Newsletter

September 24, 2005

Knowing When to Stand Aside

Market & Sector Review

This Week's Economic Reports

Knowing When to Stand Aside

In addition to knowing when to buy and when to sell it's equally important to know when to stay out of the markets and in cash. When market conditions aren't conducive to profitable tradition, just stand aside. Even seasoned professionals frequently step back and reevaluate their methods. Don't be afraid to acknowledge your limitations, take a rest, and enter the markets when you're ready. There are many practical reasons for standing aside.

You may feel tired, down, or just not feeling at your best. At times like these it is best to stand aside until you are rested and can return to the positive objective mindset you need for trading. If your psychological resources are depleted you may act emotionally and or impulsively. If you are tempted to trade when your psychological resources are depleted you risk putting on bad trade after bad trade, not only will your account balance be hit so will your ego.

Another good reason to stay out of the markets is when your method seems to cease to have its winning edge. No trading method works indefinitely. When market conditions change, even a "foolproof" method can stop working. Don't make this situation even worse by continuing to trade. When a method stops working, it can really stop working. Your account balance will decline with each trade.

Most professionals often say that they are at their best when their old method starts to falter and they have to devise a new one. They view the situation as a puzzle they must solve. They step away from the markets, and take a close look at their methods. They try to identify what went wrong with the method, and look forward to tweaking it until it works again. They search for market factors that may have changed, and when they think they have found the solution, they put on a few small trades to test out their new, revised method. So when your method stops working, don't continue trading at the same level of activity. Step back, look things over, and wait until conditions are just right before entering.

Trading profitably requires that you keep track of the market moods and your psychological moods. When either one is not conducive to trading, it's best to stand aside and wait for the situation to change. By staying out of the markets, you can survive to trade another day, when you're in a peak performance mental state and the market conditions are optimal.

Market & Sector Review

The good news is the hurricane season ends in about a month (November 1) at which time we can get back to almost normal trading, without forecasts for the "perfect storm", driving prices of commodities and stocks with each daily and intra-day change in the weather forecast. As this letter is sent out Hurricane Rita is preparing to come ashore somewhere around the Texas and Louisiana sate line. Fundamentally what is causing the markets daily hiccups is the potential dislocations in the oil refining and drilling operations located in these areas and right on top of the dislocations that occurred with Hurricane Katrina. Gasoline and heating oil, refineries in Houston and Texas City process 2.3 million barrels of crude oil or 13.5 percent of daily U.S. refining capacity. The Beaumont-Port Arthur, Texas, refineries account for another 1.1 million barrels in refining capacity. The one thing I have always felt the market, in general, hates is uncertainty, and we have short-term, plenty of uncertainty. In fact for those interested NMEX (New York Mercantile Exchange) will open electronic trading of energy futures Sunday morning at 10 a.m.

I believe the real and as yet unanswered questions: is the recent decline in the market being driven by the double dose of Katrina and Rita, two of the most deadly and destructive hurricanes to ever hit our country, and I believe the only time we have had two such deadly events in one season and so close in path, interrupting and otherwise unfinished up trend. Or is this decline due to the completion of the cyclical bull advance and the hurricane's are only providing a catalyst or an excuse if you will, of what was to occur anyway? I think you will find the bulls subscribe to the former, while the bears subscribe to the latter. While I personally subscribe to the former and see plenty of reasons why this market should hit bottom shortly, I also see many things in the trading I do not like.

As of Friday's close the S&P 500 is up a whole 3 points on the year, the NASDAQ composite is down 59 points, the NDX-100 is down 50 points, and the DOW is down 364, not exactly what one might term a bull or a bear market. It's also very interesting to note that oil prices have not even approached their post Katrina highs, in fact they were down rather sharply on Friday, this along with the NYMEX trading on Sunday (a very unusual event), the increased margin rates for oil, may be a real good signal that the top in oil is in. You will find over time that you will be much better off concentrating your research on sectors rather than major averages, as the old market cliché states "there is always a bull market somewhere", it's our job as speculators to find and to ride it, which our find in energy early last year and precious metals a few months ago significantly attest to.

After last weeks discussion on Gold and my personal strategy of partial liquidation into strength I received several e-mails asking for further clarification of that strategy and if I really thought Gold could be heading for $800 why would I sell now. I think perhaps this is a good topic to discuss for this weeks newsletter, both in terms of projecting long term prices into the future as well as a strategy of trading around those projections.

First let's talk about Gold's potential, note I said potential. The following chart is courtesy of Adam Hamilton, CPA, and published by Zealllc.com. It shows both Oil and Gold prices back to 1965 but expressed in 2004 dollars. That merely means if we account for inflation over the years, then go back, price these commodities in current dollars we can then compare their price today versus their price then.

Notice that adjusted for inflation Oil peaked at $93 per barrel (in 2004 dollars) in 1980 and Gold peaked then at $1,600 per ounce, again in 2004 dollars. Oil prices plunged from the inflation adjusted $93 per barrel in 1980, to about $12 in 1998. Before forming its final bottom, it formed a potential double bottom first in 1986 then again in 1994, around $21 which is a Fibonacci 78.6% correction of the high price, then the false breakdown and subsequent reversal. Likewise Gold corrected from its inflation adjusted high of about $1,600 to just under $300 in 2000. That is an 81% correction. The next thing to notice is how over the 40 year span oil and gold prices have correlated pretty well if you measure major secular trends (years), although short to intermediate term they can and often do diverge from one another. At the hurricane Katrina high in oil, of about $70 per barrel, crude oil regained 75% of its previous inflation adjusted high. Had that price increase occurred steadily over several decades, the price today would not be the shock it has been, and it is the shock of the spiraling prices that has affected the markets and consumer psychology so much?

If Gold were to match that performance it would now be at $1,200 per ounce, it is lagging, however over the longer term (years not weeks) it could very well catch up. Now that you are aware I am sure you are anxious to mortgage everything and put it all into gold, hah, well - don't! While the longer term secular trends correlate well, the shorter to intermediate term trends do not and once the hurricane season ends (November 1) and ports and refineries come back on line I, for what its worth, fully expect a fairly large correction in oil. The obvious question then, assuming of course the analysis is correct, does gold also go down with oil or does it dance to its own drummer so to speak. And that no one knows at this time, in fact on Thursday gold suffered an outside reversal day normally considered a bearish event, at least for the short to intermediate term.

The gold bear market lasted 19 years (1999-1980), the longest bear market in commodity trading history. If this gold bull market, were to last but half as long as the bear market, it will take us to 2008 or 2009, equally as long takes us to 2018. There is plenty of time to pick your spots for entry if you are not already in, and if this scenario proves correct the volatility should increase dramatically. The time to buy will be when it looks awful and the time to sell will be when it looks like nothing can stop it.

Now to strategy! No matter how convincing an argument, technically or fundamentally I make to you or to myself personally I always sit back and ask myself, but what if I am wrong? Remember the old Hewlett Packard commercial "We always ask what if"! What if there is something I have failed to consider or what if conditions suddenly change, how should I approach this trade and/or investment? That is where certain strategies come into play. When you have been around the markets as long as I have you learn that no matter what you know or think you know, outside of inside information, you can always be wrong, and most often the mere probabilities will suggest that you will be wrong at some point. It's just a mere fact of life like the sun will rise tomorrow. Once this simple fact is totally understood, and you let go of your ego, trading becomes easier because it is no longer me against the big bad market it's me and probability, me and money management. Let's go over the accumulation first, then the distribution.

If you will recall in early to mid-June when we began to uncover the potential in the precious metals I presented a chart of NEM (Newmont Mining) and stated hint: there are stronger relative strength precious metals mining companies (June 18 Newsletter)? One of the stocks that popped out at me was AAUK (Anglo-American PLC ADR) which had a much higher relative strength ranking than most precious metals issues. I focused my attention there as well as GLD the streetTRACKS ETF which holds physical gold. Lets take a look at the chart of AAUK first.

The big gap open a week ago Friday suggested that this and most gold stocks were about to go parabolic and it was time to consider taking something off the table. Last week I stated I was preparing to jam stops on 20% of my holdings virtually begging to be stopped out, it was a bit of an overstatement but let me go over the exact strategy now. Remember and this is important, I am only looking to liquidate 20% of my position, take some money off the table, and reduce my exposure. Perhaps it's an overly conservative strategy but one that has worked well for me over the years. If the market continues higher I participate with an 80% position instead of 100%, will probably look to liquidate another 20% at sometime on further strength, and if we correct I am then presented with choices anew. Personally I view it as an enviable position to be in.

A tool that I have employed on countless occasions when stocks begin to make strong parabolic moves is to calculate, in the case of an up trend a 5-day simple moving average of the LOWS. The green line on the AAUK chart above is a 5-day SMA of the lows. Often I have been utterly amazed at how prices will hug that moving average. The strategy is - if on a given day AAUK were to close below that moving average then tomorrow I place a hard stop just under that days low. You will notice that has not happened as yet in the case of AAUK so the stop has not really been jammed, if you will. The reason I wait till the next day is to insure there is a follow through to the downside and the break (usually small) was not a fake out.

I hope this helps to clarify any confusion created in last weeks letter, but if not please do feel free to send an email. A special thank you to those who took the time to send their emails asking questions. To finish here is this weeks most improved as well as most unimproved, if you will, list. Great trades a month or two from now are beginning to show themselves, can you find them?

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.