Wiser Trader Stocks and Options Newsletter

Issue No. 10 – January 24, 2005

http://www.WiserTrader.com

Systems@WiserTrader.com

James A. Andrews

 

 

1.0 Researching a Down Market Filter

 

      A stock candidate filter created specifically for down trending markets would be a useful addition to the set of stock screening tools that are used to build watch lists.  This issue of the newsletter explores filter modifications that could increase the potential for a price decline in down trending markets.

 

      While the current stock candidate filter used with the TTC-A trading template works well for trading options in up trending markets, it is unclear how it will work when markets trend downward.  Dr. Cooper explains that filtered stocks, having heavy inflows of money in up markets, are the very ones that have large outflows of money in a down trending market.  Those of us with less trading experience must either take this on faith or, as he suggests, stay out of the market when uncomfortable about conditions.  There have not been any problems with the stock candidate filter for finding rising stocks in rising markets.  It’s just that there has been very little experience with its ability to select falling stocks in down market conditions.

 

      Not wanting to stay on the sidelines for unnecessarily long periods, I began to reengineer the stock candidate filter for finding falling stocks in down trending markets.  Unless I miss my guess, the markets are going to provide conditions for testing the new hypothesis in the very near term.   I will be requesting your thoughts on this and other subjects as testing for this new filter develops. 

 

      The intent is to change only those parts of the stock candidate filter that are likely to improve performance in a falling market while still relying on the TTC-A trading template.  The filter for rising stocks in rising markets works well enough and will be left as it is.  The new filter for falling markets will generate an additional experimental watch list.  One needs to remain mindful that a watch list does not necessarily mean that the listed stocks are actually being traded.  A watch list is just a list of candidates for possible trading.  You will get a chance to witness how the new watch list is tested and modified before being taken more seriously.

 

      The following will analyze the current stock candidate filter, propose some changes to strengthen its ability to find put option candidates in down markets and outline a test procedure to see how the new filter performs.  

 

2.0 Analysis

 

 

The Current Stock Candidate Filter

 

      The stock candidate filter criteria are listed in Table 1a.  A screened stock must first of all be optionable in order to trade short term options.  Requirements for NASDAQ and NYSE exchanges are there because of a familiarity with their basic levels of volatility. 

 

Table 1a

Stock Candidate Filter

 

 

      A natural skepticism arose about the stock candidate filter’s ability to select shorting candidates in a down market because the selected stocks are all high performers in up markets:  A minimum price of $50, EPS Growth over the past 12 months greater than 80%, Percentage relative strength over the past 6 months greater than 90%, and within 5% of their 52 week high. 

 

      These four factors taken together lead one to expect that such good stocks should fall the least, if at all, in a down market.  However, when markets turn lower, it is the most overpriced stocks that are likely to fall the most.  One must realize that the stock candidate filter selects momentum stocks, some of which have PE ratios as high as 50 to 70.  Cautious investors are likely to bail out of overpriced stocks when market conditions turn sour.  A PE ratio of 50 implies that a stock’s annual yield on investment is 2%, calculated by taking the reciprocal of the PE ratio.  Not impressive.  Bonds that are much safer currently yield more than 4%.  So it is not farfetched to expect prices for high PE stocks to decline in a down market driven by expectations of slowing economic growth, higher inflation, higher interest rates and declining profits.

 

       Still, the overall historical bias of the stock market has unquestionably been up over the past century.  This makes finding selection criteria for strong rising stocks in an up market somewhat easy.  Finding rules for selecting falling stocks can be a bit tricky.  Stocks that perform poorly may do so for chronic or for temporary reasons.  By the time a company’s troubles can be safely classified as chronic, the stock price is likely to have already fallen too low for the stock to be a good candidate for shorting.  This leaves relatively good stocks that are temporarily behaving badly with the understanding that a company’s imminent recovery could be announced or anticipated by insiders at any time.  The potential sudden rise in a stock’s price makes shorting it a rather treacherous affair.  A bit of comfort can be found in an overall falling market that would moderate the price recovery of a poorly performing stock.  Still, one needs to have a good exit strategy. 

 

 

 

Modified Filter

 

      In constructing the initial list of criteria for a new stock filter, price behavior for recent declines in major market averages during the first two weeks of January was taken into account.  An arbitrary minimum PE of 50 was used as a basis for comparison.  The 80% EPS growth over the past 12 months was replaced with a net EPS decline.  To add emphasis, the company had to have missed analysts’ earnings expectations with a negative quarterly surprise.

 

      Referring to Table 1b, the original stock candidate filter is compared with the down market candidate filter. Corresponding criteria are grouped together.  A $50 minimum stock price is preferred to insure adequate leverage for put options.  But out of 8,763 stocks in the database, there were only 495 NYSE and NASDAQ stocks having a closing price above $50 last week.  Out of those, only three met the initial criteria, with only one declining in price by 3% during the previous four weeks. 

 

Table 1b

Comparison between Original and Modified Filters

 

 

 

      When a % Relative strength ranking of less than 50% over the past four weeks was imposed, no stocks made it through the new filter at all.  When the minimum stock price was lowered to $40, two stocks filtered through declining by -2 and -5% in the previous four weeks.  When the minimum stock price was lowered to $30, five stocks filtered through, all declining by -2 to -5% in the previous four weeks.  When the minimum stock price was lowered to $20, eight stocks filtered through, all declining by -2 to -13% over the past four weeks. 

 

      For stocks in the short term options watch list based on the original stock candidate filter, 6 were net gainers for the past four weeks, ranging from 0.8% to 16.8%, and four of them declined by -0.6% to -4.8%. 

 

      Over the past month or so, there appears to be some correlation between the price of a stock and its percentage price decline with higher priced stocks from the original filter declining by a lower percentage.  The implication is that higher priced stocks from the original filter were affected less by the type of market decline recently experienced.  This picture could change for a more protracted decline than the one currently being experienced.

 

 

 

 

 

      The time period over which a stock has declined is symptomatic of the cause of the decline.  The short term nature of the 4 week percent rank relative strength and the quarterly negative surprise are indicative of temporary company problems that could be corrected with the next quarterly report.  The initial values for the new filter should be considered preliminary as they may need to be adjusted after testing.  Rather than employ extensive back testing on historical data, the new filter will simply be tested going forward.

 

 

Testing the Initial Filter

 

1.      Use the original stock candidate filter in rising market, as before, without any changes.  That is to trade oversold stocks long (buy call options) in up markets and sideways markets.  This part needs no testing.

 

2.      Compare the original Stock Candidate Filter with the new Down Market Candidate Filter in shorting overbought stocks (buying put options) in down markets and sideways markets.  This will be the primary test.

 

 

Market Analysis

 

            The industry leaders list contains the top 10 industries for four periods consisting of 1 week, 1 month, 2 months and 3 months.  Results are ranked highest to lowest based on the average percentage gain per week within any period times the number of appearances of an industry in the four top 10 lists. 

 

 Market Summary

 Week ending 01/22/05:

 Indices for the Week:

 Dow Jones     -1.6%

 NASDAQ        -2.6%

 S&P500 Index  -1.4%

 Russell 2000  -1.0%

 Industry Leaders:

 Real Estate Holding & Devel.

 Home Construction

 General Mining

 Tires

 Health Care Providers

 Tobacco

 Toys

 Steel

 Pipelines

 Full Line Insurance

 Hotels

 Medical Supplies

 Distillers and Vintners

 Food Producers

 Food Products

 Platinum and Precious Metals

 Drug Retailers

 Gold Mining

 Mining

 Food and Beverage

 Specialty Chemicals

 Coal

 Exploration & Production

 Gold for past 30 days:

 USD    -4.61%

 CAD    -4.23%

 CHF    -1.19%

 GBP    -0.67%

 EUR    -1.40%

 JPY    -5.23%

 

 

      The five week RSI for the major indices is neutral while the 5 day RSI is oversold. 

 

Table 1c

Sentiment Indicators 01/22/05

 

 

3.0 Procedure

 

      The following stock screens were generated with tools from AAII.  The short term trading filter used for Table 2a looks for optionable stocks whose percentage relative strength over the past 6 months is greater than 90%, EPS Growth over the past 12 months is greater than 80% and are within 5% of their 52 week high with a minimum price of $50.  An additional key column has been added to improve clarity for short term options.  When a trigger has been received, call or put options are supplied depending on the direction of trend as reflected by the respective positive or negative slope of the 30 day SMA. 

 

 

 

Key

 

 

 

 

 

 

Table 2a

Short Term Options (Original Stock Candidate Filter) as of   01/22/05

 

 

 

 

 

 

Table 2b

Experimental Down Market Candidate Filter (Short Term Options) as of   01/22/05

 

 

 

 

 

 

      The stock filter resulting in Table 2c is for the potential to write covered call options.  The only difference between screens for Tables 2a and 2c is that in 2c the maximum stock price is $20.  No new stocks filtered through the screen this week.  All are from previous weeks.  I bought CREAF and sold the Feb $15.00 covered call for $2.50.  The stock has since fallen back leaving me a tiny net positive gain.  This was not a great trade.  But the potential to write additional covered calls against the same stock after the February expiration offers some potential benefit.

 

 

 

 

Table 2c

Short Term Covered Call Writing Screen as of   01/22/05

 

 

 

      For the screen in Table 2d, the number of selections is reduced by eliminating stocks having P/E’s greater than 30.  No new stocks filtered through the screen this week.  Those highlighted in green are repeats from previous weeks.

 

Table 2d

Growth Momentum (Intermediate Term) Screen as of   01/22/05

 

 

 

 

      For the Peter Lynch screen in Table 2e, again the number of selections for this screen is reduced by eliminating stocks having P/E’s greater than 30.   FMST and MEDQ, which are traded on the Pink Sheets, were removed because of their light volume and the difficulty in confirming their PE ratios.  Although AIRT filtered through the screen this week, it lost 31% in the past 4 weeks and was removed, as well.

 

 

Table 2e

Peter Lynch Value  (Intermediate Term) Screen as of   01/22/05