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Buying Early

Never test the depth of the water with both feet

Everybody loves a sale.A Grand Opening sale.A Going-Out-of-Business sale.Memorial Day sales, Back-to-School sales, Labor Day sales.The Day After Christmas, January White Sales, Presidents' Weekend.And that's only the beginning.There are also garage sales, yard sales, rummage sales, clearance sales, and midnightmadness sales.

And if there are no sales at that particular moment, we look for bargains, anywhere wecan get them. Home Depot, Wal-Mart, K-Mart, Target. Art City, Tie City, Food City, OakCity, Dinette City, Toy City.

And we won't even begin to think about Factory Outlet Stores.And then there's the stock market. Who doesn't like getting a great stock at a cheapprice? After all, that's what you're supposed to do, isn't it? Buy low and sell high? Plus

there's the added bonus of outwitting all those idiots who can't see the value that's staringthem right in the face. Jerks. Don't have the brains that God gave a goose.

So why don't we do it? Why do we find it so all-fireddifficult to buy quality stocks at low prices and hold themuntil we can sell them at close to fully-appreciated prices?Why instead are we forever paying too much for thewrong stocks, or paying too much for the right stocks atthe wrong time, then selling them at a loss? Sometimes apretty substantial loss. Other times, of course, we go outof our way to prove to the market that we're not so dumbourselves, so we just hold on to the damn thing, refusingto sell, watching it just lie there week after week, monthafter month, year after year, as though somebody hadbroken every bone in its body. Eventually we just up and

die and bequeath the thing to our children. Let themworry about it.

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There's dollar-cost-averaging, of course. That's supposed to short-circuit ourscatter-brained approach to the markets and solve that problem. But when the marketand/or the stock collapses and presents us with what we thought would be a buyingopportunity in the unlikely event that it ever occurred, we find that the rest of the economyain't in such great shape either, and the last thing we need to be doing with our mortgagedmoney is putting it into some damn-fool stock. What are we doing in the market anyway?We've got kids to feed.

But even if the economy is just fine and our bank account is just filled to bursting,something stops us from making that call, placing that order, writing that check. Maybeit'll get cheaper. Just how bad can it get? Shouldn't we be holding onto what we've got,

just in case? Who knows what can happen? Don't want to wind up living in a box, forGod's sake. What if we're not as smart as we think we are? What if we shouldn't even beallowed to have our own bank accounts?

Some might call this "prudence". Others might call it"fiduciary responsibility". "Aversion to risk" might also springto mind. But the root of all these attitudes is ordinary fear.Not necessarily panic-stricken and hysterical flopsweat fear.Perhaps just uneasy, queasy Tums fear. But fear all the same.Fear of losing it all. Fear of winding up living out of a shoppingcart. And it is this fear - not our rational analysis - thatprevents us from taking advantage of just those opportunitieswhich we claim to have been waiting for all this time (boy, if

only I had bought ACME way back then...).Strangely enough (we human beings are a fascinating lot), even if we were to somehowgird our loins and scrape up the money somewhere to go ahead and buy that unfairlymaligned gem, we would very likely not clutch it in our white-knuckled little hands andthen sell it high. We would at best sell it fair to middling, perhaps at only a small profit.Why?

Let Your Losses Run

Once upon a time, two behavioral scientists named Daniel Kahneman and Amos Tverskyasked subjects what they would do if they were given $1,000 plus either

1a) a certain gain of $500 or

2a) an even chance to gain $1,000 or gain nothing.

A strong majority, 84%, selected the certain gain of $500, passing up the 50% chance todouble their money.

A second group was asked what they would do if given $2,000 plus1b) a certain loss of $500 or

2b) an even chance of losing $1,000 or of losing nothing.

The result of the first option in each case is identical, either$1000 + $500 ($1500) or

$2000 - $500 ($1500).

One might reasonably expect, therefore, that investors would be indifferent to thesedistinctions and show the same preference for both scenarios. However, in the secondscenario only 31% of subjects selected the certain $1,500 (choice 1b). The other 69%elected to gamble on the possibilityof losing $1000 in option 2b rather than accept thecertaintyof losing $500 in option 1b.

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So what does all this have to do with our kicking our toes intothe dirt every time the opportunity to pick up those bargainbasement stocks presents itself? Since the subject who choosesoption 1 in either case winds up with exactly the same amount ofmoney, there has to be something in options 2a and 2b thataccounts for the disparity in the number of people who chooseoption 1a in the first scenario (84%) and the number of peoplewho choose option 1b in the second scenario (31%), and thatsomething is fear.

In the first scenario, we are more afraid of gaining nothing than we are hopeful of gaining$1000. Therefore, we'd rather lock in the $500 gain offered in option 1a and pass onoption 2a altogether.

In the second scenario, the idea of a certain loss (1b) - even though we'd wind up withexactly the same amount of money as in option 1a - not only does not appeal to us, mostof us don't even consider it. We prefer instead to gamble on option 2b. There is, after all,a chance in option 2b of losing nothing, whereas if we were to choose option 1b, we wouldlose $500 for sure (there is also a chance of losing $1000, but it's not a certainty).

Put another way, the pain of loss which would result from choosing option 1b is so muchgreater than the pleasure of the gain that would result from choosing option 1a, we will doanything to avoid it, even if that means chancing an even greater loss by choosing option2b. The potential loss represented by 2b is after all onlypotential. It's in the future.

Something might happen that will enable us to avoid it. For example, the world mightblow up and we'll be off the hook (anyone who's ever watched a gambler increase the sizeof his bets as he loses will recognize this phenomenon in action; amateur investors whocontinue to buy stock as it declines in order to lower their "break-even" point are avoidingthis same rendezvous with loss).

If all of this sounds crazy, that's because it is crazy. The pain of loss is so great, and ourfear of it is so ingrained, that we will do anything to avoid facing it. We will hold onto astock all the way to bankruptcy to avoid facing it (if we don't sell it, it isn't reallya loss).

Cut Your Profits

Even greed is a limp-wristed wimp next to ourfear. When we're in the black, our fear of losingeven a trivial profit is so great that we'll grab it

just so we don't have to think about it anymore.If our greed somehow manages to gain the upperhand, it will do so only temporarily for the fearnever leaves us. It's always there, like the noisefrom the highway. Ultimately it will race throughus like a nerve toxin and we'll rush for the exits,which is why stocks fall so much faster than theyrise.

This ever-present fear and the increasingly itchy trigger-fingers of trader/investors (TIs)whove dutifully placed their stops have created problems for those TIs whove beendisciplined to buy new highs, or at least to buy within a narrow percentage of new highs,having been persuaded by the logic of a stock breaking for daylight, with no overheadsupply, with nothing in its path that will prevent it from growing to the sky. In the early80s - after we emerged from the last bear market -- through the early 90s, this strategyhad a great deal going for it. Conditions were near perfect for its success.

But the explosive growth in the number of market participants, in the amount of moneythey were willing to put into the market, and in the number of funds created to absorb andmanage all this l iquidity combined to create a new market environment (look at a chart ofthe market pre and post-1994). And when so many funds began to put Modern PortfolioTheory into practice (asset allocation, diversification, risk management) along with theCapital Asset Pricing Model, an effective cap was placed on just how far stocks could gobeyond a new high, except in the very short term (hence the phenomenon of periodic"profit-taking"). When the internet, deep-discount brokers, and online trading were addedto the mix, many momentum TIs found that they were being faced with a choice of eithertaking their profits quickly from stocks bought at new high breakouts or buying into thosestocks at earlier opportunities and toting up more substantial profits.

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Buying Early(er)

Buying early is only a step away from bottom-fishing, an act which most momentum TIsconsider to be tantamount to a sin. But, like sin, bottom-fishing can be both profitable andsatisfying if one is willing to confront his fears and develop a disciplined and objectivestrategy. About buying early, that is. Sin is explored elsewhere.

Fear (and its siblings doubt and anxiety) is an element of every action in the market to atleast some degree, less so when chasing a momentum stock because we at least havecompany, but more so when buying early because at no other time are we so alone, andthe earlier we buy, the more alone we are. Therefore, even though every marketparticipant must have at least a nodding acquaintance with fear, the participant whodecides that he's interested in buying early -- much less in bottom-fishing -- will take fearout for a drink, then dinner, then home to meet Mother. He'll move in with it and live withit on a daily basis. And if it doesn't drive him crazy, he may just learn to control it and touse it, as a reminder that he's not quite as smart as he thinks he is, as a check on hisarrogance, as a yellow flag when he begins to let his rules slide, as a slap in the face whenhe gets lazy in his research or in his daily routine.

The act of bottom fishing stirs up anodd mixture of fear and anticipationin the TI, similar to that felt bysomeone who has been out ofcirculation for a while and is nowfacing a date with a fix-up who justhappens to be a babe. On the onehand were eager for the moment ofengagement to arrive, but on theother hand were afraid well screw itup when it does. The degree oftrepidation we feel will have a greatdeal to do with how successful weexpect to be, and our expectations ofsuccess will depend on just what theobject of our affections is.

There are a variety of choices (I hesitate to characterize allof them as opportunities)facing the TI as he tries yet one more time to buy something low (or deep, as they say inthe trade), but two of these are not only common, but also provide genuine opportunities

to both the value TI and the momentum TI.

Two Roads Diverged in a Yellow Wood

The first of these has a personality similar to that of the Acapulco Cliff Diver (e.g., Cisco orMSFT, at least for now) and appeals mostly to the momentum TI. It stands on a pinnacle,bathed in sunlight. Its hot, its sexy, everybody wants to be seen with it. But then thetime comes for it to step off the cliff. Everybody knows that it does this periodically with noharm. Theyve even come to expect it. And they fully expect it to emerge from the waterand climb right back up again. They even make bets on it, and so do you.

But you never know for sure that it wont hit its head on arock. Or lose its Speedo and decide to stay down there for

a while. And in the meantime, everybody gets bored andgoes back to the clubhouse for a Margarita. What do youdo? Do you take an extra side-bet that the Diver will bobback up at any time and begin a new climb? Do you stickwith what you have and wait, maybe pitch a tent whennight falls and nothing has emerged? Or do you give upwith all the rest, tear up your betting slip, and head forthe bar yourself? Even with what seems like the surest ofbets, there is always the possibility that things wont workout, and the fear lurks in the background.

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(Quibble: many momentum TIs would claim that "buying on the dips" is not buying early,much less bottom-fishing. And under the best of circumstances, they have a point.However, in order to separate buying on the dip from bottom-fishing, one has partly to lookat the extent of the pullback. Some will say, for example, that the stock should not pullback more than 20%, that if it pulls back as much as 30%, it may be "broken" and requiremore time to resume its advance. But what about a stock that falls 25%? Or 21%? Andwhat if the market as a whole is going into the toilet and everything is down at least 30%?There are many factors to consider, and good men disagree. However, the skills requiredto buy on dips are essentially the same as those required to bottom-fish, and the necessity

for coming to terms with one's fears are equally important, regardless of the object of one'saffections. The defining differences lie in thepreferred personality characteristics of thevalue TI vs the momentum TI.)

The other possibility is more like the Man from Atlantis (e.g., specialty retailers orsemiconductors). The MFA appreciates our world for what it is and takes his own pleasuresfrom it in his own way. And when hes above ground, he has loads of friends, though mostof them wear gray suits and have gray hair. But he also enjoys the world provided by theocean and is perfectly adapted to it. He can stay down there for days. Weeks. Years.Which is why most of his friends have gray hair: they got that way from waiting for him toemerge. And if he had too many bad tacos the last time he was above ground, he may bedown there for quite some time.

Most bottom-fishers will be attracted to oneor the other of these general types, the

momentum TI to the stock which is in a stronguptrend, dips in order to provide him with anopportunity either to enter or to add to aposition already taken, then fairly quicklyresumes that strong uptrend, and the value TIto the more seasonal/cyclical stock that has apredictable ascension/descension pattern(yep, buy low and sell high). A surprisingnumber of TIs, though, are almost what onemight call bipolar, i.e., they have patiencewith the Mermen and, after buying them atthe right time, are able to put them aside andnot get all hyper about them, but they arealso comfortable with the special risks andrewards that are endemic to the Divers anddont expect to be making any long trips when

deeply involved in their performances (younever know when those rocks will crack a skullor two). Clearly, though, the odds of anyindividuals success in bottom-fishing aregreatly increased if he knows what he expectsand knows what to look for. He doesnt buyFord expecting a ten-bagger, but neither doeshe buy Rambus for his widowed mother onwhat he thinks might be a short-lived dip.

Fortunately, there are a number of signals, markers, flags, ahoogahs which occur againand again and can be recognized as familiar, and this sense of familiarity helps the TI tomanage his fear (or his caution, if you prefer). Additionally, if the TI recognizes andaccepts that he must be patient for whatever buy signal, regardless of how eager he is to

jump into the issue, the type of issue he chooses wont matter much. In fact, he can select

both a Diver and a Merman for consideration, as long as he understands that he probablywont be entering both at the same time. (Patience, of course, is not singular. There is aconsiderable range between "good things come to those who wait" and "enough isenough".)

Before getting into these signals, however, the TI would do well to ask himself a fewquestions. For one, if the stock is a Diver, was it in a long-term uptrend before it jumpedoff the cliff? If it wasnt, then a dip-buying strategy wont be of much use. In fact, thestock may be a broken ex-momentum stock that will neverrecover. If the stock is aMerman, is it (or was it) approaching the historical high of its multiple range, i.e., if it hastraditionally reached a certain multiple coincident with the top of its cycle, is it close to thatlevel now (or, if it has already begun to decline, was it near that level before the declinebegan)? Finally, at least for now, what is the rest of the group doing? What is the marketdoing? The behavior of the group and the market will have an effect not only on theamount of time it will take for your stock to recover but possibly on whether your stock will

recover at all.

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The Market/The Group

The market, along with the group of which the stock is a part, will generally have a strongand unavoidable effect on the behavior of the stock. While there may not always be aperfect correlation between the behavior of a given stock and the behavior of its group thethe market, attempting to buy something that seems to be breaking out or reversing adowntrend can be an expensive error if the market isn't taken into consideration.

Knowing what's happening with the market and with the group of which the stock is a partis a type of insurance. Common signals will emerge depending on whether the market iscorrecting and the group is not, or vice-versa, or both, or neither. The depth and durationof whatever corrections may be taking place will also be pertinent. Or perhaps the marketitself will diverge, as with the Nasdaq and the NYSE during the winter of 2000, and themarket on which your stock trades will influence its pattern. Groups can also act withconsiderable independence from the market. For example, semiconductors and oil & gasstocks can pretty much dance to their own demand and supply rhythms. Many retail stocksare largely seasonal, and some groups -- such as home furnishings -- can be dependent onthe health of others, such as residential construction.

Assuming that everything is in trouble from the market on down, certain easily recognizedand distinctive phenomena will pop up again and again, though they may wind up beinglimited to the particular correction being studied (or endured).

In 1998, for example, the market seemed toend in September the long slide it had begunin July. But after a brief rally attempt, itplunged into October. Many stocks resistedthe September pull to one degree or anotherbefore succumbing to October's pressure.With the rapid and sustained rally from thebottom, fueled in part by two successive ratecuts, these stocks, along with the indexes,

developed a peculiar "funnel" shape with aledge or "rest stop" near the level of

theSeptember high. This Funnel With Handlepattern became fairly common during the '98correction (and during the final ride theNasdaq took on the Tower of Terror inDec '94), and that "handle" represented anexcellent buying opportunity to those whorecognized it for what it was, since the marketwas barreling ahead virtually without pause.

Other stocks formed a more typical "W"shape,

or else resisted the October decline altogether.

The latter, of course, would have been amongthe first one would have wanted to buy.

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The 2000 "correction", on the other hand, wasentirely different, both in a fundamental andtechnical sense. Technically, while the '98decline took place in two legs down interruptedby a rally, the 2000 drop encompassed threelegs down with two intervening rallies. Somestocks made new highs on the first bounce,some echoed the Nasdaq in its 3-leg move,some took only two legs to reach the same

level. But anyone who did not wait for a thatlast leg down and instead tried re-entering themarket on what looked like a test after aselling climax wound up with a giant wedgiefor his efforts.

TXCC provides a good example of what to avoidsince the traps it laid were so seductive. Wecan draw a trendline beginning with the earlyMarch top. This is broken to the upside onstrong volume on March 22. The Nasdaq movesto the upside as well at the same time.However, the volume on the Nasdaq wassuspiciously light and the rally failed. Anyonepaying attention to this activity would have

been prepared for TXCC's failure. Anyone notprepared may have had an ugly surprise if hewasn't using a tight stop.

Another opportunity apparently arose from a breakout through a trendline drawn fromMarch 29 to April 17. The volume on this breakout wasn't nearly as strong as that of theearlier breakout, but strong enough to get it past the TL. At this time, however, the marketvolume for its own breakout attempt was really sort of pitiful, and when the market beganits May decline, it dragged TXCC right along with it.

Finally, a third trendline can be drawn with the same starting point but extending throughthe end of May (due to the new low on the 24th). This breakout, on June 1, is also onmoderately strong volume, but this time it coincides with the Nasdaq's action, dramaticallyincreasing the probability of success, and even though these rallies were only a breatherbefore the ensuing decline, they were profitable enough for the quick and the disciplined.

JNPR provides an example of the importanceof staying out when staying out is the smartthing to do, while at the same time knowing

just what to look for as a signal to get backin without hesitation. As with TXCC, onemight be forgiven for moving back in oradding to positions in March since thebounce seemed so strong. But note that thevolume accompanying that first bouncewasn't all that impressive, and the severityof the decline was so severe, as were thenext two, that they begged to be broken tothe upside if only for a few days. Again,paying attention to the Nasdaq's activity

would have paid off bigtime. JNPR broke itstrendline on moderate volume on 5/30 whenthe activity in the Naz was still tentative.But by the time JNPR had advanced for a fewdays and taken a rest in early June, the Nazhad been advancing strongly, and JNPR'smove up from that seemingly too-shortthree-day base on strong volume could havebeen bought with confidence.

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But even if the market is in a strong uptrendor at least mounting a strong rally attempt,buying a stock without regard for what itsgroup is doing can also be a waste of timeand money. POWI, for a variety of reasons,

just couldn't get out of its own way fromMarch onward. PWAV seemed to do prettywell, particularly in May. But even when theNasdaq took off for a 40% rally (followed by

another two years' decline), the group wasjust too much of a drag, and PWAV deflatedto join POWI.

All of which sounds good. And simple. And it is. Sort of. But tossing around words like"market" and "group" is one thing. Defiing them is another. The public, for example,generally defines "the market" as the Dow. The professinal more likely defines it as theS&P (and, no, that doesn't stand for "salt and pepper"). The growth/momentum TIprobably focuses on the Nasdaq. None of which matters much if all three are moving inconcert. But if they're moving in different directions, it's important to determine of whichmarket your stock is a part.

As for groups, novices commonly dig far too deeply and become entangled in far too muchdetail. If, for example, one is surveying 200 or more groups, he is less likely to be takingthe pulse of the true market movement than he is to be analyzing the wrong group of amisplaced stock.

Rather than jump from the study of a market or two to two hundred groups, then, peel theonion layer by layer and create a context for whatever conclusions you reach. The oddswill be far less than you end up on a detour to nowhere.

Currently (2004), BigCharts.com provides an excellent means of peeling back these layers,with charts (Yes, Virginia, charts!). Beginning with the market itself, one can then studythe ten sectors -- as charts -- which make up the market, then the 30 or 40 groups --again, as charts -- which make up those sectors. For nearly all practical purposes, diggingthis far should be plenty, but, if there is some particularly good reason for doing so, or ifyou are chronically anal, you can study the charts of over two-hundred smaller groups,though the odds at this level of the stock being misplaced (and thus compared to the wrongsiblings) are greatly increased. Remember that you're just looking for a little insurance,not guarantees (there aren't any, so why bother looking?). And you may have learned bynow that what may sound like a good idea isn't necessarily something that you'll actuallydo, especially when you discover just how long it takes to analyze all those frigginggroups. I've tried to make things at least a bit easier by listing all the sectors and groups

in outline form at the end of this file. These can be exported into Word or Excel (orwhatever you have) and each entry converted into a hyperlink to the relevant chart atBigCharts. I've given you a start by providing hyperlinks for the first few, along with thechart symbols (you'll find these at BigCharts) and the equivalent ETF (giving you somethingthat you can actually buy) for the first sector, "Basic Materials". You may, of course, electto create hyperlinks for only the first level (the sectors), or the first and second, or the first,second, and third, or . . .. Just depends on how much time you have and how much timeyou want to devote to it (and how much work you think is necessary for reaching yourobjectives).

Specialty indexes are another option, e.g., the SOX for semiconductors, the OSX for oildrillers and field services, the BTK for biotechnology. These indexes do not yet provide thecoverage that the 200+ group classification schemes do, but they continue to multiply likerabbits, and what is currently available can be used to confirm the sector and groupinformation that you'll find at BigCharts or some other service.

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The Stock

If the market is acting as your box spring and the group as your mattress (and I'm talkingBeautyrest here, not Goodwill), you can then begin to look at potential entry points intoindividual stocks with somewhat greater confidence, though the key word here is"somewhat".

Perhaps the biggest mistake that both value and momentum TIs make is to buy too early(I say "mistake" advisedly because the value TI may not care if -- a year later -- his stockhas done nothing, but whether he cares or not doesn't change the fact that he bought it tooearly). They both often fail to ask themselves basic questions about the stock and thecompany it represents. Momentum TIs are particularly prone to skip this part because somany of them believe that everything is in the chart. And everything probably is in thechart. The problem is that the momentum TI may see things that aren't really there, orignore things he really doesn't want to see.

Momentum

When the momentum TI sees a stock that he's been waiting forbegin to drop, he needs to recall a few things before feverishly

logging on to his online broker. For starters, he needs toremember that groups -- much less individual companies --normally go through five stages from the formative and rapidgrowth stages through mature growth to maturity and declininggrowth. What the momentum TI (or some pubescent fundmanager) may see as a "dip" and a "buying opportunity" may infact be the first stumble in a much deeper and longer-lastingdecline. Before nickel-and-dimeing himself to death jumping onbreakouts and getting stopped out and jumping on breakouts andgetting stopped out and jumping . . . , he needs at least to considerthe possibility that his momentum stock may be a momentum stockno longer.

Momentum stocks can become ex-momentum stocks for reasons other than just age. Theymay, for example, preannounce a shortfall, or report lower-than-expected earnings.

According to a study done at Prudential Securities, such stocks can be expected tounderperform for at least a year. In fact, more than half the stocks studied failed tooutperform their benchmark indexes aftera year. Louis Navellier concurs that, although"big-cap stocks can bounce back a lot quicker", small-cap stocks "can take as much as twoyears to recover" (for more on pre-announcements, see the "Earnings Season" file).

The reasons for a stock's being taken out and shot do seem to matter. Missing earningsestimates is a relatively minor sin, particularly if the miss is "just". Even so, less than halfof those most likely to do best -- the small-caps -- will outperform the Russell 2000 after ayear. And part of the severity of the damage depends on how much the stock was run upprior to the announcement, if at all, though if earnings estimates had been cutpriorto theannouncement, or if a series of cuts had been made prior to the announcement, the actualannouncement may actually spark a recovery and present a buying opportunity. If thestock was run up prior to the announcement, one should look at the relationship betweenthe extent of the sell-off and the extent of the earnings miss. For example, if the companymissed by 10% and sold off by 30%, there would seem to be a disconnect and the stockmay represent a bargain. On the other hand, if the stock was overvalued, trading wellabove the market multiple and/or its own growth rate, a hit greater than the amount of theearnings miss might not be such a big surprise.

The real damage, as just suggested, is done by downwardearnings revisions. Less than a quarter of midcaps that tookthis particular bullet outperformed the S&P 400 after a year,but even here, the severity of the cut is important: 2 to 3%may be tolerated fairly well, but a cut of 10% or more may bethe kiss of death. And, again, size matters. Big caps tend torebound fastest, small caps slowest. Momentum TIs temptedto jump into one of these stocks, then, may find that they'llhave to wait at least a quarter before the stock begins to gainconsciousness, particularly if the volume on the downside washeavy, and even if it does begin to revive, it better beat

estimates pretty soundly. On the other hand, if there was anywhiff of accounting irregularities throughout any of this drama,best to pull up a chair, with footstool, or just move on.

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If nothing cataclysmic has happened to the stock and it hasn't undergone any Mr. Hydetransformations (a downgrade due to being "fully valued" is one of the most trivial ofreasons and one of the most quickly overcome, often eliciting a Sez Who?), then buying thedip may be appropriate if the risk in doing so is minimal. First, the TI should look at otherstocks in the same group to see if anyone else is in trouble. His prey may be declining allby itself (bad). Or it may be declining purely in sympathy with some other stock but sharesnone of that other stock's problems (good; on the other hand, if the group as a whole isdeclining due to slackening demand, be wary of an odor). Second, he should measure thedepth of the decline, remembering that should the stock decline much more than 20%,

holders may be a bit too eager to get the hell out once it begins to re-assert itself (lessthan 20% and they're more likely to hold, or even to buy more). Third, if the stock doesdecline more than 20%, he should determine whether or not the stock tends to trade in arange. If its market cap is relatively high, and the trading range is reasonably predictable,he will find less risk in buying at the bottom of that range, unless of course Canadadeclares war and the market plummets. Fourth, he should ignore the stock for themoment and look at the company, whether or not it is still a "good" company(fundamentally) and whether the announcement had anything to do with a change in thecourse of the company's business or with circumstances that were completely outside thecompany's control. Before going further, though, let's check the Value Channel.

Value

The value TI must also look at the stage of development which his company occupies(assumedly nearer the "maturity" end of the scale), the reasons for its decline, and itssize. But he must also rein in his lust for a "deal". Oddly enough, the momentum TI andthe value TI are equally concerned about price. But while the momentum TI bases his viewof "cheap" on the chart, the value TI bases his view of "cheap" on the fundamentals. Eastis east and west is west, but it doesn't really matter since we're all just trying to make abuck.

Because the value TI is particularly attuned to buying "low", he has to be extra careful toremember that a "low" price isn't necessarily a "cheap" one. A stock can be cut in half andstill not be anywhere within shouting distance of "cheap". And even if the value TI focuseson 3M, Gillette, and Wal-Mart, he knows full well what opportunity costs are (missing outon equally attractive stocks that just happen to be going up instead of down) and howcompounding works (and it works againstyou if you pay too much as well as foryou if youdon't) and what the effects on his portfolio will be of having his money do absolutely

nothing for a year or more. Instead of being concerned with reduction in price, he shouldinstead be concerned with reduction in risk. Low risk is, in fact, a large part of what valueinvesting is all about, isn't it?

First, you have to wait until the stock has stopped falling.This may be particularly difficult to do if you already ownsome and have been waiting for an opportunity to buymore. But jokes about "if you liked it at 200, you'll love it at50" aside, nothing is gained by paying more than you reallyhave to for a stock you like, even if you've been waiting formonths or years for the opportunity.

Second, remember that truly great stocks just don't dip that much or that often.Therefore, a closer-than-usual examination of the reasons for the decline are in order,particularly if the investor believes that the general perception is wrong. Great care must

be taken, though, that ego not be allowed to enter the picture since perception doesdetermine price, and the investor isn't going to do himself a whole lot of good by arguingwith the Street if he is losing money in the process. Waiting to put his money down untilThe Street has come to see the light that he saw long ago will only make more efficient useof his capital.

A value TI thinks nothing of waiting a month or a quarter or a year forhis stock to show signs of life, but there's no reason why his moneyshould be in it while it's recuperating. His money can instead beinvested in something else that's already on the road to recovery. Inthe meantime, he can check to see if the price has continued to fall whilethe company's prospects have remained the same. Or perhaps the pricehasn't fallen further, but the company's prospects have improved (the Ehas caught up with the P). Either way, there's been a reduction in risk.When the stock begins to stir, the moment may have come to put some

money to work.

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The Recovery Room

After they've been beaten up, treated, and spent some time in the recovery room, somestocks are ready to go straight to a private room and others have to go to intensive care fora while. The TI who doesn't want to spend his investing life reading The Hobbit to a stockthat's in a coma (much less, God forbid, The Lord of the Rings) will want to recognize thesigns that his one-and-only is not only ready to move beyond the lime Jello but isbeginning to pinch the nurses and demand his cigars.

If the market is or has been correcting (and most groups will have been as well unless it's avery minor correction), some patterns will repeatedly surface. In the examples providedearlier, the '98 correction generated a lot of V bottoms, most of which grew handlesanywhere from the 50%+ retracement level all the way up to the level of the left-hand sideof the V or higher. These looked like a Funnel With a Handle. The Winter/Spring '00"correction" produced a lot of stocks with a 3-leg slide interspersed with two interveningrally attempts, followed by a series of bounces during a bottoming process. The '02-'03"bottom" (at least as of mid-2004) spawned group and stock formations which closelyechoed the selling climax/test/higher low dynamic of the market average. Therefore, whenlooking to take signals off formations which pretty much parallel the action of the index,watch the index and group carefully and be ready to act at the appropriate moment.

The formations discussed below are general and common. They are not an outgrowth ofthe characteristics of a particular correction and can occur anytime. I cannot emphasizeenough, however, that seeking these patterns in isolation is likely to be a money-losing

propostion. The market is Godzilla, and what it says goes. The group is also adeterminant of success, unless your stock is so important that it is the group, and can beexpected to lead it rather than follow something else (though you always keep your eye onpossible usurpers; don't forget Caesar and the senators). If your stock is that important,then it will drop to its knees only for the market.

One of the two most common formations has a bowl or cup shape (the other, later, is theW). It forms a gentle arc downward within an uptrend, volume preferably subsides as onesettles into a base (though there may be a climax sell-off at the beginning of or just beforethis base). In the best of all possible worlds, this will attract some volume pulling out ofthe base, form a little ledge in the right place, and break out of this ledge in just the rightway. However, it may also just rocket out of this base without even a backward glance.Buying early, before the ledge, while riskier, does eliminate the possibility of being left atthe station when the Rocket Unlimited takes off for parts unknown.

This stock had a nice run up until Nov 2, at which point it slipped into what would becomea cup. Before mid-December, though, there was no way one could know that it wouldbecome a cup. Drawing a trendline downward across the tops of the rally peaks and highsgives one a bar to cross. This occurs on Nov 17, but volume is subdued until Dec 7, whichprovides a tentative buy signal (the buy signal off the ledge (such as it is) doesn't occuruntil two weeks later at nearly double the price.

"Gentle", of course, may not be the first wordthat comes to mind when describing this arcdue to the selling climax the week of the 8th,but the overall pattern is that of a glide into abase. Note, however, that if this climax hadnot occurred and the arc had been moregentle throughout, the low for the periodwould have occurred on Nov 24, rotating the

trendline a bit higher; this would not havechanged the ultimate buypoint.

Note also that both the market and the grouphave recovered from their l ittle blups by Dec6, and both give their "permission" to makethe trade.

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As noted above, buying these patterns before a cup has a chance to form -- much less aledge -- is a lot dicier than "buy a breakout from the ledge on strong volume", butheightened awareness and attention to daily and sometimes intradaily movement are thecost of the potential benefits of buying early. One of the chief advantages of this sort of"watch", in fact, is that one is much less likely to lose sight of the goal. He will be sharpand focused, and this is always tough to beat. He will also be spending his time on clearcutand definable trendlines and volume rather than wasting it on the is-it-or-isn't-it- a-CupDance.

Since these arcs can be so shallow, early entrymay seem to represent a lot of effort for notmuch result. But powerful stocks can barrelout of pullbacks like you wouldn't believe, andearly entry in this example would put you insafely ahead of the "new high" turmoil (notethat the low on Dec 14 is exactly the same asthe low on Nov 23, so no new trendline isnecessary, but one can draw a new line if helikes; doing so doesn't change the indication ofstrength (and buy signal for the risk-tolerant)on Dec 15, or the standard buy signal on Jan 3.

Acting on trendline/volume signals requires a tolerance for risk on which many TIs mightpass as the market doesn't break its trendline until Dec 19, four days after the "buy". Thegroup doesn't break its trendline until the 27th, nearly two weeks after the "buy". If yourknees are beginning to wobble, though, notice that the stock shows much greater relativestrength than the market index, and even somewhat greater than its own group; that is,the stock strongly resisted the downpull of both the group and the index, suggesting that itwas ready to move at the earliest opportunity. If any of this makes you dizzy, well, it'sperfectly okay to wait for the market/group to join the party, though you may find yourselfto be an uncomfortable distance from your stop when you finally do enter.

This stock actually precedes the market,the sector, and even its own group.However, by the time it pulls back inmid-May, all cylinders are firing and onecan buy with confidence andwith a tight

stop, just below the pullback low.

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The Double Bottom or W is another common pattern which can provide a reasonably safeentry if one waits for the second leg down. If one instead decides to buy the first bounceoff the first leg down thinking that the pattern might be a V, he is faced with the prospectof a daily vigil, waiting for that moment when the bounce fails and the V turns into a W (or,worse, a lower low in a continuation of the decline). While it does seem, however, that Vsare more common nowadays, whether due to online trading, instant news, wide availabil ityof charts, etc., keep in mind that a V in one bar interval (e.g., weekly or daily) is likely to

be a W in one of the lower intervals (e.g., daily or hourly). In any case, the TL and thevolume remain your friends.

One could consider 4/15 to be an anomalyand lower the second trendline a bit and thiswould result in a penetration on 4/30 (itcould also result in one's telling oneself whatone wants to hear). However, the group(below left) shows considerable strength bythat point, and one could be forgiven forassuming the risk. A lower-risk entry wouldbe 5/7 due to the volume and to the fact thatboth the group and the index are behind thestock by then, still 10% below the Februaryhigh, the "standard" entry for the buyer ofnew highs.

In this case, both the group (below, fromMay forward) and the stock are in decline.Except for 7/18, there are no high volumedays which come even close to penetratingthe TL until 7/31, a reasonable buypoint --even though the stock is forming a "V" --since the stock's resistance to the downwardpull is so much greater than that of thegroup or the market during that week. Thegroup has double-bottomed by then, andwhile it hasn't given its blessing, it at least ismoving in the right direction. Ditto for theindex chart. Again, only the last trendlinehas been drawn.

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The "double U" is much more leisurely. Thebuy signals for A and B occur long before themidpoint of the W is reached. The signal forC coincides with the midpoint.

A third type of double-bottom pattern is acombination of the V and U and was labelledan "Adam and Eve" by some chartist whohadn't left the house in a very very long

time.

Erudite explanations of yet anotherbottoming pattern, the "reverse head andshoulders", can be found in fat andexpensive books devoted to technicalanalysis, but this "pattern" is essentially a Wthat's playing "gotcha". If the W you'vebought looks as though it's going to fail,don't abandon it. It may just wind up beinga reverse h&s. Sometimes mini, sometimesmaxi. This is a mini:

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Finally, one can use what are called "Indicator Stocks" to gain early entry into stocksthat are on their way or are at least backing out of the driveway. Indicator stocks are thosewhich invariably take part in a group and/or index move and may in fact even be largelyresponsible for whatever move may take place. In other words, if the stock moves, it'sgoing to take other stocks with it. However, other stocks aren't going to make muchprogress if it decides not to go along. Keeping an eye on such stocks can give you clues asto potential or imminent group or index moves even before a surrogate can.

Some indicator stocks are obvious, such as GE for the Dow and CSCO or MSFT for theNasdaq, though in an index, nothing is forever, and even the days of CSCO and MSFT maypass. The objective is to find that stock which is so much a part of its group/index that itacts as a "bellwether" for the group/index. These stocks generally have better balancesheets and more predictable earnings than most others in the group.

The first example focuses onSemiconductors. Since this group iscomposed of two major components, thechips themselves and the equipment used tomake them, one must come up with at leasttwo indicator stocks, one for eachcomponent. The king of chips is generallyconsidered to be INTC and the king ofequipment stocks AMAT, though one cannever be sure that the same stocks will

assume the same leadership positionscoming out of every cyclical bottom.

Following a specialty index -- in this case,the SOX -- which includes both chip andequipment stocks is not a bad idea, butshould not be done as a time-saving device.As can be seen in these charts, INTC movedwell before the SOX did and not onlyprovided a signal that the group had reachedits cyclical bottom, but a signal for its ownpurchase as well.

Equipment stocks actually lagged the SOX(and, of course, the chips), and AMAT wasamong the first out of the gate. Using anequipment stock for anything other than anindicator for the equipment stocks, therefore,would have given a mistaken impression ofthe strength of the chip stocks, led by INTC.

The second example focuses on the Oil & Gas sector. In this case, we have two specialtyindexes, the XOI for exploration and production, and the OSX for drillers and field servicesand the like. Since any increase in the price of oil would benefit first those who sell it, onemight assume that he could use the XOI as an indicator for the OSX. In other words, one

would expect the XOI to move first, and once the XOI began to move, one mightreasonably expect that eventually orders would be placed with OSX companies, those thatprovide services. One might also assume that the OSX would give him early warning ofmoves in its component stocks.

Notice, however, that the XOI doesn't give the anticipated warning at all. In fact, both theXOI and OSX lift off at about the same time. Can individual stocks provide us with betterindications of movement?

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Exxon launches itself at about the sametime as both the XOI and OSX. However, itslow in March is easily higher than its low inSeptember, suggesting much greaterstrength in at least some of the componentsof the group than is implied by the XOI.

Turning to the OSX and its components, one would not expect all service companies to seenew orders at the same pace. One would assume that those service companies whichprovide project management or oil field measurement, for example, would see immediateupticks in orders with every additional barrel of oil that's pumped because of the newer andhigher prices. One such stock which has been around for dog-years and has a solidbalance sheet and experienced management is Schlumberger. Additionally, one wouldassume that those stocks which are principally engaged in drilling would be tapped later,as supplies need to be replenished. DO will be used to represent this sub-group.Eventually the phones of the ship and rig builders should begin to ring. And so on downthe line. Supposedly.

Examining these charts, one finds that not only do the above assumptions turn out to becorrect, i.e., that a services company such as SLB would move in advance of a driller suchas DO, but SLB also precedes the move of both the XOI and the OSX by several months.True, it does make a false start in October by breaking that first trendline, but the movebegun in December is confirmed later by the strength in the XOI and OSX and one canmake a reasonably safe "early entry".

As for Diamond Offshore, it waits, as expected, and launches itself along with the XOI andOSX. However, since Exxon gave better signals than the XOI, and Schlumberger gavebetter signals than the OSX, there's no reason not to rely on indicator stocks -- such as DO-- to telegraph movements amongst the drillers as well.

If At Third You Don't Succeed, the Hell With It

Perhaps the most frustrating aspect of bottom-fishing -- or "buying early", if you prefer --is the prospect of buying too early. The stock reaches your stop and you're determined tobe a good little soldier this time and trigger it. Then another "signal" is flashed and youbuy again. And your stop is reached again. And you trigger it again. Then Round 3. And4. And finally you figure to hell with it, you're not going to trigger your stop again, you're

just gonna let the damn thing do what it's gonna do. At which time it drops another 50%and who knows how long it's going to take for this dog to sit up.

Unless one abandons all attempts at timingand just buys without regard for how longhis money is going to sit there doing nothingfor him, the probability of being stopped outat least once is high. And the temptation toavoid triggering the stop is strong since,after all, one can't fall out of bed if he'ssleeping on the floor, right? I mean thedownside risk is minimal, right? Right. AndI have this once-in-a-lifetime investmentopportunity . . .

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All the rules and commands and charges and warnings aside, the fact remains that cuttingyour losses and letting your profits run is counter-intuitive. As explained at the beginningof this epistle, our instinct is to avoid the pain of loss, no matter what. And since the painof loss is greater than the pleasure of gain, our instinct is to cut our profits short beforethey become losses and to let our losses run since "they aren't reallylosses until they'resold" and there's always a chance that "they might come back".

Establishing and maintaining a proper bottom-fishing or "buy early" discipline, then,requires that one actively and continuously fight against his own natural instincts, and that

-- no matter what anybody says -- is no picnic in the park. It can be so wearing, in fact,that some people just burn out and abandon the strategy. Either that or they avoid stopsand just keep trying again and again, losing more and more money, until they either giveup or go broke.

Granted we are talking about MSFT here, not the first company that comes to mind whenthinking of potential bankruptcies. But there aren't that many Microsofts around, no matterhow much you might love the object of your attentions, and cutting one's losses short atthe very first sign of trouble is an absolute necessity.

Chart reading almost invariably focuses on good entries. And that's not difficult tounderstand. After all, if you don't own the stock, you're more interested in entering it thanexiting from it. However, there isn't a trader alive who is great on entries and terrible onexits who's still trading. Knowing when to cut your losses and how long to ride a profitabletrade are the things that separate a good trader from a bad trader (or investor, as far asthat goes; even Warren Buffett sells).

Once More Unto the Breach, Dear Friends, Once More

You should never be without a list of companies withsolid management, market share momentum, strongbalance sheets that you would like to buy but think aretoo expensive. No matter what the company,opportunities will arise, and it will be up to you to beready when those opportunities start banging on yourdoor.

The inescapable fact is that bad things happen to good companies, even if the bad thing isno more than the bad luck to be in the same group as the real barker. Sometimes the badthing is just some bit of debatably bad news that the mindlessness of herd behaviortransforms into a crisis (remember that institutional investors go to the same schools, learnthe same portfolio management techniques, vacation at the same spots, eat at the samerestaurants, drink at the same bars, lust after the same bonuses and perks, have the sameworries about losing their jobs). And professional investors are not necessarily any betterthan retail investor/traders at separating a company from its stock and remembering that adecline in share price need not have anything to do with the company itself (rememberpre-Bubble, when Intel was hammered due to the Pentium "bug", or when AOL was cut offat the knees because subscribers were complaining about wait-times and disconnects?).

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The TI who's considering testing the waters ofbottom-fishing, then, needs to be prepared with areasonably thorough knowledge of the fundamentals of thecompany he's interested in trolling for. At the very least,he'll want to make sure that it is, in fact, a fish and not anold boot. And that if it is a fish, it's not on its last legs (soto speak). Taking advantage of these bad-news baths,however, does not mean stepping in when everyonearound him is screaming "Sell" and stampeding for the

exits (or "catching a falling knife", as they say). It meanschoosing one's target carefully, for reasons other than thatit's fallen 50%. It means letting the dust settle. It meanswaiting patiently for one's moment. Above all it meansnot allowing one's disdain for "the herd" to breed anyarrogance whatsoever, much less any tendency to believethat one is "smarter" than the market.

Taking advantage of these "inefficiencies" also means avoiding the siren call of"anchoring", in this case the inclination to use some previous highpoint as a target for onewhat might reasonably expect of the stock price, even if that highpoint was ridiculous tothe inflationary extreme, and particularly if one recognizes the insanity of that price.Anchoring is an extraordinarily seductive tendency and can prevent one from making anobjective and rational appraisal of the value of a company and its stock, much less make anobjective and rational appraisal of what one can expect the company to earn and of theprice one can expect the stock to reach. The fact that a $15 stock sold for $250 severalmonths ago does not mean that the stock was "worth" $250. It may be worth exactly whatit's selling for: $15. Or even less. Anchoring is part of what causes amateurs to buy moreand more of a stock that is in terminal decline. It is also a significant source of thefrustration bottom-fishers feel when their stock doesn't rebound to the heights they expect(even though they may understand that there's absolutely no reason to expect that thoseheights will ever be reached again, except perhaps in a parallel reality). Focusing on theleft lip of what one expects to become a cup is a form of anchoring since the cup hasn'tformed yet, much less the handle. Focusing on what is is more likely to keep thebottom-fisher out of trouble than is a preoccupation with what was or what might be.

The bottom-fisher cannot afford the luxury of even the slightest bit of laziness, at least inhis attention to detail and in the tidiness of his mental home, or his "zone". Stocks thathave fallen are more likely to fall further than those that are in strong uptrends. So planyour trade, be patient, buy low, place your stops, sell high. There's this villa in the Southof France...

Grandmasters rely on illogical thinking, but they call it the element of surprise. Generallythey start the game according to the rulebook, but then they make a move which isunexpected: It is illogical. This causes the game to go into uncharted waters. The winner isthe one who navigates the new terrain the best. The more illogical a master's move seems,the bigger advantage he has, because his opponent becomes totally confused. The weakopponent thinks only inside the box. By the time the confused victim figures out what hashappened, he is history ...

Likewise, the markets prey on the confused trader who plays only by the established rules.The more unpredictable and chaotic a market is, the more a true master wins. He is able totranscend rules and logic to another level of understanding. --Leonard Kreicas

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Basic Materials (BSC; example ETF equivalent:XLB)Basic Resources(BAS)

Forest Products & Paper(FRP)Forest Products (FOR)Paper Products (PAP)

Mining & Metals (supply the remaining symbols and links forwhatever you're interested in)

AluminumMiningNonferrous MetalsPrecious MetalsSteel

Chemicals (CHM)Chemicals, CommodityChemicals, Specialty

Consumer, Cyclical (CYC; ETF:XLY)Automobiles (ATO)

Auto Parts & TiresAuto PartsTires

Automobile Manufacturers

Cyclical Goods & Services(CGS)Airlines

Home Construction & FurnishingsFurnishings & Applicances

Home Construction

Leisure Goods & ServicesCasinosConsumer Electronics

LodgingRecreational Products & ServicesRestaurants

ToysTextiles & Apparel

Clothing & Fabrics

Footwear

Media (MDI)Advertising

BroadcastingEntertainmentPublishing

Retail (RTS; ETF: RTH)Retailers, ApparelRetailers, Broadline`Retailers, Drug-basedRetailers, Specialty

Consumer, Noncyclical(NCY; ETF: XLP)Food & Beverage(FOB)

BeverageDistillers & BrewersSoft Drinks

Food

Food ProductsNoncyclical Goods & Services(NCG)Consumer ServicesCosmeticsFood Retailers & WholesalersHousehold Products

Household Products, DurableHousehold Products, Nondurable

Tobacco

Energy (ENE; ETF:XLE)Coal (COA)Oil Companies, Major(OIL)Oil Companies, Secondary(OIS)Oil Drilling, Equipment & Services(OIE; ETF:OIH)

Pipelines (PIP)

Financial (FIN; ETF:XLF)Banks (BNK)

Banks, Ex S&L

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Savings & Loans

Financial Services(FSV)Diversified FinancialReal EstateInvestment Services

Insurance (INS)Insurance, Full-LineInsurance, LifeInsurance, Property & Casualty

Healthcare (HCR; ETF:XLV)Biotechnology (BTC; ETF:BBH)Healthcare Providers(HEA)Medical Products(MTC)

Advanced Medical SuppliesMedical Supplies

Pharmaceuticals (DRG; ETF:PPH)

Industrial (IDU; ETF: XLI)Construction (CNS)

Building MaterialsHeavy Construction

Industrial Goods & Services(IGS)Advanced Industrial EquipmentAerospaceContainers & PackagingElectric Components & EquipmentGeneral Industrial Services

Industrial ServicesPollution Control

Industrial EquipmentFactory EquipmentHeavy Machinery

Industrial TransportationAir FreightLand Transportation EquipmentMarine TransportRailroadsTransportation ServicesTrucking

Technology (TEC; ETF:XLK)Industrial, Diversified(IDD)Communications Technology(CMT)Semiconductors (SEM; ETF:SMH)Software (SOF; ETF: SWH)Technology Hardware & Equipment(THQ)

ComputersOffice Equipment

Technology Services(TSV)Diversified Technology ServicesInternet Services (ISV; ETF:HHH)

Telecommunications (TLS)Fixed-Line Communications(FTS)Wireless Communications(CTS)

Utilities (UTI; ETF:XLU)Electric Utilities(ELC)Gas Utilities(GAS)Water Utilities(WAT)

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Assorted Market Indexes (that one can buy)

Dow-Jones (DIA)

S&P 500(SPY)

Nasdaq (QQQ)

MidCaps(MDY)

SmallCaps (IWM)


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