Newsletter

May 5, 2007

Increasing Your Mental Capacity

Market & Sector Review
Winning on Wall Street

Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

Increasing Your Mental Capacity

Trading can be, and most often is, a complex activity. We must study and integrate a very broad range of information. Not only do we need to keep up on news and other factors that may affect market action, we also have to look at indicators, such as price and volume, in order to anticipate the next market move. Regardless of what some say, it isn't easy to identify many chart patterns. If only we had more computing power? We could then process all the information we needed to trade more efficiently. Unfortunately, the mind has limits. We have to work around them.

The mind is like a computer. We store memories in the hard drive, while our ongoing experience is processed by the CPU and stored in RAM. We can only attend to, and process limited amounts information, and when we move beyond that limit, the information is no longer processed. Ever notice; it is possible to read a telephone number and remember it for only a short time? Then you become distracted and the information is lost. Unless you memorize the information, it is lost.

How can mere humans increase the mental capacity of our minds? It isn't easy. You cannot just add extra RAM or a faster CPU. What we can do is "over learn" some of the tasks we do while trading.

Think of it as learning to drive a car. In the beginning we must focus all your attention on each task separately. Over time however, we learn to monitor speed, look for hazards, monitor road signs i.e. engage several tasks automatically. Even while doing all this we can talk with a friend in the passenger seat and insert a CD into the stereo. With enough practice it all becomes "over-learned"; automatic.

In trading it's much the same; you can identify signals that precede a breakout almost automatically. Practice, practice, practice and all of a sudden a lot of steps that you once had to perform deliberately and tediously are now completed with very little effort. "Intuitive" decisions merely seem as if they are "gut instinct", but in fact they are based on many valid and reliable inputs that you have now processed automatically. You will often hear me or others say "I've just got a feeling". What we are really saying is all the information has been processed but at the moment we cannot point directly to a specific piece of information for you. Experience! The more time you spend practicing new skills, the easier it will be to multi-task.

Active trading requires increased mental capacity. You can increase your mental capacity through practice. The more you study market conditions and develop an intuitive feel for the markets, the more you can do multiple tasks simultaneously. You'll find you will increase your mental capacity and trade more profitably.
Market & Sector Review
Winning on Wall Street - The Martin Zweig Approach

The next screen that I'm including in our watch list database is from Martin Zweig's book "Winning on Wall Street". Before I get into a brief explanation, allow me to give a little background on Martin Zweig for those unfamiliar with him. This information comes directly from his web site http://www.martinzweig.org. Overlook his work at your own peril.

According to AAII (American Association of Individual Investors), the Martin Zweig Stock Screen returned more than 1,700 percent between 1998 and 2006. Interested?

Martin Zweig's basic stock market strategy is to be fully invested in the market when the indications are positive and to sell stocks when indications become negative. Risk minimization and loss limitation are a crucial. Zweig says, "People somehow think you must buy at the bottom and sell at the top to be successful in the market". That's nonsense. The idea is to buy when the probability is greatest that the market is going to advance". Zweig uses fundamental company data to select stocks to buy during positive market swings. The inspiration behind a number of Martin Zweig's methods came, he says, from Jesse Livermore. How many of you have read "Reminisces of a stock operator"? If you haven't make it your next book purchase.

Martin Zweig does not study any single stock in great detail. He prefers to use what he calls a shotgun approach. He screens thousands of stocks purely on their financials. Zweig finds that 5 out of 8 of the stocks that get through his screens perform well. When it comes to stock-picking, Martin Zweig screens many fundamental numbers. He gives greatest weight to two parameters - the earnings trend and the PE ratio (price/earnings ratio).

Earnings Trend
 Before he will consider buying a stock, Martin Zweig needs to see the company's earnings rising consistently for the last four or five years. He also needs to reassure himself that nothing has gone wrong recently, so he checks that the most recent quarterly earnings have shown growth compared to the same quarter a year ago. The upward earnings trend should be backed by a parallel sales trend. Zweig believes that earnings growth will not be sustainable if earnings are rising due to cost cutting rather than increased sales.

Price/Earnings Ratio
 Of equal importance to increasing earnings is the price/earnings ratio. This is calculated by dividing a stock's current share price by its earnings per share. A PE ratio of 10 means it costs you $10 to buy $1's worth of annual company profit.

Zweig comments: "The data going all the way back to the 1930s show conclusively that stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the longer term".

For most big companies the PE ratio in recent years has been somewhere in the teens or low twenties. (Zweig believes that when the average PE ratio of the whole market is in the high teens or twenties, poor performance is likely to result.) There have been times when companies in Dow Jones Industrial Average have had an average PE of over 20. In these circumstances, a bull market is almost certainly nearing an end. In 1974, the average PE of the DJIA, at the end of a terrible bear market, was just six. This was a good time to buy stocks for the longer term.

Zweig is interested only in stocks whose PE ratio is not unusually high relative to the current market. He believes high PE stocks are risky. If they fail to deliver, even slightly, on the high expectations associated with their PE ratio, their prices can quickly plummet.

Zweig rules out stocks whose PE is unusually low (values of around 5 or lower) because it takes odd circumstances - usually there is something worryingly wrong with the company - to produce very low PE values.

Since he is looking for stocks with better than average growth rates, Zweig says it is unusual for him to find many stocks trading at average PE ratios. If, for example the average PE of the market was 10, he expects he will usually find the sort of stocks that interest him trading at PE ratios of 14 or 15. This style of investing is sometimes referred to as GARP investing, where GARP stands for growth at a reasonable price.

Although some companies do prosper after achieving earnings growth through cost cutting and some stocks do advance appreciably after being marked down to very low PE ratios, Zweig is interested in probabilities. On average, companies that don't fit his criteria won't deliver the strongly rising share price he desires; therefore he avoids them.

A Sample Check List of Fundamentals For a Martin Zweig Screen
  • The company should have annual earnings growth of 20 percent or more for at least four years.
  • Sales growth should be similar to earnings growth.
  • The PE ratio should not be too low. Reject companies with a PE of five or less.
  • The PE ratio should not be too high. Fast growing companies tend to have higher than average price/earnings ratios. Reduce the risk of overpaying for growth by rejecting any companies whose price/earnings ratios are more than 60 percent above average for their sector.
  • Company debt should be average or below average for the sector the company operates in.
  • Management should not have overestimated earnings during the last 3 years.
  • There should be no selling of stock by insiders. If more than one insider is selling, they should be selling fewer shares than other insiders are purchasing.
Some Martin Zweig Stocks courtesy of AAII.
If a company passes this screen and the market is in an upward trend, then use your favorite technical analysis methods for timing your purchases.

Are Martin Zweig's stocks on your radar screen? Should they be? Are you ahead 1,700% in 8 years?
You decide!
Largest Changes In Raw Numbers (21 Days)

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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.