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Newsletter December 10, 2005 Trading Decisions & Emotional Influences Market & Sector Review Largest Changes This Week This Week's Economic Reports I will be taking a couple of weeks to enjoy the holiday season and festivities. The members area will be updated as usual however there will be no newsletter for the next 2 weeks. The next newsletter will be on December 31, 2005 where I will be looking at intermediate and longer term cycles and therefore what we might expect from and look for in the market and a few sectors in 2006. Allow me to take this opportunity to wish each and everyone of you the merriest of Christmases and a Happy, Healthy, and very Prosperous New Year! Bill Trading Decisions & Emotional Influences Greed and fear, do they play a roll in your market decisions? When we fear a potential loss, we sell. When we are greedy, we buy or buy too much. It is a little more complicated though. Regret and hope also play a roll. People may trade in or out to avoid feelings of regret or may hold on to losing positions out of denial and a hope that the loser will turn around. Emotions play a powerful role in decision making. Dr. Jennifer Lerner of Carnegie Mellon University conducted a series of studies on how emotional states influence trading decisions. In one study it was shown that people who experience intense levels of anger tend to be willing to accept greater risks. Anger is experienced when we feel unfairly treated or we have been slighted. If you take things too personally it's easy to feel slighted by the markets when they don't go our way. To gain control we get angry. We fight back and enact our revenge. When this occurs we act out of desperation and often take on risks that we shouldn't. In another study reported in "Psychological Science," Dr. Lerner and her colleagues showed that emotional states that have nothing to do with a financial issue might have a subtle impact on a subsequent economic decision. Participants watched films that made them feel one of two emotions, sadness or disgust. The movies had absolutely nothing to do with business or decision-making. The first film was about a loved one passing away, while a second film was about a man using an unsanitary public toilet. Participants were subsequently asked to estimate the value of a possession while in either a sad or disgusted emotional state. At the start of the experiment, participants were given a pen and asked to hold on to it. After the emotional states were elicited, participants were asked to estimate the value of the pen if they were to sell it. In some ways, you might see how this is analogous to holding a position and determining how much the price of the stock needs to move before you would be willing to sell. In contrast to participants in a neutral mood, participants who were incidentally disgusted or sad greatly underestimated the value of the pen; neutral participants estimated its value as about $4.50, while sad and disgusted participants put its value at about $3.00. The interesting aspect of this study is that there was no obvious connection between the emotional state and the financial decision to sell. It would be as if you watched a sad television show right before the open, and for no good reason whatsoever, under-valued a position and immediately sold too early. One event should have nothing to do with the other, yet in Dr. Lerner's study feeling sad or disgusted influenced a subsequent economic decision. Ideally, it would be nice if we could trade with a totally objective, disconnected and purely logical mindset, but we are merely humans. The impact of common emotions of fear, greed, hope, and regret may seem obvious to many. Realize, it's possible that incidental emotions that have nothing to do with the markets may have an influence on our decisions. It just goes to show that trading is in many respects a pure psychological endeavor. The more you can stay logical and objective, the more you'll trade profitably. Market & Sector Review Other than time, meaning the age of this cyclical bull market, there is no current reason to think anything major is about to happen. On the weekly charts posted below of the major averages I have drawn a Raff regression channel (2 parallel lines 1.5 standard deviations from the center linear regression line) from the July 2004 bottom, and as you can see the intermediate term trends remain up. One characteristic to determine a change of trend over the intermediate term will be if prices come out of this channel and follow through on the downside. Again this is an intermediate term look, not a short term look. There have been plenty of short term swings within the channel, if you have the ability to trade those short term trends more power to you. Notice how both the S&P-500 and the NYSE Index briefly penetrated the bottom regression line in October, yet the NASDAQ composite was not even close to penetrating the bottom regression line. This of course was reflected in the relative strength out performance by the NASDAQ during the October decline, and when the NASDAQ outperforms it is generally good for the market overall. Although I am becoming increasingly bearish on the basis of time, while prices of these averages stay within these channel lines I will personally consider this bull market alive and well. When this current short term correction is over, one can make a nice bullish case, bases Fibonacci retracement levels from the 2000 top through the 2002 low. If we can break convincingly above the 61.8% level (see monthly chart below) we can then project the S&P 500 to reach the 1400 level. The 78.6 % retracement is approximately the same retracement the NASDAQ made from its 2000 high to its 2002 bottom. The 78.6% level is often overlooked yet many times very valid retracement level. That is the bullish case and as long as the weekly charts remain in their respective channels that outlook is alive and could fit well with a blow off top scenario, of which I have personally been looking. The primary bearish case is based on time, the 4-year presidential cycle as well as the major 20 year secular cycles, more on these in the next newsletter. When one looks at cycles such as these you must realize they are not exact and often times have a left or right translations (in terms of time). Remember, however that regardless of what the major averages do there will be sectors and/or individual groups and stocks that will dance to their own drummer so-to-speak, so stock selection as always is of primary importance. Our homework for 2006 is to determine if the strong tends in 2005 such as: Energy; Metals and Mining; Banking; Financials Services; Insurance; Health Services; Transportation; and Utilities will continue in 2006 or will other groups and sectors come to the forefront replacing them? Yale Hirsch publisher of the "Stock Market Almanac" now has his son Jeffrey running the Almanac Investor. Yearly, I believe in January they publish "Wall Streets Free Lunch", while I nor anyone personally know has used this strategy it certainly appears very interesting. Free Lunch (Almanac Investor) - Five years ago, we altered our Free Lunch Strategy. The original strategy stated that stocks hitting new lows around December 15 tend to outperform the market by February 15. We tweaked the strategy by shifting the purchase date to the end of December, three days from the last trading day of the year with good results. The original strategy also only consisted of NYSE traded stocks. The updated strategy incorporated AMEX, NASDAQ and OTCBB stocks with great results. This year we noticed that there were indeed two Free Lunches, one most likely caused by institutions selling off their losers and one, we theorize, caused by individuals doing the same. The institutional free lunch occurs around the 15th of the month after the last mid-month cash inflows for the year. The individually triggered free lunch occurs three days before the last trading day of the year. This is the last day of the year you can sell a stock and have it settle that calendar year; thus allowing for tax losses to be claimed for the year. The first course of the Free Lunch will be emailed to Almanac Investors before the open on the 16th, the second course the morning on the 28th. As a reminder this is a short-term trading strategy. You get in and get out as soon as you have a significant gain. The stocks all behave differently and there is no automatic trigger point to sell at. Standard trading rules do not apply for these trades. You should be out of all of these stocks between the middle of January and the middle of February. Advice a la G.M Loeb, never forget why you bought a stock. To view the history of this strategy visit and check out the selections of the last few years then visit: Free Lunch Editors Note: I nor The Prudent Trader receives any compensation should you decide to subscribe to their or any newsletters mentioned in this letter. Having no experience or back test results I cannot endorse this strategy. I personally am not a subscriber. You need to make up your own mind. 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.