The Tao Jones Averages: A Guide to Whole-Brained Investing

Market Dynamics - Relative Strength Point and Figure Charting

MARKET DYNAMICS Performance Management System This site was last updated on 02/10/2006 A tremendous amount of new material is added every week to this site so take your time and check it out. These research reports are a regular part of the Market Dynamics investment service that is used by many investors to help improve their investment performance. The primary orientation of this site is to provide profitable research material for long-term investors. Both individual and professional portfolio managers will find useful ideas and research techniques on this site. The buttons along the left margin will help you to navigate the site. While this site is primarily about long-term technical methods, the author believes in and has used both fundamental and technical analysis to successfully manage long-term investment portfolios for many years. The fundamental analysis approach is analytical, logical, mathematical, sequential, language oriented and therefore a left-brained activity. The technical perspective is more holistic, pattern using, artistic, intuitive, visual and therefore a right-brained activity. To succeed in the difficult world of investment management we need to develop and exercise both sides of our brains and let each contribute to the final result. It is very important for long-term investors to achieve an appropriate mix of both the methods of fundamental analysis and the techniques of technical analysis. Be sure to read the description of "Lazy Stocks" that is presented farther down this page. Please feel free to contact me by e-mail if you have questions or would like to direct feedback to me about the site [email protected]. While I cannot give advice about specific stocks, I would be happy to give you my opinion of the long-term, technical trend for any stock. Just send me an e-mail with your question - be sure to include the ticker symbol for the stock. For further material on "whole-brained investing" see The Tao Jones Averages - A guide to whole brained investing by Bennett W. Goodspeed, Dutton ISBN 0-525-24201-5 - published in 1983.

W. Clay Allen CFA Centennial, Colorado

A special technical analysis review (01-20-2005) of the Homebuilders industry group can be viewed by clicking on the following link Homebuilders Industry Report by W. Clay Allen CFA

A new analysis of the performance of the buy list during 2005 has been posted on the Performance page http://www.clayallen.com/ (1 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

A special technical analysis report (12-28-2005) on the energy sector can be viewed by clicking on the following link Energy Report by W. Clay Allen CFA

Fundamental Investment Rating Changes Brokerage analysts change their ratings on the stocks they follow all the time. BUY? SELL? HOLD? OVERWEIGHT? OUTPERFORM? INLINE? _______________________________________________ How do you know whether you should follow their advice or not? What do the ratings really mean? Does the advice fit with the objectives of your portfolio? Does the rating change affect one of your favorite stocks? Does the analyst have a good track record? What do you do if several analysts have conflicting ratings on the same stock? How do you decide? Where can you get a second opinion? _______________________________________________ An Independent perspective on analyst's ratings The chart below is an actual example from a new report that provides a second opinion on changes in the investment ratings on stocks by brokerage analysts http://www.clayallen.com/ (2 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

Technical Perspectives on Analyst's Rating Changes TPARC It is a daily report showing the long-term technical perspective on stocks with fundamental rating changes by brokerage analysts. A description of the report and a brief background on the analysis can be viewed by clicking on the TPARC button on the left.

This week's portfolio management letter - click on the following link.

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Market Dynamics - Relative Strength Point and Figure Charting

Every Four Years - The Bear Comes Back To view additional portfolio management letters click on the Newsletters Button

Winning The Performance Game Lazy Stocks Don't tolerate lazy stocks in your portfolio Successful portfolio management is quite a bit more than just good stock picking. Stock selection is never one hundred percent accurate and problem stocks will invariably creep into the portfolio. It is best to think about the portfolio as a business and the investments in the portfolio are the workers in the business. As in all business endeavors, not all of the workers will perform as desired. Some will be lazy, others won't follow instructions, some just goof-off. There will always be some proportion of the workforce that drags down the performance of the business. The business manager, i. e. the portfolio manager, must deal with the lazy stocks. He must be able to measure the job performance of every worker in order to eliminate the workers that don't perform as desired - the lazy stocks. The first step is to measure the job performance of every worker This is best done using a technique called relative strength. This process measures the performance of every stock in the portfolio compared to a major market index - usually the S&P 500. The price of the stock is divided by the closing price of the S&P 500 on a daily basis and these ratios are then recorded. If the path of the ratios is up then the stock has good relative strength and it is outperforming the market. If the trend of these daily ratios is down, then the stock is performing worse than the market. A lazy stock has a trend of relative strength that is going down. The steeper the descent of the relative strength, the greater the negative drag on the performance of the portfolio. The relative strength is usually presented using a graph to show the progression of relative strength against time. In my experience it is far more productive to analyze the trend of relative strength as opposed to using a ranking of relative strength over http://www.clayallen.com/ (4 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

some arbitrary period of time. The relative strength calculation has the benefit of removing the influence of the overall market from the price of the stock and letting the price performance that is specific to that stock show through on the graph The next step is to convert the relative strength into a graph that compresses time and eliminates the noise from the price data. The type of graph that compresses the time covered by the chart and also eliminates the random noise is called a three point, point and figure chart. It is one of the oldest forms of charting that has been used in the stock market. The three point method of construction does not record movement that does not accumulate to three points on the chart and that effectively eliminates the noise from the price data. The use of the three point filter changes the nature of the chart from being based on performance versus time to performance versus alternations of trend. It is only when the ratios accumulate to three points or more that the trend has changed and a new column is plotted on the chart. The X's record increases in the relative strength ratios and O's record declines in the ratios.

X-axis measures risk Y-axis measures Alpha (excess return) By using the three point filter to remove the short-term variations in the data, it is not uncommon for a chart to cover four or more full years of history in a very small space on the chart. This filtering process introduces another very important change into the charting method. The X-axis on the chart marks off the alternations of trend as time passes. These alternations of trend are truly a function of the stock's volatility. A very volatile stock will show many alternations of trend while a less volatile stock will show far fewer alternations of trend. Volatility is considered a proxy for risk so these charts actually measure risk along the X-axis and relative performance along the Y-axis. This simple transformation of the price data allows the portfolio manager to record and measure the movements of excess return (alpha) versus volatility (risk). Sample chart

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Market Dynamics - Relative Strength Point and Figure Charting

The chart shown above is for BTU and it covers a full four years of history. The steep ascent of the relative strength ratios shows clearly on the chart in spite of the alternations of the up trends shown by X's and the downtrends shown by O's. This type of chart has the advantage of being crystal clear and very hard to misinterpret. My personal belief is that the chart should "shout its message" without much analysis and these charts "fit the bill". A chart of a lazy stock follows.

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Market Dynamics - Relative Strength Point and Figure Charting

The steep and persistent decline of the relative strength ratios shows clearly that this is a lazy stock. A few lazy stocks in the portfolio can completely offset the performance of several strong performers. As a business manager you would not tolerate lazy workers working in your business and as a portfolio manager you should not tolerate lazy stocks.

The wrong way to manage a portfolio http://www.clayallen.com/ (7 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

As Peter Lynch of Fidelity Magellan fame says of a gardener who "Pulls the flowers and waters the weeds."

A successful portfolio manager pulls the weeds and waters the flowers. This is the same as eliminating the lazy stocks from the portfolio while retaining the good workers. The objective is to eliminate the slackers, the goof-offs, the weeds and the lazy stocks and to retain the strong performers for as long as possible. This is how investment performance is improved.

The development of the Market Dynamics Charting software and service. I have been using long-term relative strength P&F charts for almost fifteen years. In late 1999 I developed the present software and system that is called market Dynamics. It was developed by a portfolio manager for use by portfolio managers. I send my subscribers a CD with the software that they install on their PC. The data for the system is updated on a daily basis by sending data files as attachments to an e-mail. The system is easily updated and very fast. I regularly review the entire composition of the entire S&P 500 in forty five minutes or less and as a result, I have a very good feel for the strong stocks and the lazy stocks in that index. A free trial subscription for three months is available to help portfolio managers learn the technique and get accustomed to its use. If you would like to subscribe to the free trial then scroll down to the free trial link further down this page.

I am currently in the process of a complete update of this web site so some of the pages may be out of date or under-construction. Use the links along the upper-left margin of this page to jump to the sub-pages that may interest you. Those with a serious interest in improving their performance will probably want to download the free tutorial. This charting technique is being used by some of the biggest mutual fund portfolio managers, investment advisors, stock brokers and serious individual investors both in the U.S. and abroad. I will be adding a sub-page soon that will cover what I call the "secret to better investment performance" so stay tuned. http://www.clayallen.com/ (8 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

The cost of the service is $2000/year for institutional managers and $500/ year for individual investors. Institutional investors can arrange for soft dollar payments for the subscription. Some institutional investors desire a more complete consulting package with more specialized coverage and this can be arranged as well.

Thanks for your interest

Much more follows

The performance of the 12-31-2003 Market Dynamics buy list during calendar 2004 is now available. You can jump to the performance page by clicking on this link or by clicking on the Performance Studies link along the left border.

A free charting software package on CD and three months of data updates are available to interested long-term investors

click here> FREE TRIAL

A new special report on Exchange Traded Funds is available click on the following link Exchange Traded Funds

Stock Purchase Highlights Market Dynamics usually sends out two stock purchase highlights per week. These highlights cover stocks with especially attractive long-term point and figure chart patterns. The stocks that were covered by the highlights this week are XLTC and PONR. These are sent to users by e-mail and that e-mail can be viewed by clicking on the following link. Sign up for a free trial subscription to stock purchase highlights by sending an e-mail to [email protected] Stock Picks

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Market Dynamics - Relative Strength Point and Figure Charting

Market Dynamics A service for investment professionals and serious long-term individual investors. Weekly Portfolio Management Letter for 02-03-2006 click on the following link

Be Careful How You Use The Word Too A new letter about some aspect of portfolio management is posted every Friday. Be sure to review the new material on the CBOE VIX "Fear index" on the market trends page. Additional portfolio management letters can be viewed at the Newsletters page.

free trial subscription to Market Dynamics W. Clay Allen CFA

relative strength point & figure charting service

what you will receive. ●

Daily updates on over 3800 stocks by e-mail for three months.

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Software that is fast and easy to use - a CD will be mailed to you

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P&F charts are long-term in perspective and the chart signals are clear.

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Regular daily stock screens to identify the big winners and big losers

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Special reports weekly on what stocks are showing attractive bases

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The automatic Performance Alarm tells you which stocks are performing poorly.

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You can draw support and resistance lines - a most important feature

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Market Dynamics - Relative Strength Point and Figure Charting ●

Save charts to the hard drive for pasting into reports and e-mail

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Review your complete portfolio list of stocks quickly and easily

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Free 300+ page tutorial on relative strength charting - free download here

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Free e-book of essays and newsletters on CD

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Attractive sectors and industry groups are easy to find

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Hold winners - "water the flowers"

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Sell losers - "pull the weeds"

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Relative strength screens - best and worst - everyday

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Used by major mutual funds, investment counselors and hedge funds

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Proven effective by a wide range of users

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One of the oldest and most effective charting methods

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Long-term RS P&F charts reveal the hidden order in stock prices

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Bigger profits and smaller losses - the picture tells you which way to go

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Free Trial Subscription for three months

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The system developer has over 35 years of experience in charting and investment management and has been a CFA since 1971.

For a free trial subscription - send your name and postal mailing address by email to [email protected]

A new analysis of the stock market and a market forecast is posted here every week - This report is sent to subscribers every Thursday - to view this pdf report click on the following link (in red) Review of Market Breadth 02-09-2006 If you would like to receive a free e-mail copy of the Market Breadth report weekly - just send a request to [email protected]

Its All About How To Improve Portfolio Performance Extensive educational material about P&F charting is available on this web site. - feel free to follow the http://www.clayallen.com/ (11 of 13)2/11/2006 4:12:45 PM

Market Dynamics - Relative Strength Point and Figure Charting

links along the left margin or at the bottom of the page. This information has been prepared by an investment professional with over 35 years of experience in investment management. The Market Dynamics Tutorial is a free downloadable PDF document that is over 300 pages and is designed for professional long-term investors. I would be interested in any feedback you might be willing to offer. send comments to mailto:[email protected]

Philosophy of Portfolio Management Page - Manage the Portfolio Like A Business and weekly essays on portfolio management.

Please pass this web page link, www.clayallen.com, along to your friends and associates who may be interested in better portfolio management and more profitable investing. Market Dynamics Tutorial A free electronic book (300 + pages) that is available for viewing/download - click on the link above

This entire web site is copyright 2000-2006 by W. Clay Allen CFA - All rights are reserved Back to the top of this page

Send an e-mail to mailto:[email protected] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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Market Dynamics - Relative Strength Point and Figure Charting

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TPARC

MARKET DYNAMICS Performance Management System A new daily report from Market Dynamics "Technical Perspectives on Analyst's Rating Changes" A copy of a recent TPARC report can be viewed by clicking this link.

A few unanswered questions ●

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When an analyst says a stock is a "hold", does he really mean SELL? Is the analyst just promoting the stock of an investment banking client? Is the analyst a recent MBA graduate with less than two years in the business? What is the track record of the analyst rating the stock? Is the analyst just reporting the fundamental story as told by the management of the company? Is the analyst simply following a fad? What are the odds that the analyst's rating will be correct? What about flat wrong? Is the analyst's written report simply promotional material prepared for use by the firm's sales people?

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TPARC

How do you know? A sample of common fundamental stock ratings used by brokerage firms. ●

Buy

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Sell

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Hold

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Under-perform

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Over-perform

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Out-perform

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In-line

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Over-weight

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Under-weight

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Aggressive buy

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Neutral

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Peer perform

What do these fundamental ratings really mean? To the average investor it's somewhat like throwing a dart!

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TPARC

A copy of a recent TPARC report can be viewed by clicking this link. How does an individual investor make sense out of these ratings? Use the long-term point and figure charts to either confirm the ratings by the analyst or to produce a perspective that indicates you should not follow the analyst's opinion - at least for now - or until the longterm trend of relative strength confirms the opinion of the fundamental analyst. This is a new dimension to the Market Dynamics Service This is a new daily feature that provides a long-term technical perspective on the stocks that have had a rating change by a major brokerage firm's analyst. These rating changes are usually based on long-term fundamental considerations and analysis. It is almost impossible to tell in advance which analyst will be right about which stock. The long-term investor is facing a bewildering array of opinions about stocks and these opinions may produce investment results that vary widely from the expectations expressed in the analyst's rating. The changes in fundamental ratings by brokerage analysts are published daily on the Internet by Briefing.com. Almost all major brokerage firms are covered by this service. These rating changes are http://www.clayallen.com/tparc.htm (3 of 5)2/11/2006 4:18:26 PM

TPARC

available to the public. The rating changes on widelyheld stocks by major brokerage analysts are used to select the stocks that are covered in the "Technical Perspectives on Analyst's Rating Changes" report. The comments on the long-term trend of relative strength are very brief and should leave little doubt about the author's conclusions regarding the direction of the major long-term trend for that stock. This will help the investor to focus on stocks with strong longterm up trends in relative strength and avoid the rest. The goal is to improve the investors "hit" ratio and keep the portfolio fresh with new, high payoff investment ideas. The investor must keep in mind that no investment method is perfect or infallible. However, it does seem reasonable to believe that a combination of a fundamental buy rating coupled with a strong positive trend of market performance will lead to improved investment results. The author has used this combination of analytical methods for many years with good results - not perfect but good. A copy of a recent TPARC report can be viewed by clicking this link. Click the Back Button to return to the web site after viewing the pdf document These reports are a regular feature of the Market Dynamics Service and a free trial subscription is http://www.clayallen.com/tparc.htm (4 of 5)2/11/2006 4:18:26 PM

TPARC

available by sending an e-mail to request the free trial to [email protected]

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INTERVIEW

MARKET DYNAMICS Performance Management System Ms. Kate Welling is a well known financial reporter and investment letter author. Her service is a very good source of independent market analysis and interviews with leading investment managers and analysts. She can be reached at Weeden & Co. The interview in .pdf format with Ms. Welling can be viewed by clicking the following link.

Clay Allen Interview by Kate Welling

[ Home ] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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INTERVIEW

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INTERVIEW

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Exchange Traded Funds

MARKET DYNAMICS Performance Management System A new special report on exchange traded funds is available. The report will be updated weekly. This report covers over 150 ETFs in a regular, longterm, relative strength point and figure format. The report is in Adobe .pdf format so you will need the most recent version of Acrobat Reader which you can download free from www.Adobe.com .

ETF report for 01-30-2005 Return to Home [ Home ] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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Exchange Traded Funds

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Exchange Traded Funds

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New Page 1

MARKET DYNAMICS Performance Management System

A Proven Method for Discovering the Hidden Order within Stock Prices There are three sources of changes in stock prices

Stock price changes are influenced by each source of change every day. The percentages shown are assumed values and they will also vary in their relative influence from day to day. The main point is that it is very important to separate out the random influences in the raw data from the sources of price change that are due to factors that are specific to that company. These company specific changes tend to subtly accumulate over time and it is the process of accumulation that is important. The random changes more or less tend to cancel each other out - over time. The random changes do not produce a lasting effect on the price as the company specific factors do. http://www.clayallen.com/newpage17.htm (1 of 5)2/11/2006 4:18:35 PM

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The histogram of the day-to-day price changes in percent is shown for the stock of Coach Inc. over the year ended 03-23-2004. The familiar bell shaped curve is shown, suggesting randomness, however, the mean is considerably different from zero and the distribution shows a significant degree of positive skewness roughly five times the skewness that should have been expected. The skewness indicates that there were many price changes that were considerably greater than the mean and additionally fewer price changes that were meaningfully less than the mean.

Transform the data to show the hidden order The day-to-day data of highs and lows of price is now converted into a long term point and figure chart of relative strength. That chart is shown below.

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This chart covers a much longer time period than the histogram above and it shows a very orderly uptrend that has persisted for almost four years. The chart is a three box, point and figure chart that filters out short and intermediate price changes that do not accumulate to the required minimum three box movement. In other words, this minimum amount removes the short-term noise from the chart. This chart is also based on relative strength ratios so the influence of the fluctuations of the overall market is removed from the chart. The two sources of mostly random, meaningless variation have been effectively removed and the remaining chart shows the hidden order in the stock price movements of COH over the recent four years. The appearance of a strong and orderly advance in the stock can be seen clearly. The columns of Xs represent intermediate uptrends and the columns of Os represent intermediate downtrends. The alignment of the tops of the columns of http://www.clayallen.com/newpage17.htm (3 of 5)2/11/2006 4:18:35 PM

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Xs and the bottoms of the columns of Os define the direction of the trend. These tops and bottoms of intermediate trends are usually called pivot points. The study of the alignment of the pivot points shown by long-term PnF charts and other methods has been in use since at least the time of Jesse Livermore, i.e. in the early part of the 20th century- almost 100 years ago. The transformation of the time series data by the point and figure methodology has an additional and very important feature. The x-axis on these charts does not measure time. It measures the alternations of intermediate trends up and down. When the minimum amount for a new intermediate trend is exceeded, the charts moves over a column and a new intermediate trend is recorded. The frequency of the alternations of trend is a function of the stock's volatility and volatility is usually considered a proxy for risk. Therefore, the long-term PnF charts of relative strength provide a method for measuring relative returns against risk. This is another dimension of the hidden order revealed by charts of this type. These charts are used to measure and record the performance of stocks relative to some market benchmark, e.g. the S&P 500. Since most investors set a goal of having their portfolio perform better than the benchmark, this type of charting is perfect for performance oriented investors. In my opinion, the number of variables that must be accurately forecast makes the prediction of the future performance of a stock impossible. These charts are not used to predict future performance but to measure the performance that is being recorded by the charts. When the specific performance of a stock becomes unacceptable it should be sold, since the reasons for poor long-term performance are seldom purely random and are usually created by forces that can negatively influence the performance of the stock for a long time. Conversely, a stock with good performance should be retained in the portfolio for as long as the performance remains positive. Therefore the use of this type of chart assures the retention of the good stocks in the portfolio and the elimination of the poorly performing stocks from the portfolio. This is "watering the flowers and pulling the weeds" as Peter Lynch would say. The advantages of the use of this method to remove the randomness and let the hidden order show through cannot be overestimated. Many professional investors have been completely convinced by the academic arguments that charts cannot predict the future because of the randomness in the data and as a consequence they allow their performance to be a function of that very randomness. It seems far better to accept the reality of randomness and use a proven method that can effectively remove the meaningless random variation that can be such a drag on performance. Once the hidden order can be seen, most investors are unwilling to act without its benefit!

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Fundamentals & Charts

MARKET DYNAMICS Performance Management System Combining Fundamental Analysis with Technical Analysis Fundamental Buy Ratings - A Bewildering Array of Choices Most individual investors and many institutional investors must use outside sources to develop buy ideas. Individual investors are not professionally trained in securities analysis and also have little opportunity for contact with corporate managements. As a result they must rely on the opinions of others as to what stocks should be considered for purchase. Many of the well known sources prepare reports on the "stock of the week" and long lists of stocks rated buy and strong buy. One well known investment survey carries lists of 100 stocks rated 1 or strong buy, and another list of 300 stocks rated 2 or just a simple buy. The financial channels and other TV sources carry interviews with financial experts who comment very briefly on a few stocks and why they should be considered for purchase. The Wall Street Journal, Barron's, various financial magazines and newspapers may carry interviews with managements, about their company and why it will be a good investment. Various sites on the internet regularly display columns by market experts that recommend stocks to their readers. Most brokerage firms have research departments that regularly "follow" groups of stocks in various industries and make written recommendations as to rating a stock as a buy, sell or hold. Recently this investment research has been exposed as tainted by the brokerage firms relationships with their large investment banking clients. How does the investor decide whether these recommendations are right for his/her portfolio and whether the stocks fit their needs - to say nothing about the honesty and veracity of the opinions expressed in the recommendations. This http://www.clayallen.com/newpage12.htm (1 of 5)2/11/2006 4:18:38 PM

Fundamentals & Charts

research is often pushed on clients by aggressive salespeople that are motivated by the need to generate stock trading commissions now! In my experience in the brokerage business, at several firms over almost twenty years, the brokers had very little regard for the opinions of their firm's research analysts but they sent the reports to customers and sold the ideas to clients anyway! Many individual investors, after the bad experiences of the past several years in the market, have moved to discount brokerage firms to lower commission costs and this has created a need for good investment research and stock purchase recommendations. Some have hired independent investment advisors, some have subscribed to advisory letters and services written by qualified experts and others have decided to do their own research on stocks. The need still exists to narrow the focus down to just a few stocks for a more complete analysis. It is expected that the independent advisory opinions will be based on "good" fundamental research and that the opinions of buy or strong buy can be relied upon to have been prepared without influence from other factors that might taint the recommendation.

Validate the buy recommendation with technical inputs The Market Dynamics Service is just such a system to validate the opinion of outside, independent analysts for individual and institutional investors. Many times these fundamental buy ratings are developed without regard to the stock's technical position. The investor can easily eliminate many stocks from further consideration by viewing the long-term trend of the relative strength, point and figure chart. If the relative strength p&f chart has given a sell signal and the trend is clearly down, there is little need to give that stock any further attention. The only stocks that are seriously considered for purchase are those that are in clear uptrends but the chart pattern can be further studied to the narrow the list even further. Stocks that have been going up for a long period of time are probably too late to purchase. The ideal stock is a stock with a fundamental buy rating by an

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Fundamentals & Charts

independent advisory service that has been going sideways for a considerable period of time and has turned up recently. The sideways movement is called a base on the chart and it indicates an extended period of time when the supply and demand for the stock has been in equilibrium. The recent turn up on the chart indicates that the demand for the stock has now started to exceed supply and the trend is now higher. This change to an uptrend provides an essential validation of the fundamental buy opinion on the stock. Without the confirmation of the uptrend the fundamental buy rating must be considered suspect. The trend on the relative strength, point and figure chart is a defense against poor or faulty fundamental research. The width of the base on the chart also suggests the amount of stock that has changed hands during the formation of the base. A broad base indicates a very large amount of stock has been transferred from one holder to another. a base is a sign of dullness and dullness tends to encourage speculators to sell since there is little action or excitement. The buyers, on the other hand , as longterm investors, must be motivated by other considerations, usually related to their knowledge of the long-term fundamental value of the stock. A base on a chart actually shows the process of speculators and frustrated investors selling out and knowledgeable, long-term investors accumulating the stock. This is the process whereby stock is transferred from the hands of weak holders, i.e, speculators, and into the hands of strong holders, i.e. long-term investors. Both the use of a fundamental buy rating from a reputable source and the chart analysis that shows an uptrend from a base, are equally important to the selection of the stock for long-term investment. The two tools reinforce each other and greatly enhance the probabilities for long-term investment success. The weekly stock purchase highlights that are prepared and sent to subscribers of Market Dynamics, represent the application of this double-edged selection technique - start with the fundamental buy rating and confirm with the technical pattern of a base with a recent change to an uptrend on the chart. This may sound difficult and complicated at first, but it becomes much easier with practice and application. One of the primary advantages of the http://www.clayallen.com/newpage12.htm (3 of 5)2/11/2006 4:18:38 PM

Fundamentals & Charts

relative strength, point & figure technique is that it is difficult to misinterpret the chart pattern. You don't have to perform a complicated analysis of the chart - if it does not look like it is going up, then it probably is not going up - so reject that stock. If the chart convincingly indicates that the stock is going up then you can be confident that it is, indeed, going up and it is probably a good purchase. There seems to be an endless and distracting debate within investing circles, that fundamental analysis is better than technical analysis and vice versa. That technical analysis is voodoo and worthless. That fundamental analysis is tainted and flawed and too slow anyway. In my opinion, this debate is silly and neglects the powerful results from using both forms of analysis. If the combination produces better results than the single application of one method of analysis by itself - then by all means use the combination. Over my many years in this business, I have repeatedly proved, to myself and my clients, that the combination works better!

To view some examples of past stock purchase highlights the viewer can jump to the following page

Stock Purchase Highlights - Weekly suggestions for stocks to buy.

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Fundamentals & Charts

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Good Bargains

MARKET DYNAMICS Performance Management System

Good Bargains vs. Bad Bargains Many investors search for stocks that are significantly down in price. By buying a stock that is down in price, the investor usually gets a problem stock and not the good bargain he thought he was buying! A "good bargain" usually sets up by recording a broad base on the chart. The horizontal base proves that the stock has stopped going down!

How To Find Good Stock Market Bargains Most investors share a common desire to buy bargains. This is a throwback to ordinary, day to day behavior when purchasing tangible goods. If you can buy it cheaper today than it was selling for last week, then that must represent a "good" deal. With stocks, a decline in price does not necessarily mean that the purchase of the stock is a good deal. The declining price may suggest just the opposite - that the stock is a very poor purchase. That the company has serious problems and that something is fundamentally wrong! Why should an investor believe that the market is wrong! Is the market "right" when stocks go up and "wrong" when stocks go down? Hardly! http://www.clayallen.com/find.htm (1 of 3)2/11/2006 4:18:41 PM

Good Bargains

The stock market has been characterized as a gigantic machine that registers the votes of investors. If the voting is persistently against a stock (i.e. a declining price ), why should we believe that the lower price represents an attractive purchase? Why are all those other investors casting negative votes? Do they know that something is wrong with that company? Are the sellers actually insiders or other knowledgeable shareholders who have a more complete understanding of the fundamental situation in that stock? The declining price is proof that the supply of stock exceeds the demand for the stock - for some reason that may not be publicly known. The desire to purchase a bargain is what leads many investors into a losing investment. It is OK to buy stocks that are down in price Vs the price a year ago provided one very important criteria is met. The stock must have stopped going down and it must be able to prove that it has stopped going down. The proof is found by inspecting a long-term relative strength point and figure chart. The plot on the chart will have been going sideways across the horizontal for a period of time. This sideways movement is called a base and the wider the base the better. This is a period of time when supply and demand are in balance and the stock is moving back and forth with no or little net progress. When the base is completed the bargain stock is ready for purchase. What completes the base? The plot on the chart will move above the tops of recent columns of Xs. This is called a breakout and it signals that the stock has stooped going down and has now turned back to the upside. There is nothing magic about this sequence of movement and it has been observed countless times in the day to day movements of the market. The sequence of relative strength going down, and then going flat, and finally going up, is what qualifies a bargain stock as ready for purchase. This is a very important application of relative strength charting. Searching for bases is how these attractive bargain stocks are found. The author has been searching for broad bases for years to successfully identify good stocks. This process does not depend upon the analysis or research of others but gives the investor a better chance to make selections on his/her own. This identification of bases does not depend upon market conditions and it has been my experience that there are always stocks with good bases that are ready for purchase even in bad bear markets. W.C.A. The Market Dynamics System includes a regular screen based on more than 3000 individual stocks that are showing a major base on their http://www.clayallen.com/find.htm (2 of 3)2/11/2006 4:18:41 PM

Good Bargains

relative strength charts. The user of Market Dynamics does not have to search through a long list of stocks to find bargain stocks that are ready to go up. This job is done by the system and updated on a daily basis. Users quickly learn to go to part 3 on the "Lists" drop-down menu and review the list of stocks with major bases to identify stocks with substantial long-term potential. If the declining stock does not form a base it is reasonable to believe that supply still exceeds demand and the stock may be getting cheap, but that it is still too early to purchase. Many times after a speculative collapse of a stock price, the stock may go sideways for a very long time but never develop a believable upside breakout. And investors who become involved with a prolonged period of dullness will have their patience severely tested. There are studies that show that tax loss selling can persist for three full years. Buying into a declining stock is like a forward pass in football - There are three things that can happen, two of which are bad. The next two pages are examples of the basing pattern that occurs when a stock reverses direction from down to up.

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Relative Strength P&F for individual investors

MARKET DYNAMICS Performance Management System Relative Strength Charting Individual investors in common stocks want to take more control over the management of their portfolios. The accounting scandals of the past several years along with the revelations of serious conflicts of interest tilting stock research away from the needs of the individual investor and in favor of the big investment bank/brokerage houses have contributed to the desire among individual investors to search for more independent methods of stock research. Methods that are not only independent but also effective. Investors are also asking very legitimate questions about the very high commissions and management fees they have had to pay when the results are so poor and the stock research is so questionable. Many investors have moved and are moving to discount brokers in large numbers and this is a very important trend. It increases the need for effective tools for the individual investors to allow them to make their own decisions and judgments regarding the management of their portfolios. These tools need to be effective but also easy to use and understand. At the same time, large numbers of individual investors do not want to become short-term traders but want to remain committed to the principles of long-term investing. The long-term price changes are usually much larger than the short-term fluctuations and, if held long enough to qualify for long-term tax treatment, the tax on the gain is much lower. I believe that most individual investors do not want to be told what to do, but they want systematic and believable guidance and research regarding the management of their portfolios. They are ready, willing and able to take full responsibility for the management of their own affairs and they just want the tools to get the job done. Most individual investors now understand that investment success is a process that requires the effective use of both fundamental and technical analysis. The fundamental side of the equation is usually supplied by services such as Value/Line, IBD, The Louis Navellier Blue Chip Growth Stock letter, Personal Finance by Stephen Leeb, Standard and Poors and a wide range of other selection services and letters that concentrate on fundamental analysis. The technical side of the equation is where many individual investors are uncomfortable and less experienced. Most technical services have a very short-term orientation in perspective and that seems to clash with the objective of long-term investing. For long-term investors their technical inputs should be committed to a long-term time perspective. Many times, the individual investor does not want to spend the necessary time to keep up with short term trades - they want a less active approach that is focused on the big picture - but effective nonetheless. The problem that most individual investors face is that there are far too many buy recommendations and how does he narrow the list down to just a few? For example, the Value/Line Investment Survey has an outstanding record of performance but its ranks regularly show 100 stocks rated 1, or strong buy and over 200 stocks rated 2, which is also a buy. The individual investor then has to choose one or two from this list of 100 or 200. These lists have an excellent record of delivering performance on average but it is very likely that the best 20% of each list that will probably generate the excess returns. The Market Dynamics System will help narrow the list down to a few stocks that are performing well and the individual investor can stay invested in those stocks for as long as they perform. In my experience, stocks that are recommended on the basis of fundamentals and have a high performance chart pattern have a much higher potential for substantial gains. Use the Market Dynamics relative strength measurement system to narrow the

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Relative Strength P&F for individual investors

selection down to the very best and then manage the position according to the subsequent actual performance of that stock. The individual investor does not, and should not, buy his stocks and then ignore them for years in the hope that everything will work out. He needs a watchdog or a sentry to tell him when danger is approaching his property. He doesn't want or need a watchdog that barks at every shadow that sweeps across the property but a guard that should only respond to the serious indications of danger and trouble. Even a smoke alarm will give false signals from time to time but the signal should not be ignored - the alarm is there to warn against danger. See the page on the Performance Alarm The author has used the 3-box point and figure charting approach for many years in the management of long-term stock portfolios for both institutions and individuals. The shift to relative strength from purely price was made in a direct attempt to make the charting more effective in the management of long-term stock positions. It certainly seems to be borne out by experience that relative strength in a point & figure format accomplishes the goal of remaining long-term in perspective and successful in application. The average short-term trader will say that P&F is too slow and he is right because he is a short term trader. The very act of slowing the charts down to order to capture the big, long-term moves is what is desired and the P&F RS charts do the job in a very effective way.

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Relative Strength P&F for individual investors

Was JDSU a good stock? It went down a lot - over a long period of time! BAD STOCK!

Many times I have heard the individual investor exclaim that he just wants to own "good stocks" and that is a very frank and understandable goal. To me, a good stock is a stock that goes up for a long-time and it goes up a lot. Stocks that go down in a persistent downtrend are not good stocks. Stocks that bounce around within a trading range, without much long-term net gain, are not good stocks. The definition of a good stock involves two characteristics - big gains that take place over a lengthy period of time. Can you find and participate in this type of stock with short-term trading methods? NO! Both the fundamental tools and the technical tools must support each other to identify these stocks and both must be focused on the long-term.

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Relative Strength P&F for individual investors

PCAR was a good stock! It went up a lot - over a long period of time! GOOD STOCK! It seems fairly obvious! To be a winner in the stock market, I think you need a very clear idea of the objective you want to accomplish and what you must do to get there. Once you know what you need to do, the mechanics of doing it become minor and there will be little or no dependency on others, since you already know what tools to use and how to use them. You should shoot for big gains and gains that provide a chance for a long-term holding period. Good stocks are always available in the stock market. You just need to know how to find them. Take advantage of the low costs of a good discount broker to manage your portfolio. The Market Dynamics Service that will allow you to manage your portfolio independently from Wall Street research and according to your own style.

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Who is W C A?

MARKET DYNAMICS Performance Management System

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Who is W C A?

W. Clay Allen CFA BS General Engineering, University of Oklahoma '63 - concentration in math and physics. Computer programming starting in ‘62 at OU on mainframes MBA University of Denver '68 - emphasis Finance and Economics Chartered Financial Analyst '71 -Charter number 2941 Investment analysis and Portfolio Management, '64 to date: Large regional bank trust department managed common funds and large institutional accounts including the City and County of Denver Employees Retirement Fund. Long range planner and economist for a large regional bank holding company - 3 year assignment. During the eighteen years ending in '98, I provided institutional investment research services to major institutional investors nationally as a broker for NYSE member firms. These research activities included P&F analysis as well as fundamental value modeling, relative strength studies and portfolio simulations. For more than twenty-five years I have used the 3 point - point & figure method of tracking securities prices and interest rates. In the earlier years, I used chart services purchased from others as well as P&F charts that I maintained on a daily basis. I maintained between 300 to 500 P&F charts daily for over 25 years. More recently, as data services have become more readily available and reliable, I have used computer programs that I have written and developed to facilitate the analysis of stock price movements utilizing P&F methods. This work includes P&F applications to relative strength, foreign market indices, industry groups and other price filtering methods similar to 3-point - point & figure charting. These experiences cover many different market conditions and interest rate environments. Economic conditions have varied from stagflation to recession to boom and world political conditions have moved from hot wars to cold wars and in-between. Throughout these periods the P&F charts have proven to be an invaluable guide to me in the evaluation of these trends and their reversals. It is my very strong belief that the markets function because of change not in spite of it. These macro changes create fundamental changes in the economy and the fortunes of companies that lead to changes in price trends over the long term. We all need effective tools to help track these long term trends and my experience confirms the three point - point and figure charting method to be just such a tool. I have been committed to the development of Market Dynamics System since June ‘98 From ’91 to ’98 I was a VP at a national brokerage firm. My duties were as a institutional broker in the Englewood, Colorado office of this national brokerage firm. Teaching experience in Economics and Investments: University of Denver, Colorado School of Banking at University of Colorado, Boulder; Regis College MBA program, Denver, Colorado and American Institute of Banking, Denver, Colorado ( 60’s to 80’s – teaching not continuous – off and on) The field of investing and investment management is my primary area of interest, experience and expertise. W. Clay Allen CFA 7325 S. Jackson St

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Who is W C A?

Centennial, Colorado 303-804-0507 e-mail at

[email protected] Software development and Market Dynamics

I developed the Market Dynamics software system for my institutional clients beginning in the mid '90s and now I am making it available to individual long-term investors as well. These methods and techniques were founded in my experience with the day to day posting of point and figure charts on over 300 stocks, every day, on data from the Wall Street Journal, for over 25 years. Technical analysis, especially point and figure charting, can be of great value to individual investors. In my opinion, the main thrust of technical analysis is the measurement and recording of the performance and the management of the investment positions in individual stocks. Market Dynamics is primarily a tool for portfolio managers. Any individual investor with a sizable portfolio and a long-term investment time horizon is, in fact, a portfolio manager. The real "trick" is to eliminate the noise from the stock price data and to remove the effects of the overall market from stock price movements. This is not as difficult as it sounds and is based on common sense methods. The application of relative strength calculations removes the effects of the market. Specific stock predictions are always highly suspect and are often completely wrong, but investors need some believable way to make sense out of stock price movements. That's what I believe Market Dynamics does for investors. We all need hard evidence to base our decisions to buy or sell a stock. This evidence should be independent of Wall Street research which is often tainted by conflicts of interest. Point and figure charting has successfully with-stood the test of time in the market and the only prediction that is involved, is that if things continue in the future as they have in the recent past then the stock should bought, or held or sold. This approach is based on hard evidence from the market - not on the investor's supposition, hope, fear or the sales efforts of Wall Street stock brokers. Investment philosophy My investment philosophy is based on taking advantage of the evidence from the market itself, remove the noise and remove the effects of the market from the data and act accordingly. Predictions usually don't work out but the evidence usually does. Keep your eyes focused on the objectives of the portfolio. Above all else, let your winners run and sell your losers as soon as you can be assured that the stock is in fact a loser! Only the evidence from the market should convince you that the investment is a loser! But when the stock proves to be loser - sell it quick - don't try to nurse it back - just let it go and get a better stock for the portfolio. W. Clay Allen CFA

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Who is W C A?

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P & F Charting

MARKET DYNAMICS Performance Management System The pages that follow cover topics related to P&F charting click on the green links below to view the discussion on one of these topics.

Major reversals of trend The making of a point and figure chartist Bullish support lines Bearish resistance lines High performance support lines Conventional trend lines Chart Construction This page is still under construction and new pages and links will be added to those shown above.

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P & F Charting

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P & F Charting

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Newsletters

MARKET DYNAMICS Performance Management System Essays in Portfolio Management These letters are sent out weekly and they cover various aspects of investing and portfolio management - Click on a red link to view the letter - be sure to read the "Manage the portfolio like a business" essay that follows the list of letters.

Market Dynamics letter for 02-10-06 -"Every Four Years The Bear Comes Back" Market Dynamics letter for 02-03-06 -"Be Careful How You Use The Word Too" Market Dynamics letter for 01-27-06 -"The Systematic Pursuit Of Good Performance" Market Dynamics letter for 01-20-06 -"What Is Distribution? How Does It Work?" Market Dynamics letter for 01-13-06 -"Performance Engineering" Market Dynamics letter for 01-06-06 -"Trend Persistence" Market Dynamics letter for 12-30-05 -"The True Source Of Bad Performance" Market Dynamics letter for 12-23-05 -"Portfolio Managers Wear Many Hats" Market Dynamics letter for 12-16-05 -"Observation Versus Prediction" http://www.clayallen.com/newslett.htm (1 of 5)2/11/2006 4:19:00 PM

Newsletters

Market Dynamics letter for 12-09-05 -"How Long Does It Take To Build A Base?" Market Dynamics letter for 12-02-05 -"Portfolio Upgrading The Never Ending Job" Market Dynamics letter for 11-25-05 -"Market Swings Overboughts and Oversolds" Market Dynamics letter for 11-18-05 -"A Different Way To Look At Risk" Market Dynamics letter for 11-11-05 -"Don't Buy Or Hold Poorly Performing Stocks" Market Dynamics letter for 11-04-05 -"Verify Your Expectations" Market Dynamics letter for 10-28-05 -"Does "Hold" Really Mean "Sell"? " Market Dynamics letter for 10-21-05 -"Randomness Means The Charts Are Indispensable" Market Dynamics letter for 10-14-05 -"Downtrends Usually Tell The Truth" Market Dynamics letter for 10-07-05 -"Good Portfolio Managers Have Good Luck" Market Dynamics letter for 09-30-05 -"The Case For Longterm Relative Strength" Market Dynamics letter for 09-23-05 -"A Common Mistake

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Newsletters

By Long-term Investors" Market Dynamics letter for 09-16-05 -"Why The Random Walk Does Not Apply" Market Dynamics letter for 09-09-05 -"What Does Randomness Really Mean?" You can subscribe to the free weekly discussions by sending an email to [email protected] with "subscribe to weekly letters" in the subject line

Investing as a Business You Should Manage The Portfolio Like A Business Your Stocks are Your Employees They Have A Job To Do! You should manage your portfolio as you would manage a business. Your stocks represent your employees. They work for you and only through them can your business accomplish its goals. You must decide what tasks your workers are to perform and it is also up to you to define what constitutes acceptable job performance. It is your responsibility to periodically review the job performance of your workers against the standards of performance that you have defined. When their performance on the job becomes unacceptable - it is your responsibility to fire that employee and replace him/her with a worker who is judged to be more capable of getting the job done. If you do not upgrade your work force then the goals of the business will not be met and you might even be forced out of business. Firing workers is not pleasant but it has to be done or the business could fail. This activity does not require predicting the future but only the measurement of actual job performance. Poor job performance is http://www.clayallen.com/newslett.htm (3 of 5)2/11/2006 4:19:00 PM

Newsletters

not to be tolerated and since there is always a reason for poor job performance - the simple fact of unacceptable job performance is grounds for dismissal. In this way the portfolio can be kept fresh and the performance can be managed in a businesslike manner. Poor portfolio performance is simply a result of holding too many poorly performing stocks for too long. Each investor is free to define his/her own standards of performance. But if performance standards are not established, the substandard performance of some stocks will drag the overall portfolio down. It is not a complicated process but it does require discipline and a willingness to act. It also requires a system to monitor and measure the performance of each stock. The Market Dynamics computer software provides just such a performance management system. Market Dynamics provides the essential feedback that allows an investor to quickly and effective evaluate the investment performance of each stock in the portfolio.

A weekly newsletter is sent out to subscribers by e-mail each week. This is in the form of a one page essay and I cover topics of interest to investors regarding relative strength, point and figure charting techniques, portfolio management topics and sometimes I share stories from my experience in the investment management business. These letters sometimes range into the psychology of investing and common mistakes that are made by investors. The field of investment management has intrigued me for years and I have collected numerous examples of investor behaviors that are very revealing in terms of human behavior and the stock market. Overall, I write these short reports to share my experiences in the market and what I have learned about successful investing - of course, P&F charting is a very large part of this effort. Several examples of recent discussions of portfolio management are available for viewing and/or download.. These weekly essays are in Adobe Acrobat format so you may need to download the Acrobat Viewer from www.adobe.com. I have been writing these weekly letters for almost two years and a complete set of weekly essays is included on the software CD that comes with the free trial subscription. Just click on a link to view the letter. These .pdf reports can be saved, printed or attached to an e-mail and sent to a friend or colleague. http://www.clayallen.com/newslett.htm (4 of 5)2/11/2006 4:19:00 PM

Newsletters

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Market comments by W. Clay Allen CFA

MARKET DYNAMICS Performance Management System To go to the VIX "Fear Index" click here

Market Analysis and Comments A weekly review of market breadth is sent out to subscribers by e-mail usually on Thursdays. The primary focus is on the percent of stocks in various sectors of the stock market that are currently in uptrends. In my experience the stock market has always moved in alternating waves of optimism and pessimism. The extremes of these moves are usually referred to as overbought markets and oversold markets. The oversold markets are by far the most important to record because they often provide very profitable buying opportunities for the long-term investor. The S&P 500, the S&P 400, the S&P 600, the NASDAQ 100 and a sample of highly volatile stocks are tracked each week to record these waves of buying and selling. I comment on the other factors that I have found to be useful, especially monetary indicators, time cycles and sentiment measures that track speculative sentiment. These comments are offered as a guide to the state of the market in terms of measures of the market being overbought or oversold. Caution -We all spend entirely too much time worrying about the "market" when the most important activity is to track the stocks we own or are thinking of buying. These reports are a regular weekly feature of the Market Dynamics Service and are included in the free trial offer. This document is also in Acrobat PDF format so you may need to download the Acrobat viewer from www.adobe.com in order to view these reports. Just click on the following link to view the report

Review of Market Breadth for 02-09-2006

The review of market breadth includes a current chart of the VIX indicator. The Fear Index The volatility index (VIX) is calculated by the Chicago Board Options Exchange (CBOE). It is based on the Black-Scholes option pricing model. The data for a series of options, both puts and calls, on the S&P 500 index are used to calculate the VIX. The strike price, the amount of time to expiration, and the market price of the option are used to solve the model for the expected or implied volatility that is, in effect, being used by market participants when they buy and sell these puts and calls. This results in a number that actually quantifies the expectations of option market participants. Expectations of high volatility in the future result in high prices for these options and a high reading on the VIX. Expectations of high volatility are usually thought of as an expression of fear in the market. The greatest amount of fear is usually recorded precisely at market lows and the VIX almost always spikes up into high readings right at the market lows. Conversely, low levels of the VIX suggest little fear of the market and these readings are usually seen at market peaks. The timing of market peaks by the VIX is not nearly as precise as at market lows. This seems to suggest that fear really is a more urgent and intense emotion than greed or optimism. In Market Dynamics, the VIX is presented in a relative strength format to even further enhance the swings of the indicator. Additional information on the VIX can be found at the www. cboe.com web site. Relative strength applied to the VIX - RSAVIX http://www.clayallen.com/market.htm (1 of 3)2/11/2006 4:19:04 PM

Market comments by W. Clay Allen CFA

The current chart of the VIX

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Market comments by W. Clay Allen CFA

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Winners and losers

MARKET DYNAMICS Performance Management System Three types of stocks Major Winners - Major Losers - Trading Ranges The statistical distribution of returns from stocks is bell shaped but it is characterized by extremely fat tails. A much higher proportion of the population is found in the extreme reaches of the tails on either side of the distribution. This means that there are many more big winners(5 to 10 times more) in the stock market than you would expect from the typical bell shaped curve - but there are also many more big losers(also 5 to 10 times more). The objective is to own stocks in the right-hand positive tail and to avoid the disasters in the left-hand tail. The stocks in the middle of the distribution are usually trading range stocks that have limited potential for gain and should be traded and managed differently than the stocks with major trends.

1. Major up trends - right-hand tail - 15% to 20% of all stocks. Major winners are extremely dynamic stocks that show up clearly on the relative strength point & figure charts. They will remain above their Bullish Support Lines for extended periods. These stocks are typically mid-cap or small-cap although a few big cap stocks will show major up trends. A major uptrend is clearly distinguished by its pattern of higher highs and higher lows at can persist for many columns on the charts. Examples are shown on the following pages.

Major winners p1 Major winners p2

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Winners and losers

2. Major down trends - negative left-hand tail - 15% to 20% of all stocks. the category of major losers is the left-hand tail of the distribution and it includes big-cap stocks as well as mid and small cap names. It should be remembered that stocks go down about twice as fast as they go up and this shows up clearly on the relative strength point & figure charts. These are stocks that must be avoided for they will destroy the performance of the portfolio. A major downtrend is clearly distinguished by its pattern of consistently lower lows and lower highs and a down trend will usually show at least one column of Os that will be unusually long and dramatic as the stock falls after a negative news or earnings event. Examples of major losers are shown on the following pages.

Major losers p1 Major losers p2. 3. Trading range stocks - main body of the distribution - 60% to 70% of all stocks. This is the most common pattern for large cap stocks. The trading range is clearly defined by the highs and lows of the past few years. This is why charts should be constructed using at least four years of data. Since a stock market cycle usually covers about four years the choice of four years of history was made to ensure that a complete cycle would be recorded. Some stocks are so volatile that the chart does not cover the entire four year span but trading ranges still show up clearly. Examples of major trading ranges can be found on the following pages.

Trading ranges p1 Trading ranges page 2 Back to top of this page http://www.clayallen.com/distribu.htm (2 of 3)2/11/2006 4:19:06 PM

Winners and losers

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Free Trial

MARKET DYNAMICS Performance Management System Information on the Free Trial Subscription to Market Dynamics Send [email protected] an e-mail with "request trial subscription" in the subject line be sure to include your mailing address so I can send you the CD.

NEW Winning The Performance Game by

W. Clay Allen CFA July 2005 A free copy of my new book (243 pages) is now included on the CD in .pdf format. It can be viewed or printed out. This book is devoted to the analysis of long-term point and figure charts of relative strength. It is truly a performance management system for long-term investors. If the book is printed out in http://www.clayallen.com/informat.htm (1 of 3)2/11/2006 4:19:12 PM

Free Trial

color the Performance Alarms that are shown in bright red will be dramatically highlighted. Click here for the Free Trial Subscription to Market Dynamics

A three month free trial subscription is available to all investors worldwide. The free trial includes the software CD that is sent to subscribers by regular mail. The software CD also contains the complete Market Dynamics Educational Tutorial for those investors that are new to long-term point and figure analysis of relative strength. The tutorial also contains new material and http://www.clayallen.com/informat.htm (2 of 3)2/11/2006 4:19:12 PM

Free Trial

recommendations about RS P&F that will benefit even experienced P&F analysts. The CD contains a complete set of one page weekly essays that cover my "investment philosophy" of investing and portfolio management. Recent newsletters can be viewed by clicking on the "Newsletters ' tab along the left margin. The free trial includes three months of daily updates of all the data needed to use the system to manage a portfolio. This includes the various buy and sell screens and the weekly stock purchase highlights, the newsletter and the weekly market comments. The data updates and other items are sent to subscribers via the Internet. Send Market Dynamics an e-mail with "request trial subscription" in the subject line be sure to include your mailing address so I can send you the CD.

Click here for the Free Trial Subscription to Market Dynamics Back to top of this page [ Home ] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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MARKET DYNAMICS PERFORMANCE MANAGEMENT SYSTEM Special report For

Market Dynamics Users Home Builders Industry Home Builders Industry comments. The group still has a positive tone overall but there are several stocks that have been the subject of a Performance Alarm and now show long-term downtrends. The stocks showing the red Performance Alarm should probably be sold. Several of the leaders in the industry still show well-defined uptrends and others have seen their up trends resume after a considerable correction in the market. Persistent long-term up trends are shown on the charts in blue. BZH, DHI, CTX, KBH, LEN, PHM, RYL and WLT appear to offer the best opportunities. W. Clay Allen CFA

1/20/2006 W. Clay Allen CFA

Page 1

1/20/2006

BZH -

BHS - Serious loss of upside momentum. Sideways movement may be a consolidation or a top.

CHCI -

W. Clay Allen CFA

Page 2

CTX -

1/20/2006

DHI -

HOV - Breaking down.

W. Clay Allen CFA

DHOM -

KBH - Uptrend resumed.

Page 3

1/20/2006

LEN -

MDC - Persistent long-term downtrend.

MHO -

MG631 - Uptrend resumed. Breakout above the 45-degree bearish resistance line.

W. Clay Allen CFA

Page 4

1/20/2006

MTH -

NVR - Too much resistance. Backing away from resistance.

PHM -

W. Clay Allen CFA

Page 5

RYL -

1/20/2006

TOA -

SPF - Serious loss of upside momentum.

WCI - Backing away from resistance. TOL - Trending down.

W. Clay Allen CFA

Page 6

1/20/2006

WLT - Close to a new recovery high.

WLS - Persistent long-term downtrend.

W. Clay Allen CFA

Page 7

1/20/2006

Performance Studies

MARKET DYNAMICS Performance Management System Market Dynamics Performance Test 12-31-2005

Buy list gained +9.86% versus S&P 500 gain of +2.87% in 2004 Excess return = +6.99%%

The following is a report on the hypothetical performance of the Market Dynamics buy list that was sent to subscribers at the end of 2004. This test covers the period from 12-29-2004 to 12-30-2005 and is based on a buy and hold strategy. There were 98 stocks on the buy list at 12-29-2004 that had a continuous existence throughout 2005. The average gain for this sample of 98 stocks was +9.86% - well above the +2.87% recorded for the S&P 500. The range of performance recorded for this sample was from –47% to +170%. The relative strength, point and figure charts that were used to assemble this list were based on the performance of these stocks relative to the S&P 500. This list is a regular, daily feature of the Market Dynamics Service and W. Clay Allen CFA updates it several times each month. The performance data showed a significant skewness to the right. The following histogram was prepared using Microsoft Excel:

(over)

The bin size was marked off by 5 percent increments. The unusual spike on the far right of the http://www.clayallen.com/newpage2.htm (1 of 8)2/11/2006 4:19:38 PM

Performance Studies

histogram indicates that almost 12% of the buy list of 98 stocks gained 50% or more during the year. This is a most unusual result for a market that is supposed to be random and normally distributed. The median gain was just over 5.5% and the skewness was 1.83 indicating a 7.4-sigma tilt out into the positive tail. A z score for skewness of 7.4 indicates that this amount of skewness is significant that the 99.9% level of confidence. This is a clear example of a sample with a very "fat positive tail". The performance results of these buy lists are tested on a regular basis and communicated to subscribers. The positive spread between the buy list and the S&P 500 is usually within the range of +5 to +15 percentage points. This test had a positive spread of +6.99 percentage points. It seems that results such as these could hardly be the result of chance. It is reasonable to conclude that the process used to select these stocks is highly effective in the identification of future stock market winners.

There were actually 100 stocks on the buy list that was sent to Market Dynamics subscribers as of 12-292004. Two stocks had ticker symbol changes, were the subject of a buyout or dropped off the list for some other reason. The results of this performance study were not adjusted for these stocks.

This study represents a hypothetical test, but the buy list was actually delivered to subscribers at year-end 2004 and could have been purchased at that time. Commissions and dividends were not included and this test does not represent real transactions. Past performance does not guarantee future results. The detailed data to support this study is available upon request from clayallen@msn. com.

Summary of Returns

Market Dynamics buy list

S&P 500

Excess Returns

2003

+38.8%

+26.4%

+12.4%

2004

+17.6%

+9.0%

+8.6%

2005

+9.9%

+2.9%

+7.0%

Regards

W Clay Allen CFA

http://www.clayallen.com

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Performance Studies

Market Dynamics Performance Test 03-08-2005 Buy list gained 17.6% Vs. S&P 500 gain of 9.0% in 2004 Excess return = 8.6% The following is a report on the hypothetical performance of the Market Dynamics buy list that was sent to subscribers at the end of 2003. This test covers the period from 12-31-2003 to 12-31-2004 and is based on a buy and hold strategy. There were 89 stocks on the buy list at 12-31-2003 that had a continuous existence throughout 2004. The average gain for this sample of 89 stocks was +17.6% well above the +9.0% recorded for the S&P 500. The range of performance recorded for this sample was from –36% to +143%. The relative strength, point and figure charts that were used to assemble this list were based on the performance of these stocks relative to the S&P 500. This list is a regular, daily feature of the Market Dynamics Service and W. Clay Allen CFA updates it several times each month. The performance data showed a significant skewness to the right. The following histogram was prepared using Microsoft Excel:

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Performance Studies

(over) The bin size was marked off by 5 percent increments. The unusual spike on the far right of the histogram indicates that almost 30% of the buy list of 89 stocks gained 30% or more during the year. This is a most unusual result for a market that is supposed to be random and normally distributed. The median gain was just over 12.3% and the skewness was .996 indicating a 3.8-sigma tilt out into the positive tail. A z score for skewness of 3.8 indicates that this amount of skewness is significant at the 99.9% level of confidence. This is a clear example of a sample with a very "fat positive tail". The performance results of these buy lists are tested on a regular basis and communicated to subscribers. The positive spread between the buy list and the S&P 500 is usually within the range of 5 to 15 percentage points. This test had a positive spread of 8.6 percentage points. It seems that results such as these could hardly be the result of chance. It is reasonable to conclude that the process used to select these stocks is highly effective in the identification of future stock market winners. There were actually 100 stocks on the buy list that was sent to Market Dynamics subscribers as of 12/31/2003. Eleven stocks had ticker symbol changes, were the subject of a buyout or dropped off the list for some other reason. The results of this performance study were not adjusted for these stocks although the number of buyouts suggests that the performance of these stocks would have contributed to the overall result in a very positive way – maybe increasing the average return by as much as two percentage points. This study represents a hypothetical test, but the buy list was actually delivered to subscribers at year-end 2003 and could have been purchased at that time. Commissions and dividends were not included and this test does not represent real transactions. Past performance does not guarantee future results. The detailed data to support this study is available upon request from clayallen@msn. com. The test for 2003 is available upon request. Regards

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Performance Studies

W Clay Allen CFA http://www.clayallen.com

Performance Test Buy list gained 38.8% Vs. S&P 500 gain of 26.4% in 2003

The following is a report on the performance of the Market Dynamics buy list that was sent to subscribers at the end of 2002. This test covers the period from 12-31-2002 to 12-31-2003 and is based on a buy and hold strategy. There were 101 stocks on the buy list that had a continuous existence throughout 2003. The average gain for this 101 sample of stocks was +38.8% - well above the +26.4% recorded for the S&P 500. The relative strength charts that were used to assemble this list were based on the performance of these stocks relative to the S&P 500. This list is a regular, daily feature of the Market Dynamics Service and it is updated by W. Clay Allen CFA several times each month. The performance data showed a significant skewness to the right. The following histogram was prepared using Microsoft Excel :

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Performance Studies

The bin size was marked off by 5 percent increments. The unusual spike on the far right of the histogram indicates that almost 30% of the buy list of 101 stocks gained 60% or more during the year. This is a most unusual result for a market that is supposed to be random and normally distributed. The median gain was just over 30% and the skewness was .836 indicating a 3.4 sigma tilt out into the positive tail. This is a clear example of a sample with a very "fat positive tail". The performance results of these buy lists are tested on a regular basis and communicated to subscribers. The positive spread between the buy list and the S&P 500 is usually within the range of 5 to 15 percentage points. This test had a positive spread of 12.4 percentage points. One of the institutional subscribers to the Market Dynamics Service reported during the past week (01-08-2004) that his typical portfolio gained approximately 40% for the full year 2003. This is certainly consistent with the test reviewed above. This study represents a hypothetical test, but the buy list was actually delivered to subscribers at year-end 2002 and could have been purchased at that time. Commissions and dividends were not included and this test does not represent real transactions. Past performance does not guarantee future results. The data to support this study is available upon request from [email protected]. http://www.clayallen.com/newpage2.htm (6 of 8)2/11/2006 4:19:38 PM

Performance Studies

Scroll down for more on Market Dynamics

A free copy of a special report is available that covers the stocks that currently represent attractive long-term investments in the S&P 500. This report was recently prepared by W. Clay Allen CFA using long-term point and figure analysis of relative strength. W. Clay Allen CFA is an independent investment analyst and developer of the Market Dynamics software. This report is not available elsewhere. To request a copy of this report send an e-mail to [email protected] with "request S&P500 report" in the subject line.

To all Market Dynamics users: RE: Performance review Based on the Market Dynamics S&P 500 Bases (buys) and S&P 500 Tops (sells) lists Average gain

Better than market

Worse than market

number of stocks

S&P 500 Bases +39.93%

63.2%

36.8%

57

S&P 500 Tops

+27.12%

45.0%

55.0%

60

S&P 500 Index

+25.55%

The bases list beat the tops list by +12.81% on average and it beat the S&P 500 by +14.38% on average. The average gain for the bases list was over 50% ahead of the gain recorded by the S&P 500. In my opinion, the http://www.clayallen.com/newpage2.htm (7 of 8)2/11/2006 4:19:38 PM

Performance Studies

difference between the means of these two samples is significant at the 1% level of tests of significance. The two lists were of similar size and there were quite a few more stocks outperforming the market on the bases list. This seems to confirm that, in a general sense, stocks that are emerging from major bases have a better chance to outperform the market. The performance review is based on the S&P 500 bases report (buys) and the S&P 500 tops report (sells) that was prepared by WCA and actually went out to subscribers on March 3, 2003. This performance review is based on a buy and hold approach for the time period covered. These lists do not represent actual trades and commissions have been excluded. This comparison represents a hypothetical test and the results could be different under different market conditions. The purpose of this comparison is to evaluate the general tendency of stocks moving up from relative strength bases to outperform stocks that are falling away from relative strength tops. The time period covered is from 03/03/2003 to 10/29/2003 and dividends are excluded. If you have questions – please call or e-mail Regards W Clay Allen CFA This data was covered in an e-mail report that was sent to Market Dynamics users on October 29,2003

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Performance Alarm

MARKET DYNAMICS Performance Management System

A completely new tool for investors THE PERFORMANCE ALARM

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Performance Alarm

A new feature has been added to the Market Dynamics System and software. The Performance Alarm feature is a completely automatic conversion of the chart to red whenever the trend condition falls into a pre-defined under-performance movement. The alarm is totally objective and does not depend upon analysis or interpretation of the chart. The Performance Alarm was developed to represent a clear sign of danger to investors. Portfolio managers do not have to study technical analysis patterns and methods to benefit from this feature of the software. It is completely automatic and the computer program recognizes the conditions of a Performance Alarm. The individual positions in a portfolio will automatically call attention to their under-performance and the point and figure chart will remain red for as long as the under-performance persists. The image above is a sample of a real chart that has shown unacceptable performance for an extended period. I believe that when a stock persistently displays the Performance Alarm - the probabilities of selling increase - and selling losers is a very important part of successful investment management! As long as the relative strength remains acceptable the point and figure chart postings will remain black. The program provides a toggle command button to turn the alarm off if it becomes an annoyance. The recent major bear market has shown the serious need for such an alarm system to warn portfolio managers and help them avoid major losses in the stock market. The Market Dynamics Performance Alarm is based on long-term portfolio goals and is completely automatic. It does not represent a subjective opinion about a stock's performance because it is an objective measure that highlights and warns investors about unacceptable performance. You won't sell at the top but won't ride them down either! A new chapter has been added to the Market Dynamics Tutorial that contains numerous examples of the Performance Alarm from the past several years of market history. You can instantly jump to that chapter by http://www.clayallen.com/performa.htm (2 of 3)2/11/2006 4:19:47 PM

Performance Alarm

clicking on this link.

Examples of the onset of the performance Alarm are shown on the next page click here. Back to Top of this page

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E-Book tutorial

MARKET DYNAMICS Performance Management System Welcome to the Free Market Dynamics Tutorial A complete course in relative strength P&F charting Click on any link (in red) below to open the chapter or document. These chapters can be downloaded and saved or printed for further study.

Technical Analysis for Long-term Investors Relative strength in point and figure format Learn relative strength point and figure charting Buying - How to find the big winners in the stock market Selling - How to avoid the big losers in the stock market.pdf How to manage stocks in long-term trading ranges Managing portfolios using Market Dynamics

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E-Book tutorial

Performance Alarm Tutorial How to subscribe to Market Dynamics Installing Market Dynamics and using daily updates Market Dynamics Service Back to top of this page To return to the MARKET DYNAMICS home page – click here [ Home ] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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E-Book tutorial

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Sign Up

MARKET DYNAMICS Performance Management System Send me an e-mail with your postal mailing address to [email protected] and I will send you a free CD disk that includes the Market Dynamics System and the complete educational tutorial and a set of newsletters covering about the past two years. A free - three month trial subscription is available to investors and institutional portfolio managers( click to subscribe ). The annual fee for individual investors is $600 per year payable - $50 per month - arrangements are being made so that credit cards can be accepted. Individual subscribers will be limited to only e-mail access to the author regarding questions about individual stock charts and investment opinions. Answers to subscribers questions may be broadcast to the entire list of all subscribers. The subscription for institutional investors provides for a site license for up to five users per site and the fee is $2000 per year. Institutional investors with only a single user may sign up as an individual. Soft dollar payments can be arranged for institutional investors. Institutional subscribers will be able to contact the author by phone or e-mail and a prompt response to questions will be forthcoming. Institutional investors will also be able to request a review of a portfolio of stocks on a quarterly basis.

The subscription includes the software CD and daily updates of the complete data base ( over 3400 stocks) and daily stock selection screens , weekly newsletters, weekly market comments and highlights of individual stocks that represent attractive chart patterns. In addition, a complete review of all the stocks in the S&P 500, S&P 400 and S&P 600 is sent out monthly. These reports highlight the stocks emerging from bases ( buy candidates) and stocks falling away from major tops ( sell candidates). Special reports are also prepared when timely on sectors of the market and industry groups. These

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Sign Up

updates and special reports are sent to subscribers via the Internet. The author and developer of the Market Dynamics Service is also available for questions about individual stocks and the best techniques for using the Market Dynamics System effectively. It is anticipated that a weekly stock purchase highlight will be sent to subscribers on a weekly basis. This stock purchase highlight will be drawn from lists of buy recommendations from a well known investment advisory service that recommends stocks primarily based on fundamental factors and the purchase highlight will focus the subscribers attention on those stocks that have the dual features of good fundamentals and a good long-term technical position as well. It is a primary objective of the Market Dynamics Service to catch high performance stocks while it is still early in the life-span of their move - this will allow for bigger gains and a better chance at a long-term holding period for tax purposes. The stock purchase highlights will incorporate both of these factors in the selection process. W Clay Allen CFA Author and developer of Market Dynamics

[email protected] Back to top of this page

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Sign Up

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Picking Sectors

MARKET DYNAMICS Performance Management System Sector Analysis The analysis of economic sectors and industry groups is a very important part of portfolio management. The following pages show examples drawn from various sectors and industry groups. The Market Dynamics relative strength point & figure system provides a perspective on industry groups and economic sectors that is difficult to misinterpret. The signals are clear and fairly objective. The investor should concentrate his/her efforts on those sectors that stand out as clearly representing the groups and sectors with the best and most dynamic performance. Use the following links to jump to the following pages;

Sectors I_shares Foreign markets I shares Strong industry groups Weak industry groups e-mail at [email protected]

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Picking Sectors

[ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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Picking Sectors

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New Page 1

MARKET DYNAMICS Performance Management System How to Manage for Performance Almost all institutional portfolios are managed today on the basis of an objective to perform better than some market benchmark. This relative performance goal conveniently eliminates the need for market timing and as a result most institutional portfolios are managed on the basis of being fully invested at all times. Thus the portfolio manager can concentrate his efforts strictly on stock picking and making sure the portfolio holds a mix of stocks that will perform far better than the market benchmark. Unfortunately the majority, by far, of institutional portfolios fail to meet what appears to be a modest objective. Why? Almost all business schools in the U.S. have taught, since the mid-Sixties, that all forms of charting are completely worthless and most portfolio managers today are products of that aggressive indoctrination. This is based on the fact that short-term stock price movements are random and unpredictable. The academic damnation of charting is without reservation and all forms of charting are equally condemned. In the business schools of the United States, the condemnation of technical analysis is taught as "something known for sure" about investment management while the remainder of the field has to be approached on the basis of a philosophy that is very iffy and indeterminate. This has had the result of producing a whole generation of investment managers who do believe that no form of charting could help them achieve the investment objectives of their portfolios. A typical comment from a 1978 investment text book by a well known author follows; "Many regard technicians as members of the lunatic fringe of the investment world. Descriptions of their activities are felt to be a suitable subject for anthropologists, but inappropriate in a book intended for the serious investor. Fundamentalists far outnumber technicians, a situation that may be expected to continue in the future".

William F Sharpe Investments 1978 by Prentice Hall

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The fact that fundamentalists far outnumber technicians is not disputed. There are over 50,000 CFAs, the world over, and I earned my CFA over 30 years ago when the program was only 5 years old. A preponderance of fundamentalists does not seem to have corrected the problem of poor performance by the majority of institutional portfolios. It seems that the strong form of condemnation of technical analysis has not been adequately challenged, in spite of the poor record generated by a preponderance of more or less pure fundamentalists. A young man with a major money management institution once called me "the keeper of the shrunken head", implying voodoo, because I dared to suggest value in the technical approach. He must have felt extremely sure of his position, but then again, that was when the bull market was in full swing in the year 2000, so he had all of that learning experience ahead of him! Early in my career as an institutional portfolio manager using fundamental analysis, I also learned that technical analysis, in a special format, could be an especially valuable tool. That method of charting was constructed to remove the noise from stock price data and to focus the portfolio manager's attention on the long-term. It is called 3 box, point and figure charting and I have used it, in addition to fundamental analysis, to manage portfolios and to advise clients regarding stock investments for many years. It is not used to make short-term predictions but to measure a stock's performance in the market. The only prediction is that the long-term performance of the stock has developed for good reasons and that those generating factors will probably continue to produce a similar performance in the future. It is the measurement of the stock's performance that is critical to successful portfolio management. It acts as an important check and verification of the expectations regarding future fundamental developments. Long-term relative performance for an individual stock will ultimately change direction and it is these changes in the direction of performance that are important. It is especially important for a fundamentally oriented portfolio manager to observe and consider these reversals of direction. The reversals are not predictive, in and of themselves, but they act as an alarm or an early warning system and should lead the portfolio manager to check into his reasons for owning the stock. When the reversal is to the downside, unless the portfolio manager can verify that the reasons for continuing to own the stock are compelling, he/she should consider selling the position out of the portfolio. The reversal of the trend of performance is a very important "clue" that a significant change has taken place in the perceptions of the true fundamentals or in the actual financial performance of the business. A downward trend in the market performance that persists should eventually cause the portfolio manager to consider sale, hopefully, before the deterioration of the fundamentals is made public by some announcement of surprisingly bad news. In my opinion, "bad news" always leaks into the market ahead of its announcement!

"You cannot manage what you do not measure" There have been many explanations as to why professional investors don't perform better, but in my opinion, there is only one true explanation; professional portfolio managers do not measure and therefore cannot manage the performance of the stocks in their portfolios. In http://www.clayallen.com/newpage14.htm (2 of 6)2/11/2006 4:20:00 PM

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many cases, they sell the best performing stocks and buy more of the poorly performing stocks. To paraphrase Peter Lynch " they act like gardeners who pull the flowers and water the weeds". There is only one explanation for poor investment performance - too many poorly performing stocks are held for too long! This does not seem to be a difficult concept to grasp and the situation could be remedied by a simple proposition. Measure the performance of the stocks in the portfolio and act accordingly. Don't believe in predictions of what the stock should do - believe that the current performance of the stock will probably continue! The 3 box, method of point and figure charting uses a minimum relative performance movement of three boxes on the chart. Any accumulated movement that is less than 3 boxes will be ignored as representing noise and meaningless random variation. The 3-box method thus expressly recognizes the existence of considerable noise in stock price data and applies an important filter to remove its effect on the direction of movement of the relative performance. The first step is to measure relative performance. Performance relative to what? Usually relative performance is measured by calculating the ratio of the stock's price to a major market average, i.e. the S&P 500. The relative performance will accumulate over time in small, random increments. These increments will be larger in the direction of the primary long-term movement of the relative performance and smaller on the retracements against the primary trend. There will still be movements up and down in a saw-tooth pattern, but the primary relative performance will accumulate either up or down into a visible trend. In this way the effect of the overall market will be removed from the record and the movement that is specific to that stock will show through. In my opinion, I think we can say safely say that stock price movement is not 100% noise. If we conclude that stock price movement is 100% noise then any form of analysis is meaningless and stock price movements will have nothing to do with fundamental financial performance. Past history suggests that prices could be manipulated in the short-run, sometimes in an extreme way, but not in the long-term and this is probably still true today. In the long-term it seems that stock prices will eventually reflect the underlying financial performance of the stock. This is not to say that investors and short-term traders are not often driven by emotion and extreme behaviors but that the stock price will eventually reflect the true fundamental situation. The forecast of what that fundamental situation might turn out to be needs to be regularly checked against the long-term relative performance of the stock. This is why the charting methodology should emphasize the long-term movements of relative performance. Once the portfolio manager gains confidence in his/her ability to measure and see the longterm trend of relative performance, the effort to eliminate poorly performing stocks will be natural. Stocks with good long-term relative performance will be retained in the portfolio, for as long as the performance remains acceptable. Losers will be identified and eliminated from the portfolio. The overall performance of the portfolio should improve dramatically. The distribution of long-term returns from stocks suggests that the tails of the distribution are extremely fat and there will always be winners in almost any sort of market conditions. By measuring relative performance these winners will constantly show up while there is still considerable excess return ahead. In this way the portfolio manager can remain fully invested and relatively unconcerned with market conditions. The Market Dynamics relative strength charting system is actually a performance management system. Relative price movement is recorded in the ups and downs along the http://www.clayallen.com/newpage14.htm (3 of 6)2/11/2006 4:20:00 PM

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vertical y-axis. The gradual accumulation of relative performance shows up as movement up or down in the y direction. Professional investors will recognize this as movements in the Alpha of the stock. The stock will be fluctuating with the overall market and the price will be influenced by noise, but the accumulated push on the Alpha, either up or down, will stand out. Observation shows that Alpha can and often does change in a significant way and it is when the Alpha starts to change direction that the portfolio manager can react accordingly. This is how you can effectively manage the portfolio Alpha. A couple of extreme examples follow Strong upside performance

Major downside movement from a couple of years ago

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Buy Ideas

MARKET DYNAMICS Performance Management System Stock Purchase Highlights To all Market Dynamics users: 02-07-2006 Today's stock purchase highlights cover PONR and XLTC. Stock purchase highlights are a regular weekly feature of the Market Dynamics service. These are suggestions of stocks for purchase as long-term investments.

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I will highlight attractive stocks as they appear. Usually I will be looking for stocks as longs that are moving up after an extended period of basing. Not all of these stocks will be major winners but the chart setup usually precedes a period of excess returns. http://www.clayallen.com/new_page_1.htm (3 of 5)2/11/2006 4:20:10 PM

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Should any of these stocks subsequently reverse their uptrend in relative strength with a triple bottom sell signal and fall below a 45-degree bullish support line, the recommendation should be considered withdrawn at that time. The complete recommended list is sent out daily with the regular Market Dynamics updates. The complete Market Dynamics Tutorial is now posted on my new and revised web site at www.clayallen.com. The web site includes an offer for a free trial of the Market Dynamics service for three months - just send an e-mail that includes your mailing address with "free Market Dynamics trial" in the subject line. These stock purchase highlights are strictly for the use of Market Dynamics subscribers and should not be copied or forwarded without the written consent of Market Dynamics. copyright by W Clay Allen CFA To unsubscribe from this list - send a reply to this message with "unsubscribe" in the subject line. 303-804-0507 <mailto:[email protected]> THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

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MARKET DYNAMICS Performance Management System The following link opens a .pdf file that contains a preview of the book

Winning The Performance Game by W. Clay Allen CFA July 2005 The preview contains several chapters from the book and it is designed to give a brief introduction to the book.

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The book is available for purchase at www.lulu.com Return to home page [ Home ] [ TPARC ] [ INTERVIEW ] [ Exchange Traded Funds ] [ Hidden Order ] [ Fundamentals ] [ Good Bargains ] [ RS Charting ] [ Who is W C A? ] [ X & O Charting ] [ Newsletters ] [ Market Trends ] [ Winners and losers ] [ Free Trial ] [ Performance Alarm ] [ Free E-Book ] [ Sign Up ] [ Picking Sectors ] [ Investment Results ] [ Performance studies ] [ Buy Ideas ] [ Book Preview ] [ Contact Us ]

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MARKET DYNAMICS Performance Management System Market Dynamics can be contacted by email at [email protected]

The mailing address is: Market Dynamics 7325 S. Jackson St. Centennial, Colorado 80122

303-804-0507 303-804-0513 Fax

The system and software for Market Dynamics was developed and written by W. Clay Allen CFA. http://www.clayallen.com/contact_us3.htm (1 of 3)2/11/2006 4:20:14 PM

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The system is written in Visual Basic 6.0 for PCs running MS Windows 95 and higher.

Market Dynamics and all of this web site are copyright 2000 to 2005 by W. Clay Allen CFA All rights are reserved. A paperback copy of the book Hidden Order can be purchased from http://www.lulu.com

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MARKET DYNAMICS PERFORMANCE MANAGEMENT SYSTEM Special report For

All Market Dynamics Users Energy sector indices and averages 12/28/2005

Technical perspective on the energy sector The stocks in the energy sector have gone sideways relative to the overall market for the past several months. This sideways movement follows an extended period of very strong relative performance. The oil service sector has been able to breakout to the upside from this period of sideways consolidation ( see the charts for OSX, OIH and MG125). The oil service stocks have resumed their up trends relative to the S&P 500 and it appears that the consolidation zones will now act as strong support for these stocks during any corrective phase in the overall market. The index that shows the most definite topping pattern is the chart of the major integrated oil companies ( i.e. MG121) and these stocks should probably be avoided until they can demonstrate that their up trends have resumed. Only 4 of the 17 charts (24%) in this report are on a Performance Alarm. Most of the charts are showing a successful test of the 45degree bullish support lines and these zones of consolidation will not become tops unless the 45-degree bullish support lines are violated.. The indices of the smaller independent oil and gas companies have also broken out to the upside and are close to recording new recovery highs. The consensus investment opinion seems to be that the price of oil will almost certainly drop after the winter heating season is past and the oil stocks in general will probably decline. As a result of this thinking, the prices of these stocks, as well as the price of crude oil, have become highly sensitized to the fluctuations of the weather. This action has produced the sideways movement shown on the charts. It seems clear that the up trends of the oil service stocks and the smaller independent oil and gas producers only paused and they have already resumed their long-term positive performance in spite of this sensitivity to the weather. It seems reasonable to believe that there will be many acquisitions of small and mid-sized oil and gas producers by the large integrated oil companies during 2006. This should be a source of continuing strength for these stocks. It is also important to consider that there have been few announcements of major new oil and gas discoveries since the price of crude oil began to rise over a year ago. I remember that in 1980 and 1981 there were several extremely large oil and gas discoveries that eventually led to a supply glut of oil and a downtrend in the price. The stimulation of high oil prices to exploration activity does not seem to be adding to the supply of oil the way it did in the past. The historical model of high oil prices resulting in a supply glut may not be appropriate under today's conditions. Natural gas seems to be in a totally new situation of an ongoing limited supply. In summary, it seems clear that the best opportunities in the energy sector are the oil service companies and the smaller oil and gas producers. The major integrated oil companies have limited performance potential. W. Clay Allen CFA 12-29-2005

DJUSE -

IXC -

MG120 -

IYE -

MG121 -

MG122 -

MG123 -

MG124 -

MG125 -

NYE -

OIH -

OIX -

OSX -

VDE -

XLE -

XNG -

XOI -

V o lu m e 5 Is s u e 6

Ma r ke t Dyn a mi cs

F eb r u a r y 10 , 2 00 6

Every Four Years—The Bear Comes Back Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law As a graduate student at the University of Denver in 1968, I asked the then chairman of the FRB a question about the movements of the money supply and the behavior of the stock market. Mr. Martin’s answer: “Next question!” A collection of recent newsletters is available by clicking this box

Market Dynamics www.clayallen.com 7325 S. Jackson St.

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

Conventional wisdom teaches that something as simple as a long-term, four year time cycle cannot have any forecasting value in the stock market. The historical record seems to suggest otherwise. I entered the investment management business in late 1964 and I have personally experienced major bear markets that bottomed out during the following years; ‘66, ‘70, ‘74, ‘78, ‘82, ‘87, ‘90, ‘94, ‘98 and 2002. The only variation from a regular four year frequency was in ‘87 and ‘90, which included a long cycle of five years followed by a short cycle of three years. All those cycles averaged out to almost exactly a four year cycle measured from low to low. It seems that a prudent investor should learn from history and a four year cycle certainly seems to be an important feature of stock market history. Somewhere along the line, I came across a book by J.M. Hurst that was published in 1970. (The Profit Magic Of Stock Transaction Timing ). He studied weekly stock market history from 1921 to mid1965 (44 years) and by using sophisticated computer techniques to analyze cycles, he found the existence of a cycle of 4.3 years in length on average during that time period. The history of the stock market prior to my entry into the business followed a four year cycle and certainly my experience in subsequent years proved that the stock market oscillates within the context of a four year cycle. Hurst also found the existence of a one and a half year cycle and a one year cycle. These cycles will become important when considering the current situation. Not all of these bear markets were devastating like 1929, 1974, 1987 or 2002 but they all showed a common tendency for a decline, peak to trough, of roughly twenty percent or more. The most common cause of major bear markets over a very long period of time has been tight money policies of the Federal Reserve Bank and the associated increase in interest rates. It

Performance Management System

seems that, in reality, the stock market is highly sensitive to liquidity flows through the banking system. This sensitivity also shows up in the historical record of monetary panics that occurred in the second half of the nineteenth century and that was before the FRB was established. The historical record also shows a strong tendency for bear markets to bottom out in the month of October. Some outstanding examples of October bottoms include 1929, 1937, 1974, 1987, 1998 and 2002. It seems that the tendency for the market to record lows in October is also related to seasonal liquidity flows through the banking system. To bring all this up to the current situation, we need to consider that the last major bear market low was in October of 2002. If the four year cycle lives up to its reputation we should expect trouble in the market later this year with a potential bottom in October 2006. The market experienced a serious oversold condition in October 2005 so a one year cycle also points to a low in October of 2006. The market also experience a deep oversold low in April 2005 so a one and a half year cycle also suggests a low in October 2006. This seems to be more than just an interesting coincidence. The FRB has been raising interest rates for more than a full year so the presence of a tight money policy should be considered as a contributing factor to the outlook for a bear market later this year. Does it have to happen? No! The cycle might just skip a beat but that seems to be unlikely given the historical record. The market has experienced cycles that lasted five years so this cycle might stretch out into 2007. In the stock market we are constantly dealing with probabilities and the historical record indicates that the probabilities of a major bear market bottom in late 2006 are definitely increasing. Given the average length of bear markets in the past, a low in October would suggest a peak in the market during the first quarter of 2006. We need to be sensitive to any meaningful deterioration in the price trends of the market from now on. W. Clay Allen CFA

V o lu m e 5 Is s u e 5

Ma r ke t Dyn a mi cs

F eb r u a r y 3 , 2 00 6

Be Careful How You Use The Word TOO Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law

Investors should ask themselves the following question when a stock’s price goes down. Does the inherent value of a stock go up, when the price declines? Usually not.

A collection of recent newsletters is available by clicking this box

Market Dynamics www.clayallen.com 7325 S. Jackson St.

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

Investors should be very careful when they use the word Too. In casual conversation about stocks, it is very common to hear investors say that a stock is too high, it has gone up too much, it is too cheap, or that it has gone down too much. How do they know what is too much? It seems that most investors use a simple comparison of the most recent price to the prices that prevailed a short time ago and, since they do not want to pay up for a stock, they avoid a stock that is going up with the comment that it has gone up too much. In much the same way, they will follow advice that indicates that a declining stock has gone down too much. How much is too much will only be defined by the action of the market and a price extreme can only be accurately determined in hindsight. While we are in the process of a price movement up or down, we have no accurate way to judge what is too high or too low. The pattern of price changes after a downside price extreme is usually characterized by a broad horizontal price movement back and forth that remains in the vicinity of the price low. This sideways movement is a pattern that follows a very high proportion of major price declines. This horizontal backing and filling at a low level indicates that investors should feel no urgency to buy stocks whose price structure shows a major decline. A technical analyst calls this period of dullness a base or a saucer pattern. And it can take many months to complete. The dull market action causes the holders with losses in the stock to eventually loose patience and to accept their loss, usually justified by benefit of a reduction in taxes. An extreme high in the price of a stock may be followed by a sideways movement but in many cases the stock performs a sudden reversal in trend and starts down. The sideways movement after an extreme high is called a top but a broad

Performance Management System

topping pattern probably occurs in no more than 50% of the cases. The investor therefore does not have the luxury of waiting to see if a stock forms a top after an upside price extreme. After a major rise in the price of the stock, the holder must be sensitive to an abrupt reversal of trend and the onset of a declining price movement. At this point, to say that the stock has gone down too much to sell can be a serious mistake. In the application of long-term point and figure charts of relative strength, a triple bottom sell signal after an upside price extreme can represent a good reason for the sale of the stock. It is just this type of logic that has been programmed into the Market Dynamics System to produce the Performance Alarm. It has been shown in numerous studies of investor behavior that investors are inclined to accept profits and gamble with their losses. The justification for accepting a profit is often based on the comment that the stock has moved up too fast. A refusal to accept a loss is justified by the opinion that the stock is too low to sell. In both instances, the use of the word TOO causes the investor to make a mistake. The rationalization for holding stocks that are going down and selling stocks that are going up, will usually result in small gains and large losses. Therefore, investors should be very careful when they use the word TOO. W. Clay Allen CFA

Weekly review of market breadth – 02-09-2006 S&P 500

49% advancing

Percent above ten-week ma S&P 500 49% S&P 400 59% S&P 600 63% NASDAQ 100 51% High Volatility 65% High Yield 57%

Market Comments The Diffusion Index dropped to 50% and that indicates that only half of the broad market averages are going up. This was a big drop and it suggests a transition is taking place beneath the surface of the market. The percent of the stocks in the S&P 500 that are going up fell to 49% during the past week. The other breath indicators show a more healthy picture but the trend definitely seems to have turned downward. This tilt toward the downside is occurring slightly ahead of the mid-point of the 55-day cycle and that suggests that this corrective phase in the overall market will probably drop into a bona fide oversold condition with the breadth indicators falling to the 20% level or below. The next 55-day cycle low is due around March 21, 2006. It is interesting that the market is turning down while the VIX indicator remains at very low levels and that reflects very little fear of the downside by professional investors. The survey of investment advisors at year-end showed an extremely high number of bullish advisors. A significant downturn by the market that is early in the 55-day cycle would seem to qualify as an almost perfect development from a contrary opinion perspective, given the bullish sentiment and the low level of fear that is indicated by the VIX. This behavior by the market leads to my anticipation that the next low will probably show extreme downside readings on the breadth indicators.

W. Clay Allen CFA Clay Allen CFA

Page 1

2/9/2006

S&P 400

59% advancing

Clay Allen CFA

Page 2

2/9/2006

S&P600

63% advancing

Clay Allen CFA

Page 3

2/9/2006

NASDAQ 100

51% advancing

Clay Allen CFA

Page 4

2/9/2006

High Volatility Stocks

65% advancing

Clay Allen CFA

Page 5

2/9/2006

S&P 500 with Diffusion Index

Diffusion Index = 50% advancing

50%

The Review of Market Breadth is a regular weekly feature of Market Dynamics. It is prepared by an independent research analyst with over 35 years of experience in market analysis. For a free subscription, send an e-mail requesting a subscription to http://www.clayallen.com/. There are additional weekly essays about portfolio management and special reports monthly on the S&P 500, S&P 400 and the S&P 600. Be sure to forward this report to friends and colleagues who have an interest in the stock market. W. Clay Allen CFA

Clay Allen CFA

Page 6

2/9/2006

Relative Strength Applied to the VIX

Near recent record lows on the VIX

The Fear Index The volatility index (VIX) is calculated by the CBOE. It is based on the Black-Scholes option-pricing model. The data for a series of options, puts and calls, on the S&P 500 index are used to calculate the VIX. The strike price, the amount of time to expiration, and the market price of the option are used to solve the model for the expected or implied volatility that is, in effect, being used by market participants when they buy and sell these puts and calls. This results in a number that actually quantifies the expectations of option market participants. Expectations of high volatility in the future result in high prices for these options and a high reading on the VIX. Expectations of high volatility are usually thought of as an expression of fear in the market. The greatest amount of fear is usually recorded precisely at market lows and the VIX almost always spikes up into high readings right at the market lows. Conversely, low levels of the VIX suggest little fear of the market and these readings are usually seen at market peaks. The timing of market peaks by the VIX is not nearly as precise as at market lows. This seems to suggest that fear really is a more urgent and intense emotion than greed or optimism. In Market Dynamics, the VIX is presented in a relative strength format to even further enhance the swings of the indicator. Additional information on the VIX can be found at the www.cboe.com web site.

Clay Allen CFA

Page 7

2/9/2006

HIGH YIELD STOCKS (350)

57% advancing

To unsubscribe from this list send a reply to this message with "unsubscribe" in the subject line. 303-804-0507 e-mail at [email protected] or visit my web site at

http://www.clayallen.com/ This is not in any sense a solicitation or offer of the purchase or sale of securities. The factual statements herein have been taken from sources we believe to be reliable but such statements are made without any representation as to accuracy or otherwise. Opinions expressed are our own unless otherwise stated. From time to time we may buy and sell the securities referred to herein, and may have a long or short position therein. Prices shown are approximate.

Clay Allen CFA

Page 8

2/9/2006

The Essence of Portfolio Management Successful portfolio management is not only knowing what stock to buy, but also knowing when a stock should be sold and when a stock should be held. However, most portfolio managers approach the challenge as a problem that should be solved only by superior stock selection. The image of the successful portfolio manager as a champion stock-picker minimizes the ongoing responsibility of the portfolio manager in upgrading the portfolio. It also overlooks some of the real problems in making predictions in the stock market.

Predictions Successful stock picking is believed to be a matter of making superior assessments of the future financial performance of a company and this is where the slip-ups start to develop. One of the major dangers of prediction is that the ego gets involved and the analyst finds it difficult to admit he/she is wrong, even in the presence of considerable evidence to the contrary. Being wrong in our predictions is something that few of us can tolerate very well! This is especially true when we have made public forecasts and have used considerable persuasion to get others to believe in our predictions. It is always just a matter of “you wait and see – I’ll be right soon enough”. Research has shown that many, if not most, erroneous economic and financial market forecasts are wrong not because of what the analyst used in his analysis but because of what he didn’t consider at all. We will always analyze what we know is important to the situation but why should we include anything that, as far as we know, is not important. It would be silly and damaging to the credibility of our predictions to emphasize or even “touch on” things that most observers don’t think matter very much. Enter the UNK-UNK An UNK-UNK is an unknown-unknown as opposed to a known-unknown. Most predictions are prepared using an analysis of the known-unknowns in a situation. An UNK-UNK is something that we didn’t know mattered and we don’t often know how to deal with it until we gain some experience with how it matters. The UNK-UNK is the source of major surprises on Wall Street. The UNK-UNK always favors the variables that were not considered in the current appraisal of the situation – thus the endless source of surprise. The surprise almost always catches the consensus opinion totally off guard. Consensus Opinion The consensus opinion must, by definition, be a simple phrase or slogan that is capable of being repeated over and over until almost no one doubts its validity. The consensus opinion leaves no room for consideration of an UNK-UNK. An UNK-UNK almost always comes along, sooner or later, that will lie outside the expectations formed by the consensus forecast so that a major surprise is created. Does the surprise result in a major trend change in the markets or was that trend change already

W. Clay Allen CFA

Page 1

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underway beneath the surface and the surprise just confirmed it. Some call these consensus-shattering surprises, shocks. Surprising Trend Changes The case has been built that trend changes are usually the result of an unexpected change in the workings of the market or the economy. Experience shows that in a very high proportion of cases these trend changes in security prices can be judged to have occurred in advance of the shock or surprise that supposedly produced the trend change. Why/ how can this be so? The trend change in advance of the surprise did not fool everyone – it just fooled the majority – it fooled the believers in the consensus. Did a group start to act contrary to the consensus before the trend reversal? Classical Contrary Opinion Yes. It appears that there is a significant minority of market participants that, out of habit and conviction, doubt rather than believe the prevailing consensus opinion regarding the market or individual stocks. Conventional wisdom points to corporate insiders as trendsetters but I believe there are others as well. Knowledgeable long-term investors and, importantly, long-term trend followers seem to recognize these changes in market trends for what they really are. Short-term trend followers do not seem to make that much difference to the long-term trend although they can and do exaggerate the short-term movement and volatility, especially to the downside. Long-term Trend Reversals Without being able to prove it, it seems reasonable to believe that the consensus followers will not believe the trend reversal when it occurs. Maybe they are blind to it rather than unwilling to believe that it is real. The first step in successful portfolio management is to develop an “open mind” to the possibility that a trend reversal might be real, in direct contradiction to the prevailing consensus opinion about that stock. How to SEE A Trend Reversal First of all you have to be alert! If you don’t look for it you will never see it. Be sure you are using pictures that emphasize the long-term perspective rather than short-term market noise and unexplained variation. In my opinion it is best to remove the influence of the overall market, which is usually a source of considerable noise. Market Dynamics has been designed with these factors in mind. Do not rely on a system that is complicated or requires highly mathematical rules for its implementation. Simple and objective rules are far more robust in application. Also, simple rules run a lower risk of over-fitting the data in a meaningless way! A system that identifies trend reversals in a highly objective manner is far superior to more subjective methods. In essence we need to know when to go with the consensus and when to “fade” it. When You See It – Believe It It seems remarkable to me that portfolio managers could see a significant trend reversal and not believe it – and yet it happens “all the time”! When you see it – believe it. The rest is mechanics. Major Winners and Major Losers It is an amazing fact that almost every share of stock, in every major stockmarket disaster, was held by someone who did not believe the trend was down - all the way down. It is also significant that many of the major market winners were avoided by

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a majority of investors who refused to believe that the long-term trend was up. They refused believe what they were seeing! What Successful Portfolio Managers Should Do Successful portfolio managers should identify and hold the stock market winners and move away from the stock market losers. Market Dynamics has evolved to allow portfolio managers to implement this approach. What Not To Do Behavioral finance has identified a tendency for investors to accept profits from their winners quickly but they will gamble with the losses from their losers. This is exactly what a successful portfolio manager should not do. Peter Lynch characterized it as a gardener “who pulled the flowers and watered the weeds”. The Essence of Portfolio Management Pull the weeds! Water the flowers! Believe what you see! The most important thing is how you SEE!

“I believe that Market Dynamics will be to a portfolio manager what a telescope is to an astronomer.” W Clay Allen CFA

W. Clay Allen CFA

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Portfolio Objectives 1. Maintain adequate diversification. 2. Choose portfolio investments from appropriate risk categories. 3. Create total returns from the portfolio greater than some specified measure of alternative investment (i.e. usually an inactive or unmanaged portfolio such as the S&P 500) Market Dynamics evolved as at least a partial answer to objective 3. The system is based on the measurement and comparison of price movement after the effect of the market (i.e. S&P 500) has been removed. The price action that is displayed can be thought of as movement that is specific to that stock. This is very important since the market movement day to day is a significant source of noise and unexplained variation. The format of the chart presentation is known as 3 box- point & figure. This process filters the data and removes minor variations leaving the vastly more important major trend movement. The charts are long-term in perspective and four years of data are used to construct the charts. More volatile stocks will not display four years of history because the volatility creates so much back and fourth movement that it exceeds the capacity of the chart to display only the last 70 columns, so the display will be much less than even two years.

The choice of the 3 box – point and figure technique has another very important aspect that is often overlooked. The X-axis does not measure time on these charts. The X-axis measures the number of alternations of trend back and forth. The fluctuation must be greater than a predetermined minimum amount to result in recording a reversal. These reversals of trend are a function of volatility, which is a proxy for risk. The movement along the X-axis can be considered to be recorded in units of risk. Therefore these charts record the movements of risk vs the movements of return relative to the market. This allows for the graphic comparison of risk and return. It therefore becomes possible to develop a minimum acceptable relationship between the movement of risk and return. Upward and downward sloping straight lines on the graph often define these functional relationships although higher order curves could also be used. These functional relationships define and differentiate between acceptable price behavior and unacceptable price behavior.

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The primary benefit of the use of this technique is to recognize the points when the trends change and when what was previously acceptable price behavior switches to unacceptable price behavior and vice versa. The reversal points are highly visual and do not require complicated rules for analysis and recognition. The charts are fast and easy to use. This is a tool primarily for use by institutional portfolio managers who are responsible for large portfolios with many stock positions. Speed, ease of use and effectiveness are the main benefits to be derived from this system. Successful adaptation to rapid and dramatic change in the financial markets is a primary goal of this approach. Example

Two examples of the straight-line relationships are displayed- upward sloping with a +1 slope and downward sloping with a slope of –1. These 45degree support and resistance lines are discussed in more depth in the chapter on learning relative strength point & figure. On many charts of stocks in trading ranges the reversals are not this clear and the trends are not as persistent. For the stocks that exhibit major longterm trend movement the reversals of trend stand out and the trends often persist for months.

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Portfolio Upgrading The objective of portfolio upgrading is to ensure that the portfolio successfully adapts to changes in the economy and the financial markets. This adaptation must take place before the implications of these changes are fully understood by other market participants. Constant change is taken as a given by this system. Portfolio upgrading is a process of continuously enhancing the appreciation potential of the portfolio. This is accomplished by monitoring the performance of each of the stocks in the portfolio and swapping out of the stocks with unacceptable performance into stocks that are generating a pattern of acceptable performance. The age-old tenant of “sell your losers and let your winners run” is very much at the heart of portfolio upgrading. Market Dynamics provides an objective set of rules to identify losers. The 45-degree bullish support lines and the 45-degree bearish resistance lines are instrumental in this “rule-based” system. Since there are no “magical” formulas for success in the stock market – each user is free to adopt any rule or set of rules that he/she believes will improve the results of the portfolio. The two charts below represent an extreme example of the potential of portfolio upgrading. A swap from CNC into CPN would have produced fantastic results relative to holding CNC during the decline.

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Upgrading potential example 2 The examples that follow are extreme examples of the potential rewards to portfolio upgrading - “ pulling the weeds and watering the flowers”. It must be remembered that the future is almost totally unknown at the time the swap takes place and it is easy in hindsight to say “oh yeah, I would have made that swap”. It is not so easy in real time. But experience shows that very seldom do major losers suddenly turn into major winners. Also, experience shows that stocks that fall into a major downtrend can continue to underperform for extended periods and it is usually unsafe to bet against the market. There is an old saying “ The race is not always to the swift, Nor the battle to the strong. But that’s the way to bet!”

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Upgrading potential example 3

Upgrading potential example 4

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Upgrading potential example 5

The previous examples represent extremes of relative price behavior. The extreme price movements of these stocks almost certainly surprised investors. But in a marketplace that is characterized by a distribution of returns with fat-tails these kinds of extremes occur much more frequently than they would in a mathematically perfect, normal distribution. Stocks going down turn into disaster more frequently than they should and stocks going up turnout to be major winners more often than they should. A major difference in portfolio performance can be the result of just a few disasters that were avoided and a few gainers that turned out to be major winners. This is just another version of the 80/20 rule at work.

Value managers must be particularly sensitive to stocks in downtrends since they seem to continue to underperform for extended periods, usually longer than we expect. It can be assumed that every x and o on the way down in a major market disaster represents trades by investors who thought the issue was too cheap! Portfolio upgrading can also be enhanced by the effective recognition of the extremes of trading ranges.

W. Clay Allen CFA

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Setting Up a List to Monitor the Portfolio The portfolio manager needs to set up his/her portfolio in a list that can be referenced by the Market Dynamics system. This is a list of ticker symbols that are entered into a file using the Wordpad word processing program. This file will be stored in the \MDRS folder. The screen below shows how to start Wordpad.

Setting up a portfolio list using Wordpad

To call up Wordpad use – Start – Programs- Accessories- Wordpad When Wordpad is selected – double click on it to start the program. The next screen should appear. Wordpad is a simple word processing program that comes with Windows. Wordpad can save a file as text without formatting codes

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Select a list – i.e. Elist5.dat When Wordpad is started – click File – click Open – and the dialog box shown below will appear to facilitate opening a user file in the \MDRS folder. This file will be used to hold a list of ticker symbols representing the user’s portfolio. The files that can be used are, elist1.dat to elist5.dat, and mylist.dat

Browse to the \MDRS folder – this is the folder that contains the Market Dynamics System

Select the file you wish to modify – elist1 through elist5 and Mylist are available to users - when selected - the file name will appear in the dialog box below

When the correct selections have been made – click “Open” button to open the file.

Change the “Files of type” dialog box to “All Documents”

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Deleting the contents of the file

After the elist5.dat file is opened –a list of ticker symbols will appear. Use the Edit drop-down menu and then click “select all”. This causes all the symbols in the list to become highlighted

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Deleting the existing symbols

All the symbols appear highlighted. Use the “cut” option to remove all the symbols. This will empty the file in preparation for the entry of a new list of symbols.

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Entering new symbols and saving the file

New list of symbols constitutes the portfolio list. This list can be modified and updated at any time. Just add and delete the appropriate symbols and save the file.

When – File – Save As – sequence is entered this dialog box appears. Make sure the \MDRS folder name appears in the “Save in” dialog box at the top. This assures that the file will be saved to the \MDRS folder where it can be accessed by the Market Dynamics charting system. Click on the “Save” button to save the file with the new list of tickers. A user can use the 5 files, elist1 to elist5, and the mylist.dat file to contain portfolios. The user using the steps just displayed can update these files at any time. These files should never be updated by file downloads from Market Dynamics. Remember – the format for these files is one ticker per line – in any order – with no formatting codes. Wordpad is the easiest way to setup and maintain the portfolio ticker symbol files.

W. Clay Allen CFA

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Reviewing a portfolio list Activate the “lists” drop-down menu by clicking on the “lists” button on the top line.

A list is selected by clicking the “lists” drop-down menu and then selecting a list. The user lists are shown in part 5 at the bottom of the drop-down menu

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Toggling through the list

The portfolio manager can quickly review a portfolio by calling up a list. The name of the portfolio appears at the bottom of the chart screen. To move to the next chart the PM can press the “Enter” key on the keyboard or press the ALT key and D at the same time or use the mouse to click the “draw chart button”. This can be done very quickly.

The portfolio manager can click the “print” button to print a chart for further reference later on or he could save the chart to a file, perhaps to send to a client or an associate. Printing a hardcopy of the chart is a good way to produce a reminder for later action. The PM can also move around in the stocks list box by using the arrow keys on the keyboard or with the slider in the stocks list box. To return to the main list the PM should click on the button labeled “return to main list of stocks”. To review a chart for a stock that is not in the portfolio list the PM should use the button marked “ticker symbol input”. The chart for the desired ticker symbol will be drawn but the order of selection in the portfolio list will be retained. All of the trendline option buttons are fully functional while reviewing a portfolio list. W. Clay Allen CFA

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Frequency of portfolio review

In my opinion the more frequently the portfolio list is reviewed the better. The PM will begin to learn and appreciate the quirks and patterns of individual stocks. Support and resistance levels will also become more apparent. After looking at a stock that is underperforming, day after day, the probabilities of making a sale seem to go up which is good for the portfolio’s future performance. We all learn by repetition so the more frequently we look at the portfolio the better we learn to recognize the significance of patterns and movement. The visual aspects of the system cannot be overstated. It seems to encourage intuitive judgments and creates a “feel” for the behavior of stocks that cannot be achieved otherwise. In my experience, many of my best calls were based on a “feel” or intuitive judgment that I couldn’t fully explain at the time and yet I was confident of the direction of movement. The best long-term investment ideas seem to be very fragile and will not stand up to rigorous factual analysis since the complete facts of the situation cannot be known with certainty at the time. If the facts were known with certainty – there would be no investment opportunity. To paraphrase the old saying about artists “ we don’t teach a portfolio manager how to draw, we teach him how to SEE.” Maybe successful portfolio management is a more “rightbrained” activity. W. Clay Allen CFA

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Positive turnover vs negative turnover Negative Turnover Increased turnover in a portfolio is often considered to be a negative influence on the portfolio’s performance. Increased commissions and trading costs are cited as costs that reduce performance. However I believe that the negative aspects of increased turnover are more in line with Peter Lynch’s comments about “pulling the flowers and watering the weeds”. Behavioral finance has already been cited as pointing to the human tendency for gambling with investment losses and quickly accepting investment profits. This seems to be a “built-in” behavior pattern for many portfolio managers especially in volatile and erratic markets. Therefore, “negative turnover” is defined as the activity of selling the winners too soon and holding the losers too long. This is especially true when there seems to be increased use of short-term technical trading systems of all types. A discipline is needed to guard against the tendency for the portfolio manager to engage in “negative turnover”.

Positive Turnover The long-term relative strength in point & figure format and the application of the 45-degree support and resistance lines seems to provide just such a discipline to avoid “negative turnover”. As long as the relative strength remains above the 45-degree bullish support line the stock’s behavior should be considered acceptable and it would be eliminated as a sale candidate unless special conditions developed. Stocks that are unable to hold above the 45-degree bullish support line are therefore unacceptable and become candidates for sale. Assuming the portfolio manager is following a policy of “full investment at all times” the upgrading process begins with the appearance of a sale candidate and the search for a replacement starts. Positive turnover is driven by the developing negative behavior of a stock in the portfolio – not because a portfolio manager wants to take a profit. The portfolio review process therefore needs to be continuous and focused on a search for stocks that are starting to fall below the minimum acceptable long-term performance guidelines. This is not to say that profits can only be realized when a stock turns down relative to the market! Stocks that have outperformed for long periods of time may become extended to the upside and the position may need to be trimmed back to an average position size or valuations become so excessive that the position should be eliminated. The Market Dynamics system when applied in the spirit of “letting profits run and cutting losses short” will facilitate “positive turnover”. The system is designed to allow W. Clay Allen CFA

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frequent portfolio reviews in a quick and effective manner. The portfolio upgrading process is therefore continuous and changing conditions in the financial markets and the economy are reflected in the portfolio.

Examples of selling into strength follow:

An approach to the upper channel Upper channel lines are always drawn upward to the right from a prominent high.

This is an example of a stock that rapidly became extended to the upside. The two channel lines provided a general indication of a probable high reversal point on the chart. The sale could have been initiated as the upper channel line was approached. There was no indication at that time of a reversal so the sale could only have been based on the approach to the upper channel line.

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Spike above the bullish support line

This stock spiked out about 50 boxes above the 45-degree bullish support line. In my experience, a spike 30 boxes or more above the bullish support line offers a suggestion to sell while it is still moving up. Stocks that experience an upside blowoff often retrace a large part of the move and usually the move terminates with the dramatic blowoff.

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Selling into upside extension

This stock completed a “rule of nine” move to the upside and at the top was 40+ boxes above the 45-degree bullish support line. The extension above the 45degree bullish support line provides an estimate of how far the stock might fall to reach the support line. There were no signs of reversal during the upside stretch out.

A test of the 45degree bullish support line

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Successful portfolio management – don’t buy/ don’t hold problem stocks A large number of stocks can be eliminated from consideration as a purchase by a quick inspection of the long-term relative strength point & figure chart. No need to do further fundamental research or examination on a stock that remains below the 45degree bearish resistance line. It usually will turn up someday and you can do your research on the stock at that time. You only need to spend time on stocks that are turning up convincingly and you will find that many times they have the fundamental backup to justify the investment.

This stock has been under its 45degree bearish resistance line for months. It enjoyed a recent rally but it seems to be far too early to consider purchase.

W. Clay Allen CFA

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The Importance of Sector Analysis in Portfolio management Sector analysis and the review of industry groups is one of the most important methods of making sure the portfolio is properly positioned. There are about 85 industry groups in the Market Dynamics System. All of the ticker symbols for industry groups start with WG and are followed by a number (i.e. wg100). When the stocks list box is sorted by ticker symbol all the industry groups will appear together making a review of the industry charts very easy. In addition to the industry groups, there are charts for SPYDERS and WEBS and other sectors with special symbols. At any time, there are only about eight to ten out of the 85 industry groups that will be showing the highest relative strength. The portfolio should be exposed to these industry groups and sectors. Care must be exercised to make sure the portfolio retains an adequate degree of diversification. Example of industry chart

Industry group charts do not appear to be as volatile as the charts on individual stocks. Triple top buy signals and triple bottom sell signals seem to provide the most effective indications of trends on these charts.

For an indication of the importance of sector analysis, see a speech by Robert J. Farrell that was reprinted in the MTA Newsletter, July/August, 1994, p4.

W. Clay Allen CFA

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Portfolio Management – Fundamental vs Technical Analysis “If you only have a hammer – you will treat everything like a nail” There seems to be an ongoing debate as to whether fundamental analysis is better than technical analysis. In my opinion these two methods of analysis have their strong and weak points. I think that most portfolio managers should use both tools. It seems to me that the relative weighting in a decision should vary depending on the decision at hand (i.e. buy or sell). In my experience it seems better to weight the buy decision about 80% fundamental and only 20% technical. On the other hand, the sell decision should be weighted about 80% technical and only 20% fundamental. Buy Decisions Potential buy candidates should be identified and qualified by an estimation of the future potential of the stock based purely on a fundamental appraisal of the expected financial performance and other factors such as quality of management, competitive conditions, and stock sponsorship. The portfolio manager may inspect the charts of buy candidates to confirm the positive trends in the fundamentals. Fundamental analysis should clearly dominate the buy decision. Sell Decisions The sell decision however is primarily a function of technical analysis. Changing fundamentals cause subtle changes in the supply/demand relationships in the stock market. Negative fundamental developments may be minimized and downplayed by management or in some cases management may deliberately misrepresent the deterioration in these factors of the business. Insiders may have started to sell large positions in the stock. The stock may be losing its sponsorship for a wide variety of reasons (analysts usually don’t publish sell reports). Consumer tastes may be changing or competitive conditions may be worsening. Regulatory conditions may be changing. These developments may be subtle but show a gathering trend. These changes will result, more often than not, in a change in the price trend of the stock, especially in the relative price trend. The deterioration in fundamentals casts an observable shadow over the relative strength chart that often gives a warning that the portfolio manager can act upon. Not all reversals are slow and subtle. Some are extremely fast and dramatic and can result in a catastrophic drop in the stock price without warning, but these events seem to be rare. The more likely case is when the stock turns down relative to the market and fails to maintain its relative performance for some considerable period of time - - - and then the bad news breaks. The portfolio manager who waits for the fundamental bad news to become public is often faced with a serious loss by the time the news comes out. Portfolio managers should use both fundamental and technical analysis but the relative importance of the tools should reflect the decision being made: buy decisions should be 80% fundamental/ 20% technical; sell decisions should be 80% technical/ 20% fundamental.

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Always remember to pull the weeds & water the flowers.

To return to the tutorial table of contents click

mdtutor.pdf

To return to the top of the web page click www.clayallen.com 303-804-0507 or FAX @ 303-804-0513 [email protected]

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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Market Dynamics - Relative Strength Point and Figure Charting

MARKET DYNAMICS Performance Management System This site was last updated on 02/10/2006 A tremendous amount of new material is added every week to this site so take your time and check it out. These research reports are a regular part of the Market Dynamics investment service that is used by many investors to help improve their investment performance. The primary orientation of this site is to provide profitable research material for long-term investors. Both individual and professional portfolio managers will find useful ideas and research techniques on this site. The buttons along the left margin will help you to navigate the site. While this site is primarily about long-term technical methods, the author believes in and has used both fundamental and technical analysis to successfully manage long-term investment portfolios for many years. The fundamental analysis approach is analytical, logical, mathematical, sequential, language oriented and therefore a left-brained activity. The technical perspective is more holistic, pattern using, artistic, intuitive, visual and therefore a rightbrained activity. To succeed in the difficult world of investment management we need to develop and exercise both sides of our brains and let each contribute to the final result. It is very important for long-term investors to achieve an appropriate mix of both the methods of fundamental analysis and the techniques of technical analysis. Be sure to read the description of "Lazy Stocks" that is presented farther down this page. Please feel free to contact me by e-mail if you have questions or would like to direct feedback to me about the site [email protected]. While I cannot give advice about specific stocks, I would be happy to give you my opinion of the long-term, technical trend for any stock. Just send me an e-mail with your question - be sure to include the ticker symbol for the stock. For further material on "whole-brained investing" see The Tao Jones Averages - A guide to whole brained investing by Bennett W. Goodspeed, Dutton ISBN 0-525-24201-5 - published in 1983.

W. Clay Allen CFA Centennial, Colorado

A special technical analysis review (01-20-2005) of the http://www.clayallen.com/index.htm (1 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

Homebuilders industry group can be viewed by clicking on the following link Homebuilders Industry Report by W. Clay Allen CFA

A new analysis of the performance of the buy list during 2005 has been posted on the Performance page

A special technical analysis report (12-28-2005) on the energy sector can be viewed by clicking on the following link Energy Report by W. Clay Allen CFA

Fundamental Investment Rating Changes Brokerage analysts change their ratings on the stocks they follow all the time. BUY? SELL? HOLD? OVERWEIGHT? OUTPERFORM? IN-LINE? _______________________________________________ How do you know whether you should follow their advice or not? What do the ratings really mean? http://www.clayallen.com/index.htm (2 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

Does the advice fit with the objectives of your portfolio? Does the rating change affect one of your favorite stocks? Does the analyst have a good track record? What do you do if several analysts have conflicting ratings on the same stock? How do you decide? Where can you get a second opinion? _______________________________________________ An Independent perspective on analyst's ratings The chart below is an actual example from a new report that provides a second opinion on changes in the investment ratings on stocks by brokerage analysts

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Market Dynamics - Relative Strength Point and Figure Charting

Technical Perspectives on Analyst's Rating Changes TPARC It is a daily report showing the long-term technical perspective on stocks with fundamental rating changes by brokerage analysts. A http://www.clayallen.com/index.htm (4 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

description of the report and a brief background on the analysis can be viewed by clicking on the TPARC button on the left.

This week's portfolio management letter - click on the following link.

Every Four Years - The Bear Comes Back To view additional portfolio management letters click on the Newsletters Button

Winning The Performance Game Lazy Stocks Don't tolerate lazy stocks in your portfolio Successful portfolio management is quite a bit more than just good stock picking. Stock selection is never one hundred percent accurate and problem stocks will invariably creep into the portfolio. It is best to think about the portfolio as a business and the investments in the portfolio are the workers in the business. As in all business endeavors, not all of the workers will perform as desired. Some will be lazy, others won't follow instructions, some just goof-off. There will always be some proportion of http://www.clayallen.com/index.htm (5 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

the workforce that drags down the performance of the business. The business manager, i. e. the portfolio manager, must deal with the lazy stocks. He must be able to measure the job performance of every worker in order to eliminate the workers that don't perform as desired - the lazy stocks. The first step is to measure the job performance of every worker This is best done using a technique called relative strength. This process measures the performance of every stock in the portfolio compared to a major market index - usually the S&P 500. The price of the stock is divided by the closing price of the S&P 500 on a daily basis and these ratios are then recorded. If the path of the ratios is up then the stock has good relative strength and it is outperforming the market. If the trend of these daily ratios is down, then the stock is performing worse than the market. A lazy stock has a trend of relative strength that is going down. The steeper the descent of the relative strength, the greater the negative drag on the performance of the portfolio. The relative strength is usually presented using a graph to show the progression of relative strength against time. In my experience it is far more productive to analyze the trend of relative strength as opposed to using a ranking of relative strength over some arbitrary period of time. The relative strength calculation has the benefit of removing the influence of the overall market from the price of the stock and letting the price performance that is specific to that stock show through on the graph The next step is to convert the relative strength into a graph that compresses time and eliminates the noise from the price data. The type of graph that compresses the time covered by the chart and also eliminates the random noise is called a three point, point and figure chart. It is one of the oldest forms of charting that has been used in the stock market. The three point method of construction does not record movement that does not accumulate to three points on the http://www.clayallen.com/index.htm (6 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

chart and that effectively eliminates the noise from the price data. The use of the three point filter changes the nature of the chart from being based on performance versus time to performance versus alternations of trend. It is only when the ratios accumulate to three points or more that the trend has changed and a new column is plotted on the chart. The X's record increases in the relative strength ratios and O's record declines in the ratios. By using the three point filter to remove the short-term variations in the data, it is not uncommon for a chart to cover four or more full years of history in a very small space on the chart. This filtering process introduces another very important change into the charting method. The X-axis on the chart marks off the alternations of trend as time passes. These alternations of trend are truly a function of the stock's volatility. A very volatile stock will show many alternations of trend while a less volatile stock will show far fewer alternations of trend. Volatility is considered a proxy for risk so these charts actually measure risk along the X-axis and relative performance along the Y-axis. This simple transformation of the price data allows the portfolio manager to record and measure the movements of excess return (alpha) versus volatility (risk). Sample chart

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Market Dynamics - Relative Strength Point and Figure Charting

The chart shown above is for BTU and it covers a full four years of history. The steep ascent of the relative strength ratios shows clearly on the chart in spite of the alternations of the up trends shown by X's and the downtrends shown by O's. This type of chart has the advantage of being crystal clear and very hard to misinterpret. My personal belief is that the chart should "shout its message" without much analysis and these charts "fit the bill". A chart of a lazy stock follows. http://www.clayallen.com/index.htm (8 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

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Market Dynamics - Relative Strength Point and Figure Charting

The steep and persistent decline of the relative strength ratios shows clearly that this is a lazy stock. A few lazy stocks in the portfolio can completely offset the performance of several strong performers. As a business manager you would not tolerate lazy workers working in your business and as a portfolio manager you should not tolerate lazy stocks.

The wrong way to manage a portfolio As Peter Lynch of Fidelity Magellan fame says of a gardener who "Pulls the flowers and waters the weeds."

A successful portfolio manager pulls the weeds and waters the flowers. This is the same as eliminating the lazy stocks from the portfolio while retaining the good workers. The objective is to eliminate the slackers, the goof-offs, the weeds and the lazy stocks and to retain the strong performers for as long as possible. This is how investment performance is improved.

The development of the Market Dynamics Charting software and service. I have been using long-term relative strength P&F charts for almost fifteen years. In late 1999 I developed the present software and system that is called market Dynamics. It was developed by a portfolio manager for use by portfolio managers. I send my http://www.clayallen.com/index.htm (10 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

subscribers a CD with the software that they install on their PC. The data for the system is updated on a daily basis by sending data files as attachments to an e-mail. The system is easily updated and very fast. I regularly review the entire composition of the entire S&P 500 in forty five minutes or less and as a result, I have a very good feel for the strong stocks and the lazy stocks in that index. A free trial subscription for three months is available to help portfolio managers learn the technique and get accustomed to its use. If you would like to subscribe to the free trial then scroll down to the free trial link further down this page.

I am currently in the process of a complete update of this web site so some of the pages may be out of date or under-construction. Use the links along the upper-left margin of this page to jump to the sub-pages that may interest you. Those with a serious interest in improving their performance will probably want to download the free tutorial. This charting technique is being used by some of the biggest mutual fund portfolio managers, investment advisors, stock brokers and serious individual investors both in the U.S. and abroad. I will be adding a sub-page soon that will cover what I call the "secret to better investment performance" so stay tuned. The cost of the service is $2000/year for institutional managers and $500/year for individual investors. Institutional investors can arrange for soft dollar payments for the subscription. Some institutional investors desire a more complete consulting package with more specialized coverage and this can be arranged as well.

Thanks for your interest

http://www.clayallen.com/index.htm (11 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting

Much more follows

The performance of the 12-31-2003 Market Dynamics buy list during calendar 2004 is now available. You can jump to the performance page by clicking on this link or by clicking on the Performance Studies link along the left border.

A free charting software package on CD and three months of data updates are available to interested long-term investors

click here> FREE TRIAL

A new special report on Exchange Traded Funds is available click on the following link Exchange Traded Funds

Stock Purchase Highlights Market Dynamics usually sends out two stock purchase highlights per week. These highlights cover stocks with especially attractive long-term point and figure chart patterns. The stocks that were covered by the highlights this week are XLTC and PONR. These are sent to users by e-mail and that e-mail can be viewed by clicking on the following link. Sign up for a free trial subscription to stock purchase highlights by sending an e-mail to [email protected] Stock Picks

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Market Dynamics - Relative Strength Point and Figure Charting

Market Dynamics A service for investment professionals and serious long-term individual investors. Weekly Portfolio Management Letter for 02-03-2006 click on the following link

Be Careful How You Use The Word Too A new letter about some aspect of portfolio management is posted every Friday. Be sure to review the new material on the CBOE VIX "Fear index" on the market trends page. Additional portfolio management letters can be viewed at the Newsletters page.

free trial subscription to Market Dynamics W. Clay Allen CFA

relative strength point & figure charting service

what you will receive. http://www.clayallen.com/index.htm (13 of 16)2/11/2006 4:21:39 PM

Market Dynamics - Relative Strength Point and Figure Charting ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ●

Daily updates on over 3800 stocks by e-mail for three months. Software that is fast and easy to use - a CD will be mailed to you P&F charts are long-term in perspective and the chart signals are clear. Regular daily stock screens to identify the big winners and big losers Special reports weekly on what stocks are showing attractive bases The automatic Performance Alarm tells you which stocks are performing poorly. You can draw support and resistance lines - a most important feature Save charts to the hard drive for pasting into reports and e-mail Review your complete portfolio list of stocks quickly and easily Free 300+ page tutorial on relative strength charting - free download here Free e-book of essays and newsletters on CD Attractive sectors and industry groups are easy to find Hold winners - "water the flowers" Sell losers - "pull the weeds" Relative strength screens - best and worst - everyday Used by major mutual funds, investment counselors and hedge funds Proven effective by a wide range of users One of the oldest and most effective charting methods Long-term RS P&F charts reveal the hidden order in stock prices Bigger profits and smaller losses - the picture tells you which way to go Free Trial Subscription for three months The system developer has over 35 years of experience in charting and investment management and has been a CFA since 1971.

For a free trial subscription - send your name and postal mailing address by email to [email protected]

A new analysis of the stock market and a market forecast is posted here every week - This report is sent to subscribers every Thursday to view this pdf report click on the following link (in red) Review of Market Breadth 02-09-2006 If you would like to receive a free e-mail copy of the Market Breadth report weekly - just send a request to clayallen@msn. com

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Market Dynamics - Relative Strength Point and Figure Charting

Its All About How To Improve Portfolio Performance Extensive educational material about P&F charting is available on this web site. - feel free to follow the links along the left margin or at the bottom of the page. This information has been prepared by an investment professional with over 35 years of experience in investment management. The Market Dynamics Tutorial is a free downloadable PDF document that is over 300 pages and is designed for professional long-term investors. I would be interested in any feedback you might be willing to offer. send comments to mailto:[email protected]

Philosophy of Portfolio Management Page - Manage the Portfolio Like A Business and weekly essays on portfolio management.

Please pass this web page link, www.clayallen.com, along to your friends and associates who may be interested in better portfolio management and more profitable investing. Market Dynamics Tutorial A free electronic book (300 + pages) that is available for viewing/download - click on the link above

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MARKET DYNAMICS PERFORMANCE MANAGEMENT SYSTEM Technical Perspectives on Analyst's Rating Changes The following comments are directed toward a few stocks that were either upgraded or downgraded today by Wall Street analysts. The change in rating is shown for each stock. These rating changes were downloaded from a well-known, public media web site on the Internet. This report has been prepared to offer a perspective on the long-term trends of relative strength for each stock. When I was an active portfolio manager, I was overloaded with analysts' buy recommendations and I used the charts to narrow the list down to stocks that were potentially attractive from a long-term technical perspective. This report should not be considered a criticism of any analysts' research or opinions - it is just an independent perspective. This report is for the exclusive use of subscribers to the Market Dynamics service. Not for distribution - all rights reserved. ©W. Clay Allen CFA This is not in any sense a solicitation or offer of the purchase or sale of securities. The factual statements herein have been taken from sources we believe to be reliable but such statements are made without any representation as to accuracy or otherwise. Opinions expressed are our own unless otherwise stated. From time to time we may buy and sell the securities referred to herein, and may have a long or short position therein. Prices shown are approximate.

2/1/2006

AMD - Rating change from "mkt. outperform" to "mkt. perform."

ADVS - Rating change from "mkt. perform" to "mkt. outperform." Breakout above a major consolidation Big correction. Remains above the 45-degree bullish support line. Pulling back toward support. Good support close by.

Strong up trending channel No signs of a top. Persistent long-term uptrend. Performing well.

BOL - Rating change from "neutral" to "under-perform." ASYT - Rating change from "hold" to "buy."

A major top has formed. Remains below the 45-degree bearish resistance line. Trending down. Performing poorly.

Low end of long-term trading range. Remains below the 45-degree bearish resistance line. Initial signs of a base are forming. Rally back up into resistance. Resistance will probably turn it back down.

W. Clay Allen CFA

Page 2

2/1/2006

CYMI - Rating change from "neutral" to "overweight." Successful test of support. Remains above the 45-degree bullish support line. Trending up. Performance improving.

CC - Rating change from "buy" to "neutral." Persistent long-term uptrend. Remains above the 45-degree bullish support line. No signs of a top. Performing well.

ETH - Rating change from "mkt. perform" to "under-perform." Rally back up into resistance. Remains below the 45-degree bearish resistance line. Massive overhead resistance. Resistance will probably turn it back down. FLEX - Rating change from "buy" to "hold." Long-term trading range but trending down. No signs of a base. Remains below the 45-degree bearish resistance line. Performing poorly.

W. Clay Allen CFA

Page 3

2/1/2006

FRED - Rating change from "buy" to "neutral." There were two downgrades on this stock today. Persistent long-term downtrend. Remains below the 45-degree bearish resistance line. Performing poorly.

GOOG - Rating change from "buy" to "neutral." Some loss of upside momentum. Backing away from resistance. Triple bottom sell signal. Extended to the upside. Watch for a broadening top.

IFIN - Rating change from "equal-weight" to "under-weight." Remains below the 45-degree bearish resistance line. Rally back up into resistance. Lots of overhead resistance. Resistance will probably turn it back down.

W. Clay Allen CFA

Page 4

ITW - Rating change from "buy" to "hold." Remains below the 45-degree bearish resistance line. Persistent long-term downtrend. Backing away from resistance. Everything depends on the support holding the stock up. Performing poorly.

2/1/2006

KRC - Rating change from "hold" to "buy." Strong up trend. Remains above the 45-degree bullish support line. No signs of a top. Extended to the upside.

MSTR - Rating change from "mkt. outperform" to "mkt. perform." Strong up trending channel Remains above the 45-degree bullish support line. Pulling back toward support. Good support close by.

NVDA - Rating change from "buy" to "neutral." Strong up trend. Close to resistance at the old highs No signs of a top. Close to a new recovery high. Performing well.

W. Clay Allen CFA

Page 5

NXY - Rating change from "sector perform" to "sector outperform." Persistent long-term uptrend. Breakout above the old highs. No signs of a top. Performing well.

2/1/2006

RAH - Rating change from "positive" to "neutral." Breaking down. Remains below the 45-degree bearish resistance line. Performance alarm turned on recently. Too much resistance. Trending down.

SEPR - Rating change from "sell" to "hold." A major top has formed. Rally back up into resistance. Lots of overhead resistance. The bullish support line has failed. Resistance will probably turn it back down.

SIGI - Rating change from "outperform" to "mkt. perform." Persistent long-term uptrend. Excellent long-term performance. No signs of a top. Strong up trending channel Close to a new recovery high. SU - Rating change from "outperform" to "sector perform." Persistent long-term uptrend. Remains above the 45-degree bullish support line. No signs of a top. Performing well.

W. Clay Allen CFA

Page 6

2/1/2006

SYMC - Rating change from "mkt. perform" to "accumulate."

THOR - Rating change from "buy" to "neutral." There were two upgrades on this stock today.

Persistent long-term downtrend. Remains below the 45-degree bearish resistance line. Rally back up into resistance. Resistance will probably turn it back down.

Breakout above the old highs. Strong up trend. No signs of a top. Performing well.

USPI - Rating change from "outperform" to "mkt. perform." TLM - Rating change from "sector outperform" to "sector perform." Excellent long-term performance. Persistent long-term uptrend. No signs of a top.

W. Clay Allen CFA

Page 7

Persistent long-term uptrend. Higher highs and higher lows. Remains above the 45-degree bullish support line. No signs of a top.

2/1/2006

WPS - Rating change from "outperform" to "neutral." Long-term trading range. Backing away from resistance. No clear trend. Testing support. Limited upside potential.

W. Clay Allen CFA

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2/1/2006

http://welling.weedenco.com VOLUME 6

listeningin

ISSUE 16 SEPTEMBER 10, 2004

INSIDE

Charting Performance Analyst Uses P&F Charts, Relative Strength To Improve Portfolios

Listening In W. Clay Allen, Veteran Analyst, Combines Old Charting Method, Relative Strength And Software Muscle To Sort Through Market’s Juiciest Opportunities— And Avoid Worst Pitfalls PA G E 1

Guest Perspective Andrew Smithers: Crude Reality Oil Price Rise Blackens Outlook For '05 Profits, Cashflow & Stocks ON WEBSITE

Trading Ideas Ideas MIA As Campaign Silly Season Heats Up

W. Clay Allen’s father was a rancher. So it was only natural Clay grew up thinking stock was something with a tail and horns. But fate took him to Denver in the mid-’Sixties, where he became totally besotted with an investment business in the thrall of the “Go-Go Years.” That bull market went, went. But Clay’s fascination with stocks and portfolio management has never ebbed, through stints serving mostly institutional clients in bank trust departments, investment firms and regional brokerage houses. Early on, Clay caught the charting bug—and the result, some 40 years on, is a new E-book, called the “Hidden Order Within Stock Prices,” a package of Market Dynamic$ software, and a web site, www.clayallen.com, all demonstrating the virtues of the point-and-figure relative strength system of stock analysis that Clay has spent a lifetime developing—not to use exclusively, but in conjunction with fundamental research. Clay, who years ago penned a freelance piece for me at Barron’s, sent a copy of his software to my office early this summer, and I’m hooked on his impressionistic, multidisciplinary approach to stock watching. So giving a him a ring last week seemed only right. KMW

ON WEBSITE

Acute Observations ON WEBSITE

Talk Back ON WEBSITE

RESEARCH DISCLOSURES

How did a mild-mannered bank trust department-type ever get mixed up with point and figure charting? Soon after I got started in the business in the mid’60s, I got bagged in a highly popular, high P/E growth stock that just collapsed. I had checked with welling@weeden

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five Wall Street analysts about that position. Only one was bearish, the rest were bullish, and they all said the same things. I was a youngster, so I went with the majority. But the bear was right. I was very wrong. That’s when I decided I had to have some way to protect myself from faulty research. Then, while I was casting around for solutions, I attended a presentation by Alan Shaw, who was with Harris Upham at the time, and got inspired. The point and figure charting technique’s primary attraction back then was primarily its long-term orientation, but it also offered a practical advantage: I could use it to cover lots of stocks. I didn’t have to wait for charts from a service that would be out-of-date when the mailman delivered them. I could very quickly post them myself on a daily basis. Pretty soon I was updating hundreds of charts every day, which would have been impossible, using line charts. So you started ignoring all the stories analysts spun and just watched your charts? No. I am not one of these guys who thinks technical analysis is inherently superior. You need to use both. But the wonderful thing about posting the P&F charts by hand was that it forced you to look at the stocks every single day. After following that discipline for a while, intuitive judgments would just jump off the page at you. “This stock is just not acting right. What’s wrong?” If I couldn’t find the answer, I’d sell. But that was a long time ago. Gosh, I can remember when everybody got excited by the Dow going through 800 for the first time.

SEPTEMBER 10, 2004 PAGE 1

Published exclusively for clients of Weeden & Co. LP

Kathryn M. Welling Founder Editor and Publisher

Jean M. Galvin Business Manager and Webmaster Karin-Marie Fitzpatrick Editorial Assistant Alexander Isley Inc. Graphic Design Weeden Securities Corp. Board of Directors Donald E. Weeden Barry J. Small Robert A. Cervoni Timothy McDonald Robert DeMichele Daniel V. Panker Richard Sharp welling@weeden, an exclusive service for clients and prospective clients of Weeden & Co. LP, is published biweekly on Friday mornings, by welling@weeden, a research division of Weeden & Co. LP. Editorial and partnership offices are located at 145 Mason Street Greenwich, CT 06830. Telephone: (203 ) 861-9814 Fax: (203) 618-1752 Email: [email protected] [email protected]. First-class postage is paid at Stamford, CT Copyright warning and notice: It is a violation of federal copyright law to reproduce all or part of this publication or its contents by any means. The Copyright Act imposes liability of up to $100,000 per issue for such infringement. welling@weeden does not license or authorize reproduction by clients or anyone else. However, multiple copies are available to clients upon request and limited reprint arrangements are available. Copyright 2004, K.M. Welling and Weeden & Co. LP. All rights reserved.

Charles Powell Page 1 Illustration

That certainly dates you. Nine months later we hit 1000. Then we didn’t surpass 1000 for 16 years. We were moving into a trading range, but nobody knew it at the time. In many ways, that environment was very similar to what is going on today. We had a war that nobody really understood the significance of back then, too. We had stagflation, stop-and-go monetary policy... But what convinced you that your P&F charts gave better signals than the analysts? Experience, basically. But one event really crystallized their value for me. I was still a young analyst in Denver, probably around 1972, when my boss got me invited to a lunch with “Scarsdale Fats,” the money manager whose idea-swapping meals had been made legendary in “Adam Smith’s” The Money Game. I knew I’d have to talk about a stock, that was the price of attendance—and that I’d be by far the junior guy in the room. I looked at my charts and picked a little steel company, Carpenter Technology. It had a beautiful chart and wonderful fundamentals, but I still spent most of the long lunch hoping they’d never get to me. No luck. When they finally got around the table and I announced my pick, everybody laughed. I was mortified. But of course a specialty steel maker just didn’t have the sizzle of Xerox or IBM. That must have been near the top of the Nifty-Fifty craze. You bet. Almost all of the conversation at that lunch was about which of the Nifty-Fifty was best. But that was right at the peak and soon those stocks were just absolutely destroyed. Many of them fell 70%-80%. My steel stock actually did pretty well—went up during the bear market. That was a real object lesson for me in contrary opinion. You’d better do your own homework and make your own decisions and not rely on doing what everybody else is doing. I watched as some of the guys at that lunch, some of the biggest guns in Denver’s investment community, lost their jobs as a result of the ’73-’74 bear market. Don’t get me wrong. I had been looking at the monstrous tops in the charts of the Nifty-Fifty and had been bearish on them, but I had no idea they were going to go down like that. I had never seen anything like it. These were the highly popular stocks that were owned by the best and

welling@weeden

brightest and they just fell apart. Losses were horrible, terrible, in that bear market. It was a grinder, just relentless. Yet you survived as an institutional portfolio manager? I learned some very tough lessons. I also went out after a few years and did a gig at the bank as a longrange corporate planner, which really gave me some insights into management and how an organization works. Then in 1980, I joined a regional broker to handle both institutional and individual accounts, so I have worked with a mix of basically carriage-trade individuals and institutions ever since. And I have developed a definite perspective on institutional equity management, having observed that PMs are almost invariably fully invested and long-only. I have had a great vantage point for watching money managers work and seeing their common mistakes. And I have continued, all through my career, to use point and figure charts, primarily to advise my customers on which stocks in their portfolio needed to be weeded out. Over time, I came to the conclusion that most money managers are far too complacent about stocks that don’t perform. Sometimes, I think, they are plain stubborn. Sometimes they get so committed to the idea that a stock is going to be a good investment that they let them go down far too much. Gee, they don’t like to hear that they should sell one of their darlings? Exactly. Peter Lynch was absolutely right when he said something like, “You have to pull the weeds and water the flowers, but most people do it the other way around.” They pull the flowers too quickly and let the weeds grow—producing poor performance. Is that why you chart relative performance, instead of just prices? Actually, I do both, although in my estimation the point and figure trend-following methodology of charting relative strength is far superior. My basic notion is that there are two sources of misleading information that investors have to contend with. One is the noise in the market, the random shortterm movements that are meaningless; do not really

SEPTEMBER 10, 2004 PAGE 2

influence the long-term trend. The other source of misinformation, if you will, is the movement of the market itself. What I try to do in Market Dynamic$ by using three-point P&F charts is damp out the noise, and by charting relative strength, I try to strip out the market’s impact. Your charts get rid of noise? Ignoring moves of less than three points acts like a filter on the data and damps out a lot of noise, which is very important, because you don’t want to make long-term portfolio decisions based on noise. As long as the trend proceeds in the same direction, you continue to make marks in that direction. X’s for going up and O’s for going down. What you are looking for is a reversal, which says you move over a column and start marking in the opposite direction. What difference does that make? I cannot say that the market is not random. It is random, certainly over the short term. I mean, portfolio management is not like physics. There are no equations. There are no laws. There are no functional relationships that apply at all times and the same way. Wait a minute. You just wrote a book called, “The Hidden Order Within Stock Prices.” [http://www.lulu.com/hidden-order] I called the book “The Hidden Order” because that is what those reversals, or pivot points, really show. There is a hidden order in the behavior of stocks that

© Copyright 2004 Mike Keefe. All rights reserved. Cagle Cartoons.

is not visible in all stocks and at all times. But boy, when you get out into the righthand tail and the pivot points line up, you really get useful information. What are you saying? It all has to do with the distribution of returns from common stocks. I did a study earlier this summer and found that, just as the academics claim, it is a bell-shaped curve. But it departs from the standard distribution because it has extremely fattails, and this skewing can be measured. What I found was that from June ’03 to June ’04, the distribution of returns was roughly 11 times what you would expect from a standard bell curve. And the behavior of stocks in the tails (roughly 15% of the total in each tail) is very different than the behavior of the stocks in the middle of the distribution. The 70% of the stocks in the middle tend to be trading-range stocks. The stocks in the right-hand tail tend be in strong uptrends. The stocks in the left-hand tail tend to be in severe downtrends. Now, the technical trend following methodologies that I have been talking about work best with the stocks in the tails, where the pivot points line up pointing to long-term trends. And give fits to the guys who claim that the market is totally random all the time— It certainly seems to me that there is a process at work, I did a study on Best Buy (BB) last December. The interesting thing was that Best Buy stock was up on a daily basis about 55% of the time over the year I studied, and it was down about 45% of the

welling@weeden

SEPTEMBER 10, 2004 PAGE 3

time, so the distribution of up and down days was very close to flipping a coin. Yet the average daily price change for the full year was 0.4%. So if you did the math, over the 250 trading days of the year, Best Buy’s shares climbed over 100%. Even though, on any given day, you were almost as likely to lose money as to make it. That’s the kind of hidden order I use my charts to find. So what, more specifically, do these pivot points show? Higher highs and higher lows? That’s right. Looking for the pivot points is just a way of saying this is an important reversal point on the stock. When you employ the point and figure methodology, certainly when you are in the right-hand tail, the pivot points line up in a very, very consistent way. Conversely, in the left-hand tail of the distribution, the pivot points line up in a pattern of lower lows and lower highs. It is really the alignment that tells you what the primary trend is. And as I say, it works best in the tails. So there really is order beneath the surface in the stock market but it is certainly more orderly in the tails, in both directions, up and down. That is where you really get the consistent order and the alignment of the pivot points. A money manager who recognizes this can readily identify a stock as being in the right-hand tail or the left-hand tail or being in the middle trading range. I don’t want to go to war with academia over this. I can’t argue with these PhDs with all their math, but from a common sense point of view, we are looking at daily outcomes that are pretty close to flipping a coin and yet there is a longer-term order to it. That, to me, is intriguing. What about all the stocks in middle of the distribution? You have to apply Market Dynamic$ differently when you are dealing with the trading-range stocks in the middle of the distribution. They don’t trend for very long—meaning that they may move from the top to the bottom of their trading ranges within a year. So it is more a matter of looking at historic support and resistance levels on those charts—and point and figure charts are absolutely unsurpassed, I think, for measuring that. Relative strength support and resistance levels are more informative than ones based on price. In simple terms, when you approach the high end of the trading range, you should be a seller. When you approach the low end, you can be a buyer with the idea that if the stock breaks out on the downside instead of reversing, you’ll cut your losses. But the time perspective is important. To me, a complete market cycle takes about four years—you can easily see a pattern of roughly four-year cycles on market charts going back to the ’20s. So you need to look at at least four years of data in a P&F chart to capture the highs and lows of the market cycle that determine the trading range. That gives you a much better handle, particularly on the mature stocks that are dominant in the S&P 500 or the DJIA, which very seldom move in great prolonged trends. They tend to trade within ranges—ones that investors can take advantage of. Boeing, for instance, oscillates forth in a well-defined trading range. But if the major averages have entered a long-term trading range, even at the end of 10 years there might not be any net progress, despite lots of ups and downs. So if your job is to generate alpha, you had better become adept at selling them at the top of the trading range and buying them at the bottom. And talk of a trading range market doesn’t put you in a funk? No. First, there are always stocks in the fat tails. But besides that, I am a product of my experience. For the first 16 years I was in the business, we had a trading range market. So my perspective evolved around a trading range mentality. Still, it is the fat tails that offer the great risks and great rewards. The fat tail on the left side of the distribution is where you get killed, and the work that I have done indicates that the downside is two or three times more violent than the upside. All stocks don’t trade the same? Stocks going down don’t trade the same way as stocks going up. They are quite a bit more volatile. So if you allow part of your portfolio to move into the left-hand tail and particularly if you are adding to those positions by dollar averaging down into stocks that are in the left-hand tail, you are making a double-barreled mistake. The statistics bear that out. So it is a matter of making the statistical evidence work for you. That is where the academics in finance have gone wrong. They say, “Oh, stock movements welling@weeden

SEPTEMBER 10, 2004 PAGE 4

are random, so that is it, forget it. Throw up your hands and don’t do anything.” But my contention is, sure, the data is messy—but deal with it. You have got to deal with it if you are an active portfolio manager. Otherwise, go buy the Vanguard index fund and forget about it. But I don’t deal with many managers who would be happy doing that. Unless they could figure out a way to still charge fat fees! True. But what I am getting at is that an investment portfolio has to be managed as a business. When you put it in those terms, the job becomes very clear. Peter Drucker is absolutely right: You cannot manage what you do not measure. So if you are trying to manage performance, you had better measure it. It just seems axiomatic to me, fundamentally simple. And you measure the messy data by— The way I do it is remove the noise. Remove as much of the randomness as I can. Remove the influence of the market by using relative strength. So what you are left with is the price movement that is specific to that stock, which I would say is more truly reflective of the fundamental development of that business. Is Market Dynamic$ perfect? No. There isn’t any E=MC2 in the investment world. But so what? Even academics deal with messy data all the time. Think of the soft sciences, sociology, psychology. That is what we have to do in the market. Funny, the more human the system, the messier the data— You bet. Exactly. It is a behavioral thing. Actually, the market has been characterized by the scientists at the Santa Fe Institute as a “complex adaptive system,” much like nature or, better yet, like evolution. You can describe it and you can explain it, but you can’t necessarily predict it. Wait. Then, again, why bother fussing with your charts? The job is not to predict. People get hung up on this idea of prediction, but making predictions isn’t what portfolio management is all about. My job is to manage the performance of an investment and to adapt. I use the point and figure charts to measure the performance of the investments in a portfolio. As long as that performance is acceptable, I am willing to hold them. I take the point of view that, as a portfolio manager, I am taking a risk in owning a stock and I demand to be compensated for that. If I am not, or if I am not adequately compensated for taking that risk, I have to go find another investment that will do so. I might not be able to predict that performance, but I can deal with it. That is where I am coming from. Your charts don’t make any predictions? Okay, they have some inherent predictive capacity, in that I believe whatever is happening in a chart is happening for a good reason; that a trend in motion is going to tend to stay in motion. So if I identify a stock that is acting poorly, I think it is a far better bet that it will probably continue to act poorly than to bet it will suddenly turn around and perform well. Still, predictions often lead to disastrous decisions. To me, it far better to be adaptive. But because the market is a complex adaptive system, you often have to adapt to things that perhaps you don’t fully understand. The wonderful thing for me and my customers is that the market provides tremendous feedback information to help us make these adaptive decisions. This goes back to managing a portfolio like a business. You do it by collecting feedback on the performance of your workers and firing them if it is not up-tospeed. Well, firing a stock is a hell of a lot easier than firing a person. That is never pleasant, yet sometimes it is necessary. Things are always going to change. I mean, change is the only constant and we have to deal with it. And the market has an uncanny way of adapting to things way ahead of time. There is no doubt that people believe that fundamental developments in a business influence the price of a stock. I am just turning that around and saying that the behavior of the price of the stock also tells me something about the fundamentals of the business. The feedback loop needs to be closed. We need to see both sides. And you use fundamental as well as technical analysis, do you not? You caught my eye a few months back by sending me a certain Barron’s

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piece, from back in the early ’80s, about combining both disciplines to improve stock-picking performance. You were listed among its committee of authors. [See website.] Guilty! That committee included my then-partner, a couple of academics from the University of Denver and me. We had an idea about combining technical and fundamental analysis and the people at DU had the resources to do the statistical work. We basically screened stocks by P/E and also based on six-month relative strength data, looking for stocks with the best relative strength in the lowest P/E quartile. The study covered 12 years and we found a very strong, persistent and statistically significant advantage in buying those stocks. It was basically an attempt to enhance contrary opinion with trend following. To avoid getting stuck with “values” that just kept getting cheaper? That is exactly right. It’s a way of asking a very important question: If these stocks have low P/Es because they’re held in low esteem by investors, or because no one cares about them, then why are they starting to outperform the market? Chances are, the fundamentals are improving and the stock is rising ahead of broad recognition of that trend. A good friend who is a research director at a regional brokerage firm calls that screen, “The cream of the crap.” I should have used that in the headline! I published those screens for quite a few years and they’re still effective. It just seems to be part and parcel of how the market works. People become very complacent. “This stock is a dog and it will always be a dog.” Then for some mysterious reason its market performance starts to improve. Well, that just doesn’t happen by accident, so it is a very effective screen. The same concept also works at the other end of the valuation spectrum. That is, the stocks that are highly popular and sport the highest P/E ratios are very dangerous when they start to underperform. There is always a reason. So a mirror-image screen quickly identifies stocks that are vulnerable to major declines. It just seems that with these kinds of fad stocks, people just don’t pay attention. They are not sensitive to what it means when the relative strength falls off. And I am not talking short-term. I am talking about relative strength over six months. If you have six months of persistent underperformance, you have a problem. For instance? One such institutional favorite that comes to mind today is Ebay (EBAY) Highly popular, high P/E and starting to underperform. This may be a tip-off that something is starting to change. Or at least that investor perceptions are starting to change. It doesn’t work all the time, nothing does. I regularly download a screen of lowest P/E stocks and review their relative strength with Market Dynamic$ to find buy candidates for my institutional customers. But I actually get even more of my buy ideas lately from another category: ones that have given a triple-top buy signal and then had a retracement. In other words, they have broken out and then pulled back a bit. The trouble is, there are a lot of them currently over 350. Isn’t that where the fundamentals come in? Sure. Then again, there are well over 600 stocks in the opposite category, meaning they have given a triple-bottom sell signal and then rallied. It’s one reason this market looks extremely ragged to me. Before we go there, tell me more specifically why Ebay alarms you— Historically. it has traded at 100 times earnings or so, it’s gone up and up and up, but now it’s making a double top, losing relative strength, meaning that support and sponsorship are starting to move away from it. How many examples do we have to see? Fads don’t usually end slowly. Look at Krispy Kreme (KKD). It was wonderful, nothing could go wrong—until something did. Then boom, it drops from 40 to 12 and people are left holding a great big empty bag. I put Ebay in the fad stock category, subject to sudden reversals. For heavens sakes, it’s an internet flea market. What are the barriers to entry? That’s a little of my contrary side showing. But fad stocks get grossly overdone, then the loss of relative strength points to the beginning of the end. Suddenly, it’s vulnerable. It is nothing new. welling@weeden

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Look up ancient history on Levitz Furniture or Brunswick. If you really want to bowl me over, how about sending me your screen of high P/E issues that are losing relative strength— Can do. I just did a special project, found about 100, for short-selling clients. [On w@w website.] Yet that particular screen isn’t part of your Market Dynamic$ software package or mentioned in your book? No, they’re really aimed at institutional investors, and sophisticated individuals, while the screen you’re talking about is something that hedge funds are more likely to find interesting. And they are the new kids, at least in terms of my customer base. Basically, I started writing the computer programs and supplying the software to my customers in the mid-’90s, when the data feeds that permit me to create my point and figure charts became available at a reasonable cost. Because I developed the software for my own use, it is exceedingly fast. It will put a chart on the screen as fast as you can enter the ticker, which really helps when I review large portfolios, as I do regularly, to advise PMs on what should be weeded out. I also wrote the program so that when the performance of a stock becomes unacceptable to me, the chart turns red [or gray, in the print version of W@W]. I want a PM looking at my charts to be reminded, day after day, if a stock is not performing up to par. You’re a nag? It does irritate some people, so you can turn off that feature. But my point is that persistent poor performance is a very good reason to sell a stock. I want to point my clients in the right direction. I don’t want them to sell winners until they become so outrageously overpriced that they have no choice. I want them to focus instead on upgrading the performance potential of the portfolio, by selling their losers. But there is a lot of evidence in the field of behavioral finance that suggests many portfolio managers instead do exactly what Peter Lynch warned about: pull the flowers and water the weeds. My performance alarm is simply designed to remind clients to cut their losses. You’re scarcely the first to offer that advice. As I’m fully aware. The stock market is very rich in history and it’s plain silly for investors not to study it and learn from it. But very many, quite evidently, don’t. I happen to be a great fan of Jesse Livermore. I reread his book, Reminiscences of a Stock Operative, every six months or so. At least the chapters on manipulation, which are the most instructive, Chapters 20 and 21. They are fabulous. What is more, I think it is going on today. I can’t prove it, but I think it is. What? Bull pools and bear pools? In a sense. One natural by-product of a large number of people adopting aggressive short-term trading strategies is that it puts the market maker in the driver’s seat. He can simulate their activity, just as Livermore did when he was manipulating stocks. In fact, Livermore said that he depended on short-term boardroom traders to make his manipulations successful. Well, market makers can play the same game today. They can stimulate a stock, make it active, and the people who are looking at very short-term charts jump on it—and away it goes. Maybe it lasts a while, maybe it doesn’t. But my point is that speculators employing aggressive short-term technical trading strategies are vulnerable to manipulation—and we certainly have more people employing them than ever before. When they should, instead, be doing what? I am trying to steer people into situations where a stock has gone sideways for an extended period, after underperforming, but is now turning up. Stocks breaking out of bases to the upside are what I have concentrated on for years. I never buy at the bottom, I want a stock to have proven that it has stopped going down before I buy. That is one of my biggest problems with institutional clients. They all want to buy bargains. They want to buy stocks that are down—but that just leads them like a moth to the flame into stocks with deteriorating fundamentals. A lot of the welling@weeden

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long-only fully invested guys are eager to buy a stock that has dropped to 25 from 100, because it “has” to be a good buy. But maybe not. Look at what just happened to Interstate Bakeries, even though it had been going down for a year and a half. When I was in the brokerage business, I often heard the young guys saying this or that was “too” cheap. It had dropped “too” much. I learned to say, “You had better be careful with the use of the word ‘too.’ How do you know it is too low or too cheap? You don’t, until it stops going down.” Still, who can resist a bargain? Bargain-hunting is a very human tendency. A set of tires you can buy for $50 less than last week is a bargain, if you can use them on your car. But the only thing you can do with a stock is sell it to someone else. You mentioned wanting at least four years of price history to track cyclical stocks, yet I notice that some of your charts don’t cover that much time—in fact, they seem to be all over the place. That is right. There is no timeline along the X-axis of a point and figure chart, and how much horizontal space they take up depends upon the volatility of the issue. Very volatile issues will march across the page in no time and even though my charts are based on four years of data, you may only be looking at a year, a year and a half. That is generally enough. But it is important to note that a P&F chart doesn’t measure time, it measures alternations of trend. Which is a function of volatility. So what you’re really measuring across the horizontal axis is volatility, which is usually thought of as a proxy for risk. Or opportunity— Okay, for uncertainty. My point is that the x-axis is scaled in units of risk and what the y-axis of a P&F relative strength chart measures alpha, or excess return. So the standard of performance I demand is to get one unit of return for every unit of risk. In other words, I need a box on the point and figure chart in the y direction for every box in the X direction, which can be defined by a 45-degree line. So if my stock cannot achieve a point and figure trajectory that is greater than 45 degrees, I say it is unacceptable. What I am really doing is managing risk and return on the same chart. And someone with a different risk tolerance would just use a a different angle to measure the stock’s performance. Let me ask this. Did your charts warn you that something was rotten at the likes of Enron or WorldCom, before they collapsed? I had a couple of customers who owned Enron, and I had classified it as a “source of funds,” well before the stock cracked. Issued a sell recommendation, in other words. Literally, “in other words.” You share Wall Street’s love of euphemisms? I learned a long time ago that if I go into a portfolio manager’s office and I say, “I really believe you ought to sell this

stock,” I’m endangering at least our relationship. I have had guys argue with me for hours. Then, when I turn out to be right and the guy loses money in the stock, he’s even angrier with me, decides I have slighted his stockpicking prowess. Provoking PMs serves no purpose. I want to give the guys information that says it is a source of funds. That call on Enron came when it was at about 60 bucks. I was as surprised as anyone when the stock collapsed. I had no idea it was going into Chapter 11. But I did know that the path of least resistance for the stock was down. So I didn’t have to predict, just recognize the trend. WorldCom, by contrast, was an outright sell recommendation. I didn’t mince words on that one. The trend was just so clear. Did I see that you also do relative strength charts of industry groups and sectors? Yes. In my book I quote Bob Farrell, one of the true gurus of technical analysis, who gave a speech in the early 1990s saying that he felt identifying the right sectors was more important than forecasting the market. I think that is absolutely true. There have been a number of studies showing that being in the best five market sectors is far better than perfect market timing. And you and I both know that perfect market timing is an impossible dream. But you can identify the right sectors—and the best way to do it is with relative strength. So I spend a lot of time on sector work. They are not as volatile as individual stocks so you have to make some adjustments, but the best sectors show the alignment of pivot points the same way an individual stock will. I chart the 20 best and 20 worst every week in Market Dynamic$. You indicated earlier that you’re not terribly enamored of the way the market has been acting. I think it’s vulnerable for a correction into October. I mean our last meaningful oversold condition was on Aug. 6. Prior to that, we had an oversold in the middle of May. And prior to that, we had an oversold in the middle of March. Now if you go back and look at the late ’90s and the early part of 2000, we only had one or two a year. In 1996, I think it was, we didn’t have a single oversold for the full year. In ’97, we had one. In ’98, we had two; ’99 we had one. In 2000, we had two. Part and parcel of a trending market is you only have one or two oversolds a year. Part and parcel of a trading range market is you will have three or four oversolds a year. We have already had three so far this year. I expect another in October. On what basis? Partly on the basis of cycles, but the charts look to me like we are now locked into a trading range bounded somewhere around 1150 on the high side, maybe even as high as 1200 on the S&P 500, and around 800 on the low. But if the trading range opens up, it will probably do so to the downside, not to the upside. That’s a happy parting thought. Thanks, Clay.

W@W interviewee Research Disclosure: This interview, the Market Dynamic$ web site and the Market Dynamic$ software are not in any sense a solicitation or offer of the purchase or sale of securities. The factual statements herein have been taken from sources we believe to be reliable but such statements are made without any representation as to accuracy or otherwise. Opinions expressed are our own unless otherwise stated. From time to time we may buy and sell the securities referred to herein, and may have a long or short position therein. Prices shown are approximate. Neither the contents of this interview or use of Market Dynamics software is not intended to be considered investment advice in any way. For further information, contact W. Clay Allen, CFA, 7325 S. Jackson St., Littleton, CO 80122, 303 804 0507, www.clayallen.com or [email protected].

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Welling@Weeden Staff Conflicts Avoidance Policy Disclosures In keeping with Weeden & Co. LP’s reputation for absolute integrity in its dealings with its institutional clients, welling@weeden believes that its own reputation for independence and integrity are essential to its mission. Our readers must be able to assume that we have no hidden agendas; that our facts are thoroughly researched and fairly presented and that when published our analyses reflect our best judgments, not vested pocketbook interests of our sources, colleagues or ourselves. Neither Weeden & Co. LP nor w@w engage in investment banking; w@w’s mission is strictly research. All information gathered by welling@weeden editorial staff in connection with her/his job is strictly the property of welling@weeden. It is never to be disclosed prior to publication to anyone outside of welling@weeden. Editorial staff (a group broadly defined to include Kate Welling’s immediate family) will not buy or sell any security mentioned in the journal for at least one week after publication. Staff will avoid not only speculation but the appearance of speculation and may not engage in short-term trading, the short selling of securities, or the purchase or sale of options or futures. Staff may not be otherwise compensated for securities recommendations in these pages. No w@w staff will serve as an officer or director of any publicly traded company. All securities positions entered into by w@w editorial staff will be held for at least six months unless dispensation is received, in extraordinary situations, from Weeden & Co. LP’s compliance officer. Any securities position in any company, mutual fund or partnership portfolio featured in welling@weeden that was acquired by staff in advance of the publication decision will be specifically disclosed at first mention. [No such reportable positions exist.] And that position will be frozen for six months from date of publication, again, absent extraordinary dispensation from compliance.

Weeden & Co. LP’s Research Disclosures This material is based on data from sources we consider to be accurate and reliable, but it is not guaranteed as to accuracy and does not purport to be complete. Opinions and projections found in this report reflect either our opinion (or that of the named analyst interviewed) as of the report date and are subject to change without notice. When an unaffiliated interviewee’s opinions and projections are reported, Weeden & Co. is relying on the accuracy and completeness of that individual/firm’s own research disclosures and assumes no liability for same, beyond reprinting them in an adjacent box. This report is neither intended nor should it be construed as an offer to sell or solicitation or basis for any contract, for the purchase of any security or financial product. Nor has any determination been made that any particular security is suitable for any client. Nothing contained herein is intended to be, nor should it be considered, investment advice. This report does not provide sufficient information upon which to base an investment decision. You are advised to consult with your broker or other financial advisors or professionals as appropriate to verify pricing and other information. Weeden & Co. LP , its affiliates, directors, officers and associates do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. Past performance of securities or any financial instruments is not indicative of future performance. From time to time, this firm, its affiliates, and/or its individual officers and/or members of their families may have a position in the subject securities which may be consistent with or contrary to the recommendations contained herein; and may make purchases and/or sales of those securities in the open market or otherwise. Weeden & Co. LP makes/does not make a market in XYZ. (the featured securities.) Weeden & Co. LP is a member of NASD and SIPC.

MARKET DYNAMICS PERFORMANCE MANAGEMENT SYSTEM Special Report For

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Technical Analysis for Long-term Investors Long-term investors often shun technical analysis because it is thought to be a tool used solely for short-term speculation. In fact, a large part of the literature of technical analysis is devoted to short-term timing, which confirms this belief. Many individual investors have experimented with various charting techniques and have dropped the technical approach after a few “bad” experiences. Professional long-term investors are often completely indoctrinated in the belief that the market is “efficient” and that technical analysis is of no practical value since the day-to-day fluctuations of stock prices are random. There can be little argument that the day-to-day movements of stock prices are random. And yet, the movements of individual stocks and the broad market demonstrate an uncanny ability to anticipate future fundamental developments and other factors that influence stock prices. Short-term randomness of stock prices does not seem to diminish the ability of the market to more-or-less consistently act as a long-term discounting mechanism. The random nature of stock price movements has led to the development of a primarily academic theory called the Efficient Market Hypothesis. The EMH is highly critical of professional investment management and is often used to justify a passive indexed approach to portfolio management. Most of the assumptions that make up the foundations of the efficient market hypothesis seem unrealistic to me – especially the ideas that new information is disseminated throughout the market instantly and that all investors interpret new information accurately and that stocks are always priced correctly. I have observed instances that are almost exactly opposite to this proposition so frequently as to represent a common occurrence. And still, the conclusions of the efficient market hypothesis seem to be borne out by the almost universal inability of the majority of institutional investors to “beat” the market as measured by a popular market average such as the S&P 500. The academic community smugly points to the lack of performance as an almost direct proof of the efficient market hypothesis. That “proof” is almost totally damaging to the practice of technical analysis by long-term fundamental investors. The inability

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of institutional investors to achieve performance goals is used to justify avoiding a most important performance-enhancing tool. Basically the efficient market hypothesis says that you cannot predict the future of a stock price or the stock market by using technical analysis. The “strong” form says that you can’t predict stock prices with technical analysis, fundamental analysis or anything else – period! The implied assumption in this argument is that investment success must be the result of superior predictive capability. It appears that investment success may in fact be the result of activities other than attempting to make more accurate predictions of the future and better market forecasts.

Adaptation vs Prediction While the day-to-day movements of stocks prices are random, it can be shown conclusively that most stock prices, in essence, meander randomly around a dominant long-term trend. These long-term movements primarily reflect the financial performance of the companies they represent. These trends are also effected by many other factors including investor psychology, interest rates, consumer tastes, changing technology and competitive conditions, as well as government regulations and other circumstances such as market fads and bubbles that influence the supply-demand relationship for stocks. It appears to be nearly impossible to weigh these variables sufficiently correctly to reach a reliable prediction of future prices. It should be noted that the stock market exists because of change. The prices of shares are constantly being re-evaluated by investors to account for the perceived changes in the variables that most effect stock prices. The stock markets and the economy represent a highly complex system, which can be explained and understood but not necessarily predicted – it is similar to evolution in nature. Investors must constantly adapt to changes that they can’t fully understand and whose consequences may stretch out over months or years - just as species in nature must adapt to changes in their environments - or perish.

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Also it must be realized that all of these influences are constantly being evaluated by investors in the market as a part of the price discovery process. The constantly changing relative importance of these inputs can only be guessed at - but the result, price, is constantly there for all to see. The successful solution to the problem of investment performance seems to be less a matter of prediction and more a function of an ability to measure and adapt to these trends in light of the objectives of the portfolio and the direction and durability of these movements. As the efficient market suggests, these stock price trends will be shaped by new information entering the marketplace but probably will not be felt instantaneously and maybe not even accurately. Trends will move strongly in one direction or another for an indeterminate period of time that probably can’t be predicted but can be tracked and evaluated by an analysis of the price movement. At other times, prices will meander in a meaningless back and forth oscillation, which can by its pattern indicate that the supply/demand relationship is in balance and little opportunity for investment success is present in those shares.

Long-term Technical Analysis The most important application of technical analysis is not to attempt to predict future prices but to evaluate the strength of ongoing trends and more particularly to help portfolio managers adapt to trends that are changing direction. In essence, we will use price movement to verify our fundamental predictions and validate our expectations regarding the future performance of the shares under study. Should the trend change direction we will need to critically reconsider our predictions and expectations regarding the future of the stock. In other words, “if this stock is so great, why is it performing so badly ”? It is well known that most predictions go awry not because of an incorrect analysis of the primary factors evaluated in the development of the forecast. The predictions fail, more often than not, because of variables that we didn’t consider. We didn’t take these items into account ether because we thought they didn’t matter or they occurred in a completely unpredictable manner. We also suffer from an inability to anticipate changes in the relationships that tie the independent variables together. One way or another our prediction may turn out to be wrong. The best evidence we

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can get that alerts us to a deteriorating fundamental prediction is price action counter to our expectations. Our egos usually become involved in our predictions and forecasts and we are often unable to reverse our commitments by admitting that we are wrong. This seems to be especially true for highly intelligent, hard working, well-educated individuals that seem to occupy most investment portfolio management positions. The ongoing under-performance by most institutional portfolio managers may be more of a testimony to our inability to “fess up” when we are wrong than it is evidence of market efficiency!

80/20 rules The most important use for technical trend analysis is to verify our expectations about stocks we already own. This indicates that technical analysis is critical to our thinking when considering a sell decision in the portfolio. It is not surprising, therefore, that most fundamentally oriented portfolio managers confess difficulty with the sell decision. In my opinion, they have needlessly cut themselves off from a source of extremely valuable information though neglect of technical analysis. I believe portfolio managers should weight the buy decision about 80% fundamental and only about 20% technical. But the sell decision should reverse the weights of the two inputs, 80% technical and only 20% fundamental. The proven ability of stocks to discount changing fundamentals suggests that stocks will experience a downturn in price before the bad news “comes out”. Very small negative divergences from consensus expectations can often have a devastating effect of the stock price. Therefore is seems appropriate to implement price analysis to anticipate bad news and therefore I suggest a heavy weighting of technical analysis when considering the sell decision in active portfolio management. Its not what you don’t own that hurts your performance – performance suffers because of the stocks that you hold because of a mistaken prediction - usually in

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the face of directly contrary price action. The avoidance of just a few disasters can have a very big payoff in terms of improved portfolio performance.

Some Thoughts about the “Loser’s Game” I have included one of the concluding paragraphs from the now famous article by Charles D. Ellis that originally appeared in the Financial Analysts Journal in 1975.

The Loser's Game

177

... concentrate on your defenses. Almost all of the information in the investment management business is oriented toward purchase decisions. The competition in making purchase decisions is too good. It's too hard to outperform the other fellow in buying. Concentrate on selling instead. In a Winner's Game, 90 percent of all research effort should be spent on making purchase decisions; in a Loser's Game, most researchers should spend most of their time making sell decisions. Almost all of the really big trouble that you're going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you might come out the winner in the Loser's Game. The Losers Game By Charles D. Ellis Charles D. Ellis with James R. Vertin The Investors Anthology John Wiley & Sons 1997 ISBN 0-471-17605-2 P 177

I believe the advice to concentrate on defenses and sell decisions can make the difference between good performance and no performance at all. This advice is

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even more emphatic when the shortcomings of fundamental analysis in the sell decision are considered. The attitude seems to pervade the investment community that if the buy decision is well considered then everything else will take care of itself. This belief does not seem to hold together in actual practice. In an economy and business environment of rapid change and innovation it seems that things don’t stay the same for very long. There are winners and losers – all the time. The portfolio must be kept fresh and out ahead of the changes that are driving the economy and markets. Errors in analysis will occur and some predictions will not “pan out”. We need to be able to identify “next year’s big trouble” that is already in our portfolios and sell it before the negative impact on portfolio performance becomes serious. This also has the not insignificant effect of freeing up a slot in the portfolio for a stock with better performance potential. The sell decision must be well considered and applied with discipline or the process of successful adaptation will not be accomplished. The search for sells must be continuous and effective in order to keep pace with important changes in the economy and business conditions. In my opinion the best way to approach the sell decision is with disciplined long-term technical analysis. This seems to be the best hope for winning the “loser’s game”. I believe the use of long-term relative strength charts in a point & figure format is a perfect tool to use for the sell decision.

Some Thoughts about Probabilities In my opinion there is no “answer”- fundamental or technical or otherwise - that will allow accurate and reliable “risk-free’ predictions of future stock prices. We must continually deal in probabilities regarding the future. Human beings seem to have considerable difficulty in dealing effectively with probabilities. (See literature in the field of Behavioral Finance) In the stock market, as professional investors we have to do the best we can to avoid biases in our decision-making and to limit self-destructive behaviors as well

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as guard against a self-defensive policy of overly cautious do-nothing portfolio management. We must take risks intelligently to capitalize on opportunities and yet provide an element of damage control. In my experience the long-term, relative strength charts in a point & figure format provide an edge that suggests probabilities of success in the range of 65% to 75%. This is a totally subjective estimate of the probabilities drawn from my experience. It should be understood that these subjective probabilities of success are not constant but will vary up and down within and outside the estimated range of success depending on market conditions and the skill of the user. It is a certainty that a user who will use the technique until the first failure will drop the approach shortly after the trial starts because between 1out of 3 and 1 out of 4 of all decisions will be errors. Critics of the system will be able to readily find individual examples of failure of the system and this may result in the rejection of the approach because it is not a perfect predictor rather than its ability to achieve performance objectives. Used in the proper context the relative strength P&F approach seems to assure the elimination of big losers from the portfolio and the retention of winners for as long as they perform adequately. The objective is to achieve adequate performance for the risks taken and this approach offers hope for achieving this goal.

___________________________________________________ Some Thoughts about Portfolio Turnover Most fundamentally oriented portfolio managers point to increased portfolio turnover as a reason to reject technical analysis as a tool for portfolio management. Increased commissions and trading costs as well as price slippage are often cited as the increased costs associated with higher turnover and therefore a drag on performance. Higher taxes on short-term gains are also given as reasons to reject tools that might result in higher turnover.

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The record seems to suggest otherwise! Trading commissions have probably never been lower. Price slippage and lack of liquidity are bona fide negative considerations and may act as a significant drag on the performance of large portfolios. Even so, long-term technical analysis should not be rejected as having no value because very important positive results may result. Recent studies in the field of behavioral finance suggest other factors may create negative consequences for the portfolio. This research suggests a strong tendency for portfolio managers to sell winners prematurely and to retain losers in the portfolio. The desire for enhanced tax efficiency adds to the tendency to hold losers in the portfolio. This is what I call “negative turnover”. This is turnover that directly hurts the performance of the portfolio and downgrades the potential for future appreciation. Negative turnover often results from a short-term emotional response to news or market rumors and it is a serious threat to performance where no long-term methods are “in place” to keep the portfolio manager “on course”. Long-term technical analysis, when properly applied, provides a tool to help a portfolio manager retain winners and to identify losers for sale. “Positive turnover” is achieved whenever the portfolio manager can hold the winners and sell the losers. This should also enhance the tax efficiency of the portfolio as well as improve the performance of the portfolio. The key seems to reside in the orientation of the analysis to a long-term perspective. This is why the long-term bullish support lines incorporated in the relative strength point & figure analysis are so important in providing a method to retain the winners in the portfolio. Care must be exercised when using long-term relative strength point & figure analysis to correctly categorize stocks into the proper classifications of major winners, major losers and stocks in trading ranges. This classification technique allows the portfolio manager to continually upgrade the appreciation potential of the portfolio and to adapt to important fundamental changes in a timely manner. Any portfolio management approach that cannot consistently produce positive turnover should be rejected as damaging to portfolio performance. Positive turnover depends upon the reduction/ elimination of short-term market noise, as well as, a long-term market adjusted trend perspective. The long-term charts of

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relative strength in a point & figure format were designed to provide just such a tool for portfolio management.

The Mystique of Point & Figure Charting I believe that the 3-box, point & figure charting system is the best choice of technical inputs for long-term investors. The 3-box method acts like a filter to eliminate the noisy, random, minor, day-to-day price fluctuations from the analysis. I think this is why point & figure charting has survived the test of time. Another advantage of the 3-box, point & figure method is the ability to include a long price history in a compact chart. Many charts in the Market Dynamics system are based on over four years of data. This perspective is appropriate for long-term portfolio managers. A primary advantage of the 3-box, p&f charting technique is the use of more or less objective decision rules. The signals are hard to miss and support and resistance zones show up clearly. The charts are presented in a compressed format where Xs represent increases in price and Os represent declines. The unusual appearance of the charts has led to an air of mystique surrounding the approach. There is nothing mysterious about their construction and use but the unusual appearance of alternating columns of Xs and Os gives some new users a negative impression of an initially puzzling chart. The most significant advantage of the 3-box, p&f approach is the fact that the charts do not track price vs time. They record price movement up and down on the y-axis relative to alternations of trend across the x-axis. It requires a significant movement in the direction opposite to the recently recorded trend to create a reversal along the x-axis on the chart. These reversals are a function of volatility (i.e. more volatility produces more reversals – less volatility fewer reversals). Since volatility is usually a proxy for risk these charts can be characterized as tracking price versus risk. Volatility changes as trends ebb and flow and the movements of price versus risk are critical to trend evaluation.

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RELATIVE STRENGTH The Market Dynamics charting system presents the relative strength of the stock in a 3-box P&F format. This makes these charts appropriate for the evaluation of trends relative to the market. The S&P 500 represents the market. The use of relative strength ratios removes the performance of the market from the presentation and what is left is the price action that is specific to the stock in question. This presentation is particularly important for institutional investors whose objective is to “beat the market”. The relative strength presentation also incorporates the application of trendlines with predetermined slopes to evaluate the performance of the issue. The 45-degree bullish support lines and 45-degree bearish resistance lines are important tools in the trend evaluation techniques used by Market Dynamics. These trendlines and their application are thoroughly discussed in later chapters of the tutorial.

Relative Strength in Long-term Point & Figure Format Several examples of major long-term trends follow. Since this section of the tutorial is focused on technical analysis for long-term investors and the application of relative strength in a point & figure format primarily to the sell decision – most of the examples that follow show stocks in major long-term downtrends. As the trend turns down it is impossible to estimate how far down the stock might fall but it is enough to know that the trend is down and the downside surprises investors by its severity more often than not! Many of these examples were drawn form stocks that comprise the NASDAQ 100 index.

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Examples – Major Long-term Downtrends AMZN

Conventional trendline – less steep than a 45-degree bearish resistance line

Many of the examples that follow will also show a pattern of repeated failures of 45degree bullish support lines. This is usually the case with stocks in major long-term downtrends. These support line failures provide recurring confirmation that the trend is indeed down. It is temping to say that the stock is too cheap and it should stop going down - but this is often a mistake.

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ATHM

This is an example of a downward sloping 45-degree bearish resistance line. It is amazing how frequently the relative strength trend will honor these bearish resistance lines.

After the relative strength reversed to the downside there was almost no serious challenge of the 45-degree bearish resistance line. If held for the long-term this stock would have seriously impacted the performance of the whole portfolio.

Portfolio managers who must communicate with clients will find stocks like the example shown above to be a source of conflict with clients and may even cause such a loss of credibility that the account will be lost. Stocks that become major long-term losers can create an impression of the money manager as stubborn and perhaps even incompetent. It is far better to eliminate these stocks from the portfolio before they damage client relationships.

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BRCM

45-degree bearish resistance line

The repeated failures of the 45-degree bullish support lines show clearly.

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CSCO

Shallow conventional down line

45-degree bullish support

A conventional trendline is usually less steep than a45-degree bearish resistance line. Good practice requires that the line touch the relative strength plot in at least three places to be a valid trend line. The conventional trendline, when it can be drawn, seems to have more significance in describing the long-term trend that a 45-degree bearish resistance line.

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CMGI

45-degree bearish resistance line

This is an example of an extreme decline by a speculative stock.

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CNA

45-degree bearish resistance line

This example shows a stock with relatively low volatility that experienced a downtrend relative to the market for almost four years. The 45-degree bearish resistance line was not seriously challenged during the entire period.

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CMRC

45-degree bearish resistance line

45-degree bullish support line

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CNXT

45-degree bearish resistance line

Shallow conventional downtrend line

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CNC

45-degree bearish resistance line

This is another example of repeated failures of the 45degree bullish support lines. These lines are drawn from a prominent low point on the chart upward to the right.

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CORL

45-degree bearish resistance line

45-degree bullish support line

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CPTH

45-degree bearish resistance line

45-degree bullish support line 45-degree bullish support line

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DELL

Shallow conventional downtrend line

45-degree bullish support line

Another example of a succession of repeating failures of 45-degree bullish support lines.

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DT

45-degree bearish resistance line

45-degree bullish support line

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INKT

45-degree bearish resistance line

45-degree bullish support line

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JDSU

Shallow conventional downtrend line

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JNPR

45-degree bearish resistance line

45-degree bullish support line

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LU

Shallow conventional downtrend line

45-degree bullish support line

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MCK

45-degree bearish resistance line

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MSFT

Shallow conventional downtrend line

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NTAP

45-degree bearish resistance line

45-degree bullish support line

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PMCS

45-degree bearish resistance line

45-degree bullish support line

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PUMA

Shallow conventional downtrend line

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RNWK

Shallow conventional downtrend line

45-degree bullish support line

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RAD

45-degree bearish resistance line

45-degree bullish support line

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SEBL

45-degree bearish resistance line

45-degree bullish support line

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SUNW

45-degree bearish resistance line

45-degree bullish support line

The long-term bullish support line on this stock persisted for several years. When the break of this trendline finally occurred it was highly significant.

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VRSN

45-degree bearish resistance line

45-degree bullish support line

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VRTS

45-degree bearish resistance line

45-degree bullish support line

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WCOM

Shallow conventional downtrend line

45-degree bullish support line

A succession of 45-degree bullish support line failures usually indicates a significant top. It is often a mistake to believe that the damage is done and that the stock won’t go any lower. As long as the trend is headed down it must be treated with respect. In my experience, these downtrends can really surprise investors on the downside. There seems to be a universal tendency for investors to underestimate the downside risk.

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XRX

45-degree bearish resistance line

45-degree bullish support line

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YHOO

45-degree bearish resistance line

45-degree bullish support line

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Examples – Trendless Patterns – Trading Ranges CRTK

A trendless, trading range stock almost needs no explanation. It should be sold as it approaches the old relative strength high and possibly bought when it approaches the low. The extremes of the past few years will define the boundaries of the trading range. The distribution of returns from common stocks suggests that most stocks are in trading ranges most of the time. Somewhere between 60% and 70% of all stocks are in trading ranges all the time. This is especially true for large mature companies whose business has settled down into a more or less stable pattern.

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FLEX

The heavy black lines represent the upper and lower boundaries of the trading range. It seems that long-term relative strength charts in point & figure format are ideal for the analysis of trading ranges.

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IBM

This stock has a wide trading range at almost 25 boxes on the relative strength P&F chart. It seems to offer considerable opportunity for performance, just by moving from one extreme to the other.

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LLTC

This stock has a more representative width for its trading range at about 15 boxes. Not a lot of potential in the trading range for this stock.

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LOW

This is another example of a fairly wide trading range. The width of the trading range and the extremes offers a method to estimate upside potential and downside risk.

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ORCL

This is an example of a trading range that may turn out to be a major top. After a big move up the sideways movement sets up a trading range but a downside break below the lower boundary of the trading range should be considered to be a very negative development. It is too early to tell but a drop to row E or below would be a powerful sell signal.

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MXIM

The best approach is to buy at the lower boundary of the trading range and to sell at the upper boundary. If the relative strength should breakout beyond the boundary by a significant amount the position should be reversed quickly. Trading ranges are not a guarantee of success but the odds favor entry and exit at the extremes of the range.

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TLAB

It seems that breaking down from a trading range is a more likely development than an upside breakout. If the stock is purchased at the low end of a trading range then the portfolio manager must be willing to reverse the position on a downside failure from the trading range.

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WMT

This is another example of a more-or-less mature stock in a long-term trading range.

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Examples – Major Long-term Uptrends AAS

The years are shown at the top of each chart. These examples have been chosen to illustrate the longterm persistence of these trends.

45-degree bullish support line Most of the following examples of major long-term uptrends were chosen because of the extreme nature of the upside movements. These stocks were among the top performing stocks of the prior year. These examples show how stocks can move dramatically when they reach the right-hand tail of the distribution of returns.

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COLM

45-degree bullish support line

This stock based out and turned up in mid ’99. It has consistently remained above the 45-degree bullish support line ever since. Clearly it will “Top- out” someday but there are no signs of a top at this time.

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CPN

45-degree bullish support line

This uptrend probably started in ’98 and has continued to outperform the S&P 500 by a large margin. Significant corrections have occurred but the stock has remained bullish.

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EOG

45-degree bullish support line

This uptrend started in late ’99 or early 2000. The relative strength chart shows repeated upside breakouts above 45-degree bearish resistance lines.

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HSE

45-degree bullish support line

This stock based out and turned up in early ’99 and it demonstrates the importance of the 45-degree bullish support lines.

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IFIN

45-degree bullish support line

The bullish trend was repeatedly confirmed by upside breakouts above 45-degree bearish resistance lines.

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LH

45-degree bullish support line

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MND

45-degree bullish support line

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RHB

45-degree bullish support line

The base on this stock required over a year to complete but it preceded a major long-term bullish trend.

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RJR

45-degree bullish support line

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ROIL

45-degree bullish support line

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RYL

45-degree bullish support line The recent major bullish move was preceded by a long-term bearish trend that lasted for over two years.

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SEIC

45-degree bullish support line

This is an example of a more volatile NASDAQ stock that has been in an uptrend for a little more than a year. The volatility creates more back and forth movement on the chart.

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SFY

45-degree bullish support line

The transition from a long-term bearish trend to a long-term bullish trend usually requires an extended period of sideways movement, which is referred to as a base. Major bases may take as long as several years to complete.

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SGR

45-degree bullish support line This uptrend started in late ’98. The transitional basing period shows clearly.

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TBL

Upper boundary of trading range

45-degree bullish support line

This example shows an upside breakout from an extended trading range.

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TLB

45-degree bullish support line

W. Clay Allen CFA

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Summary and Conclusions

This section of the tutorial was constructed to demonstrate the usefulness of long-term technical analysis to managers of long-term investment portfolios. The long-term relative strength in point and figure format helps the portfolio manager achieve positive turnover by holding winners and identifying and selling losers. The emphasis should be on the sell decision, which is primarily a technical analysis function. The buy decision should remain primarily a fundamental analysis function. The users of the Market Dynamics System will benefit from the clarity and simplicity of the presentation that damps out noise and meaningless price variation and lets the more important long-term trends show through. This approach facilitates adaptation to changing conditions and reduces the performance costs of prediction errors. It provides a method to successfully implement the recommendations of The Loser’s Game. W. Clay Allen CFA To Return to the tutorial Market Dynamics Tutorial.pdf 303-804-0507 or FAX @ 303-804-0513 http://www.clayallen.com/ [email protected]

W. Clay Allen CFA

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Relative strength in point and figure format

This chart is constructed with a filter that completely damps out movement that is less than three boxes. This ensures that the chart emphasizes the long-term trend characteristics of the chart. LONG-TERM 3 BOX – POINT AND FIGURE CHART OF RELATIVE STRENGTH – RS vs S&P 500 – PLOTTED DAILY.

W. Clay Allen CFA

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“You cannot manage what you do not measure”

This chart covers 3.5 years. The persistent uptrend of the past 1.5 years shows clearly.

If your objective is to out-perform a market index then it is important to measure the components of the portfolio in terms of that index. Most large portfolios are measured against the S&P 500. The data must be filtered to eliminate the noise from the market and to focus attention on the long-term major movement. This is the primary reason for tracking relative strength in a filtered point and figure format

W. Clay Allen CFA

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Combines advantages of each method relative strength with point and figure -Damps out shortterm meaningless variation (i.e. noise) - Measures price movement relative to the market - Signal patterns the same - Long-term orientation

It is important to avoid responding to short-term price action that might lead to the premature sale of a major winner

BUY SIGNAL LONG-TERM BULL MARKET MOVE

W. Clay Allen CFA

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Support and resistance lines seem to be more effective

45-degree bearish resistance line

45-degree bullish support line The 45-degree risk vs return lines are a very important part of relative strength point and figure charting. They provide a simple and highly visual method for tracking the performance of the stocks in a portfolio. It is very easy to categorize the performance as acceptable or unacceptable.

W. Clay Allen CFA

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Industry groups and market sectors #1

QQQ – NASDAQ 100 Tr.

This market basket seems to track the relative strength just like an individual stock. The 45-degree risk vs return lines seem to be very effective.

W. Clay Allen CFA

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Industry groups and market sectors #2

Market Dynamics will be significantly expanding industry group coverage in the months ahead.

W. Clay Allen CFA

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Rule based system for portfolio management - Simple – highly visual - easy to use – more or less objective – difficult to misinterpret - Retain winners / sell losers quickly.

Major winners are able to oscillate back and forth but remain above a steeply upward sloping trend line drawn from a major low. Portfolio managers can tell at a glance whether the stock is performing adequately. When it “rolls over” it is hard to miss.

W. Clay Allen CFA

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To return to the tutorial table of contents click

mdtutor.pdf

Copyright by W. Clay Allen CFA 303-804-0507 [email protected] THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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MARKET DYNAMICS

Learn Relative Strength point and figure charting LEARN RELATIVE STRENGTH POINT & FIGURE CHARTING

Copyright by W. Clay Allen CFA

W. Clay Allen CFA

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The Spirit of Technical Analysis

In my opinion the Market Dynamics version of technical analysis is a tool for judging long-term trends and the reversals of direction of those trends. It is not a tool for prediction. It has certain rules but it is more or less an art form – I certainly don’t believe it is scientific. It helps in a majority of cases (65% to 75% estimate by WCA) and fails in others or at least the trends quickly change direction from what was hoped for! If I can correctly gauge the direction of the long-term trend I will be able to advise and manage my portfolios successfully. If Market Dynamics is used with discipline - it will require the sale of losers and the retention of winners as long as they are able to perform. That, after all, is the key to successful portfolio management. WCA

W. Clay Allen CFA

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Chart construction and layout Ratio chart – price relative to S&P 500

The years are always shown at the top line on the chart

This is a long-term relative strength chart on CSCO. It covers almost four years of RS history. Relative strength is calculated by dividing the price of the stock by a major market index – i.e. the S&P 500. The ratio is then multiplied by a scaling factor (i.e. 1000). The P&F chart is plotted according to the rules pioneered by Chartcraft Inc. of Larchmont, New York. The daily highs and lows are used in the calculation of relative strength.

Since the chart is a plot of ratios - the movement relative to the market is what is being recorded. The ratios don’t mean anything in and of themselves. The letters along the Y-axis and the numerals along the X-axis are to be used only as reference points when discussing the charts. The grids on the Market Dynamics relative strength charts are square. This Three box methodwhen - Xsusing and 45-degree Os becomes important bullish support lines and 45-degree bearish resistance lines.

It is important to note that the X-axis does not measure time. W. Clay Allen CFA

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The 3-box system is designed to show major trend movement relative to the market. The rising trends are recorded with a column of Xs and the declines with a column of Os.

It seems that the stock market (maybe all markets) exhibit this pattern of alternating periods of rise and fall in price. The three box - point and figure method of charting is designed to filter out the minor movements and concentrate attention on the long-term major movements in relative price. The long-term movements are always more important than the short-term noise and this system is designed to take advantage of that characteristic behavior.

W. Clay Allen CFA

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X-axis – does not measure time –It records alternations of trend

As the relative strength moves back and forth we see a pattern of alternating columns of Xs and Os. The X-axis does not measure time. It records the alternations of trend.

X-axis measures risk

The alternations of trend are a direct function of volatility - so we can say that the X-axis is scaled in units of risk - since volatility is often thought of as a proxy for risk. The Y-axis is scaled in units of relative return. We are actually recording the movement of risk versus return. We should be gaining more in the Y direction than we are recording in the X direction if we are performing better than the market. The RS of the stock should remain above an upward sloping line if we are outperforming the market. Many times a 45-degree line that slopes upward to the right is used to gauge the performance of a stock. Above the 45-degree line is acceptable and below the 45degree line is unacceptable. This ensures a margin of excess return - over and above the performance of the market. The slope is +1 for a bullish support line, which requires one box up for each box to the right. One unit of gain for each unit of risk.

W. Clay Allen CFA

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Region of Excess Return

Acceptable relative performance

The triangle above shows the region of excess return relative to the market. The 45-degree bullish support line defines a region where a portfolio manager should try to position his/her holdings. As long as the relative strength fluctuates back and forth above the bullish support line the relative performance is acceptable. Big winners in the stock market will experience runs in relative strength that will carry the relative strength above the bullish support lines for many months. The steeper the rate of gain the higher the excess return for the stock.

W. Clay Allen CFA

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Region of serious under-performance

Unacceptable performance

Region of serious underperformance

When the relative strength starts to fall below the 45-degree bearish resistance line the under-performance has become serious. Portfolio managers should be reluctant to hold/purchase any stock that is moving back and forth below the bearish resistance line. In my opinion, signals are not as important as the position of the stock relative to the bullish support lines and the bearish resistance lines. Stocks that undergo serious long-term fundamental deterioration will remain below the bearish resistance line for many months.

W. Clay Allen CFA

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Time period covered – all charts are programmed to cover four years of history. Volatility effects how much time the chart covers.

Low volatility – Long time period

The chart on ABT covers less than half the graph and yet it covers almost three full years of relative strength movement. The fluctuations of the stock relative to the market were fairly modest indicating low risk even though the stock declined for over a year relative to the market.

W. Clay Allen CFA

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High volatility - Intermediate time period

An example of high but not extreme volatility. The time period is almost a year.

W. Clay Allen CFA

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Extreme volatility - Shortest time period

This stock exhibits “wild” volatility relative to the market. The period of time covered by the chart is only six or eight months and the plot of relative strength goes off the scale at both the top and the bottom.

W. Clay Allen CFA

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Performance relative to market

Better than market – Upward sloping graph

45-degree Bullish support line

This is an example of a stock that completely outperformed the market from late ’99 to mid-2000. The 45-degree bullish support line is always started from a prominent low on the chart and is drawn upward to the right at a 45-degree angle.

W. Clay Allen CFA

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Even with the market – flat chart

This is an example of a stock that has been flat relative to the market for almost the entire period from mid- ’97 to mid-2000.

W. Clay Allen CFA

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Worse than the market – downward sloping chart

45-degree bearish resistance line

This stock peaked relative to the market in early ’99 and has trended consistently downward into mid-2000. The stock never seriously challenged the 45-degree downward sloping bearish resistance line.

W. Clay Allen CFA

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Analysis of trends Uptrends

Bullish resistance line

This two-year uptrend has been characterized by a more or less consistent pattern of higher highs and higher lows. Stocks are usually not this consistent and will show more periods of correction.

Bullish support line

This bull move started with a column of Xs straight up.

W. Clay Allen CFA

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Downtrends

Bearish resistance line

Bullish lines are coded in green

Bearish lines are coded in red

Bullish support line

From the peak at (A,8) the stock just started going down and fell for over 25 columns without a single high rising above a prior high. Lower lows and lower highs are the hallmark of a serious downtrend.

W. Clay Allen CFA

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Bearish support line

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Signal patterns BUY SIGNALS

SELL SIGNALS

W. Clay Allen CFA

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Triple top buy signal – example #1 – There are many examples of triple top buy signals on the chart.

Triple top buy signal

45-degree bearish resistance line

45-degree bullish support line This triple top buy signal has been registered after a small decline but there is overhead resistance nearby. The bearish resistance line has been exceeded which is a good sign. If the top row of Xs at row A can be exceeded then the resistance has been taken out and a good move might follow.

W. Clay Allen CFA

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Triple top buy signal – example #2

45-degree bearish resistance line

Triple top buy signal

This example shows a triple top buy signal that has been registered shortly after the bearish resistance line was crossed. There is resistance overhead in this example but the signal looks good nonetheless.

W. Clay Allen CFA

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Triple top buy signal – example #3

Triple top buy signals were repeated on the way up

45-degree bullish support line

After the low at (K, 4) a triple top buy signal was given along with the breakout above a short bearish resistance line. After this reversal the stock became very bullish and proceeded to register additional triple top buy signals as it rose. In using Japanese Kagi charts which are similar to point & figure, there is a rule that suggests that before a trend ends - there will be nine columns up that will make new highs above the recent highs. This stock has recorded 7 so far. I have observed this phenomenon quite a few times and after the stock has recorded 8 or more new highs it is probably best to anticipate a reversal of the uptrend.

W. Clay Allen CFA

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Triple bottom sell signal – example #1

Triple bottom sell signal

45-degree bullish support line

The 45-degree bullish support line has failed and a triple bottom sell signal has been registered. This stock seems to be in a prolonged downside slide – nothing dramatic but significant nonetheless. It should be noted that previous support has been violated which is an additional negative input. Repeated bullish support line failures have been recorded which adds to the downside evidence.

W. Clay Allen CFA

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Triple bottom sell signal – example #2

A new bearish resistance line can be drawn.

Triple bottom sell signal

45-degree bullish support line

The triple bottom sell signal is shown in the example. It should usually be used with a penetration of the bullish support line. A sell signal after a major bull market move should be given more weight than a signal that is registered after a long decline. This example shows both a triple bottom sell signal and a bullish support line violation. A downward sloping bearish resistance line could now be drawn from the top at (A, 13).

W. Clay Allen CFA

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45 degree lines- Bullish Bullish support lines Bullish resistance lines

Bullish resistance line Bearish resistance line The upper bullish resistance line is started at any prominent high point on the chart.

Bullish support line The upward sloping 45 degree bullish support line is drawn from any prominent low point on the chart. A long-term investor would start the line at the lowest point on the chart. A new bullish support line should be started if the initial line is violated. These lines are a very important part of using relative strength in a point and figure format. They provide a standard of performance that almost ensures the achievement of the portfolio’s performance goals. A stock must continuously gain on the market to remain above these lines.

W. Clay Allen CFA

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45-degree lines - bearish Bearish resistance lines Bearish support lines

Bearish resistance line

The downward sloping 45-degree bearish resistance line is started at a prominent high point on the chart. It may need to be redrawn if the initial line is violated.

Bearish resistance line

Bearish support line

Bearish support line

Stocks that remain below their 45-degree bearish lines are seriously hurting the portfolio’s performance. They hurt the portfolio twice – (first) they lose performance and (second) they keep the portfolio manager from buying another stock that has a better chance of performing!

W. Clay Allen CFA

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High performance bullish support lines Use on high risk, speculative stocks Slope is 50% steeper than 45 degree bullish support line

HPBSL - Example 1

45-degree bullish support line - Slope = 1

High performance bullish support line Slope = 1.5 The high performance bullish support line rises at a rate 50% faster than the 45-degree bullish support line. The steeper slope is used to require a higher measure of excess return to compensate for stocks with higher volatility (i.e. risk).

W. Clay Allen CFA

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HPBSL - Example 2

High performance bullish support line CSCO has been one of the best performers in the recent bull market. This chart shows the effects of a stock split in reducing the historic volatility of a relative strength chart. As the stock fluctuated before the stock split the volatility was much greater on these charts than the current chart depicts. It is a function of scaling.

W. Clay Allen CFA

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HPBSL - Example 3

Note: The average length of a column of Xs or Os is an indicator of the volatility of this stock. The volatility tended to pick up dramatically right at the top and the extreme variability continued as the stock made a broad top and completed a major reversal. The ensuing decline was dramatic.

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 4

This long-term advance was very orderly and never seriously threatened the HPBSL.

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 5

Usually stocks with average volatility will consolidate for at least ten columns as they complete a top and reverse trend.

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 6

False bearish signal

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 7

Very rapid reversal of trend after a major bull move

High performance bullish support line High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 8

Almost no consolidation occurred at the top for this stock

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 9

The downside penetration of a HPBSL is almost always a serious warning that the trend is reversing direction.

High performance bullish support line

W. Clay Allen CFA

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HPBSL – example 10

Triple bottom sell signal A triple bottom sell signal was given as this stock made its top. This was the first triple bottom sell signal given during the bull move and it was a good tip-off that something was going wrong.

High performance bullish support line

W. Clay Allen CFA

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Support and resistance

Resistance

Support

A study of the distribution of the returns from common stocks suggests that most stocks are in a trading range most of the time (i.e. 20% in the negative tail, 20% in the positive tail and 60% in the narrow middle of the distribution) The trending stocks are in the two tails and the balance is moving back and forth with the market. In the absence of an upside breakout the shares of most major, mature companies should be sold as they approach the high end of the historic trading range. This is also a good reason why the relative strength point and figure charts need to be long-term in perspective. Trading ranges are very common on the relative strength point and figure charts.

W. Clay Allen CFA

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Resistance below the bearish resistance line

Bearish resistance line

Resistance

This example shows a rally back up into an historic resistance level that was also below the 45-degree bearish resistance line. The combination of the two resistance levels turned the stock down and the relative strength broke sharply.

W. Clay Allen CFA

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Trading ranges – example 1

Resistance

Support It is usually best to wait for the stock to show signs of basing at the lower end of the trading range. In my opinion it is always much easier for a stock to breakout downward through trading range support than it is to breakout to the upside through resistance at the high end of the trading range. The more times the support and resistance zones are “honored’ by the stock the more important they become.

W. Clay Allen CFA

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Trading ranges – example 2

Resistance

Support

This is clear example of a stock that has been completely controlled by its historic trading range for the past two years.

W. Clay Allen CFA

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Trading ranges – example 3

Resistance

Support

Bullish support line

A trading range is an extended period of consolidation. If it occurs after a major bull market in a stock it may actually represent a major top and reversal of trend. It is too early to tell on this stock but that scenario could actually prove out in this instance.

W. Clay Allen CFA

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Trading range – example 4

Resistance

Support

This is an example of a trading range that is extremely “tight”. Stocks like this are often used as a safe-haven during market turbulence!

W. Clay Allen CFA

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Channels Long-term up channels

The upper channel line is a bullish support line drawn from a prominent high point on the chart.

Bullish support line

The stock broke out with a triple top buy as it moved above the bearish resistance line. The base was about ten columns wide. The breakout column ran more than ten Xs straight up.

W. Clay Allen CFA

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Long-term down channels

The channel is constructed using two parallel downward sloping bearish resistance lines.

Bearish support line

Bearish resistance line

This is an example of a long-term down channel. It has been in effect for over four years. Bargain hunting in stocks like this is usually very dangereous.

W. Clay Allen CFA

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Major long-term trends Major long-term up-trends – example 1

Column with ten Xs up

High performance bullish support line Stocks that start to move up dramatically on the relative strength charts like this will appear on the Market Dynamics one-month high RS screen, the triple top buy signals screen and often on the ten box up screen. The increasing relative strength is an indication they are moving out into the positive tail of the distribution. They should have broken out above almost all-historic resistance and the up trend should be accelerating. Trend following tools work best on stocks like this. These stocks have the potential to become big winners. They are easily identified early in their moves with the screens supplied by Market Dynamics.

W. Clay Allen CFA

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Major long-term uptrends – example 2

This move ended with a major top and a downside break of the HPBSL. The signs of trouble were hard to miss on this stock.

High performance bullish support line

W. Clay Allen CFA

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Major long-term uptrends – example 3

Very steep natural uptrend lines

Trendlines that get steeper and steeper are suggesting a blow-off. These situations are usually best sold into the strength since the top will almost certainly give little warning. The rule of nine new high columns can be used to estimate the end of the rise.

W. Clay Allen CFA

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Major long-term uptrends – example 4

Relative strength ranking systems will usually rank a stock like this in the very highest ranks at the very top of the move and even after the stock has turned down. The extreme nature of the upmove will still generate very high relative strength ranks well after the top is in. In my opinion, it is far better to use relative strength trend following techniques because of this inherent weakness of longterm relative strength ranking systems.

High performance bullish support line

W. Clay Allen CFA

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Major long-term uptrends – example 5

Bullish support line

The top on this stock took quite a few columns to complete. The HPBSL acted as support for a few columns and then the stock broke the HPBSL completing the reversal.

W. Clay Allen CFA

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Major long-term uptrends – example 6

It is always easier to deal with a blow-off in hindsight! The steepening of the upward trendlines suggested the blow-off as it occurred. It is best to get out early on situations like this. Use the rule of nine new high columns to estimate the peak. Very steep natural uptrend line This is another example of the dangers inherent in long-term relative strength ranking systems. The reversal is so fast that the portfolio manager gets bagged before the ranks decline enough to indicate trouble. In my opinion, longterm ranking systems require the use of a stop-loss discipline that most portfolio managers refuse to use.

W. Clay Allen CFA

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Major long-term uptrends – example 7

Very steep natural uptrend lines

These are examples of stocks that experience wild swings in both directions. Since stocks like this are almost always extremely speculative we must be willing to leave the party on “short notice”. The violation of an extremely steep up trend line is a “good enough” reason to step aside on a stock like this.

W. Clay Allen CFA

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Major long-term uptrends – example 8

A triple bottom sell signal after a big move is a very good reason to sell.

Very steep natural uptrend line

A stock like this is like a bull rider at the rodeo – if you can “stay on” for 8 seconds you can really make the points. You don’t want to have to stay on this bull one second longer than it takes to win.

W. Clay Allen CFA

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Major long-term uptrends – example 9

Bearish resistance line

High performance bullish support line

W. Clay Allen CFA

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Major long-term uptrends – example 10

Bearish resistance line

High performance bullish support line

W. Clay Allen CFA

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Major long-term down-trends – example 1

Bearish resistance line

The bullish support line failed with a triple bottom sell signal at column 8. The stock never seriously challenged the bearish resistance line for the next two years.

This stock experienced repeated failures of short-term bullish support lines as it declined

W. Clay Allen CFA

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Major long-term down-trends – example 2

Major top

Bearish resistance line

A triple bottom sell signal was registered as support failed. The stock had traced out a major congestion zone between A and C for over a year. Many investors judged this stock to be “too” cheap all the way down!

W. Clay Allen CFA

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Major long-term down-trends – example 3

Bearish resistance line Major top

This is another example of a major congestion zone that proved to be a major top and then a long-term decline. In Dollar terms this was a drop from almost $60 to $5. During the topping process several bullish support lines failed to support the stock suggesting the approaching weakness.

W. Clay Allen CFA

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Natural trendlines Should be defined by touching the RS plot at least three times User decides if natural trend line takes precedence over 45 degree lines.

Natural upward trendline A natural trend line is defined by the action of the stock itself. A natural trend line is not required to be drawn at any predefined slope. In my opinion it should touch the relative strength plot in at least three places to draw the trend line. The user can decide which is more important - a natural trend line or a 45-degree line. In my experience, an extremely steep natural trend line does not remain unbroken for very long and is usually associated with a highly risky – volatile stock. I do not believe that it is wise to compromise performance standards because of a shallow natural trend line.

W. Clay Allen CFA

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Natural trendline Downtrend

Natural downward trendline

Connecting only two points on the chart can draw a tentative natural trend line. This tentative natural trendline began at (A, 1) and was extended through (C, 5) and later through (E, 9). It was in place for several years but it should have been classified as a tentative natural trend line during the first year and a half (i.e. late ’96 to late 97). In my opinion a tentative natural trend line is not as important and should not be given as much weight in the analysis as a fully defined natural trend line.

W. Clay Allen CFA

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Major reversal patterns Major tops – example 1

MAJOR TOP

W. Clay Allen CFA

This top took two years to form and showed a pattern of lower highs with a downward trend line. When the support at D failed the stock moved down sharply. The top essentially shows a balance between demand and supply. The breakdown shows that supply won the battle. Experience has shown that if a stock is held until the deterioration in the fundamentals has been publicly acknowledged the stock has already completed much of its decline. In my opinion the bad news leaks into the market and investors will act on this anticipation ahead of the actual announcements. The stock market always acts in anticipation of expected events and news.

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Major tops – example 2

Major top

Bearish resistance line

This example shows a top almost 20 columns wide. The width of the top in many ways forecasts the extent of the decline. The decline started with a triple bottom sell signal but shortly thereafter - a negative news item caused a dramatic one-day plunge in the stock. The stock has recently started to base but it remains far below the bearish resistance line. Experience indicates that the “sell” decision is more heavily weighted toward the technical method of analysis. Invariably the tip-off is a stock with apparently great fundamentals that consistently acts poorly on the relative strength charts. You can assume there is a good reason behind the poor performance. Rarely is it just an accident or purely a coincidence.

W. Clay Allen CFA

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Major tops – example 3

Major top Bearish resistance line

Bullish support line

Natural trendline

This is an example of a major top in a Dow Jones Industrial Average stock. The stock fell sharply away from the top. Throughout ’99 the stock appeared to be basing but this turned out to be a ledge and the stock broke to new relative strength lows. The 45-degree bearish resistance line confined the stock to a downtrend during the entire decline.

W. Clay Allen CFA

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Major bases – example 1

Bearish resistance line

Bullish support line

MAJOR BASE The completion of the major base is signaled when the downward sloping bearish resistance line is exceeded. The width of the base must match the extent of the prior decline in order to go above the 45-degree bearish resistance line. This is a very practical rule that precludes premature entry into a stock prior to the completion of a sufficient base.

W. Clay Allen CFA

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Major bases – example 2

Bearish resistance line

MAJOR BASE This stock has formed a major base and has broken out above the 45-degree bearish resistance line. It is still early in the move so we can’t know whether it will follow-through or not but the pattern looks promising.

W. Clay Allen CFA

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Major bases – example 3

Bearish resistance line

MAJOR BASE

A major base has taken over a year to complete. The move won’t be “for sure” until the relative strength can move above the recent resistance.

W. Clay Allen CFA

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Breakouts

Bearish resistance line

New bullish support line

Bearish support line

This is an upside breakout above a consolidation that was almost 15 columns wide. The breakout clears all recent resistance and should include breaking above a downward bearish resistance line. A new bullish support line can be drawn after the breakout.

W. Clay Allen CFA

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Tenboxup screen #1

Bearish resistance line

10 Xs up

Major moves often start with a “bang”. The tenboxup screen is provided to call attention to those stocks that have moved straight up relative to the market. In my opinion, the more attractive patterns are those that show a big move up from a broad base. Several examples follow.

W. Clay Allen CFA

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Tenboxup screen #2

Bearish resistance line

10 Xs up

W. Clay Allen CFA

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Tenboxup screen #3

Bearish resistance line

This move started with a column of Xs straight up.

10 Xs up

Bearish support line

W. Clay Allen CFA

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Tenboxup screen #4

Bearish resistance line

10 Xs up

Bullish support line

W. Clay Allen CFA

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Tenboxup screen #5

Bearish resistance line

10 Xs up

Bullish support line

W. Clay Allen CFA

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Tenboxup screen #6

Bearish resistance line

10 Xs up

High performance bullish support line

W. Clay Allen CFA

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Tenboxup screen #7

Bearish resistance line

10 Xs up

Bullish support line

W. Clay Allen CFA

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Some thoughts about how the market works Need to revalue assets due to changing conditions – “Creative destruction”

45-degree bearish resistance line

The process of change results in the need to revalue assets frequently. Schumpeter said that progress is the result of a process he called “creative destruction” The free market produces winners and losers. The data from the market helps portfolio managers to identify and avoid losers before it is too late. This process can be expected to continue into the future as long as markets exist.

W. Clay Allen CFA

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The difficulty in interpreting current events - Current events are not history to us – We don’t know what the consequences will be.

Triple bottom sell signal

45-degree bullish support lines

It is very easy- now that we know what happened – to say, “sure I would have sold that stock on that triple bottom sell signal” The problem is that when we see the signal we really can’t know whether it will follow through or not. We don’t know what the significance of the signal will be. In this instance the follow-through was immediate, dramatic and down. The stock market often demonstrates “non-linear” behavior in which small causes may produce unexpectedly large results. This is often true of sell signals. In my opinion, every major sell signal that includes the penetration of a bullish support line should be treated as a danger signal with potentially serious consequences. I am referring to sell signals on current positions in the portfolio. In order to ensure the avoidance of major declines - all sell signals must be honored. It is only when the market is in a state of deep distress that sell signals can be ignored. Charlie Ellis said years ago “ 80% of next years problems are in the portfolio now”. The relative strength in point and figure format is just the tool to help root out those problems before they hurt the portfolio’s performance. But to get the benefit - you must act on the signals!

W. Clay Allen CFA

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The distribution of returns from stocks - Non-normal – peaked with fat tails. Proportion of the population in the extremes of the distribution is 5 to 10 times what it would be if normal - 80/20 rule holds in the stock market why? Distribution of returns – Normal vs Fat Tails

Observed distribution Theoretical distribution

Negative fat tail in the observed distribution

Narrow peak in the observed distribution

Positive fat tail in the observed distribution

The distribution of returns from common stocks differs from the normal distribution in subtle but important ways. This is a stylized comparison of the two curves with the solid line depicting the academic normal distribution plotted with +amounts signs The existence of long-term trends Dayand to the daycurve random – large of representing the real, observed distribution of returns. noise The real world is characterized by a distribution that displays a high degree of kurtosis (i.e. fat tails). A narrower peak around the mean also characterizes it. of runs – analysis – convincingly points to long-term trends how do WhatTheory this means in “real English” is that there are far more major winners and–losers than tellexperience when the trend changes you we would if the real world direction? distribution were exactly normal. Research has indicated that there are 5 to 10 times as many stocks in the extremes of the distribution than there should be. This indicates that major long-term trends tend to run longer and farther than we should normally expect. These are also the most important trends that we should spend our time trying to find and invest in. The narrow peak seems to indicate that most stocks tend to mirror the major market averages. These are also most likely to exhibit trading range characteristics. The conclusions seem to be clear: Use a trading range approach to tracking most stocks and use a trend following methodology when dealing with stocks that have demonstrated an ability to depart from the averages and to move out into the “fat” positive tail. This also suggests relative strength as an effective way to identify major trend stocks. The difference between these two distributions has extremely important consequences for portfolio management in terms of methodology and a realistic application of portfolio management tools. W. Clay Allen CFA

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Theory of Runs

If the Xs and Os on a relative strength point and figure chart were placed by the flipping of a coin – Xs for heads and Os for tails. Using the theory of runs we would be highly suspicious that the coin used to construct the chart was extremely irregular. My tests on many charts indicated far too few runs - which means the coin was crooked. The flips were random but the outcome suggested an underlying process at work and the existence of persistent trends. It is the longterm trends, after all, that we are interested in.

W. Clay Allen CFA

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Complex Adaptive System

No functional relationships that last

“ It is statistics not physics” – from Louis Navellier Markets must have uncertainty – No need for a market if there is no uncertainty - because then everyone would agree on price and value. Like evolution in nature - we can understand, describe but can’t predict - Need to adapt to change as much as predict - Feedback goes both ways – fundamentals to price and price to fundamentals. For those interested in the implications of Complex Adaptive Systems in the stock market you should visit the Santa Fe Institute’s web site at

http://www.santafe.edu/ Also see Complexity by Waldrop Also see Dr Brian Arthur’s articles on stock markets.

W. Clay Allen CFA

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Some thoughts about portfolio management Portfolio management must be adaptive

In order to adapt to changing conditions we need a simple, visual road map that steers us toward the positive changes and away from the negative developments. It is the markets function to supply this information in order to provide signals to the holders of capital. How else could the capital markets fulfill their function? While the stock market may have many negative connotations it is not a casino and it has a very important role to fulfill. I believe that communism collapsed in Russia because the central planners did not know how to allocate the nation’s capital – only a free market can do that.

W. Clay Allen CFA

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Portfolio Simulation

Simulated portfolioending value greater than $5 mil.

S&P 500 value

W. Clay Allen CFA

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The graph above shows the results of a recent portfolio simulation that covered about 3.5 years – ending in the fall of ’99. The rules were simple; 25 stocks, fully invested at all times, 1% round-trip commission costs, 20% stop-loss against cost, if the slope of the 50 day moving average of relative strength across a span of 21 days turned negative the stock was sold the next day as of the closing price, and the strongest relative strength stock on the basis of the 21 day slope of a 50 day moving average of relative strength was purchased to replace the stock that was sold. Daily closing price data was used and relative strength was based on the S&P 500 index. The turnover was very high but commissions were charged at a reasonable rate. This portfolio simulation was drawn from a collection of 400 institutional stocks that also had high volatility as measured by their standard deviation of daily percent price changes. This database has been maintained by WCA for over ten years. All stocks in this database shared one requirement – they had to have 4 years of trading history to be included. W. Clay Allen CFA performed all programming and the data was checked for accuracy. The simulated portfolio value started at $1 mil and rose to slightly more than $5 mil almost 2.5 times the performance of the S&P 500 over this three year period. There is no guarantee that the future will be like the past but this simulation seems to confirm the effectiveness of using relative strength trend following as a portfolio management tool.

W. Clay Allen CFA

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Relative strength study – real time – uptrends and downtrend lists published by WCA in 1999 In early July ’99 I started sending lists to customers of stocks that I categorized as in uptrend or downtrends utilizing the relative strength point and figure charts produced by Market Dynamics. The lists quickly became very large and in the study I will discuss each list included slightly more than 300 stocks. I was primarily interested in the tendency of relative strength to persist. Did the uptrends list outperform the S&P 500? Did the downtrends list underperform the S&P 500? Did relative strength persist for days or months? I calculated the percentage price change for each stock on each list from the day after the list was sent out – from July 19, 1999 til the close on May 1, 2000. There were no changes from the original lists – no additions or deletions. Average % change Uptrends list Downtrends list S&P 500

number of stocks

+43.15%

330

-.71%

305

+4.31%

The 45-degree bullish support lines and the bearish resistance lines were an important factor in the analysis and the selection for each list. The lists were actually e-mailed to my customers on July 18, 1999. The samples were very large and the differences between the means of these samples were also quite large. At least for the time period covered there seemed to be a very strong tendency for relative strength to persist. In my opinion, the persistence is very important. The ability to determine the direction of the relative strength trend seems to be a very useful tool. I have to admit that it probably won’t work in all markets, for all stocks and at all times. There probably is no tool available that could stand up to a requirement as rigorous as that. Other research has suggested the usefulness of relative strength and I think my work confirms the effectiveness when relative strength is used in a point and figure format. It does seem to provide an edge that while not perfect, is, nonetheless, useful. W Clay Allen CFA

W. Clay Allen CFA

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Positive turnover Trading tactics must be subservient to longer-term goals -Retain winners as long as performance lasts- sell losers and reinvest in potential winnersNegative turnover is doing the opposite. Most portfolio managers think about turnover in a negative sense. If you could enhance the appreciation potential of the portfolio at a rate more substantial than the cost of transactions and taxes then that would constitute positive turnover. When I discuss relative strength with potential clients the objection of increased turnover almost always comes up. If the turnover produced by the application of relative strength means that you hold your winners and sell your losers then it has served its purpose. I believe most portfolio managers tend to do the opposite – they sell winners and hold/add to losers – which is negative turnover to me. Peter Lynch said “its like pulling the flowers and watering the weeds”.

W. Clay Allen CFA

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Too cheap to sell! It is unbelievable how much performance is lost because a portfolio manager makes the judgment that a stock is too cheap to sell! There is a great temptation to hope that a fallen stock will come back and “duds” are often held long after the hope should have materialized. I think we would all be better off if we didn’t use the word too when evaluating stocks. Too high, too cheap, too far, too fast, too low etc.

W. Clay Allen CFA

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To return to the top of the main tutorial – click on thefollowing link

MDTUTOR.PDF 303-804-0507 or FAX @ 303-804-0513 [email protected] http://www.clayallen.com

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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How to find the big winners in the stock market. Big Winners = Stocks in the positive right-hand tail of the distribution of returns Distribution of returns – Normal vs. Fat Tails

Theoretical distribution

Negative fat tail in the observed distribution

Observed distribution

Narrow peak in the observed distribution

Positive fat tail in the observed distribution

Stocks in the righthand tail Region occupied by major winners in the stock market The far right tail of the distribution of returns is the province of major winners. As a stock departs from the central part of the distribution the relative strength improves. In my opinion the trend of relative strength gives an early indication of significant improvement before the long-term relative strength ranking systems pick up the change. Many times the movement away from the center of the distribution will be dramatic and will register as a substantial event in relative strength on the Market Dynamics System. The key question remaining is how long the stock will participate in the far right-hand portion of the distribution. This cannot be known with any certainty ahead of time. As long as the stock performs in the acceptable region it is OK – when the stock falls out of the acceptable region a replacement should be found. Managing a position in a big winner is somewhat different than managing a less dynamic position. W. Clay Allen CFA

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Big Winners - Returns – best 10% to 20% of all stocks! The far right-hand tail of the theoretical normal distribution holds about 2.0% of the total population. In the stock market, recent studies indicate that the region under the curve at the same level of extreme as measured by +2.0 standard deviations holds about 5 to 10 times as many members of the population as the theoretical normal distribution. Therefore the far right-hand tail holds 10% to 20% of the population. Major winners are far more prevalent in the stock market than they would be if the distribution of returns from stocks was an exactly normal distribution. This is also true for the left-hand tail in that 10% to 20% of the total population lie in the extremes on the left side of the distribution. Major disasters tend to form more frequently than they should if the stock market was distributed in an exactly normal fashion. This seems to explain why the stock market follows the Pareto Principle. The Pareto Principle says that approximately the best 20% of a portfolio accounts for approximately 80% of the portfolio’s return. This principle has also been called the “rule of retailing”. This observation has extremely practical implications for portfolio management. 1. Stocks in the left-hand tail (left 20%) must be avoided. 2. Stocks in the middle 60% of the distribution are of little interest until they start to out-perform. 3. Stocks in the right-hand 20% of the distribution are the most desirable holdings for the portfolio but only as long as they continue to record excess returns as measured by relative strength. 4. These opportunities seem to exist continuously in the stock market. Care must be exercised, however, to maintain adequate industry and sector diversification in the portfolio. Many times stocks in the far right-hand tail of the distribution of returns may share common fundamental characteristics. When this is the case these stocks may all reverse direction and turn down together. In highly speculative markets the population of the far right-hand tail will be among the most speculatively priced issues in the market. In the recent major bull market, the relative strength trajectory for many of these issues became nearly vertical and suggested a blow off. Portfolio managers must keep in mind that in highly speculative stocks a reversal of the relative strength trend often occurs very quickly and positions should be sold at the slightest sign of trouble.

W. Clay Allen CFA

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Market Dynamics screens -identify as the movement begins – all of these screens are on the “lists” drop-down menu

Part 1 – relative strength screens covering various time frames

Part 1 - Filenames: Bigwnrs.dat Highrs.dat Hirs1mo.dat

Part 3 – Screens for stocks showing various buy patterns on the relative strength point & figure charts. Part 3 - Filenames: Rankjump.dat Buylists.dat Tenboxup.dat Uprs.dat Bullpulb.dat Most of these screens are prepared and distributed daily with the database update over the Internet. These screens always appear in alphabetical sequence when using the “Lists” dropdown menu on the Market Dynamics System. An effective way to use the screens is to review the screen quickly and when an interesting pattern appears the chart should be sent to the printer for later study. These lists are stored in files in the \MDRS\ folder. The files are text files that are composed of one ticker symbol per line. Some users copy these lists to other systems for review in a different W. format Clay Allen CFA Page 3 1/22/2003

Highest relative strength over the past month

45-degree bullish support line

This chart is an example drawn from the Market Dynamics screen for the highest relative strength charts over the prior month. This is a list of one hundred stocks and it is updated daily.

W. Clay Allen CFA

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Highest relative strength over the past three months

This is an example drawn from the Market Dynamics screen for the best relative strength stocks over the prior three months. One hundred stocks are included in this screen and it is updated daily.

W. Clay Allen CFA

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Highest increase in relative strength rank past three weeks

Ten Xs straight up

This stock is an example drawn from the screen that ranks the stocks by the biggest jump in relative strength rank over the past three weeks. There are 50 stocks on this list and it is updated daily.

W. Clay Allen CFA

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Stocks with a pattern on ten Xs up

Ten Xs straight up

“Big moves often start with a bang”! This screen identifies stocks with a column of ten Xs straight up. We can’t tell for sure whether the move will continue but at least we know we are observing a dynamic move up. The entire database is scanned for this condition. The list will vary in length depending upon how many stocks meet the condition. The screen is updated daily.

W. Clay Allen CFA

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Triple top buy signals

A triple top buy signal is a common condition that is associated with the beginning and development of major up moves. This screen shows all stocks with this buy signal pattern. The list varies in length depending on the number of stocks that meet the criteria.

W. Clay Allen CFA

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Best time for entry - during market oversold extremes A stock that can develop a strong buy pattern or high relative strength during a deep oversold condition in the overall market is an attractive candidate for purchase provided it is of average or above average volatility. Oversold conditions can be identified by various oscillators on market averages such as intermediate to long-term Wilder RSI or stochastics. Trend condition indicators that gauge the trend status of a broad list of stocks will also give valid oversold readings at favorable times in the market. Stocks that hold up and do well during market declines are very strong stocks and the demand for these shares must be very strong. The exceptions to this rule are low volatility stocks that don’t go down because of their low volatility – these are usually thought of as defensive issues. It is probably not good portfolio strategy to delay the purchase of a very strong stock to wait for a market oversold. The entry price may not be improved that much and big winners may get away while waiting for the oversold. Potentially big stocks will usually demonstrate their future performance capability during an oversold condition in the market.

W. Clay Allen CFA

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Managing the position - Use the High performance Bullish Support line

High performance bullish support line

Big winners will often run for many columns above the high performance bullish support line. These stocks may have serious corrections and still remain above this line. The volatility of these stocks is usually quite high so the relative strength point and figure chart may cover less than a year. The high performance bullish support line also provides a rough estimate of the risk to support should a correction take place. Should the portfolio manager decide the risk to support is too great - then a sale into strength can be made.

W. Clay Allen CFA

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Managing the position - Use the “rule of nine”

High performance bullish support line

The “rule of nine” is derived from the literature on Japanese kagi charts. Kagi charts are very similar to point and figure in construction and the “rule of nine” seems to hold for relative strength point and figure charts. It is not a “hard and fast” rule but is based on the frequently observed tendency for stocks to make nine columns that record new highs during a major move up. This example shows exactly nine columns with new highs. The portfolio manager can use this rule to judge the maturity of the trend under observation. After 7 or 8 columns with new highs the stock’s relative strength plot should be watched closely for signs of a reversal or a loss of momentum. If the stock is very volatile and the gain is substantial the portfolio manager may use the “rule of nine” to sell into strength.

W. Clay Allen CFA

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Managing the position - Use up trending channels

Sell on approaching the upper bullish resistance channel line

Resistance

Upward trending channel lines are a useful guide to taking profits. The move has been significant and the objective is to capture profits while the stock is still strong. Does this guarantee that the stock will reverse – absolutely not – but the objective of taking profits while the stock is still strong has been fulfilled. If the upper channel is bring touched at a level that matches historic resistance then the sell decision is reinforced.

W. Clay Allen CFA

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Managing the position - Buy on pullbacks if possible

8 7 Columns that made new highs are numbered Triple bottom sell signal 6 5 4 3 2 1 High performance bullish support line

This big winner started its move with an upside breakout at roughly column 3 and ran to the ultimate peak in column 8. There were at least 10 pullbacks that moved the relative strength back toward the HPBSL during the move up. The congestion zone between column 5 and 6 provided an excellent opportunity to buy this stock. The level of the underlying HPBSL always defines the risk of the situation. This move terminated after 8 columns of new highs. The rule of nine was not far off! W. Clay Allen CFA

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Managing the position - If trend starts to stall switch to another candidate – loss of upside momentum – correction or reversal?????

Significant loss of upside momentum – followed by a triple bottom sell signal

The stock market represents a stochastic process where there are no “hard and fast rules”. The future is almost completely unknown. We just have to operate on the best guess we can muster at the time. Once the opportunity is gone it may be gone forever! We cannot regret that we didn’t sell at the very top. We must be satisfied if we choose to protect a significant profit from the unknown and unknowable future. Profits may disappear and not come back. We don’t want to hastily accept small profits but big gains should be taken at the first sign of trouble! A loss of upside momentum is usually a warning of an impending change in trend. W. Clay Allen CFA

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When to take profits

Multiple high performance bullish support lines

Sell on this penetration

This chart is shown with multiple high performance bullish support lines drawn as the stock moved higher. This is one way a portfolio manager can “crowd” a big winner and be more or less confident of getting out on the first significant reaction that violates the last HPBSL. Many times the major winners experience a blow-off and a top reversal is formed very quickly. These stocks are speculative “per se” so a quick exit is required to “nail down” the hard-won profits.

W. Clay Allen CFA

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Big Winners - Summary

The best ways to find the big winners of the future are the relative strength screens shown in Part 1 and the buy-pattern screens shown in part 3 of the dropdown menu. The real problem is how to narrow these lists down to a managable number. Step 1 – Drop all stocks that are locked into trading ranges. These stocks will probably not develop into big winners in the future. Trading range stocks can provide exceptional performance if the trading range is wide enough but probably not very often. Step 2 - Drop all stocks that are mature, well-established businesses that probably won’t enjoy enough fundamental improvement to develop into big winners. Step 3 – Concentrate further analysis on stocks that have something new in their fundamental picture – the N in CANSLIM by Bill O’Neil. This could be a new business, new product, new management or some other substantially new development in their fundamental picture. ______________________________________________________________________ Time Frames - The upward trajectory for a big winner usually lasts two years – sometimes three. Speculative blowoff up moves will probably be substantially shorter. It is impossible to forecast the length of time required for the big winner to complete its move. You can only track the stock on the relative strength point & figure charts and be ready to sell as the trend reverses direction. Use the upward sloping trend channel to estimate upside targets. Use the “rule of nine” to gauge the maturity of the trend being observed. ______________________________________________________________________ High Performance Bullish Support Line - The best tool for the successful management of big winners in the stock market is the high performance bullish support line. The slope of +1.5 provides a high hurdle rate of return to assure performance from the holding. The user is free to apply an even steeper support line that he/she feels is appropriate to gauge the performance of the stock. Slopes greater than +1.5 will probably result in higher turnover but may also increase performance. It must be remembered that managing stock portfolios is a very dynamic process that is not based on scientific mathematical relationships. The effective management of stock positions is more dependent on statistical thinking. Trends run until they reverse and the relative strength point & figure system seems to be an effective observational tool to spot these reversals of trend.

W. Clay Allen CFA

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To return to the tutorial table of contents click

mdtutor.pdf

303-804-0507 or FAX @ 303-804-0513 [email protected]

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

Page 17

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How to avoid the big losers in the stock market. Major losers are stocks in the left-hand tail of the distribution of returns Left-hand tail – worst 15% to 20% of all stocks – 80/20 rule works – 80% of portfolio losses come from the worst 20% of the stocks. Distribution of returns – Normal vs. Fat Tails

Observed distribution

Theoretical distribution

Negative fat tail in the observed distribution

Narrow peak in the observed distribution

Positive fat tail in the observed distribution

Stocks in the lefthand tail Region occupied by major losers in the stock market The far left tail of the distribution of returns is the region of major losers. Damage control is a major factor in successful portfolio management. Most institutional portfolios are fully invested at all times so a process of continually upgrading the portfolio is required. As soon as a stock can be identified as a non-performer it should be sold and the proceeds switched into a stock with more potential. Losers are often held far too long and performance suffers as a result. This upgrading process assures that the portfolio adapts to change in a positive way. Stocks that are too cheap to sell hurt the portfolio twice – they underperform and they occupy a slot in the portfolio that could be invested in a winner.

Clay Allen

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1/22/2003

Experience shows that it often takes a long time for a loser to turn around.

The long-term decline in ACK has taken almost two years and there is little sign of reversal at this point. A portfolio cannot withstand the effects on performance of just a few issues like ACK. A stock that performs like ACK can also lead to problems with clients over portfolio management policy and credibility.

Clay Allen

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1/22/2003

When bullish predictions fail – the litmus test is derived from the market action – don’t wait for fundamental confirmation – sell stocks that break down – more often than not, stock prices lead the news – believe what you see.

The top on SFE formed while the relative strength was 30 boxes above the 45-degree bullish support line. The 45-degree bearish resistance line has contained the relative strength decline all the way down!

45-degree bearish resistance line.

45-degree bullish support line.

-Degree

Clay Allen

Page 3

1/22/2003

Avoid bargain hunting – stocks going down are the wrong stocks to own.

45-degree bearish resistance line

The downtrend in DCX was so persistent that no triple top buy signals were recorded during the decline to date.

Clay Allen

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Two patterns that usually precede major losers Pattern #1 – Stocks that break down from major trading ranges.

45-degree bearish resistance line

Clay Allen

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Primarily a problem for “GARP” / value managers

The long-term trading range between row A and row E contained the stock for over a year and a half.

The major top on DELL appeared first as a wide trading range. The downside breakout occurred when the support at row E failed. The fundamental developments that followed signaled a drop in expectations for future earnings growth.

Clay Allen

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1/22/2003

Usually stocks with long-term fundamental deterioration.

The 45-degree bearish resistance line has been touched 5 times during this long-term decline. The relative strength action is said to “validate” this line as an important downtrend line.

45-degree bearish resistance line

Clay Allen

Page 7

1/22/2003

Trading range develops into a major top that represents solid resistance against future price rises.

The chart for CORV shows at least three trading ranges that were converted into major tops. These tops then acted as resistance zones that turned the relative strength back down. 45-degree bearish resistance line

Clay Allen

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1/22/2003

Mature company’s stocks that go into long-term financial deterioration.

A major trading range persisted for over twenty columns before the relative strength broke the 45degree bullish support line and then began its longterm decline. The trading range turned out to be a major top.

45-degree bearish resistance line 45-degree bullish support line. EK has been under a bearish trend for almost two years. This trend has been completely contained by the 45-degree bearish resistance line. A false base across row G turned out to be a ledge

Clay Allen

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The danger of “bottom fishing” – incomplete basing patterns – negative surprises.

Major long-term trading range.

45-degree bearish resistance line After breaking down from this long-term trading range, XRX lost more than 90% of its value. A false base formed about halfway down that proved to be a ledge. The 45-degree bearish resistance line has completely contained the downside move since late ‘99

Clay Allen

The chart on XRX is testimony to the importance of the 45-degree bearish resistance line.

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Avoid stocks that show long-term distribution.

45-degree bearish resistance line

45-degree bullish support line.

WCOM has shown a pattern of distribution for more than a year. All of the overhead supply will act as resistance and will deter any upward trends.

Clay Allen

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Pattern #2 -Speculative stocks that break down / collapse

45-degree bearish resistance line

45-degree bullish support line.

The top on LXK formed very quickly and was confirmed by the reversal thru the 45degree bullish support line.

Clay Allen

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#2 Primarily a problem for momentum / growth managers

45-degree bearish resistance line

Clay Allen

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Earnings disappointments – dramatic psychology reversal.

Clay Allen

Page 14

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Rapid reversal from up to down – often does not show a major top – downside usually much faster than the upside.

45-degree bearish resistance line

45-degree bullish support line.

Clay Allen

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Prior bull move suggests magnitude of risk.

45-degree bearish resistance line

45-degree bullish support line.

Clay Allen

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Major risk associated with “bottom fishing”

45-degree bearish resistance line

JCP experienced a persistent long-term major decline relative to the market.

Clay Allen

Page 17

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45-degree bearish resistance line is critical in avoiding premature purchase.

45-degree bearish resistance line

It is always easy with hindsight to review a chart and believe that the action would have been taken at just the right time. It is far more difficult in real-time, while the issue is still uncertain, to be as confident of the result. Many times, in my experience, the best decisions are made while the outcome is very much in doubt!

Clay Allen

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Ledges – false bases and downside breakouts – stop outs

45-degree bearish resistance line

Clay Allen

Page 19

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Losers hurt performance in two ways

45-degree bearish resistance line

45-degree bullish support line.

Clay Allen

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Losers are defined by their failure to perform.

45-degree bearish resistance line

Clay Allen

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Losers occupy a position in the portfolio that could be invested in a winner.

45-degree bearish resistance line

45-degree bullish support line.

Clay Allen

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The portfolio manager must be able to diagnose and act on the transition from winner to loser.

45-degree bearish resistance line

Clay Allen

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The identification of problem stocks in a timely manner drives the portfolio upgrading process.

AMZN set up a shallow conventional downtrend line that has remained in effect for a long time. The various rally attempts proved to be false bottoms and the stock’s RS continued to deteriorate.

Clay Allen

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There is a tendency to underestimate downside risk.

45-degree bearish resistance line

45-degree bullish support line.

Clay Allen

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Summary and Conclusion Damage control is an exceedingly important part of successful portfolio management. The identification of non-performing stocks is critical to the achievement of performance objectives. The long-term relative strength charts in point and figure format are ideal for tracking the performance of stocks in the portfolio. The 45-degree bullish support line provides an easy test to assure that the stock is perforating up to expectations. Stocks that fall below the 45-degree bullish support line can be switched into more promising issues. This process of continual portfolio upgrading is key to the long-term performance of the portfolio. The upgrading process allows the portfolio to adapt to changes in fundamentals on a timely basis. Non-performing stocks will be eliminated from the portfolio while the loss is still manageable and major disasters will, for the most part, be avoided altogether. In my opinion, portfolio managers should worry less about taking profits and more about the elimination of non-performing stocks. As Peter Lynch said “we should water the flowers and pull the weeds”.

To return to the main tutorial mdtutor.pdf

303-804-0507 or FAX @ 303-804-0513 [email protected]

Clay Allen

Page 26

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Managing stocks in long-term trading ranges – 60% to 70% of all stocks exhibit trading range patterns – even in a bull market. Distribution of returns – Normal vs. Fat Tails

Theoretical distribution

Negative fat tail in the observed distribution

Observed distribution

Narrow peak in the observed distribution

Positive fat tail in the observed distribution

60% TO 70% OF ALL STOCKS ARE IN THIS REGION – ALL THE TIME

The central part of the distribution of returns holds about 60% to 70% of the population at any given time. This is also true for relative returns as measured by relative strength. These stocks do not move in major trends and more often than not they will exhibit a trading range pattern on the relative strength point and figure charts. The presentation used by Market Dynamics is long-term in perspective and four years of data are used to construct these charts. This becomes very important when assessing the extremes of historic trading ranges. Trading ranges reflect the repeated reversals of trends at about the same levels on the charts over time. The more frequently a level on the chart has proved to be a reversal level the more important that reversal level becomes. Trading ranges are a function of long-term support and resistance at work. Naturally the high reversal points offer an opportunity to sell and the low reversal points offer a chance to buy. If the trading range fails and a downside breakout occurs then the risk is limited to the level just below the failure point. By buying close to the trading range failure point the risk of the position is limited. By taking advantage of trading ranges the portfolio manager is able to sell into strength and to buy after weakness. Profits are captured at near maximums and retracement is avoided.

W. Clay Allen CFA

Page 1

1/22/2003

JPM - Trading Range

This is an example of a trading range on the relative strength p&f chart. This company is a large, fairly mature, high quality financial institution. These kinds of stocks normally do not have major bull and bear runs. It is not uncommon for large cap mature stocks to be locked into trading ranges for extended periods of time – sometimes several years or more. There is usually considerable profit opportunity from the low end of the trading range to the high. Relative strength seems to be particularly well suited to the management of stocks in trading ranges. The 45° bullish support lines are not as important in dealing with stocks in trading ranges as they are with stocks in major long-tern trends. The recent extremes of the trading range provide an estimate of the possible upside potential and the likely downside risk. These estimates should not be considered to be precise but are a general guide as to likely reversal points.

W. Clay Allen CFA

Page 2

1/22/2003

CPQ - Trading Range

This is an example of a trading range that shifted to a lower level and then narrowed considerably. This is somewhat unusual because while trading ranges may shift up and down they usually retain their range from low to high. The trading range over the past year is very narrow and shows limited upside potential even if the stock is purchased at the absolute low of the trading range!

W. Clay Allen CFA

Page 3

1/22/2003

XOM - Trading Range

This is a very narrow trading range that has persisted for over a year. This stock does offer a safe-haven during declining periods in the market but limited upside potential.

W. Clay Allen CFA

Page 4

1/22/2003

GBLX - Trading Range

This is an extended trading range that has a range of almost 35 boxes from bottom to top. This range shows a base forming recently at a level about 5 boxes above the prior low end of the range. In this case, the upside potential appears to be substantial relative to the market provided the fundamentals suggest an big upside move is about to begin. The 45° bullish support lines were late in their signals of reversals from the high end of the trading range.

W. Clay Allen CFA

Page 5

1/22/2003

FNDT - Trading Range

This trading range has shown several oscillations from low to high and back. Once setup – trading ranges seem to be better at suggesting sell points at the high end than picking buy points at the low end. In my experience, it is more likely for stocks to breakout of trading ranges in the downward direction than to breakout to the upside. It seems that more dramatic changes in fundamentals are required to generate an upside breakout. A downside breakout can be the result of prolonged dullness and a slow deterioration in the fundamental performance of the stock. When using the trading range to time a purchase, it seems prudent to wait for a meaningful base to form in the lower levels of the trading range. This adds confirmation of support at the low end of the trading range.

W. Clay Allen CFA

Page 6

1/22/2003

AOL - Trading Range

Triple top buy signal

This chart shows 45° bearish resistance lines that confirmed the prior reversal from the low end of the trading range. The stock appears to be building a base recently and may be in the process of turning up. Support has been recorded across row (C) on three occasions. In my opinion the failure point would be recorded by a drop below the main low at row (H). The upside potential as measured by the upper extreme is over 20 boxes, which is substantial. It is far from certain that the trading range will support the stock but it currently looks promising. There is a triple top buy signal that was recorded in the prior column.

W. Clay Allen CFA

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TYC - Trading Range

This stock appears to be testing the high extreme of a trading range. If the stock is currently in the portfolio it could be given some time to see if an upside breakout might materialize. If the stock was not currently owned it will probably be best to wait for a better entry point. This trading range covers several years. The longer the prior resistance levels contain the upside movement, the more likely the resistance will turn the stock back down into the trading range.

W. Clay Allen CFA

Page 8

1/22/2003

RATL - Trading Range

This stock seems to have more of an uptrend look but the trading range possibility is very real. If the stock is able to breakout, then rely on the 45° bullish support line to provide an indication of a downside reversal when it occurs. The stock has started to move sideways for the past 6 columns at roughly the level of the old resistance. This adds to the evidence that supports the trading range chart interpretation. Sometimes we just have to wait for the situation to clarify itself. In my opinion, it is always better to err of the side of conservatism, which supports the trading range opinion for this stock.

W. Clay Allen CFA

Page 9

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BBY - Trading Range

Earlier this year this stock made a minor breakout above the old highs of the trading range and then failed. The 45° bullish support line was broken after a top formed roughly at the old trading range highs. A recent move back into the upper regions of the trading range has developed. In my opinion this recent move should be given a low probability of a trading range breakout to the upside. The number of columns that have reversed at roughly the row (B) level suggests serious resistance. These are the kinds of judgments that are often used to interpret a trading range and the likely movement within the trading range.

W. Clay Allen CFA

Page 10

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GILD - Trading Range

This stock has shown several oscillations up and down within a trading range over the past year. Currently the stock has reversed downward from a level that approximates the high end of the trading range. The low end of the trading range is 15 boxes or more below current levels, suggesting serious downside risk relative to the market. The failure of the stock to hold its position above the 45° bullish support lines also adds evidence to the trading range conclusion.

W. Clay Allen CFA

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1/22/2003

NEM - Trading Range

This trading range covers over two years and the current position is at the very low end of the trading range. The very long–term nature of this trading range suggests that a dramatic turnaround will be required to breakout above the old resistance. This stock is in the gold mining industry where the current consensus opinion is that gold will never come back and gold mining stocks should be avoided completely. Even with all the negative psychology surrounding this industry, the stock has not broken below the old lows of the trading range. The low end of the trading range may hold but it is an altogether different matter to anticipate an upside breakout from the trading range. The upside breakout should be given a much lower probability assessment than an opinion that the trading range low will hold.

W. Clay Allen CFA

Page 12

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FDO - Trading Range

This is another example of a very long-term trading range. Here again a dramatic fundamental change will be required to generate a breakout to the upside from this trading range. Therefore the potential upside appears to be limited. It should also be remembered that a downside breakout carries a higher probably in the long run. This could be the result of a slow but persistent deterioration in the fundamentals of the company.

W. Clay Allen CFA

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DV - Trading Range

This is another example of a long-term trading range with limited upside potential. Previous comments apply.

W. Clay Allen CFA

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EAT - Trading Range

The big problem with long-term trading ranges is the tendency to ride them up and down with little progress as a result. In addition, I believe many more trading ranges are terminated with a downside breakout than with an upside breakout. A long-term trading range betrays a certain lack of direction, which may actually be the result of management complacency with or inability to improve upon the “status quo” in the conduct of the business. The modern economy seems to be very dynamic and companies are either moving forward or going backward. Things don’t stand still for very long! So a long-term trading range should not be considered as a positive by investors. Investors should take advantage of trading ranges and not get “locked” into them.

W. Clay Allen CFA

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EL - Trading Range

This is a long-term trading range that has narrowed considerably. Recently there has been a tendency for the swings from low to high to be only about ten boxes. Which way will the breakout go? We can’t know until it takes place! It seems clear that more interesting stocks could be found to replace a stock in such a limited trading range.

W. Clay Allen CFA

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EPG - Trading Range

The burden of proof remains with a stock like this until it breaks out. A long-term trading range should be assumed to remain in place until it is definitely replaced by a major trend movement in one direction or the other.

W. Clay Allen CFA

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MIL - Trading Range

It appears that historic resistance has turned this stock down at almost exactly the same levels as in a prior trading range. The 45° bullish support line is currently providing support but the resistance seems to be formidable. The resistance that appeared is from levels that were recorded 2 or 3 years ago. This demonstrates the need for a chart presentation that covers several years of history.

W. Clay Allen CFA

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PFE - Trading Range

The large number of long-term trading range examples that have been included in this tutorial is to make the point that dealing with long-term trading ranges is a major part of successful portfolio management. To repeat, 60% to 70% of all stocks are showing trading range patterns all the time. Unless your stock is in one of the extreme tails of the distribution, the stock is most likely to be experiencing a long-term trading range. Value managers and anyone trying to apply contrary opinion will be dealing with long-term trading ranges most of the time.

W. Clay Allen CFA

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USIX - Trading Range

In my opinion, the most likely pattern to follow a major bear market move by a stock is a long-term trading range. It is also likely that the new trading range will develop at a much lower level than the prior bull market highs. It is also unrealistic to expect the stock to recycle quickly back to the old highs if the range is as broad as it is for this stock. The lower end of old resistance will set up a new ceiling that will limit the stocks ability to go up. Investors seem to want to buy stocks that have gone down the most. This seems to ignore the probabilities that a new bull move in the stock is less likely than a longterm trading range. The distribution of returns in the stock market makes this conclusion inescapable. A long-term trading range that is terminated by an upside breakout is usually what is meant by an upside breakout from a major base. During the formation of a major base (i.e. long-term trading range) the high priced stock with losses is sold by the weak holders and the stock goes into the hands of strong holders who are willing to buy for the long-term based on knowledge of the long-term fundamental value of the stock. This process takes a long time! The upside breakout is totally uncertain until it becomes a reality. The trading range may be a base or it may be a ledge and we can’t tell “for sure” until the breakout occurs. In my experience, it is more likely that a trading range will turnout to be a ledge than a base and that it usually takes longer than you think. W. Clay Allen CFA

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DELL - Trading Range

This is an example of a trading range that developed after a prolonged bullish trend. Will this trading range turn out to be a top or a base for another move up? We don’t know and we can’t know until the breakout occurs. It is more likely to be a top than a base, in my opinion. The sideways movement through the 45° bullish support line seems to add to the evidence that it will be a top. This trading range has been in place for so long that a downside breakout will trap many investors with high-priced stock, which is being held at a loss (i.e. weak holders). Weak holders are more inclined to sell and the downside price breakout from a top converts many investors into weak holders.

W. Clay Allen CFA

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CMB - Trading Range

Another long-term trading range.

W. Clay Allen CFA

Page 22

1/22/2003

OXHP - Trading Range

This chart shows the development of a new long-term trading range after a major bear move to the downside. This stock has not quickly run back to the old highs as is hoped for by the bargain hunters that want to buy the stocks that have gone down the most. This trading range has been in place for the past two years. It makes little sense to say this stock is cheap at 20 only because it once traded at 60. The basing process that sets up the next bull move requires a prolonged trading range during which stock is transferred back into the hands of strong holders. This is what takes time! The width of the new base should be roughly as wide as the width of the old trading range that turned out to be a top. The existence of weak holders is what creates resistance and precludes rapid movement back to the old highs.

W. Clay Allen CFA

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GENZ - Trading Range

This stock has experienced several oscillations back and forth within its trading range.

W. Clay Allen CFA

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PG - Trading Range

This shows a drop from one trading range to a lower trading range. Many times the new trading range will be very similar in amplitude to the old trading range. This tendency for the amplitude to repeat is useful to investors when estimating the extent of moves in the new trading range. Several examples follow.

W. Clay Allen CFA

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DE - Trading Range

The amplitudes of these trading ranges are remarkably similar!

W. Clay Allen CFA

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EFII - Trading Range

As of the time of preparation of this tutorial, this lower trading range is only an estimate. The early oscillations have been constrained but it would seem likely to me that the new trading range should expand to match the amplitude of the old trading range. The width of the top was many columns wide and the width of the new trading range should match the width of the old top.

W. Clay Allen CFA

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ALL - Trading Range

The new lower trading range amplitude is just a little wider than the old trading range.

W. Clay Allen CFA

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TRADING RANGES – SUMMARY Trading ranges are among the most important patterns in the analysis of relative strength in point and figure format. It is important to note how frequently trading ranges appear on these charts – i.e. 60% to 70% of all stocks are in trading ranges all the time. Many times, trading ranges will persist for serveral years or more. The stocks of large cap, mature companies will often be in trading ranges for prolonged periods. The amplitudes of trading ranges seem to repeat from one time period to the next. Simple rule – buy at the lower extreme of the trading range and sell close to the hgih end of the trading range. The extremes are not precise – a box or two is close enough! In my opinion, it is easier for trading ranges to breakout to the downside vs upside breakouts. The very first step in the analysis of a chart of relative strength in point and figure format is the application of the principles of trading range analysis to the chart being reviewed. Trading ranges should limit the desire to be a bargain hunter until a trading range is in evidence and reasonable estimates of the extremes of the trading range can be relied upon. The stock must be able to prove that it has stopped going down! A trading range does not constitute a base until a meaningful upside breakout has taken place. Trading ranges show up clearly on the long-term relative strength point and figure charts.

W. Clay Allen CFA

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To return to the tutorial table of contents click

mdtutor.pdf

303-804-0507 or FAX @ 303-804-0513 [email protected]

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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MARKET DYNAMICS PERFORMANCE MANAGEMENT SYSTEM

Performance Alarm Tutorial

1/19/2003 Clay Allen CFA

Page 1

2/4/2003

Performance is a characteristic of a portfolio that can and should be managed. It should not be left to chance. W. Clay Allen CFA

AA -

45ºbullish support line

ABC -

45ºbullish support line The Performance Alarm was added to the Market Dynamics system late in the year 2000. It is designed to identify stocks with unacceptable performance and it does not require interpretation of the chart by the user. It is a completely automatic function, the chart turns red and the “PERFORMANCE ALARM” message is displayed at the bottom of the chart. The Performance Alarm requires the chart to contain a triple bottom sell signal and to have violated a 45º bullish support line.

In this chapter there are many examples of stocks that turned red and stayed red. The persistence of the PA is an important part of its use. The PA is repeated every time the chart is viewed, increasing the likelihood that unacceptable stocks will be sold.

45º bullish support line 45º bearish resistance line 45º bearish resistance line

The 45º bullish support line is drawn upward to the right at a 45º angle from a prominent low point on the chart - usually the bottom of a column of Os

Clay Allen CFA

ABIZ – This is an example of a long-term persistent PA.

Page 2

2/4/2003

ADCT -

ACK – The PA turned on and remained on for several years.

A persistent long-term downtrend will usually record multiple 45ºsupport line violations.

During the past several years of protracted bear market, many speculative stocks have fallen into a price range below $2.00. In almost every case, the Performance Alarm warned of impeding problems with the stock.

AES ANR -

45º bearish resistance line The PA remains “on” and the chart stays red until a reversing buy signal is recorded by a triple top buy signal and a move above the 45º bearish resistance line.

Clay Allen CFA

A steep uptrend line is shown on this chart.

Page 3

2/4/2003

45º bearish resistance line 45º bearish resistance line

ARBA -

AYE -

45º bullish support line

Many times over the past several years, stocks that go into a Performance Alarm turn out to be disasters in the market.

45º bearish resistance line

45º bearish resistance line

AZPN -

45º bullish support line

A red line has been drawn on the chart of AZPN to highlight the historic resistance level. The last major rally fell short of the resistance line by a small amount but a major decline followed.

Clay Allen CFA

Page 4

BAX -

A green line has been drawn to emphasize the support level on BAX. It is usually best to wait for the support zone to confirm its ability to support the stock before a purchase is made.

2/4/2003

BBI -

BDK -

The 45º bullish support line can be drawn at the highest point possible to minimize risk. A triple bottom sell signal after a prominent high point is reached will usually turn on the Performance Alarm.

It is usually impossible to know how long a Performance Alarm will persist. The longer it persists the worse the performance will become. Sticking with a stock on a Performance Alarm appears to be a very poor bet and in a large proportion of the cases, it will turn out to be a major mistake

BIKE -

BLUE -

This chart compresses four full years of data into about 15 columns. This is a case of a low volatility stock that fell into a persistent long-term downtrend. This stock has fallen so much that it has almost ceased to have any value.

Clay Allen CFA

Page 5

The PA may turn on and off several times during a long-term decline as a stock attempts to find support and minor bases are formed that do not hold up.

2/4/2003

BMY -

BRCD -

BASE Rally This is another example of a stock that topped out close to the old highs. Trading ranges often appear on the charts of large mature companies. This chart also emphasizes the fact that building a base takes lots of time. The rally that started at about row F between columns 11 and 12 it ran into significant resistance before reaching the old highs. This is usually a sign of serious weakness.

CCK – A disastrous long-term decline that covered several years. Portfolio managers must avoid the temptation to buy into a “cheap” stock in a persistent downtrend such as this. Bargain hunting in stocks like this is almost always a losing proposition.

BUD - Is this the start of something big? We don’t/can’t know - but many a disaster looked like BUD when it started.

Clay Allen CFA

Page 6

2/4/2003

CHTR -

CGO – This stock clearly shows a “ledge” about halfway down.

This is another example of a major top followed by a Performance Alarm and a disastrous decline.

CI -

CIEN – This Performance Alarm recorded two distinct waves down. It challenged the 45º bearish resistance line but could not break above it.

CI traced out a major top from (B, 3) to (B,8). A top this wide usually implies a deep downside projection.

Clay Allen CFA

Page 7

2/4/2003

CMGI – It is best to avoid stocks like this until they can reverse the 45º bearish resistance line.

CMVT – Major long-term declines usually require an extended period of time to base out and stop going down. This stock experienced several major waves down without reversing the 45º bearish resistance line.

CNXT -

CNC – this example shows a major decline, followed by a major rally and then the resumption of the downtrend - ending in Chapter 11. Clay Allen CFA

Page 8

Multiple support line failures on the way down.

2/4/2003

CPN – A persistent long-term downtrend.

45º bullish support line CPST – A break below a conventional trendline turned out to be a very serious development for this stock.

After making a significant high, a triple bottom sell signal will turn on the Performance Alarm.

CSCO – The back and forth action on CSCO was sure sign of significant distribution at work.

Clay Allen CFA

Page 9

CWP – It is always very dangerous to conclude that a stock has gone down too much!

2/4/2003

CY – Another example of a PA following a reversal at a major resistance level.

DAL – The area of distribution is very clear in this example.

DUK – A rounding top preceded the onset of the Performance Alarm. The stock has moved down into a support level but the base is still incomplete at this time. DT – This is an example of a major stock that reversed rapidly and fell into “free fall”.

Clay Allen CFA

Page 10

2/4/2003

DYN – This stock traced out a huge rounding top. A top like this acts as severe overhead resistance and will usually cause any rally attempt to fail. The depth of the decline is usually a function of the width of the top

ELN – The major top on this stock was traced out between $50 and $60 and the stock has fallen below $4.00.

EMC – bargain hunters pursued this stock all the way down.

ENE – This is an example of a major corporate fraud. While accounting reports and optimistic management statements proved to be false and completely misleading, the trace on the chart proved to be an absolutely accurate reflection of the negative developments at ENE.

Clay Allen CFA

Page 11

2/4/2003

ENMD – The red horizontal lines show multiple zones of resistance

EP – This is another example of multiple support line failures.

ERICY – Once a major speculative move has been completed it is best to avoid the stock until a major base can actually be observed.

Clay Allen CFA

ERTS – The light green line shows a level where buying support could be expected to halt the decline. This is only an estimate and it is best to wait for the stock to prove that it has stopped going down. When a base forms it will be plainly visible and the Performance Alarm will turn off.

Page 12

2/4/2003

EXPE – The PA has turned on after a major top has developed. The top should be expected to provide significant resistance against any future rally.

F – There now appears to be considerable resistance across the level between rows D and E.

FTS – The PA turned on after several major resistance areas were formed. No significant basing at this point.

FCS – Support has held so far – but the basing action does not appear capable of supporting a long-term reversal of the downtrend at this point.

Clay Allen CFA

Page 13

2/4/2003

?

GMSTE - This stock experienced a two-stage decline with a dangerous ledge in the middle.

HET – This stock has experienced excellent long-term performance but a major reversal appears to have formed and we can’t tell at this point how bad the downside might be.

JCP – This bearish move lasted over three years. It will probably develop a wide base before a bull move can be sustained.

INHL – This is another example of resistance turning a stock back down after a big rally.

Clay Allen CFA

Page 14

2/4/2003

JDSU – A common mistake is to underestimate the seriousness of the risk during a major decline.

JNPR – It is very common for a major decline to experience a significant rally about midway through the decline.

The failure of support at row E was a very serious development.

LGND – Long-term resistance turned this stock down into a major decline. It also appears that recent support is failing and the decline is set to resume.

Clay Allen CFA

Page 15

LU – Even seasoned stock market veterans got caught in this trap.

2/4/2003

MCK – All rallies on the way down were met with determined selling that constantly pushed the stock lower.

MIR – This is another example of the dangers of bargain hunting.

Clay Allen CFA

Page 16

MDR – This is another example of an extremely persistent decline that remained below the 45º bearish resistance line throughout the decline.

MM – The decline in this stock has persisted and the stock no longer trades.

2/4/2003

MO – A major rounding top preceded the Performance Alarm. The argument is frequently given that the dividend yield will support this stock. That remains to be seen!

NVDA – A major base is forming but the stock remains below the 45º bearish resistance line. Therefore, it is still too early to get involved. It is best to wait for the Performance Alarm to turn off.

NT – It is shocking to many investors that distribution can persist for so long!

Clay Allen CFA

NAFCE – A classic double top formed on this stock and it has retraced almost the entire bullish move that preceded the top.

Page 17

2/4/2003

OCAS – The reversal below a very steep conventional up trend line signaled the end of the uptrend and the onset of the Performance Alarm.

OCLR – The violation of the longterm 45º bullish support line signaled the end of the uptrend for OCLR.

OWC – This is another example of the dangers of bargain hunting. This has been a prolonged bear market, so drops like this have been quite common. OMG – A rounding top and a test of resistance preceded the extremely sharp drop experienced by OM.

Clay Allen CFA

Page 18

2/4/2003

PALM – When a speculative bubble bursts the result is usually something like this.

PBY – Another longterm bear trend with a dangerous ledge about half way down. The more recent performance has improved markedly

PCS – The major congestion zone across row G gave the appearance of a base but when it broke below row H, the ledge became apparent. PCCC – A sudden reversal from up to down was recorded by this stock. Clay Allen CFA

Page 19

2/4/2003

PCTI – The violation of a near vertical up trend line signaled the reversal to the downside.

? PDCO – A long-term major advance seems to have ended. There is no way to know how deep the decline may be.

Extremely speculative stocks do not seem to go through the extended topping, distribution phase that is usually recorded by more mature stocks.

PMTC – A double top leading to a major decline

PKI – Overhead resistance will usually limit a stocks upside potential.

Clay Allen CFA

Page 20

2/4/2003

PVN – This stock suddenly broke below support and suffered a massive collapse. This stock may remain dull for an extended period.

PRD – The failure of a conventional trend line and breaking of support was an extremely negative development for PRD. This stock no longer trades

REV – A trading range set up in late 1998 and lasted until late 1999 when the stock broke support and a PA turned on.

Q – This downtrend started with a break of a well-established support zone. More recently the stock has built a significant base.

Clay Allen CFA

Page 21

2/4/2003

SAMC – Another example of a long-term persistent downtrend.

S – This shows a fairly typical sequence. A very steep uptrend was in place for a few years and then a top formed which offered stubborn resistance to all rallies. The top was confirmed when the stock broke down and the PA turned on. The stock has now retreated almost all the way back to the point where the original uptrend began.

SAPE – A former high – flyer that fell into a persistent downtrend. SANM - Resistance turned back two major rallies before a PA turned on.

Clay Allen CFA

Page 22

2/4/2003

SEBL – A PA that turns on after a rally into stubborn resistance should be treated as a very serious negative signal.

It is hard to believe that the high price on SEBL was almost $120 per share. Investors cannot be complacent just because they are oriented to the long-term!

SEI – An abrupt reversal from up to down was marked by the Performance Alarm. This chart shows clearly the importance of the 45º bullish support line and the serious consequences that often follow a reversal of that trend line.

SFE – It is astonishing that this stock offered so many indications of unacceptable performance. Bargain hunters must have tried repeatedly to turn this stock back to the upside. SEPR – Resistance and then a reversal of the 45º bullish support line followed by the Performance Alarm provided a clear indication of poor performance on this stock.

Clay Allen CFA

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SKS – Resistance followed by the failure of the 45º bullish support line and the PA led to a serious downside move.

TLAB – Resistance followed by the 45º bullish support line failure and a Performance Alarm – a very negative combination.

Clay Allen CFA

SONE – Persistent decline. It is not a good idea to try to buck a trend like this.

TPC – A breakdown from a major sideways consolidation caused the PA to turn on well ahead of the persistent decline.

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TRI – This appears to be a major reversal to the downside. This chart also shows the failure of a long-term conventional trend line

U – Another long, slow slide into bankruptcy.

UAL – The long, slow slide into chapter 11. Bargain hunters beware!

VRSN – “The Main Sequence” – resistance -followed by the failure of the 45º bullish support line and the appearance of the Performance Alarm.

Clay Allen CFA

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VTSS – Resistance and a top usually starts the slide.

WAVX - Ditto

WCOME – The PA actually turned off about column 8 and turned back on about column 11 WMB – The PA turned on in time to signal danger well ahead of the ensuing decline.

Clay Allen CFA

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YHOO – One of the most popular Internet stocks shows the persistent PA through July 2001. The Performance Alarm subsequently turned off after a substantial base formed.

WMT – Is this the start of something big? No one knows but the PA is a clear danger signal.

To return to the table of contents mdtutor.pdf Contact Market Dynamics at 303-804-0507 or FAX @ 303-804-0513 [email protected] THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

Clay Allen CFA

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2/4/2003

How to subscribe to Market Dynamics for Windows Free trial subscription – open to all investors – three months of free data and service – no obligation Annual subscription $600 per year for individuals - $2000 per year site license for institutions. Contact Market Dynamics; 303-804-0507, FAX @ 303-804-0513 or e-mail Name

[email protected]

_________________________________

Company _________________________________ Address _________________________________ _________________________________

City

_______________________________ State ____________ Zip ________

E-mail address

___________________________________

The daily updates are only available over the Internet so we will need your e-mail address. Your e-mail address will remain totally confidential. Please allow three to five days for delivery of the CD-ROM – instructions are included

MARKET DYNAMICS

page 1

Free e-book tutorial on relative strength in point and figure format The CD-ROM includes a complete “e-book” tutorial on the use of the Market Dynamics System and how to use relative strength point and figure charting. The e-book tutorial is in Adobe Acrobat format and includes dozens of Market Dynamics examples and descriptions of important chart patterns and discussions of the most important aspects of the methodology. The Adobe Acrobat format displays an outline organized as bookmarks that allow the user to move around in the tutorial at will and to skip over basic material in order to go straight to the more advanced topics. The “e-book’ tutorial can also be used by newcomers to relative strength point and figure charting as a study guide that begins with introductory material and proceeds to more advanced aspects of relative strength analysis. The author’s experience with three boxes - point and figure charting over the past thirtyfive years provides a unique perspective on this valuable tool. The tutorial also includes research tests and simulations of the effectiveness of the relative strength point and figure approach that have been conducted by the author. The visual impact of the system will stand out and users should get a feel for the speed and effectiveness of this tool in the management of long-term investment portfolios.

MARKET DYNAMICS

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Note: The entire Market Dynamics System takes up less than 3 million bytes of storage due to a proprietary compression program for the charts. This compression routine has the added advantage of making the creation of the charts on the screen almost instantaneous. The speed allows a portfolio manager to review the relative performance of many stocks in a very short period of time. This system will not work with data provided by other vendors. W. Clay Allen CFA Market Dynamics November 10, 2003

To return to the tutorial table of contents click

MARKET DYNAMICS

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mdtutor.pdf

Installing Market Dynamics Insert the CD-ROM into the CD drive. The letter for the drive is usually D or E. The following chapter of the tutorial shows the installation process step by step. If you have an old version of Market Dynamics on your computer you should remove it before installing a newer version of the program – use start – settings – control panel – add/remove programs – select Market Dynamics – add/remove - to remove the old program. This chapter also includes instructions for downloading the daily update files from the attachments on the daily e-mails – see Daily Updates.

On the Desktop - click on START

W. Clay Allen CFA

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RUN

- click on RUN

The START drop-down menu box – Click on RUN

W. Clay Allen CFA

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Run Dialog Box The Run dialog box will open and you should enter the letter for the CD drive and “:\Setup.exe”. You can use the Browse button to find the setup file on the CDROM. When the correct drive letter and “:\Setup.exe” is entered into the Dialog Box then click enter to start the installation process. The drive letter is usually D or E.

Click on OK to start the installation program

W. Clay Allen CFA

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SETUP starts running the installation process – this screen will appear as it copies files.

Close All Programs dialog box – The first box to click

Click the OK button to proceed W. Clay Allen CFA Page 4

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Market Dynamics setup box

Click on this button to install Market Dynamics

W. Clay Allen CFA

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Program group dialog box

Click “continue” button to proceed with the Market Dynamics installation

W. Clay Allen CFA

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Progress Box – This box will show the progress of the installation process. You don’t need to do anything.

Installation Complete – When the installation is complete this box will appear.

W. Clay Allen CFA

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Creating a shortcut on the Desktop The shortcut will quickly start the Market Dynamics program.

Select this option to create the shortcut

To create a shortcut – in Windows Explorer select the \MDRS folder and then select the Market Dynamics application by clicking on it. Then right click the highlighted file and this drop-down menu box will appear. To create the shortcut click on the Create Shortcut option and the shortcut will be created. It will appear as a file in the right pane that you can select and then drag to the desktop. The desktop folder appears at the very top of the left pane when using Windows Explorer. Click on the shortcut and hold the mouse button down as you drag the file to the desktop at the top of the left pane. You can also create a shortcut by using – Start – Programs – Market Dynamics – right click and select create shortcut – then drag to any part of the desktop.

W. Clay Allen CFA

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RUN MARKET DYNAMICS – if you have not created a shortcut

To run Market Dynamics use –Start – Programs – find Market Dynamics in the programs menu and double click on it to start the program. This sequence can also be used to create the shortcut with a right click.

W. Clay Allen CFA

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Daily Updates The attachments to the “WCA-Update” e-mail are a complete set of files to totally update the Market Dynamics System. If days are missed - use only the most recent e-mail attachments to update the system – there is no need to update any but the most recent day’s files.

This shows how the e-mail appears in Outlook Express. The attachments are shown in the attachments pane.

W. Clay Allen CFA

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SAVING ATTACHMENTS Select – file – save attachments – to begin the download process. These steps will allow you to download the attachments and to update the files used by the Market Dynamics System. First select file

Second - This drop-down menu appears when file is selected. Click save attachments to move to the save attachments dialog box shown next.

W. Clay Allen CFA

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SAVE ATTACHMENTS DIALOG BOX This dialog box appears after clicking the “save Attachments” option on the file drop-down menu

When all is setup correctly – click the “Save “ button to start the download of the attachments.

List of attachments – eleven files at the present time

Save To box

Use the “Browse” button, if needed, to make sure that “C:\MDRS” appears in the “Save to” box. You can also type the “C:\MDRS” into the “Save To” box if that is more convenient. This determines the folder where the files will be downloaded. The Market Dynamics System and all data files must be located in this folder so it is important to carry out this step or the system will not update properly.

W. Clay Allen CFA

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Click “Select All” option to select all the attachments for the download. When they have been selected they will appear as highlighted

1/22/2003

REPLACE EXISTING FILES As each file is downloaded this dialog box appears to make sure you want to replace an existing file – Answer yes to each by clicking on the “yes” button. This can be done very quickly by using the mouse to click it.

By rapidly clicking on the “yes” button the files will be replaced and the download completed. When all the files have been overwritten the dialog box will disappear and you will return to the main e-mail screen that appeared at the beginning of the download process. This completes the daily download process. You can close the e-mail window and start the Market Dynamics program.

W. Clay Allen CFA

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To return to the tutorial table of contents click

mdtutor.pdf

303-804-0507 or FAX @ 303-804-0513 [email protected]

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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Advantages - system designed to enhance performance – retain major winners

After the upside breakout from the base this stock enjoyed a fairly orderly advance for the past year. The bullish support line supported the stock several times and was not seriously penetrated once the move got going.

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Eliminate losers before they do serious damage to the portfolio

This stock has been declining for almost four years. It experienced multiple failures of support lines and it remained below the longterm bearish resistance line almost all the way down.

W. Clay Allen CFA

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System oriented to portfolio upgrading

When long-term trends reverse direction- the portfolio manager has the best opportunity to upgrade the appreciation potential of the portfolio. It is probably impossible to sell at the top when using a trend following system but it is possible to avoid riding the stock back down after the trend has changed. These reversals are highly visual and do not require a complicated analysis for their recognition. Many times these signals are given in a timely fashion shortly after the top.

W. Clay Allen CFA

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Portfolio upgrading #2

This stock repeatedly formed small bases and tried to break out to the upside but the 45-degree bullish support lines repeatedly failed to support the up moves. From a performance point of view - this stock probably didn’t hurt short-term performance enough to be sold but the cumulative shortfall in performance had a serious long-term negative impact on the portfolio’s performance. In my opinion, the failure to perform is a valid reason to sell out the position. The Market Dynamics System provides a highly visual “report card” on each stock’s performance. The true cost of holding a stock like this is the performance that was not achieved that could have been realized in a better performing issue.

W. Clay Allen CFA

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Description of the service and how it works - Main Charting screen

This is the main charting screen. The use of the controls on the left will be covered in the following sections. The system is usually controlled by mouse clicks and the enter key.

W. Clay Allen CFA

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Ticker symbol input while using a list

Click the button indicating, “ticker symbol input” and the ticker symbol dialog box will appear – enter the ticker symbol in the line where the cursor appears and press enter or click on OK to draw the chart. The dialog box will disappear.

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Using the stocks list box – sort by company name or by ticker symbol Stocks list box slider – drag it up and down to move rapidly through the list box. You can also click in the column the slider moves in to make a jump up or down.

Stocks list box

Click on this button to sort the stocks list box by company name.

The active stock is highlighted

Click on this button to have the stocks list box sorted by ticker symbol

A stock can be selected and the chart drawn by entering the ticker symbol on the keyboard and pressing enter when the list box is sorted into ticker symbol order. This is probably the fastest way to access the charts.

Each time the “enter” is pressed on the keyboard the list box advances to the next stock and the chart appears in the chart window. The user can “toggle” down the list by just pressing the “enter” key. This becomes important when using user defined “lists” to review portfolios. Lists are covered in a following section. W. Clay Allen CFA

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Selecting a stock and drawing the chart

Move the cursor over the desired stock and click to highlight. Press enter or click on the draw chart button or double-click on the stock name to draw the chart.

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Printing and saving a chart

Click this button to send the chart to a file – the filename is the ticker symbol plus .bmp - the chart is written to the \MDRS\Charts\ folder in bitmap format

Click this button to send the chart to the printer.

Charts saved to a file are always saved in .bmp format, which takes up large amounts of file space. If you intend to send these files over the Internet via e-mail they should be converted to a compressed format using Microsoft Paint or other image-processing program. Old chart files should be periodically deleted from the \MDRS\CHARTS folder to free up disk space.

W. Clay Allen CFA

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Drawing the bullish support lines

B

Slope = +1.0

A The 45-degree bullish support line is automatically drawn upward to the right at a 45-degree angle. Click on the button that indicates, “Draw bullish support lines”. The line should start at a prominent low (A) with a left click on the mouse. The mouse should be moved upward to the right until the ending point is reached (B) and the line is completed by a right click on the mouse. As long as the relative strength plot remains above this line you know the stock is outperforming the market. The slope of this line is plus 1.

W. Clay Allen CFA

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Drawing the bearish resistance lines

A Slope = - 1.0

B The bearish resistance line slopes downward to the right at a 45-degree angle. Click on the button that indicates, “Draw bearish resistance lines”. The line should start from a prominent high on the relative strength chart. Left click to start (A) and move the cursor downward to the right to the ending point (B) and draw the line with a right click on the mouse. As long as the relative strength remains below this line you know the stock is seriously underperforming the market. The slope of this line is minus 1.

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Drawing the high performance bullish support lines

B

Slope = +1.5

A The high performance bullish support line slopes upward to the right at a slope of +1.5. It rises 50% faster than the bullish support line. The required increase in relative performance assures that the stock is among the better performing of all stocks. When this line is penetrated by a significant amount the position should probably be closed out. Aggressive portfolio managers may require all stocks in their portfolio to remain above this line. This line is drawn in the same manner as the bullish support line. The program automatically applies the +1.5 slope to the line.

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Drawing conventional trend lines

B

A This is an example of a conventional trend line. These lines can be placed anywhere the user selects. There are no required slopes for these lines. Click on the button that indicates, ”Draw conventional trendline”. Move the cursor over the chart to the desired starting position (A) and begin with a left click. Move the cursor to the desired ending point (B) and right click to draw the line. These lines can be erased by selecting another chart and then coming back to the original chart to replace the trend line in a better position. Experience shows that extremely steep trend lines are often reversed quickly. W. Clay Allen CFA

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Buy and sell patterns – lists provided daily to save time and focus attention on opportunities

The “lists” drop-down menu includes two sections that contain lists of stocks that exhibit buy signal patterns (part 3) and sell signal patterns (part 4). These lists represent the standard point and figure triple top buy signals and triple bottom sell signals as well as stocks with signals and a retracement. One list shows all stocks with a large jump in relative strength over the past three weeks. The recommended list is prepared by the author and updated weekly and includes stocks that appeal to him as “buys”.

W. Clay Allen CFA

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Drop-down menus – Lists box

There are six “lists” that are reserved for use by subscribers. These lists are composed of the tickers that make up a portfolio. They can be set up with a word processor such as WordPad. One ticker for each line in the file. These ticker files should be saved to the \MDRS\ folder. The reserved file names are: Mylist.dat, elist1.dat, elist2.dat, elist3.dat, elist4.dat and elist5.dat. The lists can be setup and used to access portfolios very quickly just by “toggling” through the portfolio.

This is the “Lists” drop down menu box. It is divided into 5 parts according to function.

W. Clay Allen CFA

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Drop-down menus – Tutorial drop down menu

This is the “Tutorial” drop down menu box. This tutorial is abbreviated and does not require the CD to be in the drive. The main tutorial requires the CD-ROM disk to be loaded into the disk drive.

W. Clay Allen CFA

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Updating the system

The Market Dynamics system is updated daily after the close via an e-mail over the Internet. The file attachments add up to about 600 kbytes so the download is fairly short depending on modem speed. The entire database is updated daily so there is no need to save old attachments. The screens files are attached also and are updated as necessary with the action-oriented screens being updated daily. The service currently covers about 2800 stocks and the data files are based on the past four years of data. Highly volatile stocks may show only six or eight months of history because the charts are limited to 75 columns of history on the chart. The instructions in the e-mail above call for saving the files to the \MDRS\ folder. Some ISPs (i.e. AOL) convert these files to a .zip format and they will need to be unzipped before they are saved. Use winzip to unzip these files.

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Permission is hereby given to reproduce this tutorial in its entireity or any part for educational or non-commercial purposes.

Copyright by W. Clay Allen CFA

To return to the tutorial table of contents click

mdtutor.pdf

303-804-0507 [email protected] THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES. THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE RELIABLE BUT SUCH STATEMENTS ARE MADE WITHOUT ANY REPRESENTATION AS TO ACCURACY OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE STATED. FROM TIME TO TIME WE MAY BUY AND SELL THE SECURITIES REFERRED TO HEREIN, AND MAY HAVE A LONG OR SHORT POSITION THEREIN. PRICES SHOWN ARE APPROXIMATE.

W. Clay Allen CFA

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Sectors

MARKET DYNAMICS Performance Management System Sectors It is very important for investors to identify the strongest sectors in the market and to participate in those sectors for as long as they show high relative strength. This page covers ten major market sectors as examples of sector analysis although they are not all strong. The database covers a large number of holder’s trusts and sector indexes to facilitate this important part of investment analysis and successful portfolio management. The turning points of the long-term trends are very clear on these charts.

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Sectors

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Sectors

Back to top of this page [ Home ] [ Up ] [ Sectors ] [ I_shares ] [ Foreign Markets ] [ Strong industry groups ] [ Weak industry groups ]

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I_shares

MARKET DYNAMICS Performance Management System I-Shares The ten charts on this page are examples of charts drawn on the relative strength of I-shares. There is a growing interest in investing in I-shares and this will probably continue to expand. All I-shares are covered as soon as there is enough price history to prepare meaningful charts. The analysis of these charts is very similar to the analysis of individual charts although the I-shares may be less volatile.

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I_shares

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Foreign Markets

MARKET DYNAMICS Performance Management System I-Shares Foreign Markets There is increasing interest in investing in foreign markets and the I-shares provide a very important entry into foreign investing. There are ten country sectors on this page and they have all significantly outperformed the S&P 500 over the past year or more. It seems that there will always be a bull market somewhere around the world and relative strength is the best way to find it. Some of the trends recorded by the country I-shares have truly been impressive. All I-shares will be included in the Market Dynamics database to facilitate the coverage of these markets.

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Foreign Markets

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Foreign Markets

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Strong industry groups

MARKET DYNAMICS Performance Management System Strong Industry Groups This page covers ten industry groups that have been exceptionally strong recently. The Market Dynamics System covers almost 225 industry groups and screens are prepared daily to identify the 20 strongest and the 20 weakest industry groups. These screens are sent out along with the daily updates. These screens allow the user to focus his/her time on the strongest groups.

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Strong industry groups

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Strong industry groups

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Weak industry groups

MARKET DYNAMICS Performance Management System Weak Industry Groups The ten examples on this page represent industry groups that have shown weakness. It is interesting to note that some of this weakness has persisted for long periods of time. Performance is enhanced by avoiding industry groups that are showing persistent weakness such as these industry groups.

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Weak industry groups

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Major Reversals

MARKET DYNAMICS Performance Management System Bases and Tops The only topics developed so far on point & figure charting are these pages which cover major reversals of long-term trends and how they appear on the relative strength point and figure charts. Other topics will appear under the Point & Figure page as they are developed. The main purpose for using long-term P&F charts is to spot major, long-term reversals of trend. These are usually called bases and tops and these extended sideways movements set up buying opportunities (i.e. bases) and opportunities for taking profits (i.e. tops). It is interesting to note that the sideways movements on bases and tops represent situations where supply and demand are roughly in balance - the primary trend has gone flat or sideways and yet these are the most important patterns in all of technical analysis. This is what happens when the trend changes its primary direction. The relative strength P&F charts experiences a period of more or less random movement where the mean or average change in price falls off to zero (i.e. no net progress)

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Major Reversals

In this highly stylized image, the flat arrows at A, B, C and D represent the sideways movement between major long-term trends. The red arrows show the direction of movement when the sideways movement terminates. The movement from A was a continuation of the up trend. The red arrow after B shows a new down trend after the sideways movement. The red arrow after C shows a reversal back to the upside and there is no red arrow after D indicating the sideways movement is continuing.. While stock price movements are not this simple and easy to see, the principle is clear. Watch for the flat spots, the sideways movement and then recognize the new trend when it emerges from the sideways pattern. The point and figure charting method removes the noise from the day to day movement to make the sideways patterns stand out in more relief. After a long up trend has been in place, the beginnings of a sideways pattern will cause the investor to view the situation as probably developing in a direction that is detrimental to his long position - i.e. probably a major top. The converse is also true - after a major long term drop, a sideways movement is probably going to turn out to be a major reversal of the down trend, i.e. a major base. In the case http://www.clayallen.com/major3.htm (2 of 3)2/11/2006 5:27:54 PM

Major Reversals

of a base after a long-term down trend, it is always best for the investor to wait for the completion of the base and not enter a long position until the pattern is complete. No one knows how long the stock will remain in the base and the investors capital can be tied up in the base for a long period of time before the stock starts to go up. It is also possible for the base to fail and the down trend to resume - this is called a ledge!

The two pages that follow show examples of major tops and major bases - click on a link to view. Major bases Major tops Back to top of this page

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Making of a Chartist

MARKET DYNAMICS Performance Management System

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Making of a Chartist

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Making of a Chartist

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Support lines

MARKET DYNAMICS Performance Management System The 45-degree Bullish Support Line

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Support lines

The 45-degree Bullish Support Line is drawn upward to the right at a 45 degree angle to the horizontal. The line is started from a box just below a prominent low on the chart. The BSL is drawn in black. The slope of the BSL is 1 which indicates that a stock that remains above the BSL will gain at least one box of return for every box along the X-axis. This is a key relationship and stocks should remain above the BSL to ensure that the stock is performing in an acceptable manner. To draw the BSL on the chart the user should click on the Bullish Support Line button and then move the cursor to the chart at a position just below a prominent low and then leftclick - then move the cursor upward to the right and when it is at the appropriate position on the chart the user should use a right click on the mouse to draw the BSL. When charts are printed or saved the BSL will be saved or printed on the chart.

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Resistance lines

MARKET DYNAMICS Performance Management System The 45-degree Bearish Resistance Line

The 45-degree Bearish resistance line is drawn downward to the right from a prominent high point on the chart. As long as the chart remains below http://www.clayallen.com/bearish1.htm (1 of 2)2/11/2006 5:28:46 PM

Resistance lines

the BRL it is performing in an unacceptable manner. The BRL is automatically inserted onto the chart by the Performance Alarm but it can also be drawn by the user. The BRL means that the stock must move back and forth across the X-axis for as many columns as the stock has declined in terms of rows down. This ensures that the stock that is held in weak hands will be transferred into strong hand and that process takes time. It is not unusual for bargain hunters to buy into a stock after a major decline only to be frustrated by the length of time required before the stock bases out and starts to go up. A base can take several years to complete and the long-term investor should be very leery of buying into a situation too soon after a decline. The BRL is a method for avoiding premature purchases.

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Performance Lines

MARKET DYNAMICS Performance Management System The High Performance Support Line

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Performance Lines

The High Performance Support Line slopes upward to the right at an angle of almost 60-degrees and it is shown in green. A button to select the HPSL is on the main screen and it is drawn with the usual left click - right click sequence with the mouse. The HPSL is designed for use with highly volatile stocks that carry unusual risks. To remain above the HPSL the stock must rise with a slope of 1.5 to 1. This higher slope assures a higher rate of return because of the higher risk. No stock goes up forever so the HPSL provides a more stringent performance requirement that the stock must meet if it is to be retained in the portfolio. The users can also draw a conventional trend line with an even greater slope to gauge the movements of more speculative stocks.

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Trend Lines

MARKET DYNAMICS Performance Management System The conventional trend line

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Trend Lines

The conventional trend line should touch the relative strength chart in at least three points to have a valid conventional trend line. The placement of the trend line is not precise but the more points that it touches the more important the trend line will be. The slope of the conventional trend line provides the key its use - the steeper the better from a performance point of view. The appearance of a shallow conventional trendline almost defines a trading range stock. The conventional trend line is drawn in blue to distinguish it from the other trend and support lines. A button to select the conventional trend line is shown on the main screen and the line is drawn with the same sequence of left click and then right click with the mouse.

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Chart Construction

MARKET DYNAMICS Performance Management System The Basics of Relative Strength in a 3 box - Point and Figure Format ●

Xs record a rise in relative strength

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Os record declines in relative strength

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Horizontal X-axis - does not measure time - measures alternations of trend - volatility is a proxy for risk Vertical Y-axis measures returns relative to the market Trends of less than three boxes are ignored - damp out the noise Relative strength ratios remove the effects of the overall market on the performance 45-degree Bullish Support Lines require good relative performance Performance Alarm turns chart red when performance becomes unacceptable - automatic

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Relative strength in a P&F format measures performance

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Hard to misinterpret

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Very visual and therefore very fast

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Signals are very objective

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Charts are simple and easy to read - eliminate the problem of seeing what you want to see

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Chart Construction ●

Measures risk on the X-axis and relative return on the Yaxis

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Relative strength ratios = price of stock/ S&P 500

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Scaled as a regular 3-box point and figure chart

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Chart Construction

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January 28, 2006

The Systematic Pursuit Of Good Performance. Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law

“The stock market functions because of uncertainty, not in spite of it.” The Intelligent Chartist by John W. Schulz

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The output of the investment management process is a return on investment usually expressed as a percentage relative to some widely available alternative investment such as a market index. The record of the performance results of professionally managed portfolios seems to suggest that investment managers are unable to produce the desired result in a majority of cases. This under-performance is often excused because the market is random or because some totally unforeseen event caused the market to zig or zag in unpredictable ways. An investment manager has to deal with uncertainty at all times. To try to avoid responsibility for the results of the investment process because the outcome proved to be uncertain is to beg the question. This goes to the heart of the practice of the investment management. Is the true nature of investment management to predict the outcome of uncertain developments or to recognize the futility of prediction and to commit the organization to the goal of successfully adapting to any event that may take place. It seems that those investment management organizations that are committed to adaptation are in a far better position to deliver on their performance promises. Randomness can be eliminated easily because price fluctuations around a zero mean tend to cancel each other out over time. It is the price movement with a non-zero mean that results in persistent trends in the stock market. It seems that many active portfolio managers have been taught in business school that these trends are meaningless and they don’t even take the trouble to measure or record these movements in any meaningful way. The unwillingness to measure these persistent long-term trends in the stock market removes an important source of information about the validity of the forecasts that led to the investment in the first place. Stock selections are always based on some expectation about the future finan-

Performance Management System

cial performance of the underlying company. Many times investment managers become overly committed to these expectations about the future performance of the stock in the market. What happens when the portfolio manager’s expectations about future market performance are not realized in the market? If the manager does not record the trend of performance in the market he is cutting himself off from a very important source of information that might cause him to question his optimistic expectations. This seems to be the result for those managers who do not believe that relative price fluctuations in the market have any valuable insight to offer. The day-to-day variation in stock prices tends to obscure these negative trends and the portfolio manager is caught unaware of the true seriousness of the situation until it is too late. The investment management approach should continuously monitor price information from the market as a check on the validity of the expectations that led to the purchase of the stock. We should not assume that all of our predictions will work out as expected and the failure of a stock to perform as hoped should be treated as a red flag or warning signal that something is going wrong. It is bad enough to ignore the warning signals from the market and a far more serious matter when a commitment to a prior prediction is maintained in the face of direct evidence to the contrary. Successful adaptation to changing conditions begins with the willingness to use information from the market to trigger a move away from a stock that is not performing as desired. In my experience in portfolio management, it has not been uncommon for the actual under-performance in the market to materially lead a spectacular investment disaster that was totally unexpected by the majority of investors. For example, the serious negative trend in the performance of ENRON preceded the collapse of that stock by many months. It was there for all to see. W. Clay Allen CFA

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January 20, 2006

What Is Distribution? How Does It Work? Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law “Actually, the procedure one should follow is to sell the bad stock and to keep the good stock. With rare exceptions, stocks are high because they are good, and stocks are low because they are of doubtful value.” My Own Life by Bernard M. Baruch A collection of recent newsletters is available by clicking this box

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Distribution in the stock market is usually defined as the sale of large blocks of stock to the unsuspecting public at an inflated price relative to the true value of the stock. This is usually thought of as comparable to a wholesale to retail function. This has been a very common occurrence in the stock market for many, many years. Why do investors seem to fall into this trap over and over again? Why is the public so unsuspecting when dealing in the stock market? The common answer is that the retail investor is misled by the evil people on Wall Street. The AG of New York, Eliot Spitzer characterized this condition as the result of “1000 wolves and 90 million sheep.” This is a frequent complaint by investors who have lost money in stocks. It is undoubtedly true in some cases but it does not provide an adequate explanation for the pervasive behavior that allows investors, both large and small, to be victimized by distribution. It is certainly true that corporate insiders and other knowledgeable investors (including marketmakers) in a company will have a better feel for the true value of the stock than the man on the street. Also, they can be expected to be active sellers in large size when the stock becomes excessively overvalued at a speculative peak in the price of the stock. But that is only half of the story. Why are other investors, usually retail investors, willing to buy an overvalued stock? It seems that their behavior is motivated by the desire to buy a stock that is cheap. The small investor tends to compare current stock prices with prices that were recorded fairly recently and if the stock is significantly down in price it is considered to be cheap and therefore an attractive purchase. Little thought is given to considerations of why the stock price

Performance Management System

went down. It is enough to say that the stock went down “too” much. In dealing with tangible assets that have a value by virtue of their worth as an item of consumption, their decline in price does in fact create a bargain. It must be remembered that intangible assets have no real intrinsic value or worth since they cannot be consumed or used up. A stock is only worth what someone else will pay you for it. In truth, the decline in price is clear evidence that other investors think the stock is worth less but the desire to buy bargains attracts retail investors to just this kind of stock. It seems that they mislead themselves by thinking that the decline in price is a good thing when it actually represents a collective judgment that the true value of the stock is going down. This behavior often leads to the purchase of stocks with financial problems that will probably be made public at a later time. When the bad news does come out, the investor who is losing in the stock is likely to cry foul and try to blame someone else for his misfortune. However, the true responsibility for the mistaken stock purchase is the desire to buy stocks that are cheap rather than stocks whose value is definitely increasing. Is the stock market so blind that a majority of investors cannot distinguish between those stocks whose value is increasing and the stocks whose value is declining? In fact, the true purpose of the stock market is to provide an answer to that very question. Why else should the stock market exist? To identify the stocks whose value is increasing and to point out the stocks with declining values is a direct result of the fluctuations of the market. This is the price discovery process at work in its purest form. For an investor to say that the market is wrong or that the market does not understand the true value of a business is absurd. If the retail investor would accept stock price fluctuations as a true indication of changes in value he could not be victimized by distribution. W. Clay Allen CFA

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Performance Engineering Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law

“From no source do so many errors, and so much difference of opinion… proceed, as from the vague ideas which are attached to the word value.” The Principles Of Political Economy by David Ricardo

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In the early days of the Industrial Revolution, an engineer was one who managed or controlled an engine, usually a steam engine. In more modern times, engineering has come to mean the activities of planning, controlling, and managing any process that can be used to produce an outcome or result. For example, there are now departments in colleges of engineering that are devoted to software engineering and some business schools now offer degrees in financial engineering—but that may be stretching it a bit. Performance is a term used by investment managers to compare the returns generated by portfolios under their management to the returns offered by some generally available, but usually unmanaged alternative investment such as a market index. When I entered the investment management business, there were no index funds, so investors did not have the ability to invest in the broad market. Today there are many low cost index funds that are widely available to investors so the comparison of investment returns to an index of stocks is very legitimate. The comparison of large numbers of actively managed portfolios to the S&P 500 provides almost irrefutable evidence that most portfolio managers do not do a very good job of performance engineering. The poor showing by almost 80% of these portfolios shows that they seem unable to manage or control the process that they direct. The academic community would have us believe that this is primarily the result of the fact that the fluctuations of the stock market are random and therefore unpredictable. That is true, up to a point, but falls short of a true explanation for such widespread poor performance. It seems more likely that the poor performance is more a function of the fact that the performances of the stocks in the portfolio are not measured. How can you control an engine if you do not measure its output. Each stock investment in the port-

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Performance Management System folio represents an individual performance engine and the performance of that small engine should be recorded in order to control the process. Peter Drucker’s famous dictum is “you cannot manage what you do not measure.” The real problem seems to be that the performance of each stock in the portfolio is not measured. However, the measurement of an individual stock’s performance entails some real problems. A fairly large part of the dayto-day movements of stock prices is the noise or random variation that the academics are so fond of pointing out. There are several effective methods of removing the noise from the stock price records. The three point method of point and figure charting is a very effective way to remove the noise. The second problem involves removing the influence of the overall market from the price data. This obstacle can be overcome by the simple step of dividing the stock price by the appropriate market index and plotting the ratios. Steadily rising ratios indicate performance that surpasses the market’s performance and declining ratios indicate under-performance. These ratios can be expressed using the point and figure charting method. These charts give the portfolio manager the essential measurements necessary to manage and control the performance of the stocks in the portfolio. The trends that show up on these charts can change direction at any time but the portfolio manager can respond to these trend changes and, therefore, can control the performance of the portfolio by eliminating stocks that do not perform as desired. It is not required that these measurements be predictive in any precise way. All that they need to convey is the fact that the stock is under-performing the benchmark. These systematic records of performance promote the portfolio manager into a position to control the performance of the portfolio and that allows him to “engineer” the outcome. W. Clay Allen CFA

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Trend Persistence Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law

“You can knock forever on a deaf man’s door.” Zorba The Greek by Nikos Kazontzakis

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Every day for years I have observed stocks that behaved like the stock shown in the example. I have been told repeatedly that the highly persistent downtrend that shows on this chart was caused by a random walk. It appears that this random walker fell off a cliff. The stock peaked relative to the market between late 2002 and early 2003 and it has been persistently down ever since. This downtrend has been in place for almost three years. It seems quite simple to conclude that this was a stock that should have been avoided during the past three years. Naïve bargain hunters were attracted to this stock by the apparent cheapness of the stock relative to its price a few weeks or a few months earlier. The desire to buy bargains is the behavior that allows the process of stock distribution to take place on Wall Street with such dreadful consequences for many an unsuspecting investor. A stock that is showing such a persistent tendency to go down is providing investors with an important signal that something is wrong. The stock appears to be sliding down a slippery slope and it seems totally unable to resist the downward pull. At the very least, an investor should not buy into a stock with these characteristics. To buy a stock that is showing such a persistent downtrend is to buy someone else’s problems. If an investor owns a stock that starts to behave like this he should be willing to sell it immediately. It seems silly to believe that this trend was the result of a random process similar to flipping a fair coin. The day to day movements that are heavily influenced by the noise in the market will resemble flipping a coin but the accumulated price change looks very different and it reveals that the process that produced these changes masked a persistent negative force that biased the market downward. The coin was biased against this stock. Even though the down days and the up days occurred in

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Performance Management System

a ratio of about 50/50, the changes on the down days were quite a bit larger than the changes on the up days. Stocks that develop a lasting downtrend occupy a special region of the distribution of returns from stocks. They are stocks in the left or negative tail of the bell shaped curve of returns. Not only are these accumulated declines large, but they often persist for long periods of time. Stocks in the negative tail represent about 20 percent of all stocks and they are the ones with the worst returns. Recent research shows that stocks in the left tail of the distribution often show a strong negative skewness and that indicates that unusually large declines happened frequently. Buying stocks with a high degree of negative skewness is an example of “fighting the tape.” The three point method of point and figure charting filters out the noise and lets the major trend accumulations show through. When a negative trend appears, we must admit that we can’t predict how long it will last. It is just common sense to avoid a stock with a persistent downtrend until that decline is complete and the stock stops going down. Experience shows that the stock will probably stop going down sooner or later, but there is no reason to buy it until it proves that it has stopped going down. W. Clay Allen CFA

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The True Source Of Bad Performance Portfolios heavy with underperforming stocks almost never outperform the market. Ignat’s Law “Grove’s devotion to reason did not mean that he was a machine. Far from it. What he found in the end was the will to do what was painful, the will to let go.” An essay about Andy Grove of Intel fame. by Richard S. Tedlow Fortune December 12, 2005 A collection of recent newsletters is available by clicking this box

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The academic community would have us believe that the primary cause of bad performance by most professional investors is because the market is efficient. The long standing record of bad performance by a majority of professionally managed investment portfolios is considered to be proof that the market is efficient. At the most fundamental level, the true source of bad performance seems to lie elsewhere. Bad performance is explained by what I call Ignat’s Law and I repeat Ignat’s Law with every issue of this newsletter in the text box along the upper left margin. Simply put, Ignat’s Law says that portfolios perform poorly because many of the stocks that are held in the portfolio perform poorly. How can it be otherwise? There seems to be no other valid explanation for bad performance. The question now becomes, why are poorly performing stocks held in the portfolio at all? Is the portfolio manager unaware of their bad performance? Why does the portfolio manager refuse to eliminate the bad stocks from the portfolio? He has a choice about whether to hold a stock or not, so why does he make the wrong judgment about the bad stocks? Is he stubborn? Lazy? Stupid? Or just unaware of how bad the performance really is? After dealing with professional portfolio managers for over thirty years, I can quickly eliminate stupidity as the reason that poorly performing stocks are held in the portfolio for too long. Professional investors as a general group are usually highly intelligent and hard working, so laziness can be eliminated as well. Stubbornness can be a source of a refusal to sell losing stocks in some cases but should not be accepted as a general explanation for such widespread bad performance among professional portfolio managers. From years of experience working

Performance Management System

with professional portfolio managers, the more likely explanation for why bad stocks are held is that portfolio manager does not measure the performance of the stocks that are held in his portfolio. In fact, most portfolio managers who have been trained in a modern graduate business school have been aggressively instructed not to measure the performance of the stocks in their portfolios. The measurement of market performance is usually called technical analysis and that is a big “NO-NO” for most finance professors. Because relative performance is not measured, the portfolio manager is unaware of just how bad some of the stocks in his portfolio really are. Not only does the stock perform poorly, the bad performance may persist for a long period of time. A small mistake is often allowed to become a major disaster before it is eliminated from the portfolio. It is readily accepted that good financial performance by a company will lead to good performance by that company’s stock in the market. Good market performance by a stock happens for good reasons and that relationship is never questioned. It should be just as readily accepted that persistently bad performance by a stock in the market implies and often anticipates deteriorating financial performance by the company. It is a common experience for a declining stock price to lead the release of fundamental bad news. There are usually definite reasons behind bad performance and the bad performance should not be ignored. The measurement of the performance by a stock in the marketplace can provide important clues to a deterioration in the fundamentals of a company’s basic business. Bad performance by a stock usually means bad news is on the way. The failure to record and measure the performance of the stocks in the portfolio subjects the portfolio manager to an almost constant stream of negative surprises that could easily have been avoided. W. Clay Allen CFA.

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Portfolio Managers Wear Many Hats Portfolios heavy with underperforming stocks almost never outperform the market. “It is a basic assumption of this book that the processes of the stock market are psychological more than arithmetical. This produces the well-known tendency of stock prices as a whole to go to extremes in either direction, as optimism or pessimism holds sway.” Security Analysis by Graham and Dodd A collection of recent newsletters is available by clicking this box

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Conventional wisdom concludes that successful portfolio managers just pick good stocks for the portfolio and that is all there is to it. This places the entire emphasis of investing totally on the buy decision and all the rest is mistakenly dismissed as unimportant. Experience shows that successful portfolio management requires a lot more than just an ability to pick stocks. If we could be certain that one hundred percent of our stock selections would perform as expected, then portfolio management could be narrowed down to only stock picking. In actual practice, we will never come even close to a perfect batting average and, to be successful, we will need to address those stock selections that don’t work out as hoped. Recognizing investment mistakes and dealing with them effectively are some of the most important aspects of portfolio management. The most effective way to deal with investment mistakes is through the use of long-term technical analysis. The sell decision is best approached from the perspective of technical analysis because experience shows that stock prices lead the fundamentals. Therefore, the study of price movements is essential to the recognition of investment mistakes. The successful portfolio manager usually is comfortable with both fundamental and technical methods of analysis. There are several other hats that the portfolio manager uses to guide the portfolio management process including roles as an economist, a historian, a psychologist, a quantitative analyst and even that of a philosopher. Inputs from these varied sources can be extremely helpful in the management of the portfolio and they will take the portfolio manager far beyond the analysis of statistics drawn from income statements and balance sheets. A good understanding of both macro and micro economics is essential to good portfolio management. In particular ,

Performance Management System

money and banking along with business cycle theory are indispensable. The grounding in economics should be of a practical nature and not oriented toward highly theoretical explanations of the workings of the economy. The successful portfolio manager has a good grasp of past market cycles and the process of economic evolution. Historical perspective is essential to a good understanding of the current conditions in the stock market. This not to say that the stock market exactly repeats history because it usually does not. As Mark Twain said, “History does not repeat, but it rhymes.” The application of ideas from the field of psychology can be most useful to the portfolio manager. These ideas are used to understand the various behaviors of crowds, such as fads, panics and herding behaviors. Psychology also helps the portfolio manager to understand and control his own behaviors better while being forced to make decisions in a highly uncertain and risky environment with incomplete information. Decisions under such conditions can easily become the result of a highly emotional response unless understood and controlled. Psychology provides the ideas and guideposts for dealing with the portfolio manager’s natural emotional response. The role of philosophy in portfolio management may be the least understood of all. We speak of various investment philosophies and define the rules for their application. But there is also a practical wisdom associated with portfolio management that recognizes the differences between left brain thinking and right brained thinking and when to apply each. It seems to be clear that investment management is at least partially an art and partially a science and it is usually a mistake to try to force it into one camp or the other. Philosophy is about thinking and good judgment and good judgment is absolutely essential to good portfolio management. Having the good judgment to admit a mistake while it is still relatively small is a key ingredient to successful portfolio management. Even an art form has rules. W. Clay Allen CFA

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Observation Versus Prediction Portfolios heavy with underperforming stocks almost never outperform the market.

Conjecture: “To judge from incomplete evidence.” Guess Surmise Presume Infer Funk & Wagnalls— New College Standard Dictionary

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Much of investment management revolves around making predictions of how changing conditions might effect stock prices. We never know all the facts in a situation and our predictions must be framed using incomplete data and evidence. The predictions that lead to investment positions are usually nothing more than educated guesses about what might happen in the future and what the market response should be as a result. It is not unusual for investors to become completely committed to their predictions. This unwitting commitment can cause problems for the investor when the conditions that led to the forecast change, but the commitment to the predicted outcome doesn’t change. The process of formulating a prediction usually produces a rigid and inflexible attitude regarding the hoped-for result and an opinion that is probably unwarranted and may lead to problems when the fundamental aspects of the prediction start to change in unexpected ways. How can investors guard against this risk of sticking with a fundamental prediction that is starting to fail? How can the validity of the prediction be verified? First of all, the prediction was expected to produce a certain response in the market. The primary result of the prediction was an expected price performance by the stock. A failure of the market response to develop as expected is the first sign that the forecast may not be working out as hoped. The market performance of a stock is a valuable source of feedback from the market that can be used to evaluate the validity of the prediction. It is important that investors continuously observe the performance of their stocks to inquire into the validity of their expectations. When a stock does not perform as expected, the investor should start to ask a very appropriate question, why is this stock not performing as expected? This

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This is a heavily promoted stock that didn’t perform as expected. is an extremely important question. When a material divergence appears between the expected performance and the actual performance of a stock, the investor should be on his guard. The opinions of selling analysts and the rosy and upbeat pronouncements from a company’s management should be given serious review. This is when the true detective work begins. It may be impossible to account for the poor performance of the stock but holding the stock just because the investor cannot discover the true fundamental cause of the weakness can be a very risky strategy. At some point, the persistence of poor market performance should take control and the stock should be sold. Experience shows that it is not unusual at all, for a stock to show poor market performance well ahead of the public disclosure of the fundamental negatives. It is the continuous observation of the market performance of the stock that generates the appropriate questions about the potential causes of the poor performance. It is essential that investors become committed to the idea that the stock must perform in the market as expected or the holding is suspect. This is not to predict future performance but to recognize that market performance ultimately reflects the true financial performance of the company. Poor market performance that persists beyond the short-term is a very good indication that the expectations that prompted the purchase in the first place, were not valid. W. Clay Allen CFA

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How Long Does It Take To Build A Base? Portfolios heavy with underperforming stocks almost never outperform the market. A Speculative Round Trip There is an old saying on Wall Street that stocks make a round-trip from the safety deposit boxes of long-term investors to the margin accounts of the speculators and back again to the safety deposit boxes.

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Time is a critical factor in investment performance. This can not be overly emphasized when evaluating whether a stock has completed the transition from a long-term down trend to a long-term up trend. In most cases, it will take much longer than commonly believed for this transition phase to finish and the stock becomes prepared for a major up move in price.. This period of transition is usually called a base of accumulation. When a down trend terminates, but before an up trend begins, there is usually a extended period of accumulation. This period of accumulation produces a broad, horizontal, back and forth pattern on the point and figure charts. These are extremely important patterns on the longterm point and figure charts of relative strength and they repeat with surprising frequency. The period of accumulation ( a base) has especial significance for longterm investors. What happens during the development of a base and why is the basing pattern so important? After a prolonged downtrend in a stock, many shareholders will be holding stock at a considerable loss. They will usually express hope that the stock will quickly reverse the downtrend and go back up so they can sell-out even or with only a small loss. The stock almost always takes on a tone of dullness amid listless trading, usually on low volume while in the base. The lack of positive price action will cause some of the shareholders with losses to accept the loss on the stock. The hope for a quick turn-around soon fades into feelings of anger and resentment toward the stock. This will prompt some shareholders to take their loss. It should be emphasized that this process takes time as the shareholders with losses give up on the stock and accept their loss on what has become a glaring investment mistake. During the basing process there is probably little positive news to generate any excitement regarding the stock. Since

Performance Management System

The base that is shown below took over a year to complete and it prepared the way for the up trend that followed

there is little excitement and only minor price movements back and forth, speculators, who are often driven by excitement, quickly learn to completely avoid the stock. If the speculators refuse to buy the stock and the sellers are primarily previous buyers with losses, who are the buyers of the stock? They must be patient, long-term investors who have a better appreciation of the value of the business and a willingness to wait for an extended period to earn their profit. These investors may include corporate insiders or other investors that are knowledgeable about the value of the stock. The formation of a base represents a process whereby a large proportion of the capitalization of the company passes from the weak hands of previous buyers with losses into the strong hands of patient, long-term, value oriented investors and this may take months or even years to complete. This seems to be a never ending cycle in the stock market that is repeated over and over. When the majority of the outstanding stock has been accumulated into the hands of strong holders, the stock is ready to advance in a new bullish trend. The selling by the losers is essentially exhausted and the speculative cycle is ready to begin again. These horizontal basing patterns stand out on the long-term point and figure charts of relative strength. W. Clay Allen CFA

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Portfolio Upgrading —The Never Ending Job Portfolios heavy with underperforming stocks almost never outperform the market.

“You don’t see the garbage on the beach until the tide goes out.” unknown

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The most important responsibility of a long-term investment portfolio manager is to continuously upgrade the potential for the portfolio to perform well in the future. The upgrading process begins when the portfolio is first invested and it continues until the portfolio is liquidated. Portfolio management should be dynamic and active, even for long-term investors. Some long-term investors will argue that active management of the portfolio should be avoided because it stimulates turnover and reduces returns because of increased commission costs and price slippage when making trades. This is what I call “negative turnover.” Positive turnover, on the other hand, increases the potential for the future performance of the portfolio that is well above the costs of trading. It is best achieved when the inevitable loser in the portfolio is identified and a more positive stock is substituted in its place in the portfolio. Positive turnover is not trading just for the sake of trading. It is based on the fundamental idea that the poorly performing stocks in the portfolio can be identified and eliminated from the portfolio before their poor performance has had a serious impact on the performance of the portfolio. Experience shows that stocks that develop a persistent tendency to underperform the market will probably continue to under-perform much longer than expected. Poor performance happens for good reasons and it is not accidental. Once the bad performance starts, it is far better to accept it for what it really is and seek out a replacement for the bad stock. Long-term investors tend to be too complacent about stocks in the portfolio that aren’t doing well in the market. Constant change is the only constant in investing and there will always be stocks that are starting to suffer from changes in business conditions that effect the financial performance of the business.

Performance Management System

The first indication that fundamental change is affecting the business negatively is the behavior of its stock. The fact that the stock has started to perform poorly relative to the market is a strong indication that something is going wrong. The portfolio manager can try to discover the source of the bad performance but many times the true reasons behind the adverse trend in the market cannot be determined In the real world of portfolio management, the manager must often act on less than full information or understanding of the reasons behind the negative price trend. The market may be random and unpredictable but it is almost never wrong. To believe that the price trend is wrong is to deceive one’s self. It is far better for the health of the portfolio to accept the downtrend as real and eliminate the stock from the portfolio. As long as the stock performs in an acceptable manner it can be retained in the portfolio. Positive turnover is based on a strategy of retaining the winners in the portfolio and ruthlessly eliminating the losers. Even the outstanding market performance of major winners will eventually come to an end and they will need to be eliminated from the portfolio. Portfolio upgrading is the continuous application of positive turnover and it is a job that is never done. W. Clay Allen CFA

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Market Swings—Overboughts and Oversolds Portfolios heavy with underperforming stocks almost never outperform the market.

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” George Bernard Shaw Irish dramatist & socialist (1856 - 1950)

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Even a casual glance at a chart covering a few years of market history will reveal an unending wavelike pattern of up and down movements. What is the source of the these intermediate alternating movements of rising and falling prices? History shows that these moves can last for from a few months to as long as nine months. The extreme highs of these oscillations are often called an overbought and the extreme lows are labeled an oversold. The names imply that the market has moved too far in one direction and that a reverse move will probably follow, resulting in an over-shoot in the opposite direction. The idea that the market will regularly move beyond fair value in both directions is key to the concepts of overbought and oversold markets. The amplitudes of these waves are irregular and they don’t seem to follow any rules or logic. From time to time a pattern may develop that suggests a regular length of time from low to low. This gives rise to measurements of these regular time periods into cycles of market movement. This does seem to introduce some regularity into the movements of the waves up and down but these measurement have to be accepted as having a fair amount of variation and a lack of precision. They do not have to give precise estimates in advance of the timing of highs and lows to be very useful in anticipating the swings of the market. Over the years, market analysts have used breadth of market measures to mark the tops of overbought markets and the bottoms of oversold markets. I have used a simple measurement of price versus an intermediate moving average of price to define the trend condition of the stock. If the price is above the moving average, the trend is up and the trend is down if the price is below the moving average. I then add up the number of stocks trending up and express that as a percentage of the number of stocks in the group that I am

Performance Management System

using to represent the market. This produces a percentage that oscillates up and down and it seems to peak when eighty percent or more of the stocks are in uptrends and to trough when eighty percent or more of the stocks in the group are in downtrends. A recent example is instructive. At the oversold low that was recorded in mid-October of this year, eighty one percent of the stocks in the S&P 500 index were in down trends. As of Wednesday of this week, about a month and a half after the oversold condition, eighty percent of the stocks in that group were in uptrends. That is a major swing in the direction of the trends of the stocks in the S&P 500. Importantly, this seems to be a major change in the direction of the primary trend for the majority of these stocks. Did the fundamental business conditions of these companies go from bad to good in a month and a half? This swing in trend condition was mirrored across other sectors of the market as well, the mid-cap stocks and the NASDAQ 100 had similar moves up, generating readings of eighty percent or more showing up trends. The small cap index lagged a bit but it recorded a seventy percent reading which is still far above the levels recorded during the October low. History shows that these swings from overbought to oversold usually occur two or three times every year. In some years the market may experience four or more oversold conditions. During a major bullish move there will be fewer oversold lows than on average and during bear markets there will be more frequent oversold extremes than on average. The primary point to all of this is the oscillatory nature of the movements. Oversold lows follow overbought highs just as night follows day and so on. History shows that this has always been the case and it probably always will be. We may not be able to anticipate why the market will reverse but we can anticipate that something will come along that will reverse the movement. The market seems to be like a shark, it must keep moving or it will die. W. Clay Allen CFA

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A Different Way To Look At Risk Portfolios heavy with underperforming stocks almost never outperform the market.

"The idea in this business is to make as few mistakes as possible." The Worden Report Wednesday November 16,2005

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One of the most important aspects of point and figure charting is the focus on risk. The P&F charting approach does not measure price changes against time. The xaxis on the P&F chart records the number of alternations of trend. The alternations of trend are a function of the stock’s volatility. A stock’s volatility is often characterized as a proxy for risk so the P&F chart actually measures price movements against risk. The three box method of point and figure charting uses a required minimum movement of three boxes to recognize a reversal of trend. This minimum price change to record a trend reversal acts like a filter to remove the short-term, random and meaningless variation from the chart. The application of P&F to relative strength data adds another element of effectiveness to the technique. Plotting relative strength in a P&F format removes the influence of the market and allows the price action that is specific to that stock to show through. There are periods of time when a stock’s volatility will increase and it is important to know whether the increase in volatility is resulting in movements up or down. If the volatility in increasing when the stock goes up, the length of the columns of Xs will start to expand relative to the columns of Os. If the increase in volatility is down, then the length of the columns of Os will increase relative to the length of the columns of Xs. Analysis of data covering large numbers of stocks shows that the balance between up days and down days is usually close to 50/50. It is the change in price that is greater on the up days than the down days that creates an up trend. These are the changes in volatility the are accumulated and displayed by the alternating columns of Xs and Os on the P&F charts. The reverse is true for downtrends. In a strong up trend the tops of the

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Performance Management System

columns of Xs will constantly reach higher and higher levels while the lows of the columns of Os will not fall down as much as the prior column of Os. The standard measure of risk in a stock is the standard deviation of a large sample of daily percent changes in price. The standard deviation is a measure of the dispersion of the changes in price around the mean. Because of the long period of time used to collect the data, changes in the standard deviation are often overlooked. Also, the standard deviation has nothing to say about the trend that is being recorded The changing aspect of the volatility of a stock’s price movement is automatically recorded on the P&F chart. Increasing volatility will cause more alternations of trend and the plot will move more rapidly across the page from left to right. Decreasing volatility will cause fewer alternations of trend to occur and it will compress the chart. As a stock becomes more volatile, the risk of owning that stock will increase. As long as the trend of relative strength is up the increasing volatility results in bigger gains for the investor. Investors need to know if they are being adequately compensated for taking the risk of owning that stock. As long as the trend of relative strength on the P&F charts is rising the investor can be assured that he is being adequately compensated for running the risk of owning that stock. W. Clay Allen CFA

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Don’t Buy or Hold Poorly Performing Stocks Portfolios heavy with underperforming stocks almost never outperform the market.

“Look before you leap” Ancient wisdom

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Many, if not most, long-term investors do not bother to examine the trend of a stock they are about to buy. If the stock has been performing poorly, it will probably make a disappointing investment and a casual glance at the trend on a chart can often avoid a waste of time and capital. It seems that many investors want to buy stocks that are at bargain prices relative to their recent past. The pursuit of bargains leads to the purchase of stocks whose intrinsic fundamental value may actually be shrinking. To think otherwise requires that the investor actually believe that other investors are willing to sell their assets at a price that is less than they are truly worth. A persistent long-term downtrend in price really means that other investors are continuously willing to sell their assets at lower and lower prices. Why should this be so? Has new information been made available to the holders of the stock that causes them to believe that the stock should be sold? What is this new information and why is its impact on the stock price so negative. If you don’t know what this information is, or you can’t find out, the best course is to avoid buying the stock. If the price trend is persistently down, why bother trying to figure out why it is going down? You might just waste your time and not even get the answer. The answer that you might develop may not be the correct answer anyway. Investors should believe that there are knowledgeable investors who have a handle on the value of the stock and that they are unwilling to let it fall to a level that is significantly below their estimates of true value. There is no need for these investors to buy aggressively as long as the stock is going down. They can accumulate stock on price concessions as the overall market backs and fills. It is the buying by knowledgeable investors that will ultimately arrest the decline and a sideways

Performance Management System

A major base has formed on this stock

movement will appear. It is this process of accumulation and the subsequent sideways movement of the price of the stock that constitutes a base on the long-term point and figure charts of relative strength. The basing action can take a year or more to complete. When the accumulation process is complete there are few sellers left and the price of the stock will naturally start to rise. The sideways movement during the basing phase will tell other investors that the downtrend is over and the price probably won’t go down. The basing phase sets the stage for a movement by the stock to the upside. Market makers and other knowledgeable investors are well aware of this sequence and they take positions in addition to the others. At some point the accumulation phase ends and the mark-up phase begins. Prices start to rise rapidly in the absence of sellers. The sellers were psychologically exhausted by the prior downtrend and are thoroughly sold-out during the basing phase. The sequence of a downtrend shifting into accumulation during the basing phase is the pattern that investors should learn to seek out. As long as the trend is down, the investor should assume that the basing phase still lies ahead and that entry during the downtrend is not advisable. The basing phase can take longer than you think. W. Clay Allen CFA

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Verify Your Expectations Portfolios heavy with underperforming stocks almost never outperform the market. “The market in its broadest sense —what works in practice—is a much more reliable indicator than tons of analysis. So don't be afraid to experiment and don't persevere with losing solutions. Do not fight the market.” The 80/20 Principle by Richard Koch

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Most investors spend most of their time developing the information and data that they use to formulate their expectations about whether to buy a stock or not. It is unfortunate that these investors do not take the next step and verify whether the subsequent action of the market confirms or refutes these expectations as time passes. These expectations and hopes about the outlook for a stock are not very often influenced by the behavior of the market. It is a given that price changes over time for an individual stock are the result of changes in the performance of the business or other factors that investors believe are important in the determination of the price of a stock. Changes that are widely known and anticipated do not seem to have much influence on the price movements of the stock in the market. Information that is already known to a majority of investors has little ability to shape the movements of price. It is the unexpected and surprising changes that have the real power to cause stock prices to change. The old saying that “The stock market functions because of change—not in spite of it” seems to be absolutely true. The real question that must be continuously asked is, How closely did our original expectations for the stock’s price performance match the performance of the stock in the market? Investors do not have to ask themselves , “how well did I anticipate the unexpected changes that are causing the stock price to change? That is not the point. The investor is not in some ego-driven contest to make better predictions about future business conditions than the rest of the investors in that stock. It is OK to be right for the wrong reasons. The true objective is to be right about the market performance of the stock. Investors should continuously monitor the market preformance of the stock to make sure that its actual perform-

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Performance Management System ance confirms the original expectations that led to the stock’s purchase in the first place. There should be a limit to how far the market performance of a stock can depart from the original outlook before the investor must admit that his expectations were wrong. Most investors have a serious difficulty admitting an investment mistake. Many times they have made an emotional as well as a financial commitment to the idea that the stock will be a good investment. They may have discussed this commitment with friends and professional investment managers often are required to write reports about the reasons for their bullish outlook on a stock. The act of writing out the commitment and verbally promoting the idea, reinforce their psychological commitment to the expectation that the stock will be a big winner. Their future behavior will be strongly consistent with the prior bullish commitment, hence the problems with admitting mistakes that result in big losses ( see Dr. Robert Cialdini’s book Influence for more about commitment and consistency.” The difficulty of anticipating truly unexpected and totally surprising changes in business conditions along with the problems caused by the psychological aspects of commitment and consistency almost make the job of investing an impossible task. Perhaps this is why most professionally managed portfolios under-perform their benchmarks year-after-year. There is a way around these difficulties and the solution seems to be in the measurement of the investment performance by individual stocks. This measurement process usually incorporates a technique called relative strength. Fairly simple rules can be established to flag those stocks that are generating unacceptable performance and those stocks can be sold on a timely basis before the under-performance becomes serious. In addition, investors should be aware of the risks of becoming overly committed to their stock investments and remain adaptive and flexible when the data from the performance measurement system suggests that their original expectations were wrong. W. Clay Allen CFA

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Does “Hold” Really Mean “Sell”? Portfolios heavy with underperforming stocks almost never outperform the market.

Good performance by a stock in the market is not accidental. A stock’s bad market performance is not accidental either.

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It is a common practice for stock analysts to reduce their investment recommendations on the stocks that they follow from time to time but the downgrade usually stops at “hold” rather than dropping to “sell.” The investor is left on his own to ponder the true meaning of a reduction to an investment opinion of hold on a stock in his portfolio. Investment opinions are inherently subjective and therefore they are always fuzzy. There are no “hard and fast” rules or guidelines to be used in the preparation of an investment rating on a stock. Many of the factors that go into the analysis of an investment are predictions and projections regarding a very uncertain future. In many ways, the formulation of an investment rating on a stock is the result of financial detective work that often depends on the discovery and interpretation of soft clues rather than hard facts. It is therefore not unusual for an investment recommendation to turn out very differently from the expectations that were formulated when the recommendation was first made. It is important to know whether the downgrade follows a period of good performance in the market by a stock or whether it follows a performance that was less than satisfactory. In the latter case, the analyst is in fact recognizing an prior error in his investment opinion regarding the stock. If the downgrade to hold follows a poor market performance then the investor should probably interpret the hold recommendation as truly a sell rating. It all depends on the prior performance of the stock. Bad performance in the market is almost never accidental and the investor should not assume that the period of poor performance is over. If the downgrade to hold follows a period of above average market performance by the stock, it is reasonable to judge that the downgrade to hold is in fact a recommendation that new buying of the stock

Performance Management System

cease but that existing positions can be retained in the portfolio. Here again, the interpretation of the rating depends upon the prior performance of the stock. The ability to correctly distinguish between the true meanings of a downgrade to hold depends on the evaluation of the prior performance of the stock. Performance evaluation is usually best accomplished with a long-term chart that shows the performance of the stock relative to the action of the overall market. This calls for the analysis of the long-term relative strength of the stock. Point and figure charts of relative strength are well suited to the measurement and analysis of a stock’s performance. The point and figure approach applies a filter to the relative strength data that eliminates most of the noise and random variation in the data. These charts are not used to predict the future performance of the stock other than to evaluate the recent performance in the belief that the recent performance was not accidental and it will probably continue into the future. There are practical reasons why analyst’s opinions do not drop all the way down to sell. The analyst probably does not want to offend the management of the company by issuing a sell recommendation. He is also concerned about offending large institutional investors who have purchased the stock on his recommendation. There may be other business relationships that might be damaged by the publication of a sell recommendation. All of these considerations suggest that the investor has to shoulder the responsibility of deciding when to sell each stock in his portfolio. The sell decision is highly dependent on the prior performance of the stock in the market. The evaluation of the performance of the stock in the market, and therefore the sell decision, is best done with long-term charts of relative strength in a point and figure format. W. Clay Allen CFA

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Randomness Means Charts Are Indispensable Portfolios heavy with underperforming stocks almost never outperform the market.

“Businessmen play a mixed game of skill and chance.” The General Theory of Employment, Interest and Money by John M. Keynes

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Technical analysts resist the idea that stock price movements are random and therefore unpredictable, because it seems to prove that their approach to analysis is indeed worthless. Seasoned technical analysts, however, understand that randomness and a lack of predictability are the very factors that make charting stock price movements so necessary. First of all, experience shows that the day-to-day changes in stock prices are the result of a stochastic process that is very similar to flipping a coin and the frequency of up days to down days is usually very close to 50/50. I have recorded the frequency of up to down days for a large number of stocks and it is almost always between 45% up and 55% down and the reverse, 55% up and 45% down. But that really doesn’t tell us much. It is the relationship between the magnitudes of the up days versus the down days that is truly important. The magnitudes of the up days and the down days is almost never equal and this imbalance can last for months or even years. The differences in the daily changes accumulate into trends in the price of the stock. I have actually recorded data for a stock that went up over 100% during a year’s time and the days up versus the days down was almost exactly 50/50. In this instance, the up days minus the down days resulted in an average gain of 0.4% per day and that accumulated into the 100% rise in the stock. When the daily changes in price are recorded as a histogram, the familiar bell shaped curve always emerges. When the movement in one direction persists over a period of time this results in a distribution with a non-zero mean. A non-zero mean is proof of the existence of a persistent trend. The magnitude of the mean of the distribution is really a measure of the strength of the trend. The strength of the trend, either up or down, can result in a distortion of the bell shaped curve that is called skewness

Performance Management System

and one tail of the distribution will be greatly shortened. The calculation of skewness can give an insight into how strong the trend has been in the past without making any sort of prediction about how strong the trend will be in the future. Only the chart of the stock price will reveal whether or not the strength of the trend is maintained. It is the existence of trends that makes technical analysis useful to the investor. There is no requirement to be able to predict the length or the strength of the trend of the stock price. In fact, it is healthy to understand that the strength and duration of the trend is unpredictable. The usefulness of technical analysis of stock trends is not in its ability to predict the trend ahead of time as much as it is the power to recognize the change in the trend when it occurs. It seems more important to be able to recognize a change in the trend of a stock’s price than to become committed to a prediction of what the stock price ought to do in the future and to ignore any changes in the trend that might disagree with that prediction. The world of business is always in a state of flux and many of these changes are random and unexpected. It is this constant uncertainty that provides the opportunity for profit in the market. If investing was like physics, with laws and equations that allowed for mathematical precision in forecasting, then we could invest risk free. But, there seem to be no laws or equations that provide this kind of certainty so we have to fall back on what provides a useful insight into stock price movements. The only rule that seems to be workable is that a trend, once in motion, will continue in motion until something acts to change it. We can observe the change in trend and maybe we can find the cause for the change in direction. Finding the cause of the change in trend is not nearly as important to an investor as the recognition that the trend has changed. W. Clay Allen CFA

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Downtrends Usually Tell The Truth Portfolios heavy with underperforming stocks almost never outperform the market.

“It is the “holds” that are too cheap to sell but not attractive enough to buy that clog and clutter up your portfolio and retard your performance.” Barton Biggs Stock market strategist and portfolio manager. A collection of recent newsletters is available at www.clayallen.com

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Most investors believe that the real job of portfolio management is to “pick” stocks. This seems to miss the most important activity of portfolio management, which is to identify the losers in the portfolio. In order to upgrade the future performance potential of the portfolio it is first necessary to spot the stinkers in the portfolio. The portfolio manager is dealing with constant change. The modern investment markets are very dynamic and they reflect the changes taking place in the economy, in business management, in technology, in consumer tastes, in politics, and not just in the United States but all over the world. Some of these changes will create a positive fundamental influence on some of the stocks in the portfolio and other changes will exert a negative fundamental force on the business of some of the companies in the portfolio. It is very common for these forces to develop unexpectedly and the resultant reaction in the market can be dramatic in both directions. It seems that the unexpected revelation of negative fundamental changes can have a sudden and substantial downward impact of the market price of a stock. Experience shows that, more often than not, the market has an uncanny ability to anticipate these negative developments and the trend of the stock’s price in the market will turn down long before the actual release of the negative fundamental information. The collective wisdom of the market seems to accurately discount the information before it becomes public and widely available to all investors. This is the well known tendency for stock prices to lead the fundamentals of the business. Therefore, it only seems natural that the study of the trends of stock prices should also lead the fundamentals of the business. The technical analyst may not know the why behind the price trend but he can infer that important changes in the trends of stock prices probably reflect im-

Performance Management System

portant developments in the fundamentals of the business. The trends that are so commonly observed in stock prices do not occur by accident and trends that persist should be respected as a source of important information about fundamental developments within the company. Information about negative developments within a company always seem to leak into the market. This leakage of bad news occurs even when the management of the business tries to cover-up the story or act like nothing is wrong. Trends in the market seem to be a truth detector about future bad news. Successful portfolio managers learn to use the tendency of market trends to lead the fundamentals to help identify the stocks in the portfolio that will probably perform poorly in the future. The identification of these stocks is absolutely critical to the process of upgrading the future performance potential of the portfolio. The bad stocks with poor potential are weeded out and the good stocks with positive potential are retained. This process allows the portfolio manager to deal with changes that he may not even understand In order to successfully manage the portfolio he does not need to know the details of what is wrong with a stock. He just needs to know that something is wrong and that will be reflected by the trend of the stock price. The identification and elimination of the future losers from the portfolio is the first step in successful portfolio management. Once a stock has been identified as a future loser the temptation to buy more is completely eliminated. Adding to stocks that are locked into persistent downtrends is a dreadful way to manage a portfolio. Winners are allowed to run and losers are sold as soon as they are identified. After the loser is identified and sold the second step in portfolio management can be taken, that is picking a stock to replace the stock that was sold. Stock picking is really the last step in portfolio management. W. Clay Allen CFA

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Good Portfolio Managers have Good Luck Portfolios heavy with underperforming stocks almost never outperform the market.

“Stocks going the wrong direction are the wrong stocks to be in.” Burton Crane Famous Financial Editor New York Times

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Market Dynamics www.clayallen.com 7325 S. Jackson St. Centennial, CO 80122

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

Luck in the investment markets is very different than luck in a casino, in that, luck in the investment markets can be influenced by the behavior of the portfolio manager while luck in the casino is just the result of raw chance. It is a well understood fact that the outcome of the games of chance in the casino have been devised to favor the house. If the gambler plays long enough, the house will eventually win all the money that has been bet. There are no levels of skill nor systems of play that can alter the outcome in any way. Many gamblers resort to all kinds of superstitions in an vain attempt to change the outcome, but nothing ever works sufficiently to change this highly predictable outcome. In the stock market, however, there is no real structure to the odds of the outcome that says the investor must lose. Lose? Lose to whom? Some other investor becomes the winner because there is no house in this game. All the players are acting in the own best interest. In fact, the structure of the probabilities of the outcome of an investment can be readily observed in the movement of stock prices. The bias in the movement of stock prices is observable and is seen as a trend in the movement of prices. This trend readily identifies either the buyers or the sellers as the winners or the losers in that particular stock. You can’t make money in a stock by yourself so it is important to determine whether the other buyers are making money or not. You will most likely share the experience of the other buyers of that stock, so the price trend becomes very important information about your chances of winning or losing—your luck with that stock. The trend will unfold over time and it is probably futile to try to predict its outcome in advance. It is enough to measure the trend and to remain positioned to

Performance Management System

benefit from a continuation of that trend. Investors have long expressed their activities as “following a stock.” It is interesting that the description of “following a stock” says nothing about predicting the stock’s future market behavior. The trend cannot be accurately predicted in advance but a change in the direction of the primary trend of the stock can be readily observed. When the trend changes direction, the investor can change his position so that his investment portfolio will not be damaged by the new trend direction. By changing his position to agree with the new trend, the portfolio manager improves his chances of profiting from the position. In this way he aligns his investment position with the bias reflected in the trend and, as a result, he increases his good luck and reduces his bad luck. The day to day movements of a stock are random in nature but that does not mean that the stock price movements can’t follow a strong trend in one direction or the other. The proportion of up days to down days may be close to 50/50 but the movements in one direction can be much larger than the movements in the opposite direction. A lengthy period of time can produce a major gain or loss in a stock with a strong bias. The bias will be calculated by taking the average of the daily percent changes. The investor does not need to believe that this bias will last forever—no trend lasts forever. Only that it will persist for a period that is long enough for him to earn an unusual profit. The trend will usually lose strength before it changes direction and the changing bias of the daily changes will indicate the change of direction. Following the trend allows the portfolio manager to manage his luck—stay with the trends going your way and avoid the trends going the other way. You can’t do that in a casino. An investor who ignores the trend of the stock price can become ensnared in all sorts of ridiculous predictions about what the stock should be doing while the adverse trend depletes his capital. W. Clay Allen CFA

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The Case For Long-Term Relative Strength Portfolios heavy with underperforming stocks almost never outperform the market. “But if, as many contend, the action of market prices in moving toward their intrinsic values is a slower than instantaneous process, the study of price trends and patterns may be valuable indeed. “ The Relative Strength Concept of Common Stock Price Forecasting Robert A. Levy PhD. A collection of recent newsletters is available at www.clayallen.com

Market Dynamics www.clayallen.com 7325 S. Jackson St. Centennial, CO 80122

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

A hedge fund manager told me yesterday that he was not interested in relative strength because his goal was to achieve absolute returns and that started me thinking. Should relative strength be ignored just because the investment objective is to achieve an absolute return rather than a relative return? To most investors relative strength is a technical tool that is used primarily by short-term speculators. This idea probably has its origin in the use of relative strength rankings to select stocks for speculative trading as popularized by a leading financial newspaper. Many of these highly ranked stocks are indeed highly speculative and their high relative strength rankings can drop off suddenly. The primary application of relative strength to long-term investing is to measure not only the strength of the relative movement but to track the persistence of that movement. When the influence of the overall market is removed from the stock price by the calculation of relative strength, the resulting ratio reflects the price movements that are specific to that stock. That specific price movement is usually a true reflection of the financial performance of the company. When the financial performance of the company is unusually good it shows up as a strong trend of relative strength that can persist for a long period of time. It is the persistence of the relative strength trend that is of primary interest to the long-term investor. Usually, with stocks in strong relative strength uptrends, they go up more than the market when the market goes up, and they go down less than the market when the market goes down. This has the effect that over a long period of time, with many ups and downs in the overall market, the stocks with the persistent trends of relative strength not only produce good relative returns, they produce high absolute returns as well. It is the persistence of the relative strength trend that allows these

Performance Management System

large absolute returns to accumulate. This effect is most pronounced for the stocks in the right tail of the distribution of returns and experience shows that the stocks in the right tail have the best chance to show persistent long-term trends. After all, that is what qualifies them for a position in the right tail and these trends can continue for several years. If the investor believes that the trend of relative strength is tied to the financial performance of the company, then the persistence of the relative strength trend is a primary confirmation that the financial performance that created the trend in the first place is continuing in a positive direction. It seems that relative strength is an excellent way to identify companies with good and improving trends of financial performance. It helps the long-term investor discriminate among the universe of all stocks to find the stocks with exceptional financial performance. Experience shows that strong relative strength trends that persist for long periods of time are not accidental. Attention to the long-term trends of relative strength quickly eliminates the stocks with negative relative strength trends and these are the very stocks that produce the worst absolute returns. Stocks in trading ranges do not pass the relative strength test because their trends do not persist. It seems that a focus on long-term trends of relative strength will produce the highest absolute returns as well as good relative returns. Nothing lasts forever, and long-term investors need to pay close attention to the relative strength trends for indications that the trend may be fading. The right tail of the distribution seems to always hold purchase candidates with good relative strength trends so a switch can be made when the relative strength trend turns down. Therefore it seems possible for a long-term investor to be fully invested at all times and enjoy acceptable returns during almost any market conditions that might develop. W. Clay Allen CFA

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A Common Mistake By Long-term Investors Portfolios heavy with underperforming stocks almost never outperform the market.

“There are only two ways of telling the complete truth-anonymously and posthumously.” Thomas Sowell

A collection of recent newsletters is available at www.clayallen.com

Market Dynamics www.clayallen.com 7325 S. Jackson St. Centennial, CO 80122

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

It has been shown that long-term investors stay with stocks that don’t provide good performance for far too long. This seems to be such a strong tendency for many investors that considerable care must be taken to avoid this serious source of major losses in the portfolio. How does the investor guard against his own behavior that allows him to hold poorly performing stocks for too long? The investor must make a commitment to eliminating poorly performing stocks just as soon as they can be identified. The best way to identify poorly performing stocks is with a long-term chart that shows relative strength. The investor must have a very clear idea about what constitutes acceptable performance by a stock and what constitutes unacceptable performance. There must be a predetermined decision point that cannot be reached without action being taken to sell the stock. Experience over a long period of time shows that most stocks that fall into the unacceptable performance category, perform poorly for an extended period of time. It is often surprising how correct the collective judgment of the market can be when a stock starts to have performance problems. The discounting process of the market and the resulting poor market performance of the stock, starts to reveal the onset of negative developments in the financial performance of the company long before those fundamentals are made public. The management of the company has absolutely no incentive to reveal potential problems to investors. In fact, it is very common for managements to publicly deny the existence of serious problems. In a recent Wall Street journal editorial, Jack Welch of GE fame, discussed the common behavior by business managements to try to cover-up serious problems and that they were almost always unsuccessful in their attempts to cover-up those difficulties. It is not uncommon for insiders

Performance Management System

to be selling their own stock while engaged in public denials of potential problems or while conducting a cover-up. The stock sales by management and their friends and families and other investors that are close to the company, provide unmistakable clues to market watchers that something is probably going wrong. The poor performance of the stock in the market also provides clues to alert observers that there is trouble brewing with that stock. The onset of poor market performance is one of the best recommendations a long-term investor can get to eliminate the bad stock from the portfolio. However, it seems common for long-term investors to either overlook the poor performance or to assume that it is a temporary development and believe that better market performance will surely follow. Poor performance is euphemistically called a correction and it is essentially a denial that the stock did not go up as expected . But, in the case of a truly bad stock, the correction continues. It then becomes common for the long-term investor to believe that the stock can’t be sold because it has gone down too much. Too much relative to what? The downtrend persists and the loss becomes even greater and the long-term investor becomes psychologically trapped in the poorly performing stock. The best defense against these common difficulties is to measure the performance of each stock in the portfolio. Very clear rules can be formulated that will force the sale of a poorly performing stock while the damage is still small. It seems that the successful investor knows that the current facts of the situation are not nearly as important as the clues to what the future fundamental facts might be. One of the most important clues to future facts is the market performance now. If you have to wait for the fundamental facts to be revealed, experience shows that you will miss the clues to what the future holds for that stock— especially for a poorly performing stock. W. Clay Allen CFA

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Why The Random Walk Does Not Apply Portfolios heavy with underperforming stocks almost never outperform the market.

It is probably true that the future price of a stock cannot be predicted with any meaningful degree of accuracy. That is not to say that changes in the direction of the stock’s price trend cannot be recognized using technical analysis of stock charts. A collection of recent newsletters is available at www.clayallen.com

Market Dynamics www.clayallen.com 7325 S. Jackson St. Centennial, CO 80122

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

Academics are fond of using a statistical artifice called the random walk to prove that charts cannot help investors improve their returns from stock investments. Their application of the basic ideas of the random walk do not apply to the behavior of stock prices and therefore it says nothing about the usefulness of technical analysis. The random walk assumes an inebriated person staggering around a lamppost at night. It assumes that his steps are equally likely to be right or left, forward or back. It also assumes that the step sizes are equal. The conclusion is that the best guess about the drunk’s position after a large number of steps is that he will be back where he started, at the lamppost. That is the best guess about his position given the assumptions. The equal step size assures that there will be no accumulated departure away from the lamppost in any direction. It is then argued that stocks prices are random and therefore it is impossible to predict any movement away from the lamppost using stock price histories. That would be correct if it were not for the fact that the step sizes for stock price movements are almost never equal and that this inequality of step sizes can persist for long periods of time. Simple measurements of the daily percent price changes for individual stocks often show that the percent change on up days can be very different from the percent change on down days and this difference can persist for a long period of time. The proportion of up to down days can be very close to 50/50 but it is the relative magnitudes of the up percent changes versus the down percent changes that is important. This provides proof that the conclusions of the random walk do not apply to that stock. There can be an accumulated departure from the starting point due to the difference in the magnitudes of the up versus the down days. This accumulated departure

Performance Management System

from the starting point can be very large, commonly over +100% in a year’s time. Another way to say this is to state that the distribution of daily price changes has a non-zero mean. An average daily change of +0.4% over a year’s time results in a percent gain overall of +100%. The accumulated departure from the starting point is called a trend in the price of the stock. Technical analysis is a method for recording these trends with an objective of determining when the trend changes direction. It must be understood that the future trend cannot be predicted, other than to say that the most likely case is that the trend will continue in the given direction. The true objective of skilled technical analysis is to determine when the trend changes direction. The fact that the future price changes will be random does not say anything about the relative magnitudes of those changes. The relative magnitudes of the price changes determines the strength and direction of the trend. When the trend changes direction it is because the relative magnitudes have changed their relationship, not because they are random. The step sizes change and the trend changes direction. Most experienced investors will agree that being able to recognize a change in the strength or the direction of a trend in price is very valuable information even though we don’t know how long it will last. Just because we don’t know how long the trend will last is no reason to ignore a change in trend. It is not uncommon for a long-term trend in the price of a stock to represent the daily accumulations of price changes that were produced, at least partially, randomly. The technical methods that are used to track these random daily price changes should incorporate a filtering technique to reduce the impact of the random noise in the price data.. This is especially true for long-term investors who intend to hold their investments for a long period time, in order to let the major long-term trend develop to its fullest. W. Clay Allen CFA

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What Does Randomness Really Mean? Portfolios heavy with underperforming stocks almost never outperform the market.

“Prediction is very difficult, especially about the future.” Niels Bohr Danish physicist (1885 - 1962

A collection of recent newsletters is available at www.clayallen.com

Market Dynamics www.clayallen.com 7325 S. Jackson St. Centennial, CO 80122

Phone: 303-804-0507 Fax: 303-804-0513 [email protected]

This is an example of a real stock and how it behaved over the prior year. There were 49.4% of the days that were up and 50.6% of the days were down. And yet, this stock gained almost 70% during the prior year. The percent gain on the up days was +1.92% on average and on the down days –1.32%. This left an average daily percent gain for this stock of +0.277%. The histogram of the daily percent changes is shown in the lower graph and it fits the profile of a normal, bell shaped curve very well. This bell shaped curve is the footprint of randomness that has resulted in such academic fantasy as the Efficient Market Hypothesis and the aggressive damning of technical analysis by the academic community. There seems to be little doubt that the daily percent price changes were random for this stock over this period of time. In fact there were more days down than there were days up and yet the total gain for this stock was almost 70%. The upper panel shows the long-term point and figure chart of relative strength for this stock. The day-to-day movements may have been random but this chart of relative strength did not once indicate that the up trend was faltering. It consistently showed a pattern of higher highs and higher lows. The investor who owned this stock would have been very pleased to ride the stock’s trend upward over the past year even though the day-to-day changes were random. This example points up the primary use for technical analysis—the identification of turning points in a stock’s long-term trend. This chart did not show a single instance of a potential change in trend to the downside. In fact, the stock’s trend is still up. The proper role for technical analysis is to measure the strength and direction of long-term trends in stock prices and to recognize when those trends change direction. Prediction has little to do with successful investment management. The primary role of the investor, especially the long-term investor is to recognize when trends are changing. Technical analysis, or any other form of stock market analysis, is not physics. There

Performance Management System

Long-term P&F chart for DNA. Randomness did not cover up the true trend for this stock.

are no lasting mathematical relationships that allow for precise mathematical predictions of stock prices. Prediction aside, it seems very useful to record and measure the trends of stock prices and to benefit accordingly. The stock market and the trends of stock prices are inherently fuzzy and should be dealt with as such. The true objective of investors is not to make superior forecasts of future stock prices but to be profitable. Being profitable can be best achieved by tracking the trends of the investments in the portfolio. The only prediction that's involved is that the trend that is currently underway will probably continue. It is very reassuring to me that I can be confident that when the trend changes direction, I will see it and I can act on it at that time. Many investors, who are unaware of changing trends in the market, are often completely frustrated when their predictions don’t work out as they had hoped. W. Clay Allen CFA

To buy the full edition of Winning The Performance Game click here

Winning The Performance Game By W. Clay Allen CFA

Introduction - Take Control of Your Investment Performance My purpose in writing this book is to share my experiences and the lessons I have learned about managing long-term institutional stock portfolios for performance. The primary objective is to help portfolio managers improve their investment performance. This book is not intended to be an introductory course in portfolio management and I assume that the reader is usually a professional, long-term, equity portfolio manager or a sophisticated individual investor.

Organization and use of this e-book This e-book has been designed to allow the reader the full use of the main advantages of an electronic book – the use of hyperlinks. The table of contents is made up entirely of hyperlinks (a small hand appears over the hyperlink) to various parts of the e-book. The book has been organized into five loosely connected parts; Investment Performance – Part 1 p13 Portfolio management – Part 2 p59 Successful Stock Charting – Part 3 p98 Investor Psychology – Part 4 p164 Schooled by the Market – Part 5 p203 The e-book is made up of short essays about various facets of investment management. It has been designed for the user to jump around within the book rather than reading straight through. The user who is primarily interested in Hidden Order can use the following link to jump straight to that topic – use the back key to return to this point – Jump to Hidden Order p101. The reader can also Jump to Hidden Order to the Downside p103. Several topics are addressed repeatedly in this collection because of their importance and usefulness in successful portfolio management, particularly performance measurement, social proof, commitment and consistency, trading ranges and various aspects of chart construction and usage. If the user finds any of the repetition tedious then I recommend that the reader use a hyperlink to go to a different topic. All of the charts in this book were prepared using the Market Dynamics pointand-figure software and service. These charts and this service are now being used by some of the largest institutional portfolio managers, hedge fund managers and individual investors. A complete tutorial on the construction and application of relative strength charting in a point-and-figure format can be found at http://www.clayallen.com. This extensive tutorial is over three hundred pages in length and can be downloaded free from that web site.

The fundamental idea behind this book is that in order to manage investment performance it must be measured.

“Measure it and it will improve.” The Purple Cow Seth Godin. Since the approach is for long-term investors rather than short-term traders, it is important to describe a measurement system that eliminates the short-term noise from stock price data. In addition to removing the noise, the measurement system should also eliminate the influence of the overall market and produce an indication of performance that is adjusted for the movements of the market. It is assumed that investors want to perform better than the market. Philosophically, when we sign off on the need to measure the performance of stocks in order to manage the performance of the portfolio, we then need to determine the best methods for measuring market performance. Measuring market performance is nothing more than gathering feedback from the market to validate or to refute our hopes and expectations about the performance of a stock. The application of the three-box, point-and-figure charts of relative strength accomplishes the dual goals of removing the noise and presenting the performance data in a long-term format. I have used point-and-figure charts of price for many years and I adopted an emphasis on relative strength in the late 90’s. I have assumed that the intended reader is more or less familiar with the techniques of three-box, point-and-figure charting. The typical institutional portfolio manager is more inclined to use only fundamental security analysis in their portfolio management activities and this makes them vulnerable to performance problems whenever their expectations are too optimistic. The most important application of long-term charting is to verify those performance expectations about a stock by using feedback from the market itself. It is my basic belief that the long-term performance of an investment grade stock that is recorded in the market, good or bad, occurs primarily for fundamental reasons and these reasons often persist for long periods of time. These fundamental factors affect the performance of the stock and the price performance of the stock in the market reflects on the state of the fundamental business conditions of the company. This order in the market is often hidden from view by the short-term random noise in stock price fluctuations. This is why when the noise is removed and the price data adjusted for the influence of the market, a hidden order emerges from the data. This hidden order can be measured and used to manage the performance of the stocks in the portfolio. The results of this measurement process are not used to make predictions but are used to grade the stock’s performance as either acceptable or unacceptable within the

context of long-term investment goals. Performance measurements that indicate persistent long-term performance that is unacceptable suggest the sale of the stock. Good performers are retained in the portfolio for as long as they outperform and poorly performing stocks are weeded out. This is the essential portfolio upgrading process that allows a portfolio manager to keep the portfolio fresh and directed toward the performance goals. The economy, business conditions, and the investment fundamentals of companies are always in a state of change and this is reflected in the constant motion of prices recorded in the stock market. Conditions don’t seem to ever achieve equilibrium and the successful portfolio manager must continually adapt to these changing factors. Portfolio managers need evidence that confirms the direction of the change and the magnitude of its impact on the performance of individual stocks. Performance management is all about the sell decision. Sell and don’t buy stocks with unacceptable performance records. Buy and continue to hold stocks that have good market performance. This allows the portfolio manager to take control of his performance with an understandable method that is based on genuine evidence from the market. I first started using point-and-figure charts to defend against faulty Wall Street research and it still works. In addition to guarding against the mistakes of Wall Street analysts, I have to admit that I need to guard against my own investment mistakes and the charts are extremely helpful in keeping me on the right track. Over the past 35 years or so I have worked with portfolio managers who used many different aspects of fundamental analysis to select stocks for purchase. It does not seem that good portfolio management is completed simply by selecting a stock for purchase. It’s what happens to the performance of the stock after the purchase that counts. Performance is a function of price changes in the market and these accumulated price changes can be measured and filtered in such a way as to remove the noise and let the true performance show through. The true performance is what I call “hidden order.” The essays that make up this book were prepared over the past several years to help educate and inform my customers about my approach to the measurement and management of performance. The market experience over the past ten years has been a wonderful laboratory to test and refine these methods. Attention was given to important subjects at different times during the past two years and this has resulted in some subjects being covered more than once. To repeat, since I have chosen to include all of the weekly essays from the past two years, I hope the reader will forgive some repetition on some important aspects of the performance measurement process. The book is dedicated to my wife Maria and our two sons Frank and Walter. They have been exceedingly patient and helpful during the preparation of this book. My son Frank was especially helpful in the design and preparation of the artwork that was used for the covers of the book. My thanks to Gary Bender and Barbara Osgood-Hartness for all their help and suggestions with the manuscript. To Vern Eliason, my thanks and gratitude for being my intellectual mentor for all these years. W. Clay Allen CFA To buy the full edition of Winning The Performance Game click here

Manage The Portfolio Like A Business A portfolio manager is more likely to succeed if he manages the portfolio like a business. The portfolio manager should view the various stock investments in the portfolio as the workers in the business. The business manager organizes and directs the activities of the workers to accomplish the goals of the business. The business manager does not do the work. He manages the job performance of the workers. Feedback is gathered to provide a basis for evaluating the job performance of the individual workers. This process of gathering feedback should be almost continuous. The business manager defines what is acceptable job performance. When the job performance of a worker sinks to an unacceptable level the worker must be terminated. A new, more capable worker is then hired as a replacement. The work force of the business is constantly refreshed and kept oriented toward the goals of the business. The job performance of a worker in prior periods should not be allowed to unduly influence the evaluation of job performance in the most recent period. It is also recommended that the business manager not become too close or “chummy” with the workers because that might retard the ability to address the problem of poor job performance by the worker in the future—ditto for stocks. It should be remembered that it is the job performance of the worker that is being evaluated and criticized, not the abilities of the business (i.e. portfolio) manager. However, many portfolio managers become very defensive when stocks they have selected perform poorly. This defensive attitude seems misplaced and often gets in the way of an objective appraisal of the job performance by that worker (i.e. stock). All reasonable portfolio managers will admit that not all stock investments will work out as hoped and the feedback monitor is a direct method for dealing with disappointing investments. The controlling rule in the business of investment management is to expect the unexpected. It is best to plan for surprise. A positive surprise will take care of itself and requires no action. The negative surprise is what triggers the feedback mechanism and sets the stage for remedial action. The performance feedback process usually provides an early indication that something is developing in the wrong direction. It is usually a mistake to stubbornly maintain confidence in a prediction when the evidence from the market suggests that the prediction is suspect. Predictions must be continually tested and their “hoped-for” validity verified. The performance feedback approach allows the portfolio to adjust and adapt to changing conditions while the fundamental inputs are still in flux. Once this approach has been adopted, it is a simple matter to develop the tools to implement a job performance feedback system.

Excellent long-term job performance.

“Men must be taught as if you taught them not, and things unknown proposed as things forgot.” The Essay on Criticism Alexander Pope To buy the full edition of Winning The Performance Game click here

The Importance of the Vital Few There is an important principle that is often called the 80/20 rule (i.e. The Pareto Principle). It describes the results of many processes in human activities that are disproportionately affected by the vital few. The largest share of the results, usually 80% or more, are accounted for by only 20% of the participants. This is not a precise rule and the proportions can vary from 60/40 to 90/10. But the principle is the same. The greatest amount of the output of a process is accounted for by a minority of the inputs. This seems to be a very important factor in portfolio management. Experience shows that very often the largest share of the profits of a portfolio will be contributed by the best 20% of the stocks. Also, the largest share of the losses in a portfolio will be the results of holding the worst 20% of the stocks in the portfolio. The 60% of the stocks in the middle of the spectrum of returns will probably have a neutral impact on the overall performance of the portfolio. It seems, then, that the scales of performance are tipped by the relationship of the best 20% of the portfolio to the worst 20% of the portfolio. Therefore the best allocation of the portfolio manager’s time is to measure the performance of each stock in the portfolio relative to its benchmark, with the objective being the identification of the worst performing stocks in the portfolio. Stocks that underperform on a persistent basis are members of the worst 20% of the portfolio and should be sold. Stocks that persistently outperform should be retained in the portfolio for as long as the excess performance persists. The overall market should be continuously monitored for new ideas about the best performing stocks and economic sectors. As new groups are identified as outperformers, they should be added to the portfolio, with the weakest performing stocks used as a source of funds. This results in keeping the portfolio fresh and in step with new developments and changing business conditions. Unfortunately, the field of behavioral finance suggests that most portfolio managers tend to gamble with their losses and to take their profits prematurely. It seems that by gambling with their losses they retain the losers in the portfolio too long and perhaps even add to these losing positions by averaging down. Averaging down on losing positions almost guarantees that the worst 20% of the stocks in the portfolio are retained too long and the result is a serious drag on performance. Value oriented portfolio managers have to be especially careful about the negative effects of averaging down. Bargain hunting by long-term investors also leads them into the worst performing sectors of the market as a result of their search for “cheap” stocks. Bargain hunting should be attempted only by short-term traders and protected with stops. The best 20% of the portfolio should be monitored for stocks whose outperformance has carried them into the realm of speculative price momentum and overvaluation. When a stock achieves gross over-valuation, it can be sold into strength rather than held until the onset of underperformance that might result in a dramatic price drop without much warning.

One of the biggest winners of the prior year—among the best 20% of all stocks, a steady progression of higher highs and higher lows.

Eighty percent of next year’s major problems are probably in the portfolio now. To buy the full edition of Winning The Performance Game click here

Manage for High Excess Returns Stocks should be selected and managed for their expected ability to produce excess returns, i.e. unusual profits relative to the average stock. This seems to be a straightforward proposition and an objective that can be readily accomplished. However, in the real world of investing, this seems to be an almost impossible task for most professional investors. Why? The difficulty with the idea of investing for high excess returns seems to lie in the second half of the proposition. The selection process is usually the part of the problem that gets the most attention, and it is important, but stock selection is only part of the solution. How to manage an investment for high excess returns is often not considered, or is judged to be impossible. The game investors play is what Keynes called “ a mixed game of skill and chance.” Most investors spend too much of their time and effort trying to improve their stock selection skills, or finding a “skilled” advisor. Facing up to the element of chance is given little thought. Assume that the investor is involved in a game where chance and randomness varies from period to period but biases appear and persist for variable lengths of time. The strength and extent of these biases or trends are unpredictable and almost completely a function of chance. It would be to the player’s considerable advantage to gather data, measure the bias and to play the game so that the player would benefit from the bias that was then in effect, for as long as that bias lasted. He would also be aware of the need to change his strategy of play when the data showed a change in the strength or direction of the bias. It would be silly for the player to make predictions of the future bias in the game that would be based on anything other than the evidence from the data regarding the bias at work in the game, at that time. This hypothetical game seems to be very close to the actual situation investors face in the workings of the stock market. The bias shows up in the trend of the performance of a stock, relative to the market. The investor seeking above average returns is not satisfied with the returns generated by the average stock. The behavior of the average stock becomes the measuring benchmark, and this role is usually achieved by using a market average, for example, the S&P 500. The comparison of the performance of an individual stock to a market average is usually defined as relative strength. These increments of relative strength accumulate as a random process from the movements of both the individual stock and the market average. As long as these accumulations move up, the investor is achieving his goal. When the bias changes and the accumulations move down in a significant way, the investor is no longer moving toward his goal of excess returns. Regardless of his previous expectations or predictions, it is now obvious that the objective is not being met by that stock and it should be sold. The use of charts, particularly point-and-figure charts, is a very important management tool for investors. Charts do not predict the future, but will measure the performance of each stock and evaluate the progress toward the goal of capturing high excess returns.

The upward bias in this stock has persisted for several years. It is the performance in the market that determines whether a stock should be retained or sold - not past predictions.

“Businessmen play a mixed game of skill and chance.” The General Theory of Employment, Interest and Money J. M. Keynes To buy the full edition of Winning The Performance Game click here

They Never Tell You When To Sell A former chairman of the SEC complained vigorously about the fact that Wall Street produced 29 written buy reports for each written sell report. He alluded to the conflicts of interest between analysts at investment banks and the clients of those banks. These conflicts are certainly real. Large fines and settlements were paid by several large investment banks as a result of similar accusations. There are several additional factors that keep Wall Street analysts from issuing written sell reports. Analysts commit a large amount of time and effort in gaining the friendship and confidence of the managements of the companies that they follow. They would be foolish to risk the alienation of those very managers by issuing a negative report on the stock. There have been cases where a corporate management reacted very angrily to a negative report, going so far as to ask for the offending analyst’s “scalp.” Wall Street analysts also spend a large amount of time and effort selling their ideas to the most important institutional clients of their firm. Should their analysis point to truly negative information about the company, it is in their best interest to confidentially communicate these opinions to the large institutional investors first, so that their holdings can be distributed before these opinions gain widespread acceptance. The analyst must be careful in the preparation of his opinions in order to avoid running afoul of the laws prohibiting the use of inside information. There are many ways to couch an opinion without using illegal information, and it appears to be common practice. Many times the Wall Street analyst will have made an emotional and an intellectual commitment to the ideas behind the buy recommendation. This limits his ability to change his position in the future, in spite of changing facts in the situation. Dr. Robert Cialdini discusses the phenomena of Commitment and Constituency in his excellent book, Influence. This contributes to the inability of the analyst to actually see negative facts or to develop a sell recommendation, whether he intends to publish it in written form or not. It is also true that many analysts are primarily reporters that develop their opinions from the comments and guidance of the managements of the companies that they follow. The management of a company often has great hopes that his plans and strategies will succeed and that the company will prosper. Sometimes the management’s plans will be just completely wrong and the analyst will have been misled. When developments take a turn for the worse, it is not uncommon for a corporate management to “clam up” or to misrepresent the true seriousness of the situation. Many times when the analyst becomes uncertain about a prior recommendation he will change his opinion to “hold.” A rating of “hold” usually means that things are not working out as hoped but that the analyst does not want to move to the more drastic and negative opinion of “sell,” for all the reasons mentioned above. All this means that investors, both individuals and most institutional investors, must develop their own ideas about what stocks should be sold out of the portfolio and when. Good selling is an art and a talent that few investors appreciate or spend the time and effort to develop. In the stock market, sometimes, the best offense is a good defense. In my experience, good long-term technical analysis is the primary tool for making effective sell decisions. A persistent long-term downtrend on the relative price

chart should produce a decision to sell the stock long before the negative facts will be made public Sometimes the tape will be misleading on the way up, but it is hardly ever wrong on the way down.

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“Almost all of the really big trouble that you're going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you might come out the winner in the Loser's Game.” “The Loser's Game” Financial Analyst's Journal July/August '75 Charles D. Ellis To buy the full edition of Winning The Performance Game click here

Does a CFA Use Technical Analysis? Long-term technical analysis is a legitimate tool for portfolio managers because expectations based on fundamental analysis alone are not always correct. The expected financial performance of a company may not materialize or the expected market response may not develop, even when the expected financial performance is accurately forecast. Long-term technical analysis should be used to track the performance of the stock in the market, as a check on our fundamental expectations. The use of technical analysis is primarily to identify stocks in the portfolio that are failing to add economic value to the performance of the portfolio. Every position in the portfolio must pull its own weight in terms of performance. If the performance of the stock does not measure up, then there should be a strong presumption that the expectations (which led to the investment in the first place) are flawed. If we could accurately predict the future of stock prices then we could invest “risk free” because we would know the future. In such a situation, we could just buy our stocks and “go fishing.” There would be no need for the verification of expectations that is provided by technical analysis. Technical analysis has received almost universal criticism and condemnation by the finance faculties of business schools all across America. They preach that the stock market is random and therefore technical analysis is worthless because you can’t predict the outcome of a random process. There is no argument from me that the day-to-day movements of stock prices are random. It seems that the academic community has completely overlooked the potential of technical analysis when used to measure performance. If your objective is to achieve performance relative to some market benchmark, then the first step is to measure the performance of the investments in the portfolio against that benchmark. Poorly performing stocks are like a poorly performing employee in a business. The business manager accepts the fact that the job performance has been unacceptable and the employee is terminated. The manager does not need to make some precise mathematical prediction of the future job performance of that employee. He accepts the fact that the job performance has not been satisfactory and makes a decision to replace that employee with one better suited to the task. So it should be with investments. The measurement of performance should be based on long-term considerations and inputs. The measurement process can be constructed in such a way that the random, short-term noise in stock prices is removed. Since experience shows that stock prices usually lead the fundamentals, the measurement of the performance of a stock price will provide a useful and, for the most part, accurate check on the fundamental performance of the company.

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The relative performance of ARBA suggests very poor financial performance. It remained below the 45degree bearish resistance line for several years.

“Every enterprise should be conducted according to a system; chance alone can never bring success.” Napoleon To buy the full edition of Winning The Performance Game click here

The N = New in CANSLIM The letter N in the famous acronym CANSLIM by William O’Neil, of Investor’s Business Daily, represents the fact that major stock market winners are almost always associated with something new. It could be new products, new markets, or new management, but it has to be something new. The requirement that the company have a new dimension to its business raises an unforeseen difficulty for many investors. Most investors are seeking certainty rather than uncertainty. Something new increases uncertainty about the future of the business. Something new is, by definition, untried and different from things that have been done in the past. The new factor, that has been created recently, is probably not well understood even by the investors who are close to the company. How does an investor evaluate the potential of new management, the future of a new product, or the opportunities presented by a totally new and untried market? The management of the company itself may not have a good handle on the potential for financial success represented by something that is completely new. Many times the management of a company will direct the company on a trial and error basis, usually hoping for the best, but completely in the dark as to the probability of success. And yet, the requirement that some new factor must be present to qualify a stock as a future major winner is not disputed. How can the investor overcome the uncertainty of the outcome of some significant factor that is extremely new and different? More often than not, he must rely on someone who is closer to the situation than him and more qualified to study the business and evaluate the potential of the new direction of the business. In other words, he is forced to rely on the opinions of a stock analyst and probably this analyst is a total stranger. The investor may know little about the analyst’s past opinions or his batting average. He may only know that the analyst is employed by a major financial firm and perhaps has earned a professional designation or advanced academic degree. The investor may “feel” more certain about the future by following the opinions of an analyst with a major financial firm but is this enhanced feeling of certainty warranted? Experience shows that the translation of the new factor into improved financial performance for the company will be reflected in the trend of the stock price. Improving relative price performance in the market is close to proof that the new aspect of the business is being converted into improved financial performance for the company. Likewise, a continuing downward trend in relative price performance is almost surely an indication that the business is not working out as hoped and that the financial performance is disappointing, or at least not producing the desired result. It must be remembered that analysts can and do make mistakes, and that often their opinions are just an educated guess. It seems very straightforward that the measurement of relative price performance can be a critical confirmation of the success or failure of the new factor in the CANSLIM formula for identifying potential major winners in the stock market.

IMCL was one of the biggest winners in the market during 2003. A new drug for treating cancer produced this performance.

Don’t just buy a stock and hope for the best. Measure the relative price performance to confirm or reject the success or failure of the investment. No stock goes up forever and the investor needs to know when the upward trend reverses direction. To buy the full edition of Winning The Performance Game click here

Buy and Hold—An Obsolete Strategy? The recent, explosive growth of hedge funds, a five-fold increase since 1998 (as of late 2002), suggests that large numbers of investors believe that an investment policy based on a buy and hold philosophy is obsolete. Hedge funds not only use the short side but they also use leverage. They trade four times more aggressively than more traditional investors. Many investors, after suffering the massive losses of the past three years, have decided that shorter and shorter time frames are what are required to beat the game. Numerous short-term trading systems are being offered to the public at very low costs and these systems directly encourage increased trading activity. The idea that an investor has bought a stock “for keeps” is now considered foolish or at least “out of touch.” I seldom hear the expression that “I am a long-term investor in this company” while this phrase was heard almost constantly during the heady days of speculation in the bubble of the late ’90s and 2000. It seems that defining yourself as a long-term investor was just an excuse to participate in the most outrageously speculative market U.S. investors have ever seen. What now? The previous significant increase in short-term, aggressive speculation occurred in the middle to late ’60s to early ‘70s. It was exemplified by the experience with the Manhattan Fund, the Mates Fund, the Enterprise Fund, letter stock, conglomerates, National Student Marketing, Levitz Furniture and the Nifty– Fifty stocks with extremely high PE ratios. The Nifty-Fifty stocks were a bit of an exception. The idea was that you could pay any price for these stocks because they would deliver exceptional returns in the long run. The Nifty-Fifty were extremely speculative, but not in the sense of an aggressive trading approach. These stocks were another example of gross speculation being excused and covered over by the phrase, “I’m in it for the long run.” Most of the Nifty-Fifty stocks lost 80% or more of their value and many of those stocks are no longer operating companies. The long run did not turn out to be long enough for the Nifty-Fifty! The lack of an overall uptrend from the middle ‘60s to the early ‘80s changed the nature of the market to a zero–sum game, that was characterized by a long term trading range. The rising trend of interest rates exerted continuous downward pressure on PE ratios. The constant withdrawal of fees, spreads, and commissions by Wall Street firms and money managers left little return for the public investor and performance was substandard throughout the period. The long-term trading range began in the late ’60s, with considerable enthusiasm for aggressive trading, and ended in dullness in 1982 with most stocks more than cheap. Many of today’s short-term traders will be caught in the trap of a short-term trade that goes bad. Everyone cannot win and someone must lose in the zero-sum game. As stocks become dull and more fairly valued, the long-term investor will start to win again. How long will it take? It seems that, as of 2002, we have only started this journey.

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The long-term was not long enough for U

“A long-term investment is a short-term trade that went bad” Old Wall Street Expression To buy the full edition of Winning The Performance Game click here

Risk, Uncertainty and Fads A recurring phenomenon on Wall Street is the appearance and excitement of investment fads. While fads usually involve different stocks and even different industries from market cycle to market cycle, these fads do share common characteristics. Invariably the individual investor is left holding the bag after a fad has run its course, because fad stocks usually collapse after they have peaked. Why are these fads recurring when the disastrous outcome is so clear? There always seem to be two groups of market participants that interact in a way that allows fads to repeat. The first group is a group of risk takers that seek extremely high returns from their market activities and they are willing to take high risks to accomplish their objective. They seek out excitement and volatility, and are attracted to new developments in business that offer the potential for exceptional returns. In the stock market, things are always more or less uncertain. Under conditions of high uncertainty, investors come under the influence of the principal of social proof (i.e. the more people engaged in a behavior, the greater the proof that the behavior is correct” —see Cialdini’s book Influence: The Psychology of Persuasion ). There seems to be a tipping point at which the number of investors buying a stock reaches a critical point and the behavior becomes self-sustaining. The fad takes off. The dominant factor is the continuously rising price of the stock. Traditional yardsticks of investment value take a backseat to the price action. A bubble is born in an individual stock. The word of mouth or buzz surrounding the stock is passed from investor to investor and the more frequently the story is heard the more believable it becomes, according to the principle of social proof. The news media are trying to provide explanations for the price rise and the rising price ensures that their stories and coverage are very positive. Wall Street analysts can be included in the classification as media, and they are probably pushing the stock for all it’s worth. Fads usually last no more than three years and that is consistent with the four and a half year market cycle from low to low. Fads end when the overall market turns down. From experience, fads usually produce a multiple of the price, from the beginning of the fad to the end, of at least four to one. This implies a 4% per month compound rate of gain. A 7% per month rate of gain produces an 11 to one multiple of the ending price to the beginning price. These returns certainly qualify as exceptional. After the fad has peaked, the beneficiaries of the exceptional price rise understand the true meaning of the reversal in trend and the selling begins in earnest. Enter the second group of market participants that are critical to the profitable liquidation of positions by the successful traders. This group is composed primarily of bargain hunters. They compare today’s price to the high prices a short time ago and conclude that the stock has gone down too much. The bargain hunters are the recipients of stock being distributed by the successful fad participants. The analysis of past fads explains what is necessary to capture the profits created by the fad, and it also explains the dangerous risks in bargain hunting among last year’s fad stocks.

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Social Proof seems to be the primary cause of the herding together of stock market participants that manifests itself as a fad.

“As human beings, we are pretty good at predicting changes in the variables but pretty pathetic in predicting or even recognizing changes in the parameters.” Peter L. Bernstein In a speech in 1973 To buy the full edition of Winning The Performance Game click here

Manage Risk & Return The key to successful portfolio management is to manage risk and return simultaneously, while both are in motion. A management system that relates both risk and return would be most helpful in accomplishing this goal. The relative strength approach is a straightforward method to track relative returns. The S&P 500 is used as the benchmark and stocks outperforming the S&P 500 would show an increasing relative strength ratio and, conversely, a declining ratio for stocks that are performing poorly. Relative strength can easily be shown on a standard three-box, point-and-figure chart. The long-term point-and-figure chart has the added advantage of incorporating a measure that tracks the stock’s risk. The horizontal X-axis on the point-and-figure chart does not measure time. The number of alternating columns of Xs and Os is a function of the stocks volatility. The stock’s volatility is usually considered a proxy for risk, so movement across the horizontal X-axis actually records volatility or risk. The three box, point-and-figure chart only records movements that are at least three points, and that acts as a filter to reduce the influence of the noise in the price data. The relative returns plotted on these charts show the alternating ups and downs of returns that are a function of the natural ebb and flow of the market. Movement that matches the market will result in a horizontal line of Xs and Os across the chart. Relative returns that exceed the returns from the market will result in a pattern of alternating columns of Xs and Os that slopes upward to the right. Underperformance will result in a channel that declines downward to the right. The charts of highly volatile stocks will have many more columns of Xs and Os, relative to the chart of a stock with low volatility that covers the same period of time. If the volatility of the stock increases, the plot will show more alternating columns of Xs and Os. Increasing volatility is often observed on the charts of stocks that become highly speculative. Many times, after a major decline, a stock will have lost its speculative appeal and the volatility will subside, resulting in fewer and fewer of the alternating columns of Xs and Os. The movements of risk and return can be tracked simultaneously using the threebox, long-term, point-and-figure chart. Usually the grid on a point-and-figure chart is square, which provides an effective method to relate the movements of risk relative to return. A 45-degree line that slopes upward to the right defines a relationship that requires one unit of gain in relative return for each alternation of trend (i.e. unit of risk). If the relative strength plot can remain above this line, then the relative returns for that stock are acceptable. This upward sloping, 45-degree-line is called a bullish support line. It is not predictive, but it does allow the portfolio manager to ensure that the stock generates sufficient relative return to compensate for the risk. The upward sloping line is a key factor in the successful management of investment portfolios.

45-degree bullish support line

“You cannot manage what you do not measure.” Peter Drucker To buy the full edition of Winning The Performance Game click here

Manage Your Own Luck Too many investment managers entrust the investment performance of their portfolios to the vagaries of the market. This subjects the performance of the portfolio almost completely to elements of chance. It is more than just risk. It is almost complete uncertainty regarding the outcome of each individual investment. It seems strange to say that luck can be managed, but that is exactly what good portfolio managers do. They do more than just position their portfolios somewhere in the continuum between total safety and foolhardy risk taking. Adequate diversification produces a hedge against a run of bad luck. But good portfolio managers do much more than that. Good luck is followed up, and the exposure to good luck is allowed to increase its weighting in the portfolio by letting those stocks run. Bad luck, on the other hand, is actively suppressed and the proportion of the portfolio experiencing bad luck is systematically reduced by selling the appropriate stocks. The future is always uncertain and luck or chance is at work all the time. The successful portfolio manager knows this and he actively tries to manage the performance of the portfolio that is being influenced substantially by chance. The management of luck and uncertainty is not complicated. It only requires recognition of the true nature of the process. Some portfolio managers believe that they can reduce, or even eliminate, uncertainty by an improved understanding of the facts of an investment situation and an in-depth knowledge of the dynamics of a business. As a practical matter, this in-depth knowledge of a business tends to increase the portfolio manager’s confidence in the outcome without reducing the true uncertainty that surrounds the investment. This feeling of confidence leads to an inability to manage the effects of chance on the portfolio. True uncertainty means that we cannot even know what all the outcomes might be, much less their probabilities of occurrence. The most important factor in the management of uncertainty is the requirement that the manager must act. Action requires decision-making under conditions of uncertainty and that is never easy and can become distorted by the way we frame questions. The uncertainty often leads to inaction and procrastination. There also seems to be a difference in the way we view our psychological feedback from certain actions. A decision to accept a profit is pleasing and a decision to accept a loss is unpleasant so we tend to reduce our exposure to good luck (i.e. sell profitable stocks) and let our exposure to bad luck increase (i.e. hold losing stocks). This is not an effective way to enhance our luck and successfully deal with uncertainty. Feedback from the market is the best way to differentiate our good luck from our bad luck. For long-term investors, the feedback should be long-term in nature and the indications of success or failure should be clear and unambiguous.

Investment performance is far too important to be left to chance. To buy the full edition of Winning The Performance Game click here

Social Proof and Momentum Investing Many times investors in the stock market herd together and they feel very comfortable doing what others are doing. This is a very natural behavior, especially in situations of considerable uncertainty. This is usually referred to as momentum investing and it rests on the principle of Social Proof. The principle of social proof is based on the idea that the greater the number of people exhibiting a behavior, the greater the proof that the behavior is correct. Therefore, we need to use charts to track whether the herd continues to buy the stock or not. When the herd’s behavior starts to change, we should know and respond to that change. The verification of the social proof that feeds our expectations is clearly shown on the charts. This verification of social proof does not require a prediction of the future performance of the stock. It focuses instead on the change in the behaviors of other participants in the market for that stock. In other words, the charts provide an insight into a shifting of the social proof from an “OK to buy” behavior to an “OK to sell” behavior. As more and more investors embrace the changed behavior, the stronger the proof that the new behavior is now correct. It appears that social proof is one of the most important factors in shaping investor behavior and expectations. The primary use of charts is to track the actual performance of stocks. Portfolio management requires that we develop expectations about the future performance of a stock as an investment. We need to evaluate the success or failure of those predictions on an ongoing basis. Once an expectation has been formulated and the stock has been purchased, we all have a tendency to become overly committed to the expectation that the investment will be successful. Even casual commitments can then produce behaviors that are consistent with the previous commitment. The power of this commitment to produce consistent behaviors (i.e. bullish behaviors) is often underestimated. Portfolio managers will often defend their prior commitments in the face of direct evidence that disagrees with their prediction. We all need to collect evidence to verify or to refute our predictions. It does not matter how the prediction was formulated in the first place—it could have been based on the fundamentals, momentum, or any other factors— it doesn’t matter. The verification of our predictions is the best use of stock market charts. Charts should be used to evaluate the success or failure of our predictions. Our prediction was that the stock should perform in a certain way and the chart reflects on the accuracy of that prediction. When we purchase a stock, there is an inherent prediction that the stock will do better than the overall market or some other appropriate benchmark. The charts help answer the question: Is the stock performing as expected? A very important factor in the movement of an individual stock is the movement of the overall market. Some studies indicate that the movement of the market may account for over 50% of the stock’s price movement. Relative strength calculations remove the effects of the market and what is left is the price movement that is specific to that stock. This provides an even more important insight into the social proof that is driving the stock price.

The stocks in the tails of the distribution of returns are showing the highest price momentum and therefore are responding to the highest degree of social proof. These are the stocks where a shift in social proof can have a devastating impact on price. Stocks in the middle of the distribution are not being driven by momentum to any meaningful degree and are probably moving within a long-term, trading range. Social proof suggests buying and selling at the extremes of these trading ranges.

“…quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof.” Influence: The Psychology of Persuasion Dr. Robert Cialdini To buy the full edition of Winning The Performance Game click here