at the peaks and troughs. When mass optimism reflects no apparent justification for caution, the time for vigilance is at hand; it is then that the realists distribute to the hopeful idealists. Conversely, courage and boldness are required when everyone is frightened. When the brokers’ offices are void of purchasers, the professionals (who have little time for brokers’ offices) are often delighted to 27

Successful Speculation buy, especially if prices cease declining or even manage to rise slightly despite continued bad news. It is at these turning points that you must act the way the pub¬ lic wishes you to act. You should sell to them when they want to buy, and buy from them when they want to sell. Everything on Wall Street changes but human nature. Judging the moods of man, the one constant, provides the key. In the middle of a primary upward trend, almost everyone is right, and you would err to act contrarily. These stampedes are too massive to combat, and you should ride with the potency of public buying. But as a contrarian, you will know that a reversal in trend is soon to occur. Remember the plight of the farmer who plants soybeans. As prices rise he is tempted to plant a much larger crop. But this same thinking is followed by other farmers, and the resultant oversup¬ ply forces prices down. The time to plant heavily is when the price of soybeans is low, when competition is minimal because other farmers have shied away from soybeans. Samuel A. Nelson, the great popularizer of the Dow Theory, expressed it well: “The successful trader is obliged to serve an ap¬ prenticeship. . . .You learn by a process of elimination. You are bound to make mistakes. A healthy skepticism is seldom out of place on Wall Street so far as speculation is concerned. . . . The successful speculator must know how to sell and take his profits when the bull chorus is loudest. When he has learned this much he has learned a great deal.”

The Odd-Lotter The “little man”—the fellow who buys in less than 100-share lots—typifies the general public. His purchases and sales can be rather precisely assessed by analyzing the daily odd-lot purchases and sales, which are recorded and published in many newspapers. 28

CONTRARY BEHAVIOR Historically, in a severe market drop, such as in May 1962, the odd-lotter’s automatic inclination is to buy. Aware that prices were high and are now at “bargain” levels, he increases his purchases. As the decline continues, the odd-lot purchases mount. But at a certain point, finally realizing there is no letup to the drop, he stops buying. It is at this point of reduced buying that the bottom is signaled. Sometimes he will liquidate at the bottom, such as in a selling climax, and this usually represents the bottom. (It must be mentioned, however, that odd-lot purchases during a steep decline will gradually diminish; his purchases near the trough are usually much slimmer than they had been on the way down.) Conversely, as prices move upward in a sharp bull trend, the odd-lotter greedily takes his profit. Selling more as the Averages rise, he gradually comes to realize he acted prematurely. In the knowledge that he “missed out” he makes new purchases at the peak. In brief, when prices are advancing, the odd-lotter tends to sell (when he should be buying). When prices are declining, he tends to buy (when he should be selling). Thus, a shift toward mounting odd-lot purchases suggests that the market will soon encounter a sharp decline or will suffer a further decline. And a sharp increase in odd-lot sales—coinciding with the bottom— offers an excellent buying opportunity; the speculator is aware the odd-lotter will be out of the market when the major uptrend commences. The ratio of odd-lot sales to purchases is the odd-lot balance expressed as a percentage. Since odd-lot purchases usually tend to be about 5 to 10% greater than odd-lot sales, the “normal” ratio is between 90 and 95. (For example, 100,000 odd-lot purchases and 80,000 odd-lot sales would dip the ratio to 80.) The ratio has little significance when it is between 90 and 100, but if it drops below 90 and stays there for a few weeks, signifying a sharp ex¬ cess of odd-lot purchases over sales, the market is deemed bearish. 29

Successful Speculation Extreme odd-lot buying will drop the ratio to about 70, and such a bear signal was given in 1959, 1962, 1965, 1966, and 1967. On the other hand, excessive selling can push the ratio toward 130 to 140, as at the end of a bear market, giving an urgent buy signal. The ratio of odd-lot sales to purchases is an important market indicator, an excellent technical tool for forecasting a change in trends. By charting and observing the trend of the ratio, a superb market barometer is obtained. Its record, however, is far better for predicting the bottom of a bear trend than the peak of a bull trend. It must also be emphasized that the ratio of the odd-lot sales to purchases has far greater significance that the volume differential of its two components. Finally, since the ratio is subject to irregular fluctuations, a tenday moving average will smooth out the movements into a clearer trend line; a rising trend line, for example, signifying excess sales, would serve as a bullish indicator. The odd-lot trading ratio is the percentage of the total odd-lot trading to the market volume; that is to say, if the day’s total market activity is 11 million shares and the entire odd-lot activity is 1,320,000 shares, the ratio is 12. Since the odd-lotters usually com¬ prise about 10% of the daily activity, this ratio measures public sentiment. A 10.5 ratio signifies bearishness, and higher activity by the odd-lotters at 12 would signal a severe market drop. Boiling public optimism, usually at bull peaks, could propel the ratio to 13.5. Slight odd-lot activity, frequently at major bear market bot¬ toms, drops the ratio to about 8 and furnishes an important techni¬ cal buy signal. Here, again, a ten-day moving average will help to clarify the erratic fluctuations. Proper interpretation in both of the above oddlot indicators hinges on a change in direction. Any sudden or pro¬ longed shift in the trend of the ratios merits close scrutiny; it frequently forecasts the termination of a primary trend. 30

Chapter 8 THE PRIMARY TREND

The cornerstone of the stock market is the business cycle: stock prices in the long run are determined by industrial earnings, the degree of the national prosperity, and the broad economic picture. The state of the nation reflects itself in the market’s primary trend. No descending curtain or illuminated flare, however, announces the end of a primary bull or bear market. The transformation from one to the other may be imperceptible, with hardly anyone recog¬ nizing the new trend. And despite innumerable variations, most cycles follow a similar course—each, because of the profit motive, a story of human hopes, fear, and greed. Market cycles have ranged from about two to almost ten years, but seem to average about four years, with the different industrial groups often changing course one at a time over a six-month period. Primary bull markets tend to move prices upward by about 35% to a maximum of well over 200%. Bear markets often retrace about one-third or more of the previous advance (for an average decline of approximately 21% in about eighteen months). They are usually briefer and sharper than bull markets, conceivably be¬ cause it’s easier to tear down a structure than to build it.

31

Successful Speculation The Primary Bull Trend

A bull market (averaging about 2 !4 years in duration) is like a mountain climb in which the marchers start dropping by the wayside. Finally even the mightiest fall. But they never advance vigorously and in the next instant suffer an immediate demise. Generally, about two thirds of the time the advance is strong and optimistic. The bull cycle can be divided into three segments: 1. The accumulation phase occurs at the inception of a bull market. At the end of the previous bear trend, market prices and volume are stagnant. The severity of the decline provoked most small investors to sell whatever few stocks they had retained. Busi¬ ness news is atrocious and gloom still pervades the atmosphere. Short sales flourish. Almost without notice, prices start moving upward or drifting sideways. The public fancies this to be a temporary rally, much as any of the intermediate corrections that occurred during the massive descent. It is during this dormant trading period that the experts start accumulating stocks at “ridiculously low” prices. As the available stock diminishes, prices gradually start to rise. A few alert speculators start buying, but the general public ignores the market, ever mindful of the anguish and losses suffered recent¬ ly. The short sellers hold on. Prices move upward with the growing demand, and there are even slight traces of improving earnings and business conditions. 2. The acceleration phase occurs as the economy strengthens and expands. An increase in dividends is occasionally reported. The funds, experts, and institutions continue to accumulate common stocks at the relatively low levels. The Averages break out of their low trading ranges and frequently make new highs. Business has greater sales and higher earnings. In this middle phase—the longest 32

THE PRIMARY TREND of the three—the speculator can obtain tremendous profits; ob¬ viously it is better to buy a stock making a new high early in the bull market than to wait for the full flush of maturity or even the aging bull period when a new high may prove to be the final peakout point. A few small investors are attracted to the market and their number slowly increases. As their paper profits mount, their hold¬ ings and enthusiasm grow. Many take their profits, but the lure of constantly higher stock prices rekindles the flame and back they go,, repurchasing at the advanced levels and vowing to stay with their stocks for the bisr killing. The extent of the market advance depends largely on the degree of national prosperity, the easiness of money, the volume of trade and other fundamental elements, as well as the public’s bullish psychology and willingness to buy at spiraling prices. An increasing number of small marketeers become interested. Many hesitate or elect to wait for a reaction to lower prices before buying too heavily. If prices move sidewise, then advance briefly, and return to the “churning” range, many take this opportunity to enter the market. Favorable news reports stimulate new buying. Prices are pushed higher as the short sellers become frightened and start covering. Market corrections occur occasionally, stimulating new short sales and additional small investors to buy on the dips. Odd-lotters frequently take their profits when the market briefly corrects itself, but they buy back again as the primary move re¬ sumes. The experts continue to wait as the swelling advance creates optimism and huge paper profits for everyone (except the short sellers). 3. The over optimistic phase occurs when every Tom, Dick, and Harry is in the market. They deem it sacrilegious even to men¬ tion falling prices, failing to realize that the higher the market goes, the nearer it is to the peak; despite the evidence of past history they fancy it will rise indefinitely. (Conversely, at the end of the 33

Successful Speculation bear market, they think it has no bottom and will drop without end.) Rampant buying and intense volume result in a sharp rise in low-priced issues. The blue chips tend to remain somewhat stag¬ nant and bonds are in oversupply. .Then prices become erratic, churn on extraordinary volume, and encounter brief declines on higher activity. Yields are abnormally low, and price/earnings ra¬ tios “excessive.” The small investor still reads that the funds and trusts are buy¬ ing heavily, sees many speculative issues bolt upward, and he con¬ cludes that prices are not too high. He fails to notice that many stocks are easing gently or moving sidewise on high volume. Short sellers again become frightened and cover; they were correct in thinking the bull market was approaching its peak, but their timing was off and they sold short too soon. When they cover, thereby reducing the total amount of short interest, another bullish prop is removed from the market. During all this frenzy the experts and astute speculators are quietly distributing their holdings. They understand that the many stock splits, higher dividends, and prosperity cannot extend for¬ ever, but it is to their advantage that a bullish atmosphere persists until the distribution process is complete. They go out of their way to debunk any bearish news that may be circulating about the stocks they are selling. By creating the impression that the adverse news has already been discounted, there is a minimal decline when the unfavorable news does occur. Nor is it necessary for the professionals to act in collusion. They are delighted to spread bullish sentiment as the market at¬ tains new heights, for they depend on the little man’s aptitude for buying at the top. But even they possess no omniscience about the demise of the bull market. It never repeats precisely the same pat¬ tern and they too are fooled in the timing. Each bull peak will have a significant capricious deviation from the classic pattern that will fool almost everyone. Do not expect every cog to fall methodically and uniformly into place. 34

THE PRIMARY TREND The following tabulation shows how the key elements are affected in the primary bull cycle: BULL

Public mood

Business, production Employment, wages Prices, costs, inventory Foreign trade Interest rates Secondary

MARKET

Acceleration Overoptimism Accumulation Gloom disappearing Growing optimism Disregard of bad news, over¬ and bullishness optimism Slight improvement Rising, expanding Huge sales, profits, overexpansion Little unemployment, Rising Slow improvement Low, but gradual increase Rapid increase Low, but slight rise Infrequent

Continual rise Very high

many strikes Booming, stock¬ piling Declining, gold exportation

Rising steeply Many each week Gradual increase Increasing slowly

offerings, mergers Loans, credit

Slow rise in lending, Heavy lending money loose

Many loans, money getting tighter, monetary strain

The Primary Bear Trend The bear market, born to correct the speculative boom fever, inevitably follows.. Bull and bear markets exist because of an emo¬ tional excess; people buy with feverish enthusiasm; and later, when there is an oversupply of stock and little demand, their disdain for equities causes prices to decline unduly. The funereal gloom of a bear market is as extreme and undeserved as the overoptimism that preceded it. Fear and caution supplant confidence. A disastrous bear market can chase away investors for many years. Each primary swing tends to correct, and its severity is in direct ratio to, the previous counter-swing. There are three parts to the bear cycle. 35

Successful Speculation 1. The distribution phase commences near the bull market peak when the professionals start to unload. Volume is still strong in the pervading boom psychology, but usually diminishes on price ad¬ vances. Then, without warning, the market drops sharply. The public, surprised at first, recalls many previous dips and views the decline as a temporary correction. The economy appears healthy and brokers and newspapers report the downswing as a necessary, constructive move. Expecting a rally, the public does not sell, and prices often return almost halfway back to their prior highs. Every¬ one ignores or belittles the down-up move (except for the bears who sold short during the decline). Again the market drops, this time with greater severity. Antici¬ pating another rally, the small bargain-hunters buy more to “ave¬ rage down.” The short sellers cover profitably. New declines set in. Institutions and funds continue distributing and speculators in¬ crease their short sales. Although the little man’s earlier profits continue eroding, the glowing business news and the reports of increased earnings renew his faith. He increases his purchases. His losses now mount at a faster pace than his profits had grown in the bull trend. 2. The panic phase occurs when demand for stocks dries up. Pell mell unloading depresses prices. Earnings and dividends con¬ tinue to slip. The paper profits of the preceding primary ascent evaporate. An erratic and often steep rally may send prices upward briefly: the swifter and sharper the prior decline, the more accelerated the rally. (The rally in the 1930 bear market soared prices halfway back to their highs, and then came the 1930-32 collapse.) As pes¬ simism enshrouds the economy, prices soon resume their frantic drop in what is often the longest, most bewildering phase of the bear cycle. 3. The deterioration phase finds volume dropping to about 10% 36

THE PRIMARY TREND of a normal bull market volume. The public, which in disastrous violation of the primary trend had increased its purchase as prices plummetted, now concludes the market will never reach bottom. It starts to sell and sell, and nothing can halt the avalanche of sup¬ ply. Because of the lack of demand, rarely is there any kind of spirited rally in this phase. Many persons are obliged to liquidate to meet living expenses and other commitments. Since most margin buyers were long since forced out at higher levels, hardly any stocks are purchased on borrowed funds. The extent of the decline depends on the extent of the previous bull market and the outlook for the economy. The more harrow¬ ing it appears, the greater will be the decline. It took thirty-five years for the Dow-Jones Industrial Average to return to the level reached in 1929, and it was not until 1963 that the Rail Average did so. In the nine bear markets that occurred in the first half of this century, prices declined an average of 28% in four months, and about seven months thereafter had returned only halfway to their bull market highs. A sidewise movement in market prices will often develop into a secondary rally, prompting a surge of selling by whatever small investors still remain in the market; venturesome speculators are willing to buy at this higher level. The selling wave and upward resistance halt the advance, and prices drop toward their former low levels. This decline serves as a test of the market’s strength; bullishness is implied if prices remain above their prior lows and if volume is light, signifying a lack of selling pressure. It is not until a selling climax—a sudden, precipitous drop on massive volume (see Chapter 19)—that the technician enters the market. He reasons that although a shift to a primary bull trend rarely occurs overnight, the broad collapse and the numerous touched-off stop-loss orders signal the bear market’s death knell. (Most experts agree that the end of a bear market is more easily recognized than the end of a bull market.) Proponents of the Dow Theory wait for the official Dow signal, 37

Successful Speculation confirmation by both the Industrial and Rail Averages, before starting to purchase stocks. With the accumulation by professionals, the small speculators start to buy. Wide awake investors store away their purchases for the long-term primary advance. The reduced supply and the grow¬ ing demand helps the rise, and a sizable number of shorts run for cover. The rise quickens, and sensible marketeers increase their purchases whenever prices react in a correction on lighter volume. The following is a tabulation of the primary bear cycle:

BEAR

MARKET

Distribution Public mood

Production, business

Panic

Deterioration

Good news ignored, Renewed hope on Extreme pessimism, public ignores optimism dis¬ rallies, then market gloom appears Declining manu¬ Bankruptcies, More competition, collapse, slim facturing low demand, profits retrenchment

Employment, wages

Broad decline

Falling steadily, few strikes

Prices, inventory, costs

Declining, greater

Extremely low

Wages cut, high unemployment Reaching bottom

efficiency Almost nil

Very slight

Moratorium on

Declining

debts Low discount rate, then leveling off

Foreign trade Interest rates Secondary offerings, mergers Loans, credit

Slight drop from highs Many secondary offerings, few mergers Loans unloaded

Rapid reduction in number

Rarely seen

Banks afraid to lend

Public distaste for banks, few loans

Conclusions The shining lesson learned from the maturation and expiration

38

THE PRIMARY TREND of each primary bull and bear cycle is that the biggest loss stems from buying at high prices late in the market rise and holding too long in the major market decline. The obvious fact goes un¬ realized that the higher prices go the more limited will be the extent of the rise in the future, and the greater likelihood of an eventual larger decline. Emotional thinking and overoptimism blind the investor toward the peaks of bull markets much as fear and lack of confidence obliterate the buying opportunities at the com¬ mencement of the new bull trend. To “buy cheap and sell dear” you must determine the age and trend of the market, and have the courage to act on your convic¬ tions. Be ready to liquidate in an overbought market: “unreasonably high” prices must ultimately correct themselves. In prosperous times many individuals will affirm that a business decline is not possible because it would excite social unrest. This carries the inference that Washington can legislate and dominate the economic structure. But as long as there are differences of opinion concerning the reasons for recessions and depressions, we’ll continue to encounter intermittent setbacks such as the five ex¬ perienced since World War II. We always survive and recover when hysteria or panic engulf Wall Street, and it is then that rockbottom prices are available. Manuel Petty often remarked it didn’t matter whether it was a bull or bear market. “What the Averages are doing is not im¬ portant. I don’t b,uy the Averages,” he would say. “All I have to do is pick the stocks that are going to move up.” There is some truth to this. During a bear market, certain stocks rise, much as some stocks decline in a bull trend. Profits and losses can occur at any time. As long as you perceive the broad market picture, it isn’t necessary to categorize yourself as totally bullish or bearish. Imagine a roller-coaster ride that carries you over several hilland-valley formations. One part of the ride is mainly upward to a peak followed by another leg that is essentially downhill. But 39

Successful Speculation both parts contain intermediate ups and downs that briefly inter¬ rupt the major direction. The technician will not be fooled by these temporary reversals. Only on rare, special occasions will he risk buying equities in a bear trend, and he will then sell promptly for a quick profit. At the start of a primary bear trend, regardless of mass opinion that the decline is merely mild profit-taking or a momentary correction that offers the chance to pick up some bar¬ gains, he’ll know that, for him, the “ride” is over. It’s time to leave the amusement park.

40

Chapter 9 THE SECONDARY CORRECTION The secondary trend is a reaction, or correction, of intermediate duration, to the primary trend, usually occurring when the primary trend is too rapid or steep. It acts as a restraining safety valve to excessive moves in the major direction. These secondary correc¬ tions have been compared to a series of waves that comprise the primary tide. At least three but often many more secondary trends, each en¬ during anywhere from three to twelve weeks but tending to ave¬ rage about a month, comprise the primary trend. They are usually swift and sharp, retracing from 25 to 60% of the prior primary trend’s move. Their volatility causes them to receive more publicity and attention from the press and public than the major trend.

Of paramount importance to the long-term investor, naturally, is the primary trend. His profits come from buying growth and other worthwhile stocks in the early stages of a new bull market, while other, less conservative long-termers aim to hold them only until the next primary bear market commences. (Truly, anyone who is unwilling to devote time and study to technical analysis should invest only for the primary bull trend.) The secondary trend, however, offers the speculator and tech¬ nician opportunities for far greater profits. The ability to shed 41

Successful Speculation one’s holdings before or at the start of a dynamic intermediate reversal can spell the difference between huge profits and a mediocre long-term performance. In fact, the function of this book is to give you the technique to buy and sell on the basis of the secondary trend. Sometimes, in lieu of a secondary trend, prices may move in a sidewise “line.” The Averages may remain static for a few weeks to a month or longer, with buying and selling in balance. But eventually demand or supply will triumph and prices will move upward or downward, departing from the narrow confine. A pene¬ tration of more than 1 point in the Dow Industrial Average is usually considered a valid breakout signal. The longer the line formation and the narrower its price range, the more reliable will be the signal and the more severe the ensuing move. If the market has moved slowly in one direction, a drastic re¬ action is not likely; the sharper the primary trend, the steeper will be the correction. And remember that since prices move faster and steeper in a secondary trend than in the primary direction, you should expect precipitous declines in a bull market and tremendous rallies in a bear market. Everyone knows about the notorious plunge of 1929, but many persons today are unaware that the public returned to the market in droves in 1930, sending prices toward the 1929 peak. It eagerly bought the “bargains,” thereby losing more money in this “false” bull market—which was nothing more than an intermediate reac¬ tion in a primary bear trend—than in the 1929 crash. The primary bear trend may or may not be accompanied by high volume, but when activity shrinks drastically an upward re¬ versal is likely. This rally often ends in a sharp increase in volume (called a buying climax), and although prices may continue to rise, a drop in activity usually signals the resumption of the primary bear trend. Bear market rallies should be used to sell hold¬ ings that you may have erroneously retained. 42

THE SECONDARY CORRECTION Most secondary corrections in a bull market end with one or two days of high volume. This activity should serve as a signal of the reaction’s low point. Patient speculators will utilize this occasion as a buying opportunity. They may not know precisely where the correction will end, but they can reasonably anticipate the primary uptrend will soon be resumed. An analysis of other technical indicators will help determine whether the market is favorable, and if so, purchases can be made for the resumption of the primary bull trend.

The Minor Trend

These inconsequential market moves, often lasting less than a week and rarely more than three, were compared by Dow to the ripples on a wave (thereby completing the tide-wave-ripple analo¬ gy). These trifling price fluctuations have little significance, except as they tend to combine and fashion a secondary trend, and will be of small concern to us; whatever value they possess should be relegated to the daily, in-and-out trader.

The Swing Rule

In his Law of Action and Reaction, Dow contended that the market (or a stock) tends to retrace about 35 to 55% of the pre¬ ceding primary move before resuming it. Thus, if the Industrial Average were to rise, let us say, from 800 to 900, the secondary reaction may drop prices to 855 (45% of the 100-point advance). If the Average only corrects to 875 and starts rising again, a 43

Successful Speculation strong market is indicated and a new high in the primary bull trend can be expected. However, if the correction exceeds 50%—such as where the Average declines to 820 or so—the market is technically unfavorable and a further decline may follow. The converse would apply in a primary bear market. The same principle applies in individual stocks: if XYZ displays a sharp 10-point rise and then consolidates briefly, a decline can reasonably be expected. A drop of 3 or 4 points would signify a technically favorable situation in which further gains can develop. The swing rule, something of a corollary to Dow’s law, is a handy tool for gauging the extent of the next primary move. Sup¬ pose the Average in a primary bull market reaches 900 and then reacts down to 860. As prices start advancing again, it can be anti¬ cipated that the 40-point drop will be recovered and that prices will continue upward another 40 points (to 940). The same principle applies in a bear market or to an individual stock. If XYZ drops to 80 and then briefly rallies to 84, you can expect an 8-point decline to follow (double the 4-point advance in the secondary trend) to 76.

Despite these guide lines and the other technical tools available, the technician cannot exactly forecast the precise high or low points. Momentum and other factors cause prices in most primary or sec¬ ondary trends to vary from the expected ranges, and he must remain alert for any important shift in direction. What he must not do is convince himself prematurely that the price move he anticipates is currently in progress or that it definitely will happen. He cannot afford to operate on hunches or to conjure up faulty justifications for future moves. The technician must wait for the trend to change before he acts; he must be willing to get out of the market after the downhill slide commences and to get into favored stocks after they start advancing from their lows.

44

Chapter 10 CHARLES DOW AND THE DOW-JONES AVERAGES

The most popular, influential, and venerable of all technical mar¬ ket approaches is the Dow Theory. Charles H. Dow formulated his first index in 1884, and then collaborated with W. P. Hamilton at The Wall Street Journal and S. A. Nelson to improve his con¬ cepts for understanding and forecasting the market. Dow never maintained his tenets could foretell the movements of a particular stock nor that it was a get-rich-quick plan with which one could predetermine the timing or extent of market moves. But he did contend that the application of his theory foretold the future of industry, the business cycle, and the stock market. Criticisms of the Dow Theory are legion: it is old-fashioned and unscientific; it doesn’t always work; its signals come late; and it applies to an unpurchasable, nebulous market average. Despite the truth and half-truth of such allegations, his disciples are willing to stand on the record. In the vast majority of instances it has warned of impending catastrophe and announced the start of new bullish periods. Its signals have usually come before the greater part of the primary bull or bear move has been made, saving technicians far, far more than they would have saved with¬ out the theory. 45

Successful Speculation Dow popularized the concept of an inevitable cycle of alter¬ nating primary bull and bear trends, each with its three phases, and each trend expiring when the public least expects it. The cata¬ clysmic danger of buying at the bull peak and selling near the bear bottom was a highlight of his theory. Injected in the primary trend are the secondary corrections, which ease and modify the major direction, and the sidewise moves, which often substitute for these intermediate reversals. A third concept, a bulwark of technical analysis, is that the diverse economic, psychological, political, and financial influences on the stock market are all reflected in current prices. Everything has been discounted! Only an act of God, such as a President’s heart attack or assassination, an earthquake, or other sudden disaster is excluded from current prices.

Market Averages

The Dow-Jones Averages, established by Charles Dow, are: The Industrials (30 quality, high-grade companies, comprising about 25% of the value of all New York Stock Exchange secu¬ rities) The Railroads (20 companies) The Utilities (20 companies) Stock averages are like fever charts, mirroring the market’s health. They encompass a fairly large, diversified group of stocks, and any component stock in the Average can run similar or counter to it; their cumulative prices determines the Average. Another of Dow’s rules is that the stocks of large or recognized companies will usually fall or advance with the market average, but any speci¬ fic stock may fluctuate at variance with the Average. Dow theorists ignore the daily high and low prices, asserting that only the daily closing prices should be used. 46

CHARLES DOW AND THE DOW-JONES AVERAGES Since an average would be overly influenced by the higherpriced issues if all its stock prices were totaled and divided by the number of issues, a “divisor,” or weighted factor, is used to equal¬ ize their values. This is adjusted when a stock is split or a dividend declared. Other averages have been devised for growth, low-priced, glamour, cyclical, or industrial groups. These will be discussed shortly.

The Primary Trend

The primary trend must be confirmed by both the Industrial and Rail Averages. The market is in a primary bull trend when every advance in the Averages sends prices higher than their prior highs, and every secondary correction stops at a level higher than the previous low (see Figure 1). In a primary bear market, every decline in the Averages must drop prices lower than the previous low, and every secondary correction fails to advance the Averages to the level of the previous rally. Fig. 1. Primary bull trend. The area within the return line and the trend line is the rising bull trend channel. Each high (A,B,C) is higher, and each low (A1,B1,C1) is higher on the secondary corrections (A-A,, B-B1(C-C,).

Successful Speculation The Industrial and Rail Averages are both necessary to estab¬ lish and confirm the primary trend. If one Average reaches a new, important bottom in a primary bull market (or a new, important high in a bear market) a change in the major trend is not signaled. The two Averages must penetrate (violate) the prior intermediate low (or high) to change the primary trend; if only one Average penetrates, the trend remains intact (see Figure 2). Fig. 2. The Industrial Average made an

intermediate low of 939 in

and reached an all-time high of 995 in early February

1966.

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December

1965,

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1966,

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low was higher than the prior important low, no bear signal was given.

mid-May the Rails dropped to a lower low of 220. Thus, both Averages confirmed the primary bear trend.

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When prices remain in a sidewise pattern within the sym¬ metrical bounds to the apex, the pattern is not to be trusted. The most potent formations are those where the breakout occurs about one-third away from the apex (see Figure 2). Usually the longer and larger the pattern and the more shares traded within it, the more important will be the ensuing move. Small formations predict small moves. The extent of the move after the breakout can be approxi¬ mated in advance. Measure the triangle’s height at its left side 66

THE TRIANGLE where the formation began. Half of this height will equal the minimum move in the direction of the breakout. Thus, if your stock breaks out bullishly on higher volume, you may elect to sell or place close stops at the estimated minimum advance.

The Right-Angle Triangle This formation offers an advantage to the chartist over the symmetrical triangle in that the direction of the ensuing move is usually predictable. As with symmetrical triangles, authentic right-angle triangles break out about one-third away from the apex; and the extent of the next move is likely to be at least half of the triangle’s height. The ascending triangle is horizontal at the top. Its lower boun¬ dary slants upward, bullishly indicating that demand is growing at gradually higher prices. When the supply within the pattern is consumed, prices usually break out on the upside (see Figure 3). Fig. 3. Ascending Triangle. Increased volume is necessary at breakout to confirm bullishness.

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Successful Speculation The descending triangle is horizontal at the bottom. Its upper boundary slants downward bearishly, indicating that the increas¬ ing supply and smaller demand at lower prices will result in a downside breakout (see Figure 4).- Since the supply or demand may change before the breakout, premature action should not be taken, for it is safer to wait until the boundary has been fully penetrated. Fig. 4. Descending Triangle. Note pullback. High volume is not required at breakout but may occur a few days later.

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68

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THE TRIANGLE Broadening (Inverted) Triangles A broadening fori nation is a triangle with the apex at the left, in which prices move to the right in ever-wider fluctuations. These triangles are strong reversal patterns, usually bearish in nature, and are ordinarily associated with the top, or climax, of a primary bull market. Unlike the normal triangle, volume is often enormous at the boundaries of the pattern; and the wild, erratic price movement suggests an undisciplined and emotional stock or market (see Figure 5). Sometimes the pattern is difficult to discern until after its completion. These broadening formations may be symmetrical, descend¬ ing, or ascending triangles, but the patterns are so illogical and unreliable it is recommended that close stops be placed when they appear as a safeguard against the unexpected. An orthodox broadening formation is an inverted symmetrical triangle that, peculiarly, contains three progressively higher tops that alternate between two progressively lower bottoms. Five reversals in trend are always necessary. The pattern is completed when prices descend from the third peak below the second bottom and penetrate the lower boundary of the formation. Although full confirmation is only obtained after the downward breakout, the bearishness of the pattern is so potent that it is usually advis¬ able to prepare to liquidate when prices have started falling from the final peak (see Figure 6). m 4— -u '

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