15 posts tagged “stocks”

There are many of the difficulties encountered by institutional management. In this discussion our interest is on identifying pressures that often make discretionary managements conductthemselves in predictable, repetitive patterns. There are two basic source_sof pressure:

• Internal factors, primarily influenced by institutional structure.
• External factors, primarily influenced by the actions of clientele who have placed their funds under discretionary management.

Internal

Institutional management, whether the contributions are voluntary or involuntary, incorporates two basic elements: sales and performance. Of the two, sales is more important because if no reason is given for the contributor to entrust monies, the contributor is not going to do so. And with no money to manage, there is no institution. Elementary.

The primary institutional sales tool is image. Astute, presumably educated, well dressed personnel, plush surroundings, organizational names indicating solidarity, and other superficial characteristics are effectively utilized to project an image. Most investors buy the impression.

The average investor neither wants to take the time nor has the inclination to make objective comparison of the relative performance of the many institutions. Often the institution is chosen without any comparison because of a personal friendship with the institutional manager or salesperson, response to advertising, or media hype. For these poorly informed investors, the greatest influence on their choice of discretionary management is paid advertising, which makes the larger (more heavily advertised) institutions appear preferable. We do not intend here to demean sales. Salesmanship is an integral part of all societies; it is involved in politics and religion, as well as in the overall economy. Our point is to emphasize the sales aspect of institutional structure because it is often overlooked byinvestors, and it forms the basis of some predictable institutional market behavior.

While most investors are not keenly aware of the differences in performance among institutions, most institutional managers definitely are. With their firms having costumed and situated themselves in similar surroundings, the managers must do something more to enhance their sales. The obvious factor to emphasize is performance. However, this creates a dilemma since most institutions fare relatively poorly over time. Irrespective of what the institution has really accomplished for clientele, it isobligated (to assure its existence) to make past performance look as good as possible.

For those institutions that publish their holdings, the easiest way to project the image of superiority is for the holdings to have appreciated dramatically since the time they were purchased. The accomplishment of this task is within the grasp of any attentive third-grade student: sell holdings that are losing and retain those that have appreciated. Then—ah ha—when the institution's holdings are published, it will provide the image that the institution has a fantastic ability to achieve superior results. To add to the image, right before the holdings are to be published, the manager determines which stocks have gone up the most and are receiving the most positive media attention, and then buys some irrespective of the current high price. The end result is a published portfolio that is stuffed with winners and the "hottest" current stocks. The impression is that the institution has both a history of winning and continues to be "on top of the market" by having positions in those stocks currently in vogue.

This process of adjusting portfolio for the sake of appearance—window dressing—is most pronounced when the majority of institutions publish their quarterly portfolios, on or near the last day of March, June, September, and December. As might be expected, the window dressing effect is most dramatic during December when it is combined with selling by the public and others for tax reasons.

The problem with window dressing is, of course, that it not only involves the precise formula for loss (buying high and selling low), but also precludes optimal profit capture by retaining positions that are too high and destined to fall.

To those who conduct themselves professionally, being aware of the influence of window dressing adds to the benefits obtained by normal shifting in relative strength. In effect, window dressing aggravates pricing, making prices too high/low than they would be without the effect. Being aware of the window dressing pressures in combination with normal rotational shifts in relative strength can, in itself, more than double the return available from the market as a whole as measured by the popular averages.

The risks associated with portfolio modification for the sake of appearance are magnified in management techniques stressing "growth" stocks. Retaining a position simply because it has attained an exceptionally large gain could involve the stock's being in the attainment phase of the life cycle concept. In this phase quality stocks are most vulnerable to steep, often sudden price declines.

When we developed our investment methods, we assumed that using P/Es based on projections rather than lagging P/Es would create a significant difference in results. Over the many years that this basic portfolio modeling has been published and applied in actual market endeavors (covering a wide range of market conditions and thousands of individual stock positions), to our surprise, that the results obtained by using earnings projections in P/E calculations has not (to date) resulted in significantly better results than using lagging P/Es. In other words, although the authors use projections in their analysis, lagging P/Es so far have provided almost identical results. Whether earnings projections or lagging P/Es are utilized, taking the calculations to two decimal points is necessary to maximize the number of buy/sell points.

Since P/E is a function of price, we must consider whether price (a much easier measurement, the week's closing price) can be substituted. The answer is yes, but there will be some (to date quite minor) loss of accuracy. For example, if a stock's earnings suddenly declined dramatically and the stock's market price also declined, the decline in market price might not be directly proportional to the decline in earnings. The price would go down, but the P/E (price now divided by lower earnings) might go up because the earnings drop was proportionately greater than the price drop. Watching for changes in price, without paying attention to earnings changes as well, will prevent your gaining a refined perspective of true supply/demand.

If you choose to substitute price change for P/E change, the accuracy differential can (in most cases) be compensated for by raising the required percentage of issues that must be down or up in price to 80 percent. There will be fewer buy/sell points derived by using price rather than P/E, but (to date) the price method would have identified all major buy/sell points. Consequently, the essential elements for an indication are:

BUY: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be down.

SELL: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be up.

A question is now raised: Would it not be easier just to see if the market averages had gone lower and take that (or the P/E of the Dow or some other average) as an indication? The answer is no. The averages can be misleading. They can be significantly influenced by dramatic price moves in stocks and stock groups that do not warrant consideration (that is, stocks not on the Master List) as an indicator of investment. An attempt to gauge market conditions by the average of a conglomeration of unrelated stocks brings in extrinsic factors that are unpredictable. Our stock selection is designed to make the most important extrinsic factor (earnings) predictable.

To attempt to incorporate past changes in market averages as forecasting tools for future changes can be done, but it requires extensive calculations, including degree of price change in relation to volume change for each stock involved. It results in lower levels of accuracy than achieved by our technique. In our method, the design is not only to achieve superior results; it is also designed to be as simple as possible. In our method to get a signal from our primary indicator, the degree of decline (what percentage decline in P/E or price occurred) is not a necessary measurement. For example, if 80 percent of the stocks monitored declined in price only 1/8 of a point from their previous price level, the essential criterion for a buy indication would be met. The ancillary criteria are designed to filter for the magnitude of the primary criterion.

Why (for the basic portfolio modeling techniques) do we not consider it essential to wait for some upward price movement to occur to ensure that the effect of selling pressure is gone? Conversely, why not wait for some downward price movement to occur to ensure that buying demand is gone? The reasons are twofold.

First, often when price reversals occur, they are very rapid, and a significant portion (sometimes almost all) of the anticipated price change can occur before positions can be taken.

Second, the authors are in the business of stock trading on a scale that involves many millions of dollars. We are not engaged in theoretical observations that include the naive belief that infinite amounts of stock can be bought or sold at the prices quoted. Stated flatly, for us to acquire stock in large amounts at appropriate prices, it is necessary to have adequate sellers; to sell stock in large amounts at appropriate prices, it is necessary to have adequate buyers. Real people and real money are involved. Stock purchased at acceptable prices is available only when sufficient sellers at the acceptable prices are in place; which is usually as prices are declining, not after the price decline. Selling stock at acceptable prices can be accomplished only when there are adequate willing buyers, which is usually as prices are advancing, not after the advance.

Our determination of buy/sell points is based on a logical understanding of the structure of the market and of the behavioral patterns of fellow market participants. We are not concerned with waves, angles, astrological configurations, or other such data, which by some magical force are presumed to be satisfactory indicators of future prices.

The purpose of our timing technique is to help facilitate our objective to take the monies of others in a repetitive, consistent fashion that minimizes risk in actual market endeavors. We have no interest in theoretica abstractions in that time so spent can only detract from fulfilling our of objective. At this point, we are attempting only to ensure acceptable accuracy in forecasting changes in the major market averages. The final goal is to develop profit consistency for our stock positions at the percent- age level we have chosen (90 percent minimal) within the average holding period we have decided to use (four to six months).

Because of the upward bias in the specific stocks we utilize, we do not need k the probabilities for accurate timing of the popular averages to be as high as those associated with the specific stocks. As discussed in the previous sections, our 95-percent accuracy rate with individual stock issues needs only around a 78-percent or better accuracy probability relative to the popular averages.

In actual market participation, decisions must be made quickly and without emotion. Our timing technique, therefore, must not be influenced by emotional "subjectivity," and it must be easily and quickly calculated to avoid time lags that would take away from maximizing the number of available opportunities.

Market timing is nothing more than reviewing statistically valid data to derive probabilities for future price moves. Consequently, because of the probability variances at any given time, not all buy/sell points are created equally.

The relative strength of any buy/sell point can be compensated for by altering the "investment level," that is, by varying the percentage allocation between stocks and cash.

At this juncture, our objective is to develop buy/sell points that meet our minimum requirements related to the purchase or sale of specific common stocks. Application to options, index futures and more speculative trading strategies require adjusting our timing probabilities upward from those that are the focus of this discussion.

Our discussion of the technique, at this time, is designed for the process of buying specific stocks, then selling. The basic elements are buy indications that increase the percentage of funds allocated to common stock investment (that is, increasing the investment level), a holding period, and then sell indications that would result in selling specific positions to adjustto a lower investment level.

This buy-to-sell aspect is stressed because you cannot assume the processcan be automatically reversed. That is, the same criteria cannot be used in reverse for short selling with the same degree of accuracy in specifi_cpositions—selling short on sell indications and covering (buying back the short positions) on buy indications. The reason it cannot be reversed automatically is because of the upward bias in the stocks we utilize. For accurate short sale techniques, alterations (to be discussed) are necessary to eliminate this upward bias.

In this discussion, we are going to fully describe the criteria that w_e actually use. Some of the criteria might appear rather complex, and the information to implement exact duplication might be difficult for many investors to obtain. However, after such detailed descriptions, greatly simplified methods within reach of almost all investors will be described. In fact, the basic timing method can be compacted so it takes less than one hour each week without any need for complicated equipment. Nothing is necessary beyond the ability to read.

The factors we use to determine buy/sell points are of two types: essential (or primary) and ancillary. There is only one essential factor, and it must be present for any buy/sell indication. There are twelve ancillary factors; any six (or more) must coincide with the essential factor to have a buy/sell indication.

The Master List, whether all the issues are being monitored or only the minimal acceptable number, forms the core of the indication. These stocks, with their relatively high degreeof earnings predictability, we use both to gauge forces within the market and to make specific investments.

In effect, we are functioning in a market within a market. We want to buy low and sell high. By confining interest to specific stock issues that have demonstrated fundamental superiority, we have chosen stocks that have an upward bias relative to the market as a whole. This bias in itself, however, is far from enough to meet our goals. We are very much interested in the relationships between demand and supply. We want to purchase when there are strong signs that selling supply might be exhausted. In other words, we want to buy soon before or in conjunction with the last period in which the sellers are dominant. Once the selling dominance has been eliminated, buyers can dominate and prices can advance. Conversely, we want to sell soon before or in conjunction with the last period in which buyers are dominant. When the buyers have exhausted their influence^, sellers can dominate and prices can decline.

The best indication of seller dominance is a downward shift in marketprice relative to earnings (the price/earnings ratio). Lower P/Es both provide stock at lower prices relative to earnings and indicate that sellers are using up their influence. Therefore:

• For a buy indication, it is essential that the P/Es of the stocks monitored are falling.
• For a sellindication, the P/E condition must be the reverse of that fora buy: It is essential that P/Es are rising to have a sell indication.

Since by the design of Drach's published Time Overlay portfolio modeling we are looking at the market weekly and comparing it to four weeks before to see the relative change, we are looking for upward or downward moves in P/E relative to the P/Es four weeks ago. The minimal acceptable level is that 75 percent of the stocks monitored have moved down or up in P/E from their level of four weeks before. If the percentage is less than 75 percent, there is no indication. To repeat:

• The essential factor for a buy indication is that 75 percent or more of the stocks monitored have declined in P/E from their level four weeks before.
• The essential factor for a sell indication is that 75 percent or more of the stocks monitored have advanced in P/E from their level four weeks before.

In the calculation of P/E ratios, both price and earnings are variables, that is, both change over time. In most financial publications, the P/Es listed are "lagging P/Es." That is, they are calculated by taking the corporation's earnings over the last four quarters (one year) and dividing the earnings into the current market price. Because earnings change and because one of the criteria for stocks to qualify for our Master List is earnings predictability, it is reasonable to assume that calculating P/Es using earnings projections covering the next four quarters (the next year) would be a more accurate gauge of the P/E shift, indicating that the stock was becoming (or is) under- or overpriced.

In Drach's publication, as well as in actual account management under the author's supervision, P/Es are calculated using earnings projections. Also note that the authors' P/E calculations are to two decimal points since this significantly expands the number of buy/sell points.

The two previous factors were designed to isolate specific participants and their ability to effectuate future behavior because of their cash/noncash position. The amount of money in the overall economy is also important and is influenced by the actions of the Federal Reserve.

The figures relating to available money supply are provided weekly by the Federal Reserve and reported by all major financial publications. The money supply calculations include various categories (M-1, M-2, and M-3 being the most popular in gross form). Because of the various components of the money supply categories and changes in the economy, there is an ongoing debate within the financial community as to which measurement (with a myriad of adjustments) is the most accurate. For the purposes of our basic market timing, time and brain cells need not be wasted in agonizing as to which "M" (money supply measure) is chosen. One need only be concerned with sticking with the M originally chosen. We use M-1, which is basically the amount of cash in circulation.

As a criterion in our basic timing method, we compare the gross (not ratio) amount of M-1 to its level four weeks before.

BUY: The amount is increasing. More money is coming into the system, a portion of which can be lured into the stock market in the form of buying demand. In addition, the increased amount of available money helps the overall economy to expand.

SELL: The amount is decreasing. The withdrawal of money from the overall economy creates cash needs, on which investors draw against their stock holdings (because of the liquidity) before selling most other assets. This selling supply can function to depress prices. And the lessened money supply is often a good indication of a coming constriction in the broadly based economy.

Gold Price

The stock market, as with any other market, is constantly in competition with other investments. Gold, because of its history and physical nature relative to paper money, is a good indicator of relative popularity. Real estate, collectibles, and other "hard" commodities could probably be substituted for our gold criterion; but we have selected gold for its liquidity (with the metal being actively traded in markets throughout the world).

Again using a four-week comparison, we simply look at the net change in price for our indication. We use spot prices, but futures can be substituted as long as the same contract month is being compared.

BUY: Gold is up in price. This can be a good indication that stocks have become unpopular and undervalued. When the gold price declines and the metal disappoints investors, their buying demand can more easily shift to the stock market.

SELL: Gold is down in price. This can indicate stocks have become overvalued and can precede a reversal in investor sentiment, creating increased selling supply in the stock market.

Bonds

There is an inverse relationship between bond prices and interest rates. Higher bond prices mean lower interest rates, and lower bond prices equal higher interest rates.

There is also generally a very strong, direct correlation between stock and bond prices. Higher bond prices are usually accompanied by higher stock prices, lower bond prices by lower stock prices. The bond/stock price relationship is logical. Higher interest rates (lower bond prices) increase corporate costs borrowing and as such function to reduce earnings. Higher interest rates, because of the increased cost of capital, tend to slow the overall economy which can adversely affect corporate sales and consequently have a negative effect on corporate profitability. Within market structure, higher rates increase the cost of margin buying, which reduces buying demand.

Periods during which stock and bond prices diverge usually involve high levels of investor emotionalism. If sentiment is extremely pessimistic, high-quality bonds become viewed as safe havens and buying demand increases, adding price support for bonds while stocks falter. Conversely, during periods of extreme euphoria, bonds can become viewed as providing returns too low relative to stocks, creating selling supply in the bond market; this lowers bond prices while stock prices are advancing.

Our concern with the bond market in our timing model is the most common, direct price relationship. Using a four-week comparison period, our indication for this criterion is the next change in bond price down or up—we are not concerned with the magnitude of the differential. We use long-term U.S. Treasury bonds.

BUY: Bond prices are down. Interest rates have moved higher, probably depressing stock prices and making a price reversal more likely.

SELL: Bond prices are up. Interest rates have moved lower, possibly having an unsustainable elevating effect on stock prices and increasing the chance for a reversal.

Our previous criteria were designed to get a general idea as to our opponent's ability to participate in the market (cash or the lack of it), as well as some insight into the effect of alternative investment types.

We will now turn our attention to what is actually happening within the stock market. The two most important variables are price and volume. If volume is increasing as prices are advancing, it is indicative of an expanding number of buyers coming into the market. This can also indicate that the buyers are depleting their power and will eventually no longer be able to maintain price support. Conversely, if volume is expanding as stock prices are declining, it indicates that those selling out will eventually lose their force (depleting selling supply), which can allow prices to reverse.

In calculating this criterion, we want to know if the cumulative volum_e over the last 20 trading days is greater or less than the cumulative trading volume of the preceding 20 trading days. This is accomplished by adding up the total volume on the New York Stock Exchange over the last 20 trading days and comparing the total with the volume the preceding 20 days. Forty days of data are needed. Calculating this criterion takes only a couple of minutes: adding the newest day and deleting the latest in an ongoing total. For most indications all you need to do is look at a chart of recent volume (available in most major financial publications) by which significant changes in volume can be quickly and easily identified.

For this criterion to be given any consideration, volume must have increased. The amount of the increase is of no concern. If the volume has decreased, this criterion is not considered to have given any indication.

For the price component of this criterion, the net change (plus or minus) of a popular average will suffice. The amount of the change is of no concern, just the direction. Using a four-week comparison period, we use the New York Stock Exchange Index because of the large number of issues forming the measurement. The Standard & Poors 500, Dow Jones Industrials, or other popular averages could be substituted.

BUY: Volume is increasing as prices have declined—an indication that selling supply is being depleted.

SELL. Volume is increasing as prices are advancing—an indication that buying demand is being depleted.

NO INDICATION: Volume has decreased.

Volatility

The faster prices are going down, the faster sellers are getting out, and the higher the probability that the excess selling supply will soon diminish and allow buying demand (higher prices) to dominate. The faster prices are going up, the faster buyers are using up their money supply, and the higher the probability that selling supply can soon dominate to push prices lower.

In the past, we have incorporated beta measurements as one of our volatility criterion, but these calculations were time-consuming and difficult for many investors. We are now substituting a very simple measure of volatility rather than the more time-consuming beta comparisons. The simplified method can be applied without any loss of accuracy.

Remember that, by confining specific investment interest to the stocks that qualify for our Master List, we are effectively participating in a market within a market. When purchasing stocks, we would prefer to invest in those that will outperform the market. When selling, we want to get out when the chances are that our stocks will go down at a faster pace than the overall market. Consequently, it is to our benefit to have some idea as to how the stocks we follow are doing relative to the broadly based market. If our stocks are relatively depressed, to us they represent better values. If our stocks are relatively overvalued, they would appear more vulnerable to decline.

To determine the relative over- or underpricing, we compare the percentage price change of the stocks we monitor to the percentage price change of the NYSE Composite Average. Any other broadly based market "average" could be substituted for the NYSE Composite.

Using a four-week comparison, the percentage of advance/decline of the popular average selected is calculated and compared with the average percentage advance/decline of the stocks we follow. Whether this ancillary criteria develops a buy or sell indication depends on what direction the popular average being followed has taken.

If the NYSE Composite has declined.

BUY: If the stocks we follow have declined more than the Composite average.

NO INDICATION: If our stocks advanced or declined less than the Composite.

If the NYSE Composite has advanced.

SELL: If the stocks we follow have advanced more than the Composite average.

NO INDICATION: If our stocks declined or advanced less than the Composite.

Keep in mind that our stock market participation is limited to the very select group of stocks on our Master List. In effect, we are dealing in our market within the overall market.

At any given time, each stock on the Master List will vary as to its relative over- or underpricing when compared to the others. When a buy indication occurs, we do not want to buy the entire list. We want to choose from the list the specific issues that appear to provide the highest probabilities for appreciation.

To accomplish this objective, as well as to demonstrate valid factors that can be utilized in specific stock selection, three separate methods (earnings, yield, price) are incorporated into our portfolio modeling and each method is followed in detail in the published weekly Report.

Earnings

The most fundamental value of most corporations is earnings, which can be measured relative to stock pricing by the price/earnings ratio. The higher the P/E is, the higher the relative pricing. Conversely, the lower the P/E, the lower the relative stock pricing will be.

Lagging P/E ratios (the current stock price divided by the last full year of reported earnings) are provided in the daily stock quotations published in most major newspapers.

The problems associated with using the published P/Es are twofold.

1. The earnings of most corporations are erratic and basically unpredictable. What looks like an attractive low P/E could suddenly skyrocket with lower earnings. To overcome this, one of the conditions for inclusion on the Master List is an established record of earnings predictability. Only by confining interest to stocks with demonstrated earnings predictability can the P/E selection method be viable.

2. The published P/Es are associated with past earnings and earnings change. This is why we use earnings projections that are somewhat time-consuming to generate. To repeat, although we continue to use earnings projections in our P/E selection technique, over the many years of this technique's publication there is not a significant difference in the results obtained using either lagging earnings or projections.

Having made a reasonable attempt to overcome the obstacles associated with P/E valuations, our objective during buy indications is to purchase issues that are trading at the most attractive (lower) P/Es. Each stock on our Master List has a history of P/Es; that is, the past P/Es are available, and you can see the high and low P/Es (the P/E range) that the stock has experienced. We go back seven years in determining the range.

Not all stocks or stock groups trade in the same range. Stocks that are viewed as having superior growth will trade in a higher range than those viewed as stodgy.

During a buy indication, we want to purchase issues that are trading in the lower portion of their P/E range, thereby providing higher probabilities for appreciation than those that are trading in the upper portion of their range.

In the published portfolio model concentrating on the P/E method, generally, during buy indications, a wide variety of stocks with different P/E ranges are selling at a similar low level. Since only a very limited number of stocks are selected, a mechanical technique to determine which issues are selected from among those in similar P/E ranges is employed. You simply select those with the lowest P/E, irrespective of the range. Consequently, this selection method tends to concentrate in low-P/E stocks. In addition to the selected stocks being in the lower portion of their P/E range, they must also be selling below their price four months ago.

It can easily be seen that this strict adherence to only making buy or sell decisions once a week introduces a significant constraint: Better prices may be available during the week rather than confining the buying or selling to only one price during that week, the week's closing price. However, this is how the Report is structured. In effect, it is only looking at the market once a week at the week's closing prices to determine if any changes are warranted in portfolio modeling.

Obviously, this constraint is not necessary in actual market endeavors. In a later section involving how to expand return, we will address how this constraint can be easily overcome.

The Report follows three different portfolio models based on the three previously discussed methods of stock selection: earnings, yield, and price. Each model functions independently of the others, even though they are basically interrelated by the technique's design.

As mentioned previously, not all buy/sell indications are of equal strength. At this juncture, our concern is describing basic format structure.

Whenever there is a buy indication, five stocks are selected for purchase in each category (earnings, yield, price) using the simple stock selection techniques. The price (the week's closing price) is listed with each stock specified for purchase.

Between the time specified for purchase and the time specified for sale, the stocks are listed in the Report as "Open Positions" and the date specified for purchase. No position can be forgotten.

When a sell indication occurs, those positions selected for sale are listed with each position detailing the percentage profit/loss and time the position was held. The positions sold are then deleted from the Open Positions, and the results are incorporated into an ongoing summary of results published in each weekly Report.

Using this rigid format, each stock position is followed continuously from the time of purchase through the time of sale. With no possibility of hindsight or omission, the technique's validity is carefully documented.

4. The results summaries do not include dividend payments. The results are accordingly understated.

5. The percentage profit/loss calculations for each specific stock position take into account transaction costs in the following manner.

Inherent in the Time Overlay techniques because of the timing criteria, stocks are almost invariably purchased during declining markets and sold during advancing markets. This is by design. As such, there has always been some price decline after purchase and some price advance after sale. In other words, because of the published format's construction, stocks have never (to date) been specified for purchase at their exact low price and have never been specified for sale at their exact high price. The minimum price differential is quite specific and is incorporated into the Report to more than offset reasonable transaction costs as follows (providing 1/8th increments for each $12.50 of stock price):

For example, if the Report specified a stock for purchase at 35, by design the stock should trade at least 'A less, 34%. If the stock went to 40 andselling was indicated in the Report; by design the stock should sell at least ^IA higher, 40¹/4

In this example, the result recorded by the Report would be to purchase at 35 and sell at 40. By using the differential, the actual result would have been to purchase at 34⁵/8 and sell at 40^1/4.

This pricing differential is another constraint that need not be experienced in actual market endeavors.

6. The published portfolio modeling, is purely mechanical, totally objective, and void of any subjectivity. The published modeling will only alter model portfolio structure (buy or sell) when the primary and ancillary criteria are in agreement on a timing signal. The buy/sell signals are therefore predetermined by market conditions. Because of the modeling's design, under no circumstances will there be any change in portfolio structure unless the predetermined conditions for a buy/sell signal aregiven. In other words, the models have absolutely no concern about events between the predetermined buy/sell points.

It is mandatory that the published models function on a purely mechanical design. The injection of subjectivity would function to invalidate the published results.

This is a very significant constraint which, can be easily overcome in actual market participation.

As background to this technique, remember one of the criteria for stock selection is institutional involvement. The issues utilized, therefore, are suitable for investment consideration by at least some institutions.

This allows us a valid comparison: matching the results obtained by our methods with those obtained by institutional management over the same time period. Similar comparisons can be made by measuring the market performance that was (or could have been) obtained by following the recommendations of any broker or advisor as well as providing a valid comparison with popular market averages.

The reason for this is not to identify relative competence, but to eliminate a possible bias. If the techniques employed used little known stocks or information not widely distributed, it would detract from the validity of the results. That is, to enhance the validity of the techniques, the methods must incorporate data available to other investors during the same time period.

The timing techniques being employed use no special or inside information. All stocks utilized are well-known and widely followed. The information used in determining specific stock selection was (is) easily available.

Another aspect incorporated to eliminate bias is that the stocks utilized are usually higher-priced with relatively high trading volumes. This adds to the validity of the results. Methods using low-priced, low-volume stocks can be biased to the point of total invalidation. For example, low-priced, low-volume stocks could be easily changed in price by the action of a few individuals who through their own activities create price changes and the illusion that they have acquired actual profits. This illusion of actual price change has been used in fraudulent schemes where the investor is talked into buying a low-priced, low-volume stock from a crook who "makes a market" in the stock. The investor is unaware that the elevated price was made up at the discretion of the crook since no one else is interested in the stock. Seeing the appreciation, the crook sells the investor another stock with the same result, etc, . . . until the day comes that the investor wants to sell and there is no real market.

Crooks aside, percentage price fluctuations in low-priced stocks can often be dramatic on very low volume. Because of this, parallel (or even close to parallel) returns in actual practice would be impossible. Note that, because of this effect, many published advisory "services" that tout low price/low-volume stocks can be extremely misleading. For example, they could recommend a stock and then their followers proceed to bid up the price by their own buying. The service then identifies the price advance as an indication of the service's "ability" and may recommend sale at the higher price. The followers sell, thereby forcing price down in the same magnitude that their selling had advanced the price. The "service" looks good, but the followers could never obtain prices parallel to the service's recommendation because the appropriate prices were never really available. In other words, the followers bought high and sold low, while the service created the impression of success.

A malady shared by many analysts is selective memory loss. When they are correct, they become vocal to attract attention to their ability. When they are wrong, they shut up, and the error is forgotten. Another manifestation of selective memory loss is the "cover all your bases babble," i_nwhich market forecasts go something like, "If the market does not remain unchanged, it will advance unless a decline occurs." Such yappings are extremely common, but absolutely worthless to anyone except the analyst who, after employing selective memory loss, can point to any market outcome as proof of forecasting ability.

We, the authors, are in the market in real time. Our livelihoods are dependent on accurate price forecasting. There is no place for selective memory loss and associated nonsense. The results of our decisions are clear and crisp: Either we have acquired the money of fellow market participants or lost. Period.

In demonstrating the basic Time Overlay investment technique, we developed a format involving several controls making hindsight or omission virtually impossible and allowing the method to be easily used in actual market endeavors.

The specific application of the Time Overlay method is followed in a weekly Report which has been published continuously since January 1, 1977 by Drach Market Research.

The Report is prepared following the close of the last trading day of the week (Friday, unless a holiday when preparation is conducted on Thursday).

The Report is always mailed before trading begins the following week. This preparation and mailing sequence prohibits any possibility of waiting until the next week begins before presenting the forecast for that week.

The Report is very specific—no "if s." It states clearly and specifically to BUY, or SELL, or DO NOTHING. The text is devoted to an explanation of current positioning and outlook.

The Report uses only the week's closing prices. There are no qualifications to buy or sell if this or that happens. When a buy or sell decision is made, it is firm using the week's closing price. Period. No buy or sell decisions are contingent on anything that happens between publications of the weekly Report.

The Importance of Diversity

Two types of diversity are important in portfolio modeling: issue and time.

At the time of this writing, over the 16 years that the Time Overlay models have been published, 1065 specific stock positions have been concluded of which 1016 have been profitable. Although we consider this 95-percent accuracy rate to be acceptable (as we shall see later, it can be improved), some losses have occurred. Even though the probability is very low that an individual stock position will fail to be profitable, the possibility does exist that, if a portfolio consists of only a few stocks, they could turn out to be the losers and the method would result in loss.

Because of this, albeit very low, chance of loss, it is reasonable to reduce this loss possibility to a minimum by having several different issues in the portfolio. In actual market endeavors, over many years of employing the Time Overlay technique, we have never seen an account actually lose money that strictly adhered to the method. However, because the possibility exists, it is only prudent to consider issue diversity.

Of greater importance is time diversity. As you can see in Appendix A, listing the published buy/sell points, several buy indications are generally followed by several sell indications, and so on—an ongoing cyclical process. This inclusion of more than one buy or sell in sequence is by design. We are not primarily concerned with picking exact tops and bottoms in the popularized averages, with our emphasis being on the specific stocks we follow. Our concern with movements in the popularized averages is that these movements will enhance our profit extraction through the buying and selling of specific stocks.

As previous mentioned, there is a constant change in the relative attractiveness of the issues on our Master List. There is no reason for us to buy or sell everything at once. We want to enter the market gradually, expanding our exposure (investment level) over a series of buy indications, providing us time diversity as well as a better chance for issue diversity. When selling, our desire is the same, to gradually reduce our exposure. In other words, since the stocks we are involved with will not all hit their low or high points at the same time, it would be stupid for us to buy or sell everything at the same time.

When buying stock that qualifies for inclusion on our Master List, the lower the price is, the better. Since accumulation (buying) is designed to occur over a series of buy signals, it is possible that a stock can be bought repeatedly as its price descends, and this has occurred. The diversity in this case is by time: same issue, different prices.

In most cycles, the time duration between buy indications automatically provides issue diversity because different stocks will be relatively low- priced during different buying periods. During those buying periods in which stocks tended to duplicate—that is, the same stock was purchased during each buy indication—it might seem reasonable to conclude that the duplication increased risk. The actual results to date contradict this assumption, with the time and issue diversities of equal importance. The same stock purchased at increasingly lower prices reduced risk to the same degree as selecting several different issues.

The results of this technique, to date, also firmly indicate that the amount of diversity necessary to approach median return need not be very great. Only five to six individual positions, diversified by either issue or time, have been shown to almost invariably provide returns ± 5% of the median. This allows the technique to be employed by relatively small accounts.

Because of the careful selection technique of individual stocks, the results to date have repeatedly shown that time diversity is more important than issue diversity. It is more prudent to apply monies to a few stocks at different times than to many stocks at any one time. In fact, overdiversification as to the number of stocks can often be a severe disadvantage in optimizing return.

The important point is recognizing that both time and issue diversity are built into our investment technique. The time diversity aspect is automatic because of spacing the buy/sell points. The issue aspect is also (usually) automatic because the different stock issues appearing to have the best profit potential will generally vary between different buy indications.