A Good Intermediate-Term Strategy
This Strategy Can Be Adjusted for Different Holding Periods
One of our old strategies for intermediate-term investors required that 500 stocks be reviewed once each week to see which have the most attractive patterns (We actually used this approach for clients at one time). Our weekly review enabled us to become acquainted with the evolving pattern of each stock and also to develop a “watch list” of potential purchase candidates in the event of a sale. Then we would review the fundamentals of each candidate. The stocks selected were all tracked by The Valuator (stocks included in the publication are more thoroughly vetted than a random list of stocks) so that publication was a primary resource for our evaluations. We then analyzed each chart to determine where the last significant sell-off occurred (sell-offs were analyzed sequentially backwards in time and with manual computations until we found the most recent “significant” one). We used the percentage drop of that sell-off as an indication of where our stop-loss would have to be. From this, we computed the maximum price we could pay for the stock in order to keep losses under tight control should we have to sell.
This model uses several valuation measurements for each stock. They are the RAM, the Historical Valuation model, the PE-ratio, and the PE to Earnings Growth Rate or PEG-Ratio. The Valuator, provides each of these measurements for each of about 500 stocks. The four scores are also combined into a composite valuation score and the composite scores are ranked for all stocks. The composite score rank for each stock is given in the “Value Rank” column of The Valuator, and the “best values” for the money are listed. The Valuator spreadsheet (available by subscription) can be sorted by “Value Rank” as well as by each of the other metrics in the columns. Only the top half in “Value Rank” are considered to be potential candidates. Then, three velocity measurements are made for each stock (covering three different time periods) and each stock is ranked relative to the corresponding velocity measurement for each of the other 500 stocks. A composite of the velocity measurements is made (this is the “Velocity Rank” in The Valuator) and then the stocks remaining after the value cut are ranked by their composite velocity scores. So far, the investor sorts once by “Value Rank,” and selects the top half. Then he sorts again by “Velocity Rank” so that those with the highest and most consistent growth velocity rates appear at the top of the list. At this stage, we limited the list of candidates to the top 100 or fewer. Valuation scores, growth velocity, stop-loss requirements, price and volume patterns, and various technical measurements are considerations as the list is narrowed down to a final “target list.”
For the stop loss, a person could use the four-week rule. The “Four Week Rule” has proven itself in the trenches for years. The premise underlying the strategy is that if a stock drops enough to fall below its lowest point during the last four weeks, then it is probably changing direction. The simplicity of this approach cuts down on computation time. Please note that The Valuator gives the 20-day (4-week) low for all 500 stocks. An investor could set the stop .30 below the 20-day low. There is nothing magical about the .30. The point is to find the lowest point reached by a stock during the last four weeks and subtract from that low a certain small amount or percentage. [Insert: When this was written, stocks traded in eighths of a point, and .30 below the 20-day low would have been appropriate for a $50 stock at that time. It would be better to think in terms of 6/10 of 1% rather than 30 cents. For a $5 stock, .30 would be much too large an amount to be practical. Also, the basic idea behind the .30 was that specialists sometimes “gunned” a stock in order to trigger stop losses. However, this can be checked easily by reviewing the behavior of the stock around a rising trendline. If the stock repeatedly penetrates the trendline on intra-day spikes, then you know that the extra protection is necessary. If not, then using the 20-day low minus a few pennies should work fine.] This is definitely NOT as effective as using the Stops tool, but it will help protect assets.
This stop-loss strategy is like any asset-protection system in that it can generate false sell signals. That is, the stock may drop enough to cause the stop-loss to be triggered. Then, after the stock has been sold, it may turn around and resume its climb. Though this will make a person feel foolish for selling, that is the nature of all protective strategies, and in this market, especially, a person should always use self-protective measures, even at the risk of feeling foolish at times. The amount of time can be varied from the four-week standard to increase or decrease sensitivity. This approach is very loosely related to the actual price action and volatility of the stock in question. It is not simply a random percentage (15%, 10%, 8%, or some other set figure) that some investors “pull out of the sky.” However, it does not automatically and immediately adjust for the changing volatility of the stock as the Stops tool does. The use of 4-weeks or 20-days may not be the best time frame to use for a given stock. The Stops tool more accurately adapts itself to each stock’s own volatility.
Next review only the top 100 (or fewer) candidates to make sure their patterns are really attractive and timely and to verify that the stock’s behavior is not too wild for the stop-loss procedure being used (stocks that swing wildly should be rejected). Some stocks climb steadily and rarely sell-off. Using the old method of determining our stop-loss points, we could never buy these steady climbers because they have no nearby significant support (other than the trendline itself). A good stop-loss model will not allow a person to buy without a predetermined stop-loss point. This method, on the other hand, can give a person the prospect of “catching a ride” on one of these stocks. For example, using the standard four-week approach today on a 500-stock universe, the average stock would have a stop-loss about 7.5% below current levels. Because we want the maximum negative impact of any stock to be limited to 1% of the portfolio, the maximum stop-loss distance permitted for a portfolio of 15 stocks would be 15% (a portfolio of 10 stocks could tolerate no more than a 10% drop for a single stock, and a portfolio of 8 stocks could tolerate no more than an 8% drop for any single stock). This means a person could use the four-week procedure to determine stop-losses, but he will have to reject any stocks that require a stop-loss that will impact the portfolio more than 1% for any single position. Obviously, many positions will have much tighter stops than that because they will have 4-week lows that are much closer to present prices. The weakness of the strategy is that stocks climbing at a high angle of ascent will have stops that are a greater distance below current prices. The Stops tool can automatically factor in this aspect of price behavior. So, a person could use the strategy for stock selection and use the Stops tool for determining the sell point or the stop-loss. ~ Dr. Felt
Notice: The Valuator has been changed. The main change is its new approach to “value.” “Fair Value” has been replaced by “Center of Gravity.”