Newsletter

January 27, 2007

Beat Stress Before It Beats You

Market & Sector Review
What Works on Wall Street

Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

Beat Stress Before It Beats You

Did news items ruin your trading plans this week? Adverse events, such as foul weather (think Oil, Agriculture, Shopping patterns), is just one of the many sources of stress an active trader must contend with. If you're not careful, you can become easily overwhelmed. When you are "stressed out", you may not be able to think clearly, you won't read the markets objectively. You must do whatever you can to stay calm while trading.

Scientists have shown that stressful emotions can build up, and if not released, a person can become overloaded by stress. Laboratory animals placed in stressful situations, for example, die if the stressful events are continuous and enduring. You can't completely remove stress from your environment, but you can prevent the stressful aspects of trading from making you feel anxious and fearful. Here is a short plan to help you develop an effective stress reduction plan:
  • Avoid caffeine.
    Many people believe caffeine keeps them alert. The downside of caffeine however, is that caffeine will elevate your nervous system to the point that you feel on edge and ready to panic? Trading and life is stressful enough; you don't need to pre-elevate your nervous system.
  • Exercise regularly.
    • Many successful traders view exercise as a key component to creating a calm and relaxed mindset. You don’t need to go to a gym, take a brisk walk around the block; it will clear your mind and give you new and fresh perspectives. We must all regularly release tension that builds up each day.
  • Minimize background stress.
    • Daily hassles, such as minor arguments with your spouse or others, or traffic congestion can, when added together, be as stressful as a major life event (such as the death of a loved one). Don’t ignore these events; don’t pretend they aren’t important enough to deal with now. Deal with the hassles and then minimize them as well as you can. Seemingly minor hassles can accrue and cause you great strain in the long run.
  • Don’t attempt to exceed your trading skills.
    • Do not put extra pressure on yourself by trying to achieve trading goals that are beyond your current skill level. As an example, keep your position sizes relatively small, consider scaling into a position as opposed to an all or nothing approach and have clearly defined risk limits. If you push yourself beyond your skill set in an attempt to achieve an unrealistic goal, you will feel an extreme sense of anxiety and fear. Take your time, you will get there!
“Sometimes when people are under stress, they hate to think, and it's the time when they most need to think.”
Bill Clinton (42nd US President (1993-2001))
Market & Sector Review
What Works on Wall Street

James O'Shaughnessy is recognized as a leading expert and pioneer in quantitative equity analysis, he is the author of the 1996 book "What Works on Wall Street." O'Shaughnessy researched the returns produced by a variety of stock-selection schemes from 1951 through 1994. He tried picking stocks based on market capitalization, a variety of valuation ratios, dividend yields, earnings growth, profitability ratios and well, just about anything. He tried high and low values of each parameter separately, and in combination with each other. O'Shaughnessy found that the best-performing strategy was a blend of two seemingly conflicting investing styles: value and momentum. As a result of the research presented in this book and revised in 1997, O'Shaughnessy began the Cornerstone Growth fund.

The Cornerstone approach looks for stocks with low price/sales ratios (P/S), a criterion usually used to pinpoint value-priced stocks, and high relative strength, a hallmark of momentum investing. Those two factors, along with a modest earnings growth requirement, formed the selection strategy he dubbed Cornerstone Growth. Cornerstone Growth returned 18% on average, annually, compared with 13% for the S&P 500 index. What does that mean in real dollars? If you start with $1,000, after 20 years compounded at 13%, you would end up with $11,500. Nice return however nothing like the $27,400 you'd have it if your money earned 18% compounded annually.

As an exercise this week I will use a combination of the parameters mentioned below and what is available on the Prudent Trader site. This is just the highlights of this approach, if you wish more detail include "What Works on Wall Street" in your library.

Relative Strength:
Relative strength plays a large role in a stock's price momentum. Relative strength measures how well a stock has performed versus a benchmark over a certain time frame. O'Shaughnessy picks the top 10 stocks with the greatest 12-month relative strength (of those that fit all his criteria), for his final portfolio. He found that stocks with the highest relative strength over the past year tend to produce the highest returns the following year. Although this can be a very effective filter, he warns that it is a highly volatile approach. Stocks with high relative strength may be at or close to their peaks meaning they may have smaller upside and larger downside potential. NOTE: O'Shaughnessy later sold the funds to Neil Hennessy who tweaked the relative strength component to a combination of 3, 6, and 12 month relative strength. O'Shaughnessy became Senior Managing Director of Systematic Equity Investments for Bear Stearns Asset Management Inc., sub-advisor to the RBC O'Shaughnessy Funds.

Cash Flow Per Share:
O'Shaughnessy's Market Leaders stocks also have higher cash flow per share than the average stock. This ratio is calculated by adding depreciation and amortization to income before extraordinary items, then dividing by the fully diluted average number of common shares outstanding. Cash flow measures the actual inflows and outflows of cash by taking out non-cash items that can boost net income (a number that is then used in earnings per share calculations). This is a harder number to manipulate and can be a more truthful measure of financial strength.

Sales:
The final Market Leading criterion is stocks with overall sales that are 1.5 times greater than the average stock. O'Shaughnessy places emphasis on strong sales and a low price-to-sales ratio-the current stock price divided by the sales per share for the last four fiscal quarters (trailing 12 months). Unlike earnings, sales are less subject to management assumptions, therefore more difficult to manipulate, and are often less volatile.

All viable companies have sales, so the majority of companies will have a meaningful price-to-sales ratio. A low price-to-sales ratio is a way to identify "cheap" stocks. In "What Works on Wall Street", O'Shaughnessy found that the price-to-sales ratio was a very effective screen for stocks of all market-cap sizes and that low ratios consistently produced higher returns.

Earnings:
Earnings per share growth (revenues minus cost of sales, operating expenses and taxes, over a given period of time) is a popular way to measure a company's growth potential. Earnings per share play a critical role in a stock's price mainly due to market expectations. Low or negative earnings are often signs of young companies; however, these start-ups attempt to grow earnings quickly and can be profitable investments. The earnings growth requirement is very modest and all stocks with positive earnings growth are considered.

For members unaware, one search you can easily perform at Prudent Trader is the top 100 stocks by relative strength over the last six months and over the last twelve months.

For this exercise I will click on the top 100 stocks by relative strength percentile rank over the last twelve months, copy the text, then place it in Microsoft Excel. I then run a few fundamental scans at sites such as: MSN money and American Association of Individual Investors (AAII) and others. I find 15 stocks on that list that fit O'Shaughnessy's criteria. Six are outlined in blue in the cut up table below. These six are picked at random and should not be considered as a recommendation, they may or may not fit your personal criteria. Can you find the other nine?

I then pulled up the top 100 stocks basis six month relative strength and three of the six blue stocks appear there as well. Was this very easy to do? Yes, but it did require some time to be invested. Do I have a nice list of candidates to choose from for futures purchase, you bet. Have fun, make money! Below are charts of the six stocks shown above, appeal will obviously depend upon your time frame and trading style.

Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

Have A Great Week!

Bill

Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.