A weekly newsletter based on the fact that stock market sectors are made up of industries, that industries are made up of individual stocks, and that individual stocks in the same industries and sectors move as a group. The proven best way to profit from the stock market is to keep your funds invested in the stocks of top performing sectors/industries at all times, and the best measurement of performance of these sectors/industries is their price movement over the previous six months. Below you will find commentary of Sectors, Industries, and Stocks based on the most recent 6-month period as well as updates on the past week’s action...

October 27, 2006

The Three Bears 

LR: Storytime again?

JRR: My guess would be it's about Richard Russell, Bill Bonner, and Bob Prechter. Right?

TM: You're both wrong. Let's discuss the three bearish risks in the market, and how The Simplespread Strategy deals with each.  
LR: Losing money - that's the major risk. The one-and-only.

TM: But that one major risk can be split into three separate risks which we address here at The Simplespread Institute: the market or systemic risk, the industry risk, and the company-specific risk. As you know, things can go badly with the general investment environment, the specific factors affecting a whole industry, or concerns with a company individually.

JRR: Which is most important?

TM: All three are part of the puzzle, but research done over the past five decades shows that about 50% of the influence on a stock comes from the industry it's in, about 30% comes from the general market, and that leaves about 20% allocated to company-specific factors. So, the answer as to which is most important would be the industry.

LR: But in 80 Rules, you begin with the industry, then you progress to the individual stock, and then finally to the market as a whole. So you don't go by risk priority?

TM: True. I do that because that's the easiest way to perform the computerized calculations as you filter your way down to the handful of potential candidates. Of course software is changing almost daily, so it depends upon which vendor's product you're using and how you want to do it. But basically, these are the three factors. How you prioritize them is up to you. And, I might add, there are times when maybe one way works better than another, and vice versa.

JRR: Well, then I would say that an industry's strong relative strength must be the safe haven for industry risk because that is so much a part of our weekly discussions here.

TM: Right. Sectors, or the industries they consist of, have a habit of moving in a type of unison. Some do better than others, but there is definitely a synergy there. Energy stocks usually move together. So do the metals. And so does construction. And also transportation. As you can see, the four sectors that I've mentioned are affected by the macro factors - government fiscal and administrative policies, geopolitical rumblings, availability of land, labor, and capital, and so on.
Other sectors and industries which are more individually affected by outside factors may not have as much cohesiveness, but they all have similarities that tie together enough to treat them as a group. And the safest place to have your funds invested is in the strongest industries as measured by past performance. Winners keep on winning.

LR: But if you were rating the three risks as to making an investment decision, you would look at industry strength first, then the trend of the major average, and finally the individual stock?

TM: That's one way to do it, and it can be implemented as you say. However, you can switch the selection process around to suit yourself. The filtering process using the computer can do it quickly. For our purposes here, I think it is better to rank them on the basis of which is most trustworthy over time. By that, I mean the individual chart pattern is the most important. Support is the foundation upon which the Simplespread Strategy rests. There's an old saying on the street that it's better to buy a bad stock at the right price than a good stock at the wrong price. Support is the "good" price, and simply jumps out of the chart right into your face. You can't miss it. It works for stocks, commodities, interest rates, and all traded entities. It's driven by human psychology as is outlined in Rule 51.

JRR: But support is not sufficient to make a Simplespread investment decision.

TM: No. Although support, by itself, would probably be a successful strategy over time, we can add more filters to reduce our risk. Buying stocks at an area of support reduces the risk of the stock, but not the industry or the market.

JRR: So, in calculating industry strength, the best time period is 6-month relative strength? Why not 52-week, or 9-month, or even 3-month? 

TM: Because a great deal of research has been done over the past 40 years on which time period is most representative of market performance. You can argue the point, certainly. And I continually play with the different time periods, but keep coming back to 6 months. Additionally, since we advocate selling 3 to 6 month calls against stocks you buy, it dovetails nicely with our profit objectives.

LR: So we confront individual company risk with the concept of support. Then we deal with industry risk by using the relative strength of the industry the stock is in. That leaves the market risk. 

TM: Right. That's the risk you hear talked about in the financial press all the time - something like "a recession," or "9/11," or "a geopolitical crisis in the Middle East." It's the "Is the market heading higher or lower?" But history shows that the market, as measured by the Dow, or the S & P 500, or NASDAQ, or the Russell 3000, or Value Line, or Wilshire, or whatever gauge you want to use, has regular ups and downs, just like ourselves. Since the main influence on security prices is psychology, the market goes in moods. And moods change. PE ratios vacillate all over the place. A stock can sell at 10 times earnings at one time, then 30 times earnings at another time. Why? Because the mood of investors, professional and individual, has changed. News can be interpreted either in a positive light or a negative light. So, the safest time to buy into "the market," after you've found a strong stock in a strong industry sitting on support, is when the market is in one of its momentary "depressive" moods.

JRR: "Momentary?" We've seen bear markets last for several years and thousands of Dow points. How do you define momentary?

TM: That was probably a bad word to use. But as outlined in Rule 58, the market snakes its way upward and downward resembling a sine wave. The trick is to initiate positions as the market is bottoming out from one of its downward sine waves. True, you cannot ever be sure that the market has depleted itself on the downside. But by buying into a weakened market that is expected to snap back toward equilibrium shortly, you have the tendency to get the market on your side, right along with the stocks and the industries that you have already qualified as strong potentials.

LR: Could you elaborate a little more the good news-bad news thing? News is news. But you say news is either positive or negative based on the mood of the market?

TM: It's interesting to watch how "news" is interpreted by the market. When the market is in a good mood and prices are rising, bad news is spun into, "well, it could have been worse." But when the market is in a bad mood and prices are dropping, good news is spun into, "well, that might be okay for now, but it's not very positive for tomorrow."

LR: So it's all psychological?

TM: Of course.

JRR: You'll get plenty of argument on that point.

TM: And we can save that for another day. In the mean time, we have to deal with the three bears - the three risks. And that's what the Simplespread Strategy does. Right Stock, Right Price, Right Time. 

LR: That sounds simple enough. Is that the discussion for the week?

TM: You've got it. Does everybody have their bull and bear masks ready for Tuesday night?

FOR THE WEEK...12,000 and counting, and counting, and counting
                                                               

LM: Could we term Real Estate as being Bi-Polar? First we have some of the worst news about the homebuilding industry in decades, yet the Real Estate Investment Trusts keep climbing higher and higher. They've been in the Top Ten for 21 weeks, and today makes three straight at #1. Isn't there a disconnect here?

TM: Investors love those dividends.

JRR: As long as they keep coming.

TM: The market loves it. Everything about this market screams "safety."

LR: That's true for #2 - Utilities. They also are dividend payers.

TM: Right. And another safety haven is Tobacco at #3. People will smoke regardless of the economy. There's even one line of reasoning that says people smoke more during recessions because of worry.

JRR: Media at #4 could even be construed as safety also, couldn't it? Movies used to be considered recession proof.

TM: True. And with Drugs at #5, we can add another defensive sector to the pattern.

LR: Doesn't the Dow at #6 also lend itself to the safety equation? Investors are pouring money into the biggest and safest stocks available, and shunning the more speculative ones.

JRR: I'll add that Telecommunications at #7 is also defensive. What is more necessary than communications?

TM: Well, Consumer Non-Durables at #8 certainly doesn't change the theme of the week. Clothes, toiletries, cleaning supplies, etc. - it's stuff we have to have, regardless of the vibrancy of the economy.

LR: I guess no point in arguing whether Food & Beverage at #9 is more or less a variation on the same theme, is there?

TM: Which brings us to those wild and wooly stocks of Computer Software & Services at #10 - the only sector not directly related to "safety."

JRR: It sounds like we've just branded this the most safety-seeking market in years.

TM: You're not wrong there. Yet, we keep crawling higher and higher.

LR: You sound like you want to make a prediction. Why don't you step out on the limb and just say it?

TM: No. We don't make predictions here. But I'd certainly advise to keep a close watch on your funds. The market is telling us that Halloween is not the only reason to watch out for hobgoblins.

LR: "Hobgoblins." That's good. Let's end it on that. Okay?

TM: Fine. See you next week.

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