Early in this experimental stage, I tried several charting techniques, but eventually found that because they were too “black magic” and did not satisfy my rational side, I did not have the confidence to take large positions with them. Eventually, I found two technical factors that were backed up by academic studies and grounded in human psychology. Firstly, the stock market overeacts to events, and corrections and pullbacks occur with a greater than normal probability. However, I found that this mean reversion effect takes place over time frames of only 1-2 days, and is really suited for automated trading rather than human trading. Secondly, runs in the stock market occur with greater length and frequency than a random walk, a phenomenon called the momentum which has been attributed to many causes, including the the herding tendency of investors and to institutional investors moving prices when they enter or exit a stock. The momentum effect is most pronounced on small cap stocks, suggesting that the role of institutional investors is dominant. I figured that if I could try and spot stocks which are starting a trend, and then use manual fundamental analysis to figure out a plausible investment thesis and thus predict where the price is headed, I could hop onto stocks just when they are making a move, and then switch to other stocks once the move is finished, maximizing my returns.

For the past 3 months, I have used a strategy where I screen stocks with the ADX technical indicator to identify stocks which are in a new uptrend or downtrend, and then manually go through them to pick out the stocks where a plausible investment thesis exists. Often, I find that due to my fundamental analysis, I am able to predict quite accurately what price level the stock is moving to (stock prices often move to round PE values). This strategy, executed in the context of a rising market, has resulted in my outperforming the stock market by a significant margin. I found that if I cut my losses within 1 month if the stock doesn’t move as I predicted and let my winners run to my anticipated targets, my profits vastly exceed my losses despite the fact that I have only a 60-70% chance of picking winners.

Because I am not a long term stock holder with this strategy, and to keep my workload reasonable, my analysis of each stock will necessarily be much shorter and shallower than my previous analyses. In the future, I will be presenting my analyses as short blurbs about specific stocks instead of the more in-depth articles that I have been writing. I also intend to devote susbtantial time to the study of human psychology and how it interacts with the stock market to present opportunities that can be taken advantage of.

In the 2 months that I’ve tried this strategy, it has been modestly profitable, with gains outnumbering losses by approximately 5 to 1. And for the first time in a long while, I am finally beginning to outperform the index modestly. I have learnt several lessons.

1. There is no shortcut for fundamental research. One of my first speculative plays was Citigroup; I was unable to estimate an intrinsic value, yet decided to hold a small position. C promptly gapped through my protective stop. Thus, stops may fail, and there is really no substitute for gaining in-depth knowledge about your stocks.
2. Be equally willing to take gains and losses. Initially, I was risk averse and was quick to sell when stocks breached my support levels, but slow to take gains when they rose above resistance levels. Eventually, I found that I was taking losses repeatedly yet taking very few gains. I promptly readjusted my strategy, and everything has been okay since.
3. Monitor your strategy constantly. The greatest advantage of short-term trading over long-term buy-and-hold is that feedback is continuous. Therefore, you quickly gain an instinctive feel for what works and what does not. I also feel strongly that a trading strategy should be supported by an overall thesis (macroeconomic or otherwise). For example, I engage in channel trading because I do not think stocks are likely to make large moves upwards or downwards due to the uncertain economic climate. Once economic recovery begins in earnest, I expect the channel-trading strategy to begin to underperform a buy-and-hold strategy, and will adjust my strategy accordingly.
4. Adjust support and resistance levels proactively. The advantage of a channel-trading strategy is that one can adjust the support and resistance levels constantly, even proactively to anticipate as yet unestablished levels. I realized this when I discovered that several of my best stock ideas (GEOY, MOS, AMTD) were making higher lows and higher highs over a few months, and when I stuck to the previously established lows and highs, I was consistently missing much of the move. I decided to estimate and anticipate the constant rise in both support and resistance levels, and have done better since. Interestingly, I found that as long as the volatility is large enough, channel trading outperforms buy-and-hold after trading expenses even if the underlying stock is on a long-term uptrend. Of course, I will immediately cease to channel-trade a stock if it is approaching my estimate of its intrinsic value.

In summary, it has been educational, and its good to be making money again after the devastation that was 2008.

The experiences of many retail investors during the recent financial crisis suggest that the answer is “no”. It has been revealed that investment advisors (IAs) sold retail investors securities that were inappropriate for their risk profiles. For example, retirees were sold Lehman bonds and auction rate securities. The IAs and finance professionals involved were either incompetent, and did not understand the risks involved, or criminal, and did not care about the risks involved. In addition, retail investors lusted after higher yields and deliberately bypassed the more conservative and intelligent IAs, and other less competent but more morally flexible IAs stepped in to satisfy their needs. I remember an analagous situation which happened to a neighbour. She was given a diagnosis of breast cancer from her family doctor, but in a state of shock, she requested a second opinion from another doctor. The second doctor told her that it was a benign cyst, and she was relieved and put off further treatment and investigation. A year later, the cancer had metastasized, and she had to undergo aggressive chemotherapy. In both medicine and finance, human psychology coupled with bad incentives lead to unfortunate results. IAs and doctors are both paid on a commission basis; their income is entirely dependent on the number of trades/procedures their clients undertake. Ironically, if they provided advice that actually improved their clients’ physical and financial health, their income will go down. Furthermore, doing the appropriate things to improve one’s physical and financial health is often psychologically distasteful (think exercise and saving), and the market is always ready to provide painless free-lunch type solutions from less scrupulous practioners. Human psychology and market forces virtually dictate that IAs and doctors will give bad advice.

This is why I strongly advocate self-sufficiency in the areas of personal physical and financial health. You should know whether you are in reasonably good physical shape for your age group. You should understand the main causes of death for your age group (for middle-aged men, the top 3 causes are heart disease, cancers, and stroke), and how to minimize your risks. You should know the amount you require for a reasonable living standard after retirement and to fund your children’s education, as well as how likely you are to get to that amount given current income and expenditure growth rates. These are all important but scary questions, and it is likely that no doctor or IA will take the initiative to broach them with you, because they know that scared clients tend to leave. And that is why you should take matters into your own hands.

In this context then, the hysteria over the rapidly sinking Citigroup stock seems initially puzzling. After all, Citigroup, with an impressive array of assets (branches in multiple countries and the Smith Barney brokerage chain) and a cash flow of some $3-4 annually, cannot be worth only one times cash flow. Even if Citi’s cash flow is to shrink by 90% in the coming years and all of its assets are to be marked down to zero, then Citigroup’s current $4 stock price may still be a slight undervaluation of its intrinsic value. The above analysis, however, disregards the fundamental unstable nature of a banking business model. Banks borrow short to lend long, and in so doing perform several valuable economic activities, including allowing depositors to pool their capital to fund productive businesses, and allowing consumers to borrow against future income for current investment. This business model is intrinsically unstable, because all depositors realize that if everyone were to demand their deposits back, the bank would be unable to call back all its loans immediately, and so relies on confidence on the part of depositors in the future viability of the bank. Even in this age of FDIC deposit insurance, a bank’s business can be seriously compromised if sufficient numbers of counterparties withdraw their business or funding, or if Citigroup was forced into fire sales of assets in the current climate. While everyone agrees that an outright bank run will be immediately halted by the government (either with unlimited liquidity from the Fed or with the Treasury making a capital injection), the prospect of possible massive dilution of common shares by the government makes the declining share price a self-reinforcing phenomenon. The root of the problem is that the public believes that the stock price is an accurate predictor of a company’s future (“the stock dropped by 80%, something must be wrong”), and confidence is a precious resource to a bank.

In fact, confidence is a necessary component of a variety of business models. While I do not care whether the company I buy my chicken or airline ticket from is in existence tomorrow, I certainly do want the company I buy my insurance or car from to be viable and in existence in the future. For a subset of companies in the stock market, a plummeting share price does indeed affect their underlying business by decreasing the public’s confidence in the companies. These companies are especially susceptible to attacks from short-sellers. Because their businesses can be destroyed by loss of confidence, their stocks will decline to liquidation value once under attack, leading to the needless destruction of productive businesses.

I would like to state here that I am generally in favor of the practice of short-selling. Short-selling provides several useful functions. Firstly, it curbs fradulent IPOs out to bilk the public of their cash. Secondly, many short-sellers see impending problems in a business and provide a useful signal to the public by shorting stocks, thus limiting financial damage to the investing public. Thirdly, shorting is a necessary form of hedging in the stock market, and the availability of strategies involving shorting invites more participants to the market, increasing its liquidity to the benefit of all. However, in the current fearful climate, unscrupulous short-sellers are just out hunting for vulnerable targets, and concentrate their firepower on the weakest of the herd one at a time (ever wonder why banks fail sequentially rather than all at once?). The attacks on banks and insurance companies have an especially corrosive effect on the general economy. Banks are obviously required to finance new businesses, and a vast swath of economic activities require insurance, including sale of bonds and shipping of goods on container ships. While I do not have a good answer to this problem (limiting short-selling to certain times or certain companies seems too arbitrary and would provide too many loop-holes), I suspect that curbing the more undesirable aspects of short-selling will be high on the Geithner’s list of regulatory reforms.

As regards Citigroup, I suspect the authorities will maintain a careful watch for any run on Citi, stepping in to halt a run if they have to. If the government does indeed provide financial backing for Citigroup to halt a run, politics will require that the government take some form of equity stake to gain a profit on the upside. I hope that the government will consider taking only a modest stake in order to minimize dilution of existing shareholders. The threat of massive dilution by the government is part of what is causing the fall in many bank stocks, and by sharply moderating that threat, the government can discourage further short-selling attacks on other banks.

Disclaimer : I do not hold any shares in Citigroup.

• The weekend effect : The mean return from buying stocks on Friday and selling them on Monday is larger than buying stocks on Monday and selling on Friday. This is especially unusual since the Mon-Fri period spans 4 days and entail more risk than the Fri-Mon 3 day period. This effect is usually explained by short-term traders dumping stocks on Friday to avoid holding them over the weekend, and retail investors doing their research over the weekends and placing buy orders on Monday.
• The year-end effect : Stock prices tend to drop in the last days of December due to tax loss selling and portfolio window-dressing by professional managers selling losing stocks. The drop is rapidly reversed in January with many investors “wiping the slate clean” in their minds and placing new buy orders, and professional managers re-purchasing the same stocks they sold in December.
• The October effect : Many of the most severe stock market declines have occurred in October, including the Panic of 1907 (Oct 1907), the Great Depression (starting Oct 1929), Black Monday (Oct 1987), and the Panic of 2008 (Oct 2008).

The October effect is also known as the Mark Twain effect, which comes from the following quotation in Twain’s novel Pudd’nhead Wilson : “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

In general, these calendar effects have become much less consistent since their publication, and have tended to shift into adjacent days/months as traders take advantage of them. Most academic studies now agree that it is difficult to systematically take advantage of these effects today. However, it seems to me that in general, the autumn months are bad for stocks. There is something about the turning of the seasons and the falling of the leaves that makes greed wane and makes fear wax and brings on seasonal affect disorder. I think that there truly is a greater-than average chance of a black swan event in the autumn months due to the physiology of humans. The only recent significant decline in the stock market that has not happened in autumn is the bursting of the dot-com bubble, which happened in March 2000, and even that was a very gradual decline. Of course, I realize that I may be subject to the proximity effect, which makes more recent events seem more significant, but you can bet that when the next autumn rolls around, I’ll be scouting for some cheap put options to tide me through those months.

It is in these times that one gains a better understanding of oneself. I am an investor, not a trader. I will not attempt to out-trade the traders. I invest only with money that I do not need now, and am able tolerate even dramatic short-term losses and ride out the storm. I focus on fundamentals and businesses that I can comprehend, because this gives me the intellectual and emotional strength to hold on despite the losses. Investors in Charlie Munger’s partnership saw the value of their holdings decrease about 53% over 1973-74. In fact, for the first years of Munger’s investing life ending in 1974, an investment in his partnership would have yielded a return of just above zero, or a negative return after taking into account management fees. Several of Munger’s investors chose to liquidate in 1974 (despite Munger’s strong pleas), thus seeing their investments halved from 1972 to 1974, while missing out on the 73% gain in 1975. Fortunately, more than 95% of Munger’s investors stayed on with him through those tough years, and when Munger liquidated his partnership, these investors enjoyed a 24% compounded return over 14 years, even through the 1973-74 period. That downturn prompted the following quote from Munger :

“If you, like me, lived through 1973-74 or even the early 1990s… There was a waiting list to get OUT of the country club — that’s when you know things are tough. If you live long enough, you’ll see it.”

I’ve not lived as long as Munger, but I think I’ve seen it.

Notwithstanding the danger of sounding naive, I’ll close with the following optimistic observations. Yes, we may be headed for or already in a recession, but a prolonged depression is not going to happen. After over-consuming for the past decade, Americans should and can learn to consume less and save/produce more, and give citizens of the developing economies the chance to pick up the slack in global demand and increase their own living standards. One cannot expect foreigners to continue to produce goods for the US at subsistence wages in perpetuity. Therefore a little inflation and currency devaluation is the market’s way of correcting past excesses and paving the way for a new era of American exports. The increase in commodity prices is the market’s way of telling us to stop wasting non-renewable resources and start developing better sources of energy. America, with its dynamic and innovative economy and leading the world in technological expertise, should be able to rise to the challenge of a more balanced global economy and more expensive energy. And picking the correct stocks during this readjustment period should yield good returns, not to mention channeling capital towards the companies and industries most appropriate for this new era.

Is it feasible to beat market professionals at fundamental analysis? A popular argument is that many mutual fund managers are closet-indexers and have a follow-the-herd mentality, and do not dare to take contrarian positions. This argument is increasingly untrue today. The modern hedge fund manager is typically a major shareholder in this own fund, and stands to gain much more from performance bonuses than from asset fees, and hence is heavily incentivized to take contrarian positions. Large funds have the resources to employ analysts to collect and analyze public information, as well as generate non-public information about business and industry conditions by calling up suppliers and clients and doing their own in-house research. Furthermore, there are theoretical limits to fundamental analysis, and technological breakthroughs and other Black Swan events are essentially unpredictable. Faced with these obstacles, I think that it is hubris to assume that I can outperform the professionals in the large- and mid-cap stocks. My greatest chance is probably in the small-cap stocks, especially those that have analyst coverage.

Does active trading hurt or help? The traditional arguments against over-trading is the drag of trading commissions and tax inefficiency. In practice however, I find that these factors are overwhelmingly outweighed by the investment gains involved. In a retrospective analysis of my stock holdings, I found that in most of my losing positions, I was at one time up more than 20%, and if I had aggressively booked my profits, or cut my losses when I was down 10% or more, I would be a far better shape today investment-wise. A more serious drawback is that over-trading may cause me to liquidate a potential ten- or twenty-bagger long before it reaches its full potential (in his book, DePorre hints that this is the major drawback of his strategy). However, in practice, such situations are extremely rate, and even professional fund managers manage to find only a couple of these multi-baggers in their entire career. I am increasingly convinced that my problem is not over-trading, but under-trading.

I have decided to start experimenting with a more active trading approach. I am not going to completely abandon my fundamental value-investing roots. Fundamental analysis and value investing appeal strongly to my rational side. However, I have acquired a newfound respect for the ability of technical analysis to reveal market psychology. I will attempt to overlay technical analysis on my fundamental analysis, concentrating on small-cap stocks, which have a higher chance of being mispriced because they are both under-researched and their trading is dominated by small investors who are more prone to psychological snafus (and I might be one of those investors!). More importantly, I will adopt a more rigorous money management approach to mitigate the greater risk involved in holding small-cap stocks. An attractive aspect of the short-term investing approach is the speed of feedback. I expect to give an update to this approach in a few months.

Buffett has often pooh-poofed the idea that diversification decreases risk, and has repeatedly stated that risk is abolished by deep knowledge about the company and the industry. Professional value investors range from an ultra-concentrated style (fewer than 10 stocks, with large positions comprising 25% of portfolio or more, notable practitioners include Eddie Lampert and Tom Brown), to the concentrated 10-stock model (popularized by Monish Pabrai), to the traditional moderately diversified 20-stock model (Bill Miller and pretty much the rest of the value investor universe). I think that small investors without billions to invest should be able to choose from a far larger universe of stocks than Buffett is able to, therefore small investors should always be reasonably diversified. I frequently come across ideas not worthy of large position sizes, and in the past has just passed on them. But recently, I am beginning to think that many small positions in the aggregate may provide a beneficial boost to my return, as long as each individual small position has a reasonable margin of safety. (Given the recent disastrous disintegration of one of my oversized positions, I am only being wise after the fact here.) Interestingly, Buffett has recently been touting the advantages of index funds for retail investors, which of course is the ultimate in diversification.

Buffett has also typically frowned upon high turnover in a portfolio. The typical argument is that high turnover runs up transaction costs and is tax-inefficient. With the discount brokers today, transaction costs are insignificant even for a portfolio of several thousand dollars. If one has a 20-position portfolio and holds each position for slightly more than one year to gain preferential tax treatment, that implies a turnover rate of 1-2 per month. I think that as long as high quality ideas can be found, high turnover need not necessarily reflect bad investing habits. The value of turnover in cutting one’s losses from the inevitable mistakes, and in maximizing return by constantly replacing stocks approaching their intrinsic value with more undervalued ones, should not be underestimated. Buffett, of course, does not have the luxury of high turnover. Given his capitalization, he cannot simply exit one of his positions on a whim and wait for a more advantageous price to re-enter. However, he does have the luxury of calling up the CEO and demanding a change in strategy, or just stepping in and managing the company himself (as he has done on rare occasions, most notably at Salomon). Large and small investors have different sets of advantages. The ability to enter and exit positions rapidly is an important advantage which should not be ignored.

I am only recently trying to put these ideas into practice, starting with increasing my portfolio to 20-30 positions, and stepping up the turnover. While I think this concept is theoretically attractive, in practice it is exhausting. Therefore, I’ll be grateful if you can toss me a few ideas to help me along.