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Newsletter February 25, 2006 Always Manage Risk Market & Sector Review The Anatomy of an Index Largest Changes This Week This Week's Economic Reports Always Manage Risk As traders there is probably nothing more thrilling than correctly anticipating the markets or a particular stock and making a huge profit off the trade. You feel on top of the world. After a good winning streak it is very tempting to let lose and start making some big trades, after all you are invincible at least for now. Although you should take advantage of a hot streak when you hit upon one, you must avoid acting recklessly, it can destroy you. I have personally seen it too many times, the "BIG idea". Because we are hot and we sense a big move coming, instead of following our plan, our proper position size, we decide to risk it all. We buy as many shares as we have dollars in our account and margin it as well. The market goes against us but we feel OK because we are hot and we know we are right and the market will soon realize that we are right. I don't have to finish this because you know where it leads at least I hope you do. Even when on a hot streak, you must, for long-term survival maintain discipline and manage risk. After making a series of winning trades, you want to celebrate, and you should. However you must avoid thinking, "What do I have to lose? I'm far ahead of the game. I can take a little more risk." What is the harm of taking big risks I'm way ahead? The problem, you really don't know that your next set of trades will be wins, and when you take unnecessary chances, it's as if you are working under the assumption that you will tend to win in the future. No one has a crystal ball! Trading is about taking advantage of probabilities. From the perspective of probability theory, it's possible that you will continue to win, and by making larger trades and lowering your limits, you'll reap big rewards. But in all likelihood, the next series of trades may be losers. If you don't continue to manage your risk, you'll tend to give back all your profits and more. One may not fully consider the realistic possibility that a losing trade is on the horizon. It's important that you maintain a little skepticism, though. It's nice to feel you are running hot, but remember that your hot streak may end as quickly as it started. Never let your guard down. Always be prepared for your luck to change. An unexpected defeat is often more devastating than an expected probable setback, always be ready for a potential loss. By remembering that a loss is always possible, and that it isn't a big deal, you'll be prepared, and won't be fazed when it happens. Managing risk is a trader's secret weapon. Don't take unnecessary chances. Trading is a game of survival. Sure, you must make big profits while you are running hot, but you must avoid mounting huge losses when you are running cold. Don't be caught off guard. Consider every possibility. Continue to manage risk. It can go a long way in helping you stay profitable in the long run. Market & Sector Review The Anatomy of an Index Before we begin this week's newsletter, I'd like to point you to two videos recorded at the world outlook financial conference in Vancouver the week of February 16, 2006. The first is an interview with James Dines who continues pounding the table on uranium, and the second interview is with Dennis Gartman whose trading rules are now posted in our learning center:James Dines   Dennis Gartman Enjoy! My thoughts on the market are well known through this newsletter and most are aware I am looking for a major high soon (whatever soon means). There is an old market axiom that the markets will do what they must to confound the majority and I often sit back and wonder if I am part of that majority that the market is attempting to confound. As noted a few weeks ago the sentiment as measured by trading friends, message board postings, and the Rydex fund's ratios told me that this market was about to rally, how far I had no idea. It seems that when the market is down 2 or 3 days the bears come out of the woodwork, and when it rallies 2 or 3 days out march the bulls. For this market to reach a peak the market must convince the vast majority that dips must be bought and not sold. When that psychology is in place then the markets may drop without "everyone" short and the buy the dips folks will be filled easily and then we can continue lower. If I had to make a guess as to when, and keep in mind it is just a guess, this can all be fulfilled in a couple of weeks to maybe a couple of months. Perhaps later, if time permits, we will look at what should be watched for the downtrend to be at least partially confirmed and it will not be at or within a few percentage points of the "Top". Keep in mind the philosophy of Bernard Baruch who said he was happy to have someone else make the first 20% and another the last 20% and he was perfectly happy with the middle 60%. Sage advice! This week we are going to take the most popular and certainly the most talked about average, the venerable Dow Jones Industrials, and break down this average to see if we can determine, at least amongst these 30 stocks what is going on. The data and the charts are from a Microsoft Excel spreadsheet, we hope to have much of this data available to you on a group by group, sector by sector, and average by average basis in order to help you analyze even better what is going on. The task is daunting and it is still in the planning stages, and programming will not be started till the planning is finished. All in due time! The spreadsheet charts below are for all of 2005 thru Wednesday's (2/22) close. Much has been written and talked about the NYSE advance/decline line making all time new highs and how could the market top with new highs here? However, if we break our DOW Jones Industrials down to an advance/decline line of these large cap issues we get a different picture. Notice the double bottom in the average (circled) yet new lows in the A/D line, and on this recent trip to new highs in the average, a failure of the A/D line to even get back to the January highs. This suggests that fewer stocks are carrying the average higher. Probably the first book I ever read on technical analysis was by Joe Granville. He had a very good analogy to describe this picture, think of it as 30 pallbearers carrying the casket of an 800 lb. man. No problem for 30 men. Now suppose 10 men dropped out, now the weight distribution on each man becomes greater, it's heavy, but still doable. Now another 5 or more drop out, the weight is now extremely heavy for each man and at some point the casket just falls to the ground because the men left just cannot carry the weight. So it is with market averages. This chart presents a similar picture to the A/D line but is a bit more exaggerated. On the January decline the A/D line itself held above its recent lows however, the volume retreated all the way back to its recent low and on this recent rally hardly even budged. Is there distribution going on into new DOW highs? Looks like it doesn't it. The two charts above, % of DOW components trading above their respective 200 and 30 day moving averages also suggests fewer DOW stocks are participating in this rally, at least to the extent they participated in previous rallies. This is a very interesting chart to me. Of the 30 large cap stocks in the DOW 6 or7 stocks or 20 to 23% are very strong and probably primarily responsible for carrying this average to new recent highs. Consequently during the early fall decline about the same number of components were making new lows. This suggests that the movement in this average appears to be concentrated at any given time the movement of just a few stocks. Looking at the above chart you can see that about 10 DOW stocks or 1/3 are not participating. Carrying this market average higher is still doable by the remaining 20. This is not the action one would expect of an average making new multi-year highs is it? As defined by the Prudent Trader Momentum Calculation, DOW Stocks in: UP Trends: AA; AXP; BA; CAT; DIS; HON; HPQ; JPM; KO; MCD; MRK; PFE; PG; T; UTX; VZ. DOWN Trends: C; DD; GE; GM; IBM; INTC; JNJ; MMM; MO; WMT. UP Trends in Danger: AIG; HD; MSFT; XOM. Now go back to the Joe Granville analogy above and give it some thought. I hope this helps break down the most watched and quoted average and hopefully we will soon have the data above for most all the averages and groups. Should the 20 uptrends remain in tact and everything else remains equal there is enough strength to push this average even higher in the coming weeks. Pay close attention however to the ones that drop off and when the average may begin to succumb with not enough stocks participating. Unlike market bottoms, market tops take a very long time to form but there are signs of distribution if you look close enough as the above charts show. How long can this distribution last before the averages succumb? Almost impossible to say. If the markets seem irrational at times please remember that the markets can remain irrational longer than any of us can remain solvent. Be aggressive if it's your style but concentrate on risk management. Largest Changes This Week 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.