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TRADER'S NOTEBOOK


Timing Equity And Mutual Funds

11/04/05 09:02:13 AM PST
by Wayne Grennan, PhD

Have problems timing equity and mutual funds? This technique might be your solution.

In stock and mutual fund investing, we need to know three key things: What to buy, when to buy, and when to sell. In my research for dependable strategies, I found that there was lots written on what to buy and when to buy, but not much on when to sell. What I wanted was a strategy that did three things. I wanted a strategy that had limited losses when a stock or fund lost value after purchase; that did not involve selling prior to the securing of most of the gain when a stock has a big runup; and that allowed most of any gain in share price to be retained.

TRENDPOINT
After some tinkering, I hit upon a strategy that involves a concept I call trendpoint. I noted that the price patterns for stocks and funds can be conceived as having two main components: noise and trend. There are fluctuations in share price around a trendline, which might be up or down or sideways. The noise component can vary for different stocks. The price graph can be more or less smooth, like that of some mutual funds, or jagged, like many of the cheaper stocks. These observations led me to consider that an equity with a rising trend should be sold when the trend turns negative, but we do not want to sell if a drop in price only represents noise. The point at which this occurs is the trendpoint.

TREND REVERSAL VS. NOISE
So how do we distinguish a trend reversal from noise? At first I thought the most promising way was to identify a simple moving average (SMA) interval that fitted the stock graph. But even with an optimized SMA value, I found that buying when a stock rose above the SMA line and selling when it fell below led to too much trading, especially when the price was going sideways.

So I pressed on and eventually developed the trendpoint strategy. It involves arriving at an optimal percentage value such that when a stock's price falls by that percentage, we sell. The percentage value gives you a dollar value that, when subtracted from the highest value the stock has reached since you bought it, indicates the beginning of a downtrend, the point at which you sell. You establish the trendpoint percentage value (T!%) by studying the price pattern for the year preceding your buy date. More on this below.

Suppose you buy Consolidated Micro-Widget at $10 per share and have assigned a T!% value of 10%. At the time of purchase, your sell point (SP) is $9. Say you have chosen well and a while later it rises to $20, but then starts to drop. Your SP is now $18, and when the price falls to that level, you sell, locking in an 80% gain. No hanging on in hope of a turnaround. Just sell automatically, no questions asked. The idea here is not to let anything other than stock price movement determine when to sell. There is lots of scope for considering company performance details in deciding what to buy.

The corollary of this selling strategy is that you can use a rise of T!% from a bottom as a point at which to buy. This is the point at which an upward trend has begun.

So how can we arrive at trendpoint percentages? I haven't discovered any mathematical formula yet that can do this. What I do is inspect the price movement of the stock over the past year and decide what percentage value would not trigger buys and sells when subsequent movements show they would be undesirable.

Using this figure as a preliminary value, I would buy at the start of the trailing 12-month period and see what happens if I buy and sell at each opportunity during the 12 months, always reinvesting all funds realized from the last sell transaction. If my preliminary T!% value is 10%, I might do the scenario using 8% and 12%.

Now let's consider an example that shows the trendpoint strategy to advantage. During the past year, one of the most active and exciting stocks has been Taser (TASR). It has also been one of the most volatile stocks. The trendpoint strategy can help you participate in the gains without endangering your capital to the extent that a buy-and-hold strategy would.

Let's look at the performance over the year from May 9, 2004, to May 9, 2005. To apply the trendpoint strategy, you need a T!% value. Obviously, you cannot use this interval itself, since you would not know how the stock would have performed. My practice is to examine the movement of the stock in the year prior to the present, so in this case I would study the period from May 9, 2003, to May 9, 2004. Based on the historical price movements, I thought that a 15% value seemed appropriate. Figure 1 shows the moves you could make. "BP" stands for buy point, "SP" stands for sell point, "Bot" stands for bottom, and "Top" stands for top. For tops and bottoms I use closing prices. For SPs and BPs I use intraday values.

10 May Bot 12.885 BP = 14.82 (12.885 x 1.15)
13 May Buy 1000 at 14.82 = $14,820.
19 May Top 14.91 SP = 12.67 (14.91 x 0.85)
07 Jun Sell 1000 at 12.67 = $12,670.
07 Jun Bot 12.40 BP = 14.26
09 Jun Buy 888 shares at 14.26
06 Jul Top 22.25 SP = 18.91
19 Jul Sell 888 shares at 18.91 = $16,794.
26 Jul Bot 12.615 BP = 14.51
27 Jul Buy 1157 shares at 14.51
28 Jul Top 16.04 SP = 13.63
06 Aug Sell 1157 shares at 13.63 = $15,770.
16 Aug Bot 12.95 BP = 14.89
02 Sep Buy 1059 shares at 14.89
15 Sep Top 21.545 SP = 18.31
28 Sep Sell 1059 shares at 18.31 = $19,390.
29 Sep Bot 18.24 BP = 20.98
22 Oct Buy 924 shares at 20.98
15 Nov Top 30.425 SP = 25.86
19 Nov Sell 924 shares at 25.86 = $23,895.
26 Nov Bot 23.50 BP = 27.03
30 Nov Buy 884 shares at 27.03
30 Dec Top 32.59 SP = 27.70
05 Jan Sell 884 shares at 27.70 = $24,487.
11 Jan Bot 14.10 BP = 16.22
12 Jan Buy 1510 shares at 16.22
13 Jan Top 20.80 SP = 17.68
19 Jan Sell 1510 shares at 17.68 = $26,697.
24 Jan Bot 15.95 BP = 18.34
28 Jan Buy 1456 shares at 18.34
31 Jan Top 17.98 SP = 15.28
08 Feb Sell 1456 shares for 15.28 = $22,248.
20 Apr Bot 7.64 BP = 8.79
21 Apr Buy 2531 shares at 8.79
09 May Close = 10.94. Holding value = 2531 x 10.94 = $27689.

FIGURE 1: PERFORMANCE FROM 5/9/2003-5/9/2004. "BP" stands for buy point, "SP" stands for sell point, "Bot" stands for bottom, and "Top" stands for top. For tops and bottoms closing prices are used. Intraday values are used for SPs and BPs.

Using the 15% value for T!%, the first buy point occurs on May 13, 2004. Let's say I buy 1,000 shares at the closing price, $14.82. In buying and selling according to the strategy, I find that I would have made 17 trades by May 9, 2005, at which date I would be holding 2,531 shares as a result of always investing all the proceeds from the last sale. The closing price on this date was $10.90, so my investment is worth $27,689. My initial investment was $14,820, so my gross return (not counting trading costs) is 86.8%. If I had held the 1,000 shares I initially pretended to buy, I would have $10,940, which represents a loss of 26.2%. (These values are based on split-adjusted stock prices.)

VOLATILITY CAN BE A GOOD THING
What can be learned from this hypothetical scenario? First, it suggests that those of the buy-and-hold persuasion should not buy volatile stocks. The trendpoint strategy, on the other hand, enables you to take advantage of situations of the kind that TASR represents without incurring the losses reflected in share price changes. In this scenario, the lowest value that the one-stock portfolio had during the test period was $12,670, on June 7, 2004. That is a loss of $2,150, or 14.5%. In contrast, on April 20, 2005, the buy-and-hold investor would be down to $7,640, a loss of 48.5%. Using the trendpoint concept, you would sell off on February 8, 2005, and wait for a turnaround, which came eventually. Personally, I would find holding through a dip of this size a stressful experience, with little relief to be had from the professionals who would exhort us to "stay the course." TASR did start to rise after April 20, but no one knew it would.

An interesting feature of the trendpoint strategy is illustrated by the Taser example. You could make a profit by periodically investing in a stock over a longer period, even though the stock price at the end of the period is significantly lower than at the beginning. This isn't magic; the strategy puts you in the stock when it is rising, and takes you out when it is falling. Not for the entire rise and fall, of course. In this case, you buy only after the stock has risen 15% from a bottom. It is only then that a trend is identified.

Up to this point, the rise could have been noise. Similarly, we do not sell at a top, but 15% down from it, because only then can you say a downward trend has been identified. So in effect, you cannot sell out at a profit until the stock has risen more than 30% from a bottom. (The precise figure is 35%.) This may look like a serious disadvantage, but it's not. More volatile stocks routinely rise more than this when a positive trend begins. Larger-cap stocks may not move much more than 35%, but they have lower T!% values, typically 10%.

By providing a selling price at all times, the trendpoint approach helps us sell in a timely fashion, thereby avoiding the psychological discomfort that results from having no predetermined sell point, and the further unpleasantness of watching our gains melt away. A big factor is that it is psychologically easier to refrain from buying once you have sold than it is to sell a declining position.

The scenario described differs from my own practice in trading stocks in that I do not rebuy when they reach the next buy point except in very favorable circumstances. Normally, there are more attractive candidates reaching buy points around the same time. In the case of TASR, I would have been sold out near its top on January 5, 2005. News about the company right after this was mostly bad, including the announcement that the Securities and Exchange Commission (SEC) was making an "informal inquiry" into the safety of Taser's stun-gun. Following that, there was a spate of class action lawsuit announcements focusing on this issue. Most of us, I think, would not have rebought the stock when it rose to a buy point a week later. I like to think I would have taken my profit of 65% and looked elsewhere.

One criticism that the trendpoint strategy invites is that trading costs will consume our gains, because it can involve short-term trading. There was a time when this would have been a strong criticism, but it is no longer so. At $10 per trade, 15 trades would have cost a mere $150, which we can think of as a cost of protection from big losses. Cheap insurance!

The trendpoint strategy does not always outperform buy-and-hold. If there is a steady bull market, as there was for most of 2003, and a stock you own rises steadily over a longish period, buy and hold will work just as well. But 2003 was an unusual year. Most years involve ups and downs, and this strategy works then because it puts you on the sidelines for most of the downside and in the market for most of the upside.

There are several other advantages in using the trendpoint strategy, one of which is efficiency. Once you buy a stock, you only need to keep your selling point value current; you do not need to follow the fortunes of the company at all. The current stock price tells you what your sell point is.

After having used the trendpoint strategy in managing my own portfolio, I did make one revision after reviewing my first year's results. As I noted at the start, the first object in equity and fund investing is to limit losses. If you buy a stock that requires a 20% T!% value, as some smaller-cap ones do, it can happen that the stock drops before it gets 20% above the purchase price. Sometimes they drop immediately after purchase, in which case you will suffer a 20% loss. This is a bigger percentage loss than I was comfortable with, so I amended the strategy by adding a fixed sell point, calculated as half the T!% value. With this in place, I would have a fixed sell point 10% below the buy point. For any given stock price, the sell point is the higher of the T!% value or the fixed value.

The trendpoint strategy offers a good solution to the problem of deciding when to buy and, more important, when to sell stocks and funds.

Wayne Grennan, the author of Investing: More Success With Less Stress, is professor emeritus of philosophy at St. Mary's University, Halifax, Nova Scotia.

SUGGESTED READING
Grennan, Wayne [2002]. Investing: More Success With Less Stress. Timberlea Press.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Wayne Grennan, PhD




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