Wiser Trader Stocks and Options Newsletter

Issue No. 5 – December 20, 2004

http://www.WiserTrader.com

James A. Andrews

1.0 Trading and Investing

Brief mention of differences between long term investing and short term trading are mentioned around the web site. It seems like a good idea to go into a little more detail since their rules and methods are often misapplied and yet can differ so dramatically. For far too long after I began trading, I used the terms investing and trading interchangeably. When one invests, one wants to take ownership of something that has continuously increasing value. When one trades, one capitalizes on temporary changes in the value of an instrument. This simple difference says much about the nature of the rules for both. Much of this information comes from an excellent class taught by Dr. Stephen Cooper. He believes that you should become wealthy in the markets both through long term investing and through short term trading at the same time. You should begin with long term investing. Once this is established, then open a second account for short term trading. Both his long term investing principles and short term trading methods can be found in http://www.wisertrader.com/tradingsystems/stockandoptiontrading.html. This will not be an exhaustive discussion but is intended to just highlight some important differences.

Long Term Investing

Following Dr. Cooper, long term investing can be defined as buying and holding an instrument for 5 years or more. The reason for this seemingly narrow definition is that when one invests long term, the idea is to “buy and hold” or “buy and forget”. In order to do this, it is necessary to take the emotions of greed and fear out of the equation. Mutual funds are favored because of they are professionally managed and they naturally diversify your investment over dozens or even hundreds of stocks. This does not mean just any mutual fund and it does not mean that one has to stay with the same mutual fund for the entire time. But it does imply that one stays within the investment class.

First, the fund in question should have at least a 5 or 10 year track record of proven annual gains. You should feel confident that the investment is reasonably safe. You are not continually watching the markets to take advantage of or to avoid short term ups and downs. You have a plan.

Second, performance of the instrument in question should be measured in terms of a well defined benchmark. One such benchmark is the S&P 500 Index that is an average of the performance of 500 of the largest and best performing stocks in the US markets. Looking back as far as the 1930’s, over any 5 year period the S&P 500 Index has gained in price about 96% of the time . This is quite remarkable. If one widens the window to 10 years, you find that over any 10 year period the Index has gained in price 100% of the time. The S&P500 Index has gained an average of 10.9% a year for the past 10 years. So this is the benchmark.

If one just invests in the S&P500 index, he can expect to earn, on average, about 10.9% a year. There are many ways to enter this kind of investment. One way is to buy the trading symbol SPY, which is an Exchange Traded Fund that tracks the S&P500 and trades just like a stock. Or, one can buy a mutual fund that tracks the S&P500, such as the Vanguard S&P 500 Index Fund with a trading symbol VFINX. There are others, as well. Yahoo has a mutual fund screener at http://screen.yahoo.com/funds.html that lists scores of mutual funds having annualized returns in excess of 20% over the past 5 years. However, you should also try to find a screener that gives performance for the past 10 years. If you find one, let us know. To put this into perspective, 90% of the 10,000 or so mutual funds that exist do not perform as well as the S&P500 each year.

The fact that 10.9% is average performance is all the more remarkable when one considers that the average bank deposit yield is less than 2%, 10 year Treasury yields are about 4.2% and 30 year Treasury yields are only 4.8%. Corporate bond yields approximate those of the S&P500. There is a reason for this disparity, though. Treasuries are considered the safest of all paper investments, being backed by the United States Government. FDIC regulated savings accounts are probably the next safest while stocks and corporate bonds are considered a bit more risky. Savings accounts are possibly the most liquid, followed by stocks and bonds.

To help you calibrate the safety and liquidity question, the long bond holders are comparing bond yields they now receive with next year’s anticipated stock yields. Consider that next year’s anticipated S&P500 yield is around 4.7% based on the reciprocal of the average price to earnings ratio (P/E) of 21.2. Yet the 10 year annualized return of the index has been 10.9%. Bond holders are prepared to accept half the historical yield of stocks for added safety and stability. In any given year, stocks may go either up or down. Bond yields are not expected to fluctuate widely from one year to the next, although they have been know to do so. It is as if bond holders want to be free to invest short term, as well as, long term. Many bond holders are thereby traders and not investors and accept a lower yield for this flexibility. But if one has decided once and for all that an investment is for the long term, high yield stock mutual funds or the S&P500 Index seem the best way to go. Using the simple compound interest formula, $10,000 invested in the S&P500 index for 25 years at 10.9% a year becomes $132,827.70. At 21%, the amount after 25 years is more than $1 million. If in addition to averaging 21%, one adds just $100 a month, the total amount after 25 years exceeds $1.8 million. Dr. Cooper rightly believes that 90% of one’s capital should be allocated over a several such investments.

Here is a formula to calculate the total amount of capital A one might expect to accumulate after n years at an annual fractional yield r based on an initial investment P at the beginning of the first year and subsequent annual deposits of d made at the beginning of each successive year.

Trading

Now that you’ve allocated 90% of your funds to long term investing, that leaves about 10% for trading. Short to intermediate term trading is an area that most of us are more familiar with, probably due to its popularity. Yet it is significantly more complex and only about 12% of traders are successful. The time frame for trading is less than 5 years and is more typically from a couple of minutes to a couple of years. The typical probability of being right in the direction of a trade approaches an average high of about 70% when you use an appropriate trading system to less than about 30% without a trading system.

Even at the low end of the spectrum, you can avoid catastrophe by managing the size of your trades to less than about 4% of your trading portfolio and limiting each loss to no more than 25% of any given trade while letting your winners run until they decrease by no more than 25% from their peak. These percentages can be increased after there’s evidence that the probability of choosing the correct direction of a trade has improved.

Intermediate term trading is based more on fundamental analysis which attempts to assign a value to a company’s stock based on its history of earnings, assets, cash flow, sales and any number of objective measures in relation to its current stock price. The objective is to buy a company’s stock at bargain prices and wait for the market to realize its value and bid up the price. When the stock is fairly priced, it is sold unless one sees continuing growth in the value of the stock, in which case he moves it over into the category of investing.

Since trading depends on the changing perceived value of a stock, your trading time frame should be chosen based on how well you are able detach yourself from the emotions of greed and fear. The better one can remove emotions from trading, the shorter the time frame he can successfully trade. On the other hand, when you feel surges of emotion before, during or immediately after a trade, it’s time to step back and consider choosing your trades more carefully and trading less frequently. One’s ability to remove emotions from trading takes a lot of practice. This is not just a macho or moral statement. An entire universe of what’s called technical analysis is based on the aggregate emotional behavior of traders and forms the basis of short term trading. Technical analysis is a study of the price and volume patterns of a stock over time.

A long list of technical indicators has evolved to describe the emotional behavior of the stock market. The lower level of confidence involved in trading is the reason for the large number of indicators used. Most technical indicators are based on moving averages over a predefined time period. Indicator time periods should be adjusted to fit the trading time frame. Two groups of indicators are listed below and linked to BigCharts.com for their definitions. The first group includes those that are plotted on a chart along with price data. The second group includes those that are plotted on a separate chart but on the same time scale as price data. These indicators have concise algebraic definitions which will eventually be added to the web site.

Technical Indicators plotted with price data

Technical Indicators plotted separately

% Compare

I can not begin to list the numerous rules of trading in this space. The subject is far too large to do it justice in less than several volumes of hard cover print. However, it should be clear that the difference between investing and trading lies in the time frame and one’s level of confidence in predicting the outcome. Long term investors may need to use only a long term moving average to track investments. As traders, we use multiple indicators since we deal with shorter time frames and higher risk.

2.0 Analysis

Major industries sustained their rally earlier in the week on economic news and merger activity and fell back on Thursday and Friday. Oil gained $5 to $46.50 a barrel and the Fed increased short term rates to 2.25%. The bond market fell this past week as the 10-year note yield rose to 4.20% from 4.15% at the close of last week. The dollar was little changed.

Market Summary

 Week ending 12/19/04:

 Indices for the Week:

 Dow Jones     +1.0%

 NASDAQ 100    +0.3%

 S&P500 Index  +0.5%

 Russel 2000   +1.6%

 Industry Leaders:

 Mining

 Coal

 Tires

 Steel

 Toys

 Lodging

 Pipelines

 Medical Supplies

 Consumer Electronics

 Home Construction

 Trans. Services

 Nonferrous Metals

 Tobacco

 Home Cons & Furnish

 Healthcare Providers

 Marine Transport

 Computers

 Tech Hardware & Equip

 Gold for past Month:

 USD    +0.16%

 CAD    +2.78%

 CHF    -2.72%

 GBP    -4.43%

 EUR    -3.08%

 JPY    -0.87%

As you may have noticed from the weekly market summary, there has been an evolving search to find a robust definition for leading industries. One can resort to relying on the “A” industry rating found in the financial press. It is most reliable. However, that rating system is proprietary and the engineer in me always wants to know how things are derived. The list above contains the top 10 industries for four periods consisting of 1 week, 1 month, 2 months and 3 months. Results above are ranked highest to lowest based on the average percentage gain per week times the number of times each industry appears in any of the four top 10 lists.

3.0 Procedure

The following stock screens were generated with tools from AAII. The short term trading screen used for Table 1a 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. Maximum P/E criteria was not used but a price minimum of $50 was added.

Table 1a

Short Term Options Screen as of 12/19/04

Symbol Company Sector Industry Option

ADSK Autodesk, Inc. Technology Software & Programming ADQ GN JUL 70.00 CALL

CLF Cleveland-Cliffs Inc. Basic Materials Metal Mining CLF GS JUL 95.00 CALL

MON Monsanto Company Basic Materials Chemical Manufacturing MON GJ JUL 50.00 CALL

NUE Nucor Corporation Basic Materials Iron & Steel NUE GJ JUL 50.00 CALL

POT Potash Corp./Saskatchewan (USA) Basic Materials Non-Metallic Mining POT FP JUN 80.00 CALL

TXI Texas Industries, Inc. Capital Goods Construction - Raw Materials TXI GL JUL 60.00 CALL

TXU TXU Corporation Utilities Electric Utilities TXU GL JUL 60.00 CALL

X United States Steel Corp. Basic Materials Iron & Steel X GJ JUL 50.00 CALL

The stock screen in Table 1b was added for the potential to write covered call options. The only difference between screens for Tables 1a and 1b are that in 1b the maximum stock price is $20.

Table 1b

Short Term Covered Call Writing Screen as of 12/19/04

Symbol Company Sector Industry Option

AKS AK Steel Holding Corporation Basic Materials Iron & Steel AKS AC JAN 15.00 CALL

MXT Metris Companies Inc. Financial Consumer Financial Services MXT AC JAN 15.00 CALL

OS Oregon Steel Mills, Inc. Basic Materials Iron & Steel OS AD JAN 20.00 CALL

PNK Pinnacle Entertainment Services Casinos & Gaming PNK AD JAN 20.00 CALL

SID Companhia Siderurgica Nacional (ADR) Basic Materials Iron & Steel SID AD JAN 20.00 CALL

VIRL Virage Logic Corporation Technology Semiconductors UVB AD JAN 20.00 CALL

Repeating the Growth Momentum and Peter Lynch screens from last week, a few stocks dropped out and some new ones were added. Selections resulting from the new screens were reduced by eliminating stocks having P/E’s greater than 30.

Table 1c

Growth Momentum (Intermediate Term) Screen as of 12/19/04

Symbol Company Sector Industry

ELBO Electronics Boutique Holdings Corp. Services Retail (Technology)

FBP First BanCorp. Financial Regional Banks

MOH Molina Healthcare, Inc. Financial Insurance (Accident & Health)

MSA Mine Safety Appliances Health Care Medical Equipment & Supplies

MTH Meritage Homes Corporation Capital Goods Construction Services

PVTB PrivateBancorp, Inc. Financial Regional Banks

TS Tenaris S.A. (ADR) Capital Goods Construction - Supplies and Fixtures

VIVO Meridian Bioscience, Inc. Health Care Biotechnology & Drugs

WIBC Wilshire Bancorp, Inc. Financial Regional Banks

Table 1d

Peter Lynch Value (Intermediate Term) Screen as of 12/19/04

Symbol Company Sector Industry

BLSC Bio-Logic Systems Corp. Health Care Medical Equipment & Supplies

CSLMF Consolidated Mercantile (USA) Basic Materials Containers & Packaging

CTEL City Telecom (H.K.) Limited (ADR) Services Communications Services

KEP Korea Electric Power Corporation (ADR) Utilities Electric Utilities

PCU Southern Peru Copper Corp (USA) Basic Materials Metal Mining

SHI Sinopec Shanghai Petrochemical Co. (ADR) Energy Oil & Gas Operations

TM Toyota Motor Corporation (ADR) Consumer Cyclical Auto & Truck Manufacturers

UGP Ultrapar Participacoes SA (ADR) Energy Oil & Gas Operations

VLCCF Knightsbridge Tankers Limited Transportation Water Transportation

4.0 Results

All positions were closed and no new positions were opened in spite of the watch list stocks performing reasonably well for the week.

Table 2

Stock Trades as of 12/19/04

Symbol Buy Date Buy Price Last Action P/L(%)

CREE 11/10 $37.10 $37.45 Sold 11/23 0.9%

UPL 11/12 $50.80 $52.90 Sold 11/23 4.1%

BTU 11/23 $78.96 $74.10 Sold 12/8 -6.2%

MDR 11/23 $16.39 $15.64 Sold 12/8 -4.6%

SWN 11/23 $52.31 $48.40 Sold 12/8 -7.5%

Table 3

Option Trades as of 12/19/04

Stock Option Buy Date Buy Price Last Action P/L(%)

URBN JUN 35.00 CALL 11/23 $11.50 $9.00 Sold 11/30 -21.7%

TXU APR 55.00 CALL 11/23 $11.30 $6.30 Sold 12/2 -44.2%

USG MAY 25.00 CALL 11/23 $8.40 $12.80 Sold 12/15 52.4%

5.0 Conclusion

The average portfolio P/L is -3.3%, with -2.6% for stocks and -4.5% for options.

Disclaimer: The trades discussed in this newsletter reflect an actual personal portfolio. The newsletter is for information only and should not be considered advice to trade specific stocks. While it is believed that the information posted is factual, mistakes can be made in transcribing the numbers. Investors should trade stocks only after verifying this information with other sources and consulting with their broker or a licensed adviser.

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