______________________________________________________________________________
Issue No. 49 – October 24, 2005 Prescott, Arizona Systems@WiserTrader.com
______________________________________________________________________________
1.0 Trading
Recent discussions on the relationship between value indicators and subsequent 52 week price gains have assumed a buy and hold strategy. This assumption is not unreasonable for value stocks. However, it is interesting to compare the buy and hold approach with stock gains based on the use of a stop loss. The first value indicator used for this comparison is price to free cash flow per share (P-FCF).
1.1 Price to Free Cash Flow
The amount of free cash flow measures the ability of a company to increase dividends, develop new products, enter new markets, pay off liabilities, buy back shares, and even become an acquisition target. P-FCF values of less than about 10 indicate that a company generates sufficient cash to finance buying back all of its shares based on prevailing interest rates.
The analysis involved NYSE, NASDAQ and AMEX stocks priced above $4 that had easily accessible data on earnings, book value, sales and return on equity. Advanced Depository Receipts, Over the Counter Stocks and Exchange Traded Funds were excluded. Information was available for the group of about 2,000 stocks shown in Figure 1.
As expected, Figure 1 shows that the risk of negative gains was lowest for stocks having P-FCF of 5 or less. The trend of increasing gains with increasing values of P-FCF can be attributed to stocks being bid to higher prices over time with some being growth and momentum stocks. After all, the chart represents a general universe of stocks for which no stop loss settings were used. A question about the effect of year ago valuations on current prices is the path that prices have taken to reach their present values. In some cases prices dip below levels of prudent risk before rising well above their starting values. In such cases the use of a stop loss actually curtails profits in the process of reducing risk. In other cases the use of a stop loss is well worth the capital preservation when prices decline continuously and fail to recover.
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser. Desert Mountain Systems markets third party trading systems but has no other affiliation with trading system companies.
FIGURE 1
Since a large percentage of price movement can be attributed to behavior of the major averages, the NASDAQ, along with the DOW and S&P 500 for the past year, are plotted in Figure 2. The developing double top formation implies that many stocks that were stopped out by May of this year have since recovered and gone on to rise higher by August.
FIGURE 2
For this historical market environment, the effects of using 10% and 25% stop loss settings are shown in Figures 3 and 4. A 10% stop loss actually increased the risk of loss for P-FCF values of 5 or less while a 25% stop loss reduced the risk of loss.
FIGURE 3
FIGURE 4
This is counter intuitive until one takes the past year market behavior of Figure 2 into account. The average percentage gain after one year is shown in Table 1. Stocks are broken out into those having P-FCF above 10 and below 5 to compare the effects of using stop loss settings of 10, 25 and 40%.
Table 1
Average Percent Gains for Stocks Having P-FCF Values Above 10 and Below 5
|
Month |
% Gain at Month’s End Using no stops |
% Gain at Year’s End Using 10% stop loss |
% Gain at Year’s End Using 25% stop loss |
% Gain at Year’s End Using 40% stop loss |
||||
|
P-FCF >10 |
P-FCF <5 |
P-FCF >10 |
P-FCF <5 |
P-FCF >10 |
P-FCF <5 |
P-FCF >10 |
P-FCF <5 |
|
|
1 |
7.93 |
10.58 |
10.80 |
15.34 |
13.95 |
17.99 |
15.9 |
20.65 |
|
2 |
12.17 |
15.44 |
||||||
|
3 |
9.16 |
12.33 |
||||||
|
4 |
11.36 |
14.53 |
||||||
|
5 |
9.66 |
11.82 |
||||||
|
6 |
4.53 |
9.14 |
||||||
|
7 |
11.14 |
14.30 |
||||||
|
8 |
13.65 |
17.81 |
||||||
|
9 |
20.11 |
22.38 |
||||||
|
10 |
17.88 |
21.27 |
||||||
|
11 |
18.28 |
22.60 |
||||||
|
12 |
16.86 |
20.21 |
||||||
|
Avg. Month stop was triggered |
5th month |
7th month |
8th month |
|||||
|
Stocks stopped out by year end |
85% |
38% |
14% |
|||||
For the double top formation being formed by the major averages over the past year, the benefit of using stop losses was marginal at best and detrimental when the stop loss was defined too narrowly. The technical formation being formed by the major averages is a special case. But this is just the kind of relationship I needed to explain how too narrow a stop loss setting has been detrimental, causing excessive trading where profits were consumed by excessive broker fees. A similar result can be expected for each of the value metrics that have been recently discussed. Growth and momentum metrics will probably behave differently because higher profits per trade are expected over a short span of time.
Price to free cash flow is an important valuation metric. The percentages of stocks in Figures 1, 3 and 4 can be treated as probabilities of price gains for P-FCF ranges over the past year only. How investors evaluate stocks changes from year to year and accounts for a large portion of annual changes in the character of the market. The technical character of the major averages is another strong factor.
Once again it is good to keep in mind that long term fundamentals are inappropriate for short term trading. Next week will begin to look at trial formulations of stock filters that combine various metrics that were recently discussed.
2.0 Market Analysis
Choppiness continues as investors switch between concerns over inflation, relatively good earnings reports and the occasional earnings warnings that appear to be consistent with historical norms. At least one more week of choppiness can be expected.
Key industry ETF’s in Table 2A are Biotech and Semiconductors which confirm the NASDAQ. Transportation confirms the Dow Jones Industrial Average according to Dow Theory. Banking and Financials are confirming indicators for the S&P 500. Gold and Real Estate are respective indicators for the inverse health of the currency and the capacity for consumer spending.
Table 2A
Index Tracking Stocks, Key Industry ETF’s and Sector SPDR’s
|
|
1 month |
1 wk ago |
2 wks ago |
3 wks ago |
4 wks ago |
|
DIA (DOW) |
-1.9% |
-0.7% |
-0.1% |
-2.6% |
1.6% |
|
QQQQ (NASDAQ 100) |
-0.5% |
1.3% |
-0.7% |
-2.8% |
1.8% |
|
SPY (S&P 500) |
-2.7% |
-0.5% |
-0.8% |
-2.8% |
1.3% |
|
IWM (Russell 2000) |
-3.3% |
0.2% |
-1.9% |
-3.4% |
1.9% |
|
GLD, GOLD |
0.5% |
-0.6% |
-1.2% |
1.4% |
0.9% |
|
RKH, Banking |
0.6% |
2.0% |
0.4% |
-0.9% |
-0.9% |
|
IYT, Transportation |
0.5% |
-0.4% |
-0.8% |
-1.5% |
3.1% |
|
SMH, Semiconductors |
-4.1% |
0.8% |
-2.8% |
-4.0% |
2.0% |
|
BBH, Biotechnology |
-3.9% |
-0.8% |
1.2% |
-3.5% |
-0.9% |
|
IYR, Real Estate |
-3.3% |
0.0% |
-1.3% |
-4.4% |
2.5% |
|
OIH, Oil |
-9.0% |
-2.5% |
-1.8% |
-8.0% |
3.3% |
|
XLE, Energy |
-12.4% |
-4.8% |
-2.4% |
-7.7% |
2.1% |
|
XLU, Utilities |
-7.1% |
-1.7% |
-4.4% |
-4.0% |
2.8% |
|
XLB, Materials |
-2.1% |
0.8% |
-1.0% |
-3.3% |
1.6% |
|
XLI, Industrial |
-1.5% |
-1.1% |
-0.6% |
-1.2% |
1.4% |
|
XLK, Technology |
-1.9% |
0.8% |
-1.0% |
-3.3% |
1.6% |
|
XLV, Healthcare |
-3.9% |
-1.9% |
0.2% |
-1.9% |
-0.4% |
|
XLF, Financials |
0.0% |
1.0% |
-0.2% |
-1.3% |
0.6% |
|
XLP, Consumer Staples |
0.6% |
0.5% |
-0.4% |
-1.9% |
2.4% |
|
XLY, Consumer Discretionary |
-3.1% |
-0.4% |
-1.0% |
-2.4% |
0.6% |
