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Martin Zweig once said, “If you can protect in bear markets you don’t have to be a hero in the bull markets”.  The Sensatus Investment Club have averaged 1% return per month (0.98% to be precise) on our combined cash and investments over the last year and are now in profit; quite an heroic performance during the bear market, giving us a 36% head start on the FTSE if it turns now.

The Sensatus Investment Club set up at the end of 2006 and had built up enough cash to start investing in March 2007; just as the bear market was beginning. Over 2007 the volatility in our portfolio was extreme as we didn’t have much money to diversify with and our fate was tied up in two or three stocks.  Then the inevitable happened; one of our stocks blew up leaving us 15% down come the end of 2007. Our target had been to generate 2% return per month, however by the end of 2007 we had lost the equivalent of 2% per month.  This was not exactly the start we had hoped for. However, it was the best thing that happened to us, because as a new club we had been eager to rush in and had not been disciplined in our stock selection.  That has since changed and I’m glad we worked it out while we only had a small amount of money at stake.

At the end of 2007 we sat down and reviewed how we selected stocks and adopted an approach based on criteria reportedly used by Martin Zweig and Warren Buffett mainly:

Martin Zweig:

• Look for shares where earnings growth is accelerating
• Look for shares that are reasonably priced
• Don’t buy stocks that are under-performing the market; buy shares with some relative strength
• Look for trends and external correlations

Warren Buffett:

• Free cash flow of at least $250 million
• Net profit margin of 15% or more
• Return on Equity of at least 15% for each of the past three years and the most recent quarter
• A dollar’s worth of retained earnings creating at least a dollar’s worth of shareholder value over the past five years
• A market capitalisation of at least $500 million

The criteria that our investment club now use is based on selecting investments based on:

• History of Earnings growth increasing over time
• Earnings growing faster than Revenue
• Debt to Equity ratio, ideally under 25%
• Strong Cash position e.g. current ratio greater than 1
• Return on Equity greater than 15% (very important)
• PEG of under 1
• Low Forward PE, typically under 20 to 30
• Relative Strength
• Strong Brand
• Like Products

The results speak for themselves with the Sensatus Investment Club now profitable against a back drop of the FTSE falling 36.8% and averaging a loss of 1.51% per month since we started trading.

Sensatus versus FTSE - Monthly Internal Rate of Return (generated by timetotrade Performance - Portfolio tools):

Average Cost Return on Open Positions (generated by timetotrade Performance - Portfolio tools):

Key lessons learnt since our investment club formed:

• Don’t rush in
• When starting off, invest no more than £1,000 per stock therefore reducing your exposure to a bad investments
• Diversify by investments, sector and country (see pie charts below - currently overweighted in Retail due to strong performance in related investments)
• Be disciplined in selecting financially strong companies
• Be patient however remember that the only way to beat the market is to make investments
• Be disciplined about selling if there is a change in the fundamentals or the stock breaks through a long term support trend line

Sensatus Sector Diversification (generated by timetotrade Performance - Weighting tools):

Sensatus Currency Diversification (generated by timetotrade Performance - Weighting tools):

I better get back to work as I have to finalise a presentation for the IX Expo event on Friday. For one of the products that we are working on in timetotrade we have been testing algorithmic trading strategies and one of the strategies has generated 2,733 pips return on the EURUSD currency pair since the 2nd of February 2009.   I will be presenting the strategy at 11am at the IX Expo event in London if you feel like popping in for a chat.

There is an interesting book called “One Up On Wall Street”, by Peter Lynch, Simon and Schuster. Within the book it discusses the characteristics of the Perfect Company to invest in. It makes interesting reading to compare the investment criteria of one of the all time great stock pickers to see how well your own stock picks measure up.

According to Peter Lynch the Thirteen Characteristics of the Perfect Company are:

1. The name sounds dull – or, even better, ridiculous: “What Wall Street analyst or portfolio manager in his right mind would recommend a stock called Pep Boys – Manny, Moe and Jack – unless of course the Street already realises how profitable it is, and by then it’s up tenfold already”
2. It does something dull: “I get even more excited when a company with a boring name also does something boring. Crown, Cork, and Seal makes cans and bottle caps. What could be duller than that?”
3. It does something disagreeable: “Better than boring alone is a stock that’s boring and disgusting at the same time… Take Safety-Kleen. Safety-Kleen goes around to all the gas stations and provides them with a machine that washes greasy auto parts.”
4. It’s a spinoff: “Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, the spinoffs normally have a strong balance sheets and are well-prepared to succeed as independent entities.”
5. The institutions don’t own it, and the analysts don’t follow it: “If you find a stock with little or no institutional ownership, you found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner.”
6. The rumours abound: Look for companies that have been sold off based on unsubstantiated rumours.
7. There’ something depressing about it: “In this category my favourite all-time pick is Service Corporation International (SCI), which also has a boring name… Now, if there’s a anything Wall Street would rather ignore beside toxic waste, it’s mortality. And SCI does burials”
8. It’s a no-growth industry: “Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry like plastic knives and forks… In a no-growth industry… there’s no problem with competition.”
9. It’s got a niche: “I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche.”
10. People have to keep buying it: “I’d rather invest in a company that makes drugs, soft drinks, razor bales, or cigarette than in a company that makes toys.”
11. It’s a user of technology: “Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war”
12. The insiders are buying: “There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it”
13. The company is buying back shares: “Buying back shares is the simplest and best way a company can reward its investor.

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In the previous blog entry on leading indicators we discussed how the Stochastic indicator works well as a leading indicator when the stock is trending. In this blog entry we are going to discuss additional leading indicators and when they are best used.

Another example of a leading indicator is the RSI oscillator. Typically traders use the RSI with an interval period of 14 i.e. if the chart displayed is based on weekly interval periods, the RSI calculations are based on 14 weeks of historical price data. Using an interval period of 14, the RSI is typically considered overbought when greater than 70 and oversold when less than 30. If you look at the price movement of the QQQQs in the following price chart, each time the RSI fell below 30 and rebounded it is associated with a price low:

It should be noted that leading indicators can produce false buy and sell signals if the price movement is tightly range bound. For example, when General Electric was in a strong downward trend between May 2005 and September 2005, as illustrated by the red downward trending arrow on the General Electric price chart below, the Stochastic indicator provided a false long entry signal in June 2005.

This was repeated when General Electric was in a strong upward trend between July 2006 and January 2007, as illustrated by the red upward trending arrow on the General Electric price chart, as once again the Stochastic indicator provided a false long exit signal in October 2006 when the overall trend was still positive.

The main advantage that leading indicators have over lagging indicators is that they provide an early indication of a change in price movement, as a price pivot point is being formed, not afterwards when a trend has been established. It should be noted that when using a price pivot point to establish an entry point the overall trend should be considered.

There is greater risk associated with using leading indicators to establish when a long term trend is about to change as this can produce false entry or exit signals. A safer use of leading indicators is to establish entry and exit points for rolling a stock within a trend that is already established, i.e. repeatedly buying a stock when it is at support and selling at resistance.

Leading indicators are most effective when an equity is bouncing between support and resistance levels or trend lines within an established trend. Lagging indicators are better suited to establishing trends. For example the 100 day exponential moving average illustrated on the QQQQs price chart above, clearly indicates that the overall price movement of the QQQQs is upwards; however if you were to base your entry and exit investment timing on each time the price rose above or fell below the moving average, you would always be late entering and exiting your position.

You can use TimeToTrade to notify you when price and commonly used leading and lagging technical analysis charting conditions are met. For example, you can use TimeToTrade to notify you when the Stochastic and RSI indicators fall below or rise above threshold values, or for example to notify you when the price rises above its moving or exponential moving average.

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In the world of technical analysis, Leading indicators such as the Stochastic, or RSI oscillators, are used to try and predict price movement.

Leading indicators are typically used to provide an indication as to how ‘overbought’ or ‘oversold’ an equity is. The basic premise associated with using leading indicators is that when an equity is considered oversold it will re-bound and when it is considered overbought it will pull-back. Leading indicators are best suited to establishing entry and exit points based on price pivot points within an established trend, however for higher risk investors they can be used to try and identify price pivot points where a trend is potentially about to change direction. Lagging Indicators on the other hand are best suited to establishing the direction of a trend.

Consider the following General Electric (GE) charts that represent the 2 year price and corresponding Stochastic charts based on a weekly interval period:

In this example the Stochastic indicator works well as a leading indicator when GE was bouncing between highs and lows between October 2005 and the end of 2006. On each occasion when the stochastic was heavily oversold i.e. at or near 0, it corresponded with a price low and when the stochastic was heavily overbought, i.e. at or near 100 it corresponded with a price high.

You can use TimeToTrade to notify you when Stochastic and RSI investment conditions are met using the alert triggers beside each chart. For example you can set up an alert that will notify you when the Stochastic falls below 20% follow by a crossover whereby the green line (%k) rises above the red line (%d). When your investment conditions are met, you can be notified by email, text message to your mobile phone or instant messenger.

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Lagging indicators typically are more effective when the underlying equity is trending i.e. when the price movement is consistently setting higher highs and higher lows while in an upward trend, followed by a period when the price movement is consistently forming lower highs and lower lows and so on.

Lagging indicators are not effective when used in market conditions where the underlying price movement of the equity is trading sideways or without a definite trend, such as being tightly range bound between support and resistance levels or trend lines.

For example lets take a look at Walgreen using a 50 day Exponential Moving Average.

When Walgreen was trending the moving average produced ‘clean’ buy and sell signals. However in early 2007 when Walgreen started to trade sideways, the moving average indicator started to produce ‘noisy’ or ‘false’ buy and sell signals. As with the MACD indicator, you can use TimeToTrade moving average triggers to notify you when the price rises above or falls below the moving average.

You can use the TimeToTrade Moving Average triggers to notify you when the Price rises or falls below its moving or exponential moving average, or for example when one moving average crosses another.

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In the world of technical analysis, trend following indicators such as the MACD or Moving Average are examples of ‘lagging’ indicators. Trending indicators are indicators that help you establish the trend of the underlying price movement. The buy and sell signals derived from the use of trend following indicators typically lag the price pivot point at which the trend changes direction.

The use of Leading and Lagging indicators is not limited to technical analysis and there are a variety of economic indicators, such Wage, Inflation, Employment or Consumer Confidence produced by the bodies such as the UK National Statistics office, the US Department of Labor, or the Consumer Confidence Board; as with the technical analysis indicators, these indicators are used to try determine future market direction. In this series of blog entries we will focus on lagging technical analysis indicators and their associated characteristics.

Consider the following Walgreen (WAG) charts that represent the 1 year price and corresponding MACD charts based on a weekly interval period:

In this example the MACD works well as a trending indicator i.e. when the price is in a negative trend the MACD is trending lower and when the price is in a positive trend the MACD is trending higher as illustrated by the red arrows on the Walgreen chart above. A positive MACD crossover is formed when the green line, rises above the red line and this is an indication of a change from a negative to a positive trend. A negative MACD crossover is formed when the green line drops below the red line and this is an indication of a change from a positive to a negative trend.

The MACD crossovers do not provide an indication of a change in trend until after the event has occurred, hence the term ‘lagging’ indicator. This typically results in traders entering late into an established trend and exiting after the trend has reversed, however traders that use lagging indicators consider this strategy to be of lower risk as opposed to using leading indicators to try and determine the exact pivot point at which the trend changes.

You can use the TimeToTrade MACD triggers to notify you when there is a positive or negative MACD crossover as illustrated in the above image.

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I was recently asked, “Where do the names Bull and Bear market come from?”.

Starting with the basics, a ‘Bull Market’ is a term used to describe a stock market that is increasing in value. It is characterised by optimism, investor confidence and expectations of continued growth. A ‘Bear Market’ is a term used to describe a stock market that is decreasing in value. It is characterised by periods of pessimism, lack of investor confidence and general feelings of doom, gloom and despair about the future of the stock market.

The term Bull Market is derived from how a Bull attacks an opponent. When a Bull attacks it does so by thrusting its head & horns upward and in doing so throws its opponent into the air. By doing so the Bull’s opponent rises into the air, hence the term ‘Bull Market’ to describe a stock market that is increasing, or rising, in value. When a stock increases quickly in value, its price movement is described as ‘bullish’.

Frankfurt Stock Exchange

The term Bear Market is derived from how a Bear attacks an opponent. When a Bear attacks it does so by rising up on its hind legs and attacks its opponent by pulling it to the ground using its claws and body weight. By doing so the Bear’s opponent is either thrown to the ground or crushed in to the ground, hence the term ‘Bear Market’ to describe a stock market that is decreasing, or falling, in value. When a stock decreases quickly in value, its price movement is described as ‘bearish’.

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The concept of Support Levels and Resistance Levels as discussed in the previous blog entries, can also be applied to price movement that is bound between diagonal support and resistance lines.

A trend line is a bounding line for the price movement of a security. A support trend line is formed when a securities price decreases and then rebounds at a pivot point that aligns with at least two previous support pivot points. Similarly a resistance trend line is formed when a securities price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points. The following chart provides an example of support and resistance trend lines:

The use of trend lines is a simple and widely used technical analysis approach for judging entry and exit investment timing. If a securities price is moving between support and resistance trend lines, then a basic investment strategy, is to buy a security at support and sell at resistance, then short at resistance and cover the short at support. The belief behind this trading strategy is that when the price pulls back to test a support level, or rises to test a resistance level, the trend line will hold and the trend will continue to bound price movement.

Support and Resistance Levels or Trend Lines do not continue indefinitely. When the price movement breaks through a principal trend line of an existing trend, it may be evidence that the trend may no-longer continue. Therefore an alternative strategy is to take a long position if the security breaks through its resistance level and hold until such a time that there is a price pull back, or short if a security trades below its support level and cover the short when the price starts to rebound.

You can use timetotrade to notify you when UK and US stocks tests support and resistance levels. If the price movement breaks through a support or resistance level, then you can use the breakout or pull back timetotrade alerts to notify you of a change in price movement. For example if a stock’s price breaks out above a resistance level and you decide to take a long position, you can set up a timetotrade price alert that will notify you if there is a 1% price pull back within an interval period such as 1 hour or 1 day; alternatively you can set up an alert that will notify you if the stock price pulls back by for example 10 pence/cents within a interval period that ranges from 1 minute to 1 month. Any sudden pull back in the price that meets your alert conditions would trigger and alert that can be sent to you as an email, text message to your mobile phone or instant message. If you receive a text alert, you can then log on to timetotrade via a mobile phone or PDA that has a web browser and review the securities price and technical analysis charts.

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Continuing on from the previous blog entry on support levels, a resistance level is the highest price that an equity trades at, over a period of time, as opposed to a support level, which is the lowest price that an equity trades at. A support or a resistance level is formed when you can draw a horizontal line between two or more price pivot points i.e. a price point where an equity’s price pivots and changes direction.

A resistance level can become a support level if the price of the equity increases above the resistance level; similarly a support level can become a resistance level if the price of the equity falls below the resistance level as illustrated in the Paychex (PAYX) price chart example in the previous support level blog entry.

If a stock price is moving between support and resistance level, then a basic investment strategy commonly used by traders, is to buy a stock at support and sell at resistance, then short at resistance and cover the short at support.

As with support levels, when judging entry and exit investment investment timing using support or resistance levels it is important to choose a chart based on a price interval period that aligns with your trading strategy time frame. Short term traders tend to use charts based on interval periods, such as 1 minute (i.e. the price of the equity is plotted on the chart every 1 minute), with longer term traders using price charts based on hourly, daily, weekly or monthly interval periods.

Typically traders use shorter term interval charts when making a final decisions on when to invest, such as the following Paychex example based on 1 month of historical data with price plotted every 1 hour. In this example the early indication of a change of trend was when Paychex started forming a resistance level at approximately $39.67. The change of trend was then confirmed when Paychex started forming lower highs and lower lows.

You can use the TimeToTrade rising and falling price threshold triggers to notify you when a stock or option hits a support or resistance level.

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A support level is a price point where an equity’s price pivots and changes direction. They are formed when you can draw a horizontal line between two or more price pivot points.

The support level is the lowest price that a equity trades at, over a period of time. The more frequently a support level is tested (i.e. hits a previous support level pivot point but does not fall below it), the stronger the support at that level. Some traders believe that the stronger the support at a given level, the less likely it is to break below that level in the future. It is said that if an Equity breaks prior levels of support only by a small portion, it will drop until a new level of support is reached.

A support level can become a resistance level if the price of the equity falls below the support level; similarly a resistance level can become a support level if the price of the equity rises above the support level as illustrated in the following price chart example:

If a stock price is moving between support and resistance levels, then a basic investment strategy commonly used by traders, is to buy a stock at support and sell at resistance, then short at resistance and cover the short at support as per the following example:

When judging entry and exit investment investment timing using support or resistance levels it is important to choose a chart based on a price interval period that aligns with your trading strategy time frame. Short term traders tend to use charts based on interval periods, such as 1 minute (i.e. the price of the equity is plotted on the chart every 1 minute), with longer term traders using price charts based on hourly, daily, weekly or monthly interval periods. Typically traders use shorter term interval charts when making a final decisions on when to invest, such as the following example based on 1 week of historical data with price plotted every 15 minutes. In this example the early signs that the stock was coming out of a downward trend was when it started to form support at $30.48 and then started to form higher highs and higher lows signalling a change from negative to positive trending.

You can use the TimeToTrade rising and falling price threshold triggers to notify you when an equity hits a support or resistance level.

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