The Airline Sector by Darren Winters

It amazes me how you can fly from one of the London airports to the South of France or Spain for less than a train ticket from London to Birmingham. Now don’t ask me why you would want to go to any of these destinations, however I like France and Spain!

The point is you’re using an oil-guzzling plane in a time when oil is significantly more expensive than it has been for years, yet you’re paying less.

When I thought about researching this sector I had in mind there would be in the region of 15 to 20 low-cost airlines in Europe. It was rather a shock to find 50, I had stumbled across 50 airlines not including the full fare airlines (if there is such a thing). Bugger! Then there is the US and other world airlines to consider!

Now having studies a number of airline companies whilst doing a module on an MBA course (Laker, SAS, BA etc), I felt reasonably comfortable to say; too many, too cheap, equals losses and failure. Needless to say it did not take me long to work my way down the list before I found my first failure and I was still on the A’s! There it was, Air Polonia, born 1st April 2003, bankrupt by 5th December 2004. They lasted longer than many! I soon discovered it was almost easier to find failures than successes.

The table below shows all the failures I found during 2004. Added to these are a further 34 in 2003, 26 in 2002, 35 in 2001 and 16 in 2000. Now many analysts may put the cause of failure immediately down to the terrorist strikes on September 11th 2001. Whilst without doubt this may have been the catalyst or final straw for many, the truth is the industry was not performing fantastically well beforehand. The real reason for the problems was deregulation by governments. They have allowed companies to complete in a ‘free’ market; brilliant for consumers, bad news for the airlines who were paying their pilots more than top judges were receiving.

Demand has increased in many countries. Even with the high amount of competition we are still seeing airlines increase their passenger numbers. In Europe we are seeing a whole new market open up, albeit in the predominantly low-fare end of business. Southwest, (the original low-cost airline), JetBlue, Easyjet and Ryanair are probably the leaders in the low cost sector on their respective continents. All but JetBlue are low thrills (soon to be no thrills – Ryanair), their strategy has been great service and quality at fair prices with no weekend stopovers required.

Costs have been axed by some, but remain a major sticking point for others. The big six US carriers, American Airlines, Continental, Delta, Northwest, United Airlines and US Airways are all struggling to reduce their high wage bills. United and US Airways are both bankrupt and are only still trading under the strange chapter 11 rules. It looks like Delta might go next if they are not careful. As of the 6th January they are capping fares and removing weekend stopover requirements. This may be a strategic move to force their main competitor on 60% of their routes, US Airlines, to liquidate completely.

We have seen aviation fuel increase by around 30 to 45% in the last year. Now some airlines had the sense to hedge their exposure, others just carried on much as normal. What is for sure, those increases have not all been passed onto the passengers. British Airways may have succeeded collecting a levy but customers do not like it and some have gone elsewhere.

With the number of failures increasing you would not expect another airline to be launched. However, Thomosnfly are jumping on the bandwagon with one-way flights as low as £14.99 to Barcelona commencing in February, They will be offering 11 destinations from a number of small airports such as Coventry and Bournemouth.

The standard-fare airlines in Europe have had attempts at running low cost airlines but have often ended selling them off, as the model does not work using high cost base hubs such as Heathrow. KLM has announced it will be cutting fares from 1st January by 40%. This just goes to show the power the low-cost, low-fare operators are having.

It is not just the airlines that feel the pinch when things go wrong. GE is set to have to write off a significant amount of money if US Airways goes under. AIG the Insurance giant is also in the business of leasing aircraft. As more companies go bust, more of their aircraft could end up parked in California’s Mojave desert. The only saving grace for AIG is that there is always someone new that wants to enter the airline business.

Overall we believe that it is a sector to keep clear of, regardless of the ‘buy’ recommendations from covering brokers for some companies. Companies such as JetBlue have PEG ratios of around 3. Easyjet is well overvalued based on speculation that Icelandair were going to bid for them.

It is a case of survival of the fittest, with low cost bases that give the end customer what they want. This may be high quality, full service flights from central Airports at a premium price as SAS’s old but successful strategy several years ago; or it may be a service with fixed seats, no window blinds, no headrests, no pockets behind the seats and where the passenger carries on his/her own luggage as planned by Ryanair. Whatever, the airline sector is best left alone (or shorted) for now.



Darren Winters

Determining overbought and oversold levels by Darren Winters

Following on from the article about the use of candlesticks, we thought it was appropriate that we should accompany that article with this. Overbought and oversold indicators can be extremely useful when used in conjunction with reversal patterns in candlesticks.

If a candlestick is showing a clear reversal pattern, weight can be added to its validity if the equity is also at an extreme in price. By looking at such indicators and knowing when they are overbought or oversold, we can also be more confident of any trades that we are looking to place, whether they are buys or sells.

There are four main indicators that we use to determine if a stock or index is at overbought/sold levels. These are Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Rate of Change (ROC) and Stochastics.

RELATIVE STRENGTH INDEX

Wilders RSI compares an equity’s performance against itself over a period of time. It should not be confused with ‘relative strength’ which is the comparison of one equity’s performance to another.

It is a price following oscillator that ranges between 0 and 100. Not only is it good at showing overbought/sold readings, but it can show divergences too. Generally speaking, RSI tops when it gets above 70 and bottoms when it gets below 30.

You can use any number of different settings for RSI we often use a period 21, average 1.

RATE OF CHANGE

ROC displays the difference between the current price and the price X number of periods ago. The 12 period rate of change is very good as a short to intermediate term overbought/sold indicator. This 12 period setting tends to be very cyclical, oscillating in a fairly regular cycle. This enables you to place greater emphasis of a coming change in stock prices. Again, this doesn’t have to be your setting as everyone has different trading practices.

With this indicator, the higher the ROC, the more overbought the equity is and the lower the ROC, the more likely it is to rally. As with all indicators, wait for the market to change before entering a position. One word of warning with this indicator, when it is at absolute extremes, this could imply a continuation of the trend that is already underway.

MACD

MACD is a trend following momentum indicator. It shows the relationship between two moving averages of prices. This indicator is also useful for determining overbought and oversold levels.

Although we like plotting this indicator as a histogram, it should also be used as a line graph so that extreme levels can be seen. A setting that is often used for this indicator would be 5,35,5 although we tend to use others to accompany this.

STOCHASTICS

Stochastics compares where price has closed relative to its range over time. The stochastics oscillator is displayed as two lines; the main line is called the %K and the second line is called the %D. This second line is a moving average of the %K line.

Similar to RSI, stochastics has specific levels to indicate when an equity is overbought and oversold. These are above 80 and below 20. Generally, when the indicator moves below the 20 range and then moves back above it, that indicates a buy signal. The reverse is true when it passes through the 80 range.

Similar to RSI, stochastics can also be used to detect divergences. For instance, if price is rising but stochastics fail so surpass their previous highs, then that could be a sign of future stock weakness.

CONCLUSIONS

Using a combination of indicators can certainly help determine when a stock or index is at overbought or oversold levels. However, this is not necessarily enough to be able to gain an exact entry or exit point.

However, if using other reversal indicators like candlestick patterns in conjunction with these, then your trading can become much more effective. For example, a classic doji formation on a daily candlestick would not automatically mean a trade should be placed. But if that doji came in conjunction with overbought/sold readings from other indicators, then it can add much more conviction regarding it viability.

If you have seen a reversal pattern on a candlestick chart that is in conjunction with the readings in your indicators, you should still wait until the following day to ensure that the reversal pattern is correct before entering the trade.

It should be noted that all indicators, however good, can and do fail from time to time. It is for this reason that we always use a number of indicators and chart patterns in order for us to build a better picture of the future direction of a stock.

Darren Winters

The best stock tip we will ever give you by Darren Winters

The best stock tip we will ever give you!After trading for many years and writing for the past few, we have pretty much seen everything that is out there. From doom and gloom newsletters to stock and option tipping services in the UK and US that cost from $100 per year to $10,000. Above all, we have realise one thing, that most investors are lazy and would rather put their faith into someone else as opposed to taking their own investment decisions.

The ironic thing is that most tipping services can be beaten hands down by any investor who is willing to put a small amount of time into his or her trading. These services are very often marketed much better than their results would have you believe too. We had a look at the results of a tipping service that cost $10,000 per year and found that it would have lost you about 60% of your money for the privilege!

We are at risk of dirtying out own bath water here, but the best person to get the long term success you want is yourself. What you should expect from us are trading ideas, technical analysis tutoring and guidance about maintaining a solid discipline. Of course we write about many more topics in various investment related issues, but they are not associated with your day to day investing.

The stocks we feature have gone through our own screening processes and we will give our opinion on them. We then give ownership to you in order to put them into a watch-list if you are interested in investing into them. You should not consider this or any market letter as a substitute for a personally managed account.

No one knows or cares for your personal circumstances better than you do; how much money you have to invest, your tolerance of pain, your goals or your investment timeframe. As long as you have the right tools for the job; a resource for fundamental analysis, some decent charting software that can help with your scans and a good knowledge of technical analysis, you are on the right track to making some good money at investing.

OUR STOCK TIP

If you feel you need it, spend more time educating yourself to become a better investor. Whether this is through reading more books, this blog or attending a good seminar, it usually works out to be far cheaper in the long run than paying a fund manager or tipster.

Although it will never teach you the emotions of investing and trading, open a paper trading account and go back to basics if you feel you need to. An inevitability is that you many have losing trades. No one is right all the time, it’s just a matter of managing your positions and maintaining stop losses. Some of the best traders in the world would make a very comfortable living from being right only 40% of the time. Although that means they lose 60% of the time, their losses are always kept very small which is how they manage to do it. If you are not planning on becoming a ‘trader’ like that, then your winning trades should be much greater than this.

The all important factor here is that you take responsibility for your investing whether you intend on becoming a day trader or someone who invests for several weeks or months at a time.

ASSET ALLOCATION

This is probably the most important part of every investors strategy and yet the most under utilised. Spreading assets across different risk groups is the key to long term wealth.

If, for instance, you had £100,000 in investable assets, it should not all go into your trading account. You need to look for investments that offer a lower risk than share trading. Some people may view property as a lower risk investment and there are plenty of other lower risk vehicles around if you are willing to look.

The reason asset allocation is considered so important is because traditionally, different asset classes will perform well at different times, thus smoothening out overall portfolio returns. Asset allocation can be used in various levels even within a trading account. For instance, an investor could allocate a certain percentage of funds to stocks and a smaller amount to higher risk options.

SUMMARY

Don’t be confused being a genius with a bull market. It’s not hard to make money in a roaring bull market. Making money in a bear market will prove difficult if you have not learnt to short or use derivatives. None of us are as smart as we think we are when everything is going well. But then we are not as stupid as we think we are when we have made mistakes either. We all get caught out by the markets now and then and unfortunately it happens just when we think we’ve got it all worked out!

Having said all of that, there is no better feeling of managing your own investing using the skills you have learnt. Use regular goal setting in order to keep a focus on where your investments are headed and be willing to learn new and better strategies from time to time. Beating a fund manager should not be difficult!

Darren Winter

Looking at the order books by Darren Winters

Have you ever wished that you could make a trade in the knowledge that you knew what was going to happen? A bit like getting in your time machine and going forward for a couple of minutes and then zipping back and making a trade.

Well if you have, sorry but the technology has not yet been invented. If and when it does, we don’t think we will get to see it until the inventor has made a fortune. However, we can get a reasonable idea of what is going to happen using several methods.

Of course many use technical analysis with some excellent results. We have been using such analysis for years. At the end of the day we rely on that next tick of the stock price, right? Well you could do but that is all history.

Wouldn’t you prefer to being given an idea of what is going to happen rather than what has just happened? The good news is you can. Many investors that we speak to have asked us what level 2 (level II) screens are. Here we are going to give you a brief introduction.

In summary, a Nasdaq level 2 screen will display all the market makers identity (MMID) in each security (note, the UK versions do not generally contain this information). It will also display all the quotes (bids and asks) for each stock in real time. We will cover this in more detail in a moment. But first you are probably thinking what is level 1 and level 3.

Level 1 screens will show you only the best bid and offer. A level 3 screen is reserved for the market makers that are registered in a particular security. They are able to adjust their quotations, make trades and update their volume reports to the main exchange.

Now unless you are going to day trade, seeing what is in the order book is of little use as it changes constantly. Awareness of what it is may be useful for all, whilst some further training would be essential for anyone wishing to trade using it.

I have shown both a UK version offered by ADVFN (below left) and a US version (below right). With the US version I can buy or sell by simply clicking on the price of the market maker that I choose and then click on the buy or sell button and the trade is placed cutting out a broker.

Quite simply the bid price or the left column on the two screens is the price that the market maker is willing to buy for and the ask right hand column is the current price the market maker is willing to sell for.

By looking at the screen you can make a judgement of the way the market might move based on the volume at each price. If you take the example below left, we can see that there is some potential resistance at 998 as that is where there is some larger volume sitting in the sell orders column. Likewise by looking at the buy orders column we can see there is some support at 910. Both of these may be the extremes and may certainly move during the day.

By using a combination of a simple chart and level 2 screens it is possible to day trade with quite some success. That said, it takes time and experience to use as there are numerous actions to watch for. Market makers want to get the best price for the stock they are handling thus will do their best to hide their intentions!

Using Level 2 screens you can get an idea of just what is about to happen, this is an essential tool for serious traders.




Darren Winters

US economic indicators by Darren Winters

Each month we real off a load of data regarding both the US economy and the UK economy. We also give you the dates of all of the reports that are due out in the coming month. Well we have been asked what are the most important ones and what do they mean. So here goes a layman’s guide to economic indicators!

Firstly I should explain why they are of any interest to the markets themselves. If you can imagine a country as being a company, then the economic results would equate to the fundamental analysis.

A healthy economy should be a good place for companies to expand. You need to have a strong workforce earning a reasonable wage paying taxes. Here you have created the end consumer, if they have money in their pockets they can buy the things they most need and then most want. Needs include food, clothes and shelter, wants may include cars, televisions, computers, property and holidays etc, etc.

So if consumers are buying, then companies are manufacturing, employing people who in turn are consumers. As you can imagine the more people that are employed, the more demand for goods and services and so the cycle begins.

To give you an idea of how important each indicator is, I have ranked them 1 to 5 with 1 being the most important and 5 the least.

Okay so the main measure of the economy is the gross domestic product ( GDP) rank level 2. This is the total value of the total economic output. The components include; consumption (the most important as it accounts for roughly two-thirds), investment, net exports, government purchases and inventories. It is released on a quarterly basis and can be quite volatile so the annualised figure is given more weight.

This figure can have quite an affect on the stock markets, particularly the first edition, later revisions are normally of little interest unless they are large.

Employment is key to having a healthy economy, there are a number of figures that are released in the US. These are

1. The employment report ( Rank level 1), this is made up of two reports, one that surveys 60,000
   households, the other that surveys 375,000 businesses (known as the non-farm payrolls). The market
   is most concerned with the result of the latter broader measure.



2. The average workweek (rank level 2), this is the number of hours worked. It is important as it gives an early indication of production and personal income.



3. Average earnings (rank level 2-), this can be used as an indicator of potential inflation or deflation.



4. Initial claims (Rank level 3), this is a measure of the number of filings for jobless benefits. These
   numbers swing often wildly week to week, a move of more than 30,000 is normally seen as significant.
   We believe they are often manipulated!

Retail sales (rank level 1), these are a measure of the total receipts of retail stores. They are often viewed excluding autos due to large monthly fluctuations, that is of course when it suits! It is worth looking at the components such as food and gas, changes here are more likely to be due to price rather than consumption.

Producer Price index (rank level 2), this is a measure of prices at the wholesale level. As with many reports this is made up of three others, these being crude, intermediate and finished. The latter is deemed most important as it is closest to the point of sale and thus is a indicator of potential inflation.

Consumer Price Index (rank level 2+), this is a measure of a basket of goods and services purchased by consumers. It is seen as the main inflation indicator and as in the UK forms part of cost of living adjustments. It is reported in two formats, one being the ‘core’ rate which excludes food and energy, the other being fully inclusive. The fed would prefer to use just the core figure as the price of food and particularly energy can be very volatile.

Industrial Production (rank level 2), this is an index of the physical output of the nation’s factories, mines and utilities. When looking at the results the market will take into account the utility production as it can be very volatile due to severe climate changes.

Housing Starts and Building Permits (rank level 2-), these two reports are released at the same time. The former is simply the number of residential units where construction has started in the month. Whereas the latter refers to the number of permits provided to allow excavation to start. Large swings in the numbers can affect the markets.

Durable Goods Orders (rank level 2), this is a measure of the amount of order for goods with a lifespan of a least three years. This can move the market but you have to look at the constituents as it includes aircraft and defence orders, both of which can slew the top level figure.

These are the main market movers along with interest rates and the muttering of Alan Greenspan, the Fed chairman. If you trade the US markets it is worth plotting the dates of these reports on a calendar.

An economy is much the same as a large company, the economic reports being equivalent to a companies fundamentals.

With most reports you should look at more than the headline figures as often there can be particular constituents that effect this.


Darren Winters

Mind the gap! Technical Analysis by Darren Winters

A gap up or down in trading can be great news at the time, if it goes with you. What causes them is simply demand. If the market makers are inundated for buy-orders before trading starts, then the price will be adjusted upwards to ensure that they can find a sufficient number of sellers to balance the books. Likewise if the market makers have a lot of sell orders, they will drop the price to find enough buyers. Figure 1 shows a gap up, a gap down would simply be the opposite.



Due to it being demand that causes the gap, it is often seen as a bullish sign if moving upwards. It is not uncommon for the stock price to gap up a number of times over a short period, particularly if there is a series of news articles being released followed by an upgrade by broker. Figure 2 shows the same stock with a second gap coming about 9 days later.



THE TYPES OF GAP

A number of technical analysts have actually labelled these gaps as follows;

1st gap – Breakaway gap. This is an easy indicator to see and use. The success of using this is probably helped by so many other traders expecting a further move up. Whilst writing this article we decided to check this theory on the Dow Jones Industrial 30 (DJI 30). It showed us that in all but one stock, there was a continued move up for several days after the first gap. It also worked reasonably well with stocks moving down although it did leave us to believe that it may be linked with a rising market. Thus we would add some words of caution here, check out the trend of the overall market as well before stepping in with a trade.

2nd gap – Measured gap. This occurs in the middle of the trend, it is believed to give you the mid point of the total amount movement. Again we checked this theory with the DJI 30 and found that this worked within reason. The second move may be as much as 20% short and there was often a period of consolidation before continuing the trend. This was the case in the example shown in figure 2.

3rd gap – Exhaustion gap. This is often only recognisable after the stock trend had reversed. It is normally the smallest of the gaps and may have a slight reversal before hand. Certainly when back testing this theory we saw a drop off or a period of consolidation.

The Island reversal gap. This is often seen after any of the three above mentioned gaps. It is a bearish sigh if the stock had previously been trending up gapped and then reversed and gapped downwards as shown in figure 3. Alternatively it is a bullish sign if the stock has been trending down and reversed and gapped upwards.



MIND THE GAP

So why are we referring to ‘mind the gap’ if it looks like good news if we see one? Well in general, gaps get filled at some point in future. This may happen for a number of reasons, these may include;

1. Following a gap up, traders take the opportunity to take profits thus the stock closes the gap but may then continue it’s trend upwards.


2. Following a gap down, traders that have shorted the stock, close their positions taking profits.


3. The news that caused the gap, may soon be forgotten and the stock moves back to its longer term trend.


4. Then of course there are the brokers. If a stock gaps they would miss out on the opportunity of filling some orders. They get paid when they fill these orders so allowing the price to fall will ensure they get paid.

Wealth warning, not all gaps are closed immediately, if at all, so you will have to decide on when you take profits or loses if you are trading a stock that had gapped. They do not all act in the same way, e.g. you may get a breakout gap followed soon after by a Island reversal.

SOME EXAMPLES OF SOME RECENT GAPS

Using some stocks on our watch list and the DJI30, there are a number of stocks that have recently gapped. These include;

1. American Express (AXP), gapped down on 17th November, since then has moved back trying to close the gap. Intermediate trend down.


2. Eastman Kodak (EK), gapped down on the 17th then filled then gapped again on the 20th November. Intermediate trend consolidation.


3. General Electric (GE), gapped up on good news and broker upgrade on 18th then gapped up again and closed this gap on intraday trading on 19th November. Trend may be back on the way down to close the gap.

CONCLUSIONS

Trading on gaps can be profitable although needs time as things can change quite quickly, Look for the medium and long term trends as a guide to direction. As with any system it is best to paper trade this first, also ensure that you have your profit targets in mind and set stops.

Darren Winters

The hidden treasures in company accounts Part 2 by Darren Winters

Many of the fundamental ratios can be found on financial websites although some figures you will have to calculate yourself. Ensure the websites you use have the most up to date information possible.

Always compare a company’s stock market valuation with others within its industry.

Following on from last month’s initial look at analysing company’s accounts, we shall conclude by continuing to look at key fundamental ratios. If you are the type of investor who loves to know what is fundamentally going on behind the scenes of a company, then going through these ratios will be of vital importance.

We shall also look at what the likes of Warren Buffett and Sir John Templeton regard as one of the most important fundamental requisites before they will even consider purchasing a company. Firstly, we shall continue where we left off…..

1. Operating cash flow to operating profit. This is a simple calculation to double check the believability of a company’s accounts. Divide the operating cash flow (cash flow from operations) by the operating profit (ie profit before interest, tax etc). The ratio from this calculation should always be greater than 1 as this shows that operating cash flow is greater than profit. How could you have a profit that is greater than cash flow? Unless a company has had to purchase new plant equipment, then cash flow should always be greater than profit and therefore you always want to see a ratio of over 1. If you see a ratio of less than 1, then be cautious because the company may have overstated profits by speeding up invoicing and slowing down payments to creditors. Like we said last month, don’t just take one years figures into account, you would need to check the past five years to ensure that cash flow is normally over 1.




2. Gearing. This measures the affect of borrowing in a company’s balance sheet. Include total borrowings (debt), both long and short term and include any bond issues and overdrafts. Deduct this from cash and short term investments and then calculate it as a percentage of total shareholders funds (this is the total of share capital and reserves and can be found on the balance sheet). A highly geared company is one that you may want to be cautious of whilst interest rates are rising, as the costs of servicing debt will eat into any profits they make. Alternatively, a highly geared company in a falling interest rate environment can do even better as their costs of servicing debt reduce.




3. The Acid Test. This ratio doesn’t work for all companies, but for manufacturing groups, it can be a vital calculation to make. Simply take the total current assets and then subtract inventories (stock). Divide this by the current liabilities and hopefully you will end up with a figure of at least 1. This ratio shows how liquid a company is but without including inventories. The reason for not including them is that if the company was being sold as a result of liquidation, the value of its stock will be far less than the value of it on the balance sheet.




4. Burn rate. This is a great way of assessing loss making companies if you are looking for shorting opportunities. The burn rate helps you calculate how long it will take for a company to run out of money. Take the last half years results and extract from it the cash operating expenses. Ignore depreciation and amortization but include salaries and administration costs. Take this figure and subtract the gross profit the company made over the period and then divide the result by 6 (this is the number of months over the half year period you are looking at). This gives you the monthly rate of cash consumption. Lastly, divide this monthly rate into the company’s net cash off its most recent balance sheet and the final figure will give you how many months the company can survive at its present rate of cash burn. One caveat—bare in mind a company in this situation could undertake a fund raising exercise in order to raise cash. Having said that, if it’s performing that badly, it may be refused funds from potential creditors etc.



5. Debtor and creditor days. This measures how quickly a company pays its bills and also how quickly its customers pay it. It is important to see how good a company is at maintaining its finances and keeping a good control on its debtors and creditors. Simply divide the debtors into sales and then divide by 365. This will give you the number of days it takes the company to get paid by its customers. To calculate creditor days, you simply use ‘cost of sales’ in the previous calculation. Like we have already stated, most companies will aim to slow down the time they take to pay their suppliers and speed up the time in which their customers pay them. However, if they delay paying suppliers for too long, it could be a sign they are in financial difficulty and will incur late payment fines and interest.




6. Depreciation. This is the annual reduction in the value of a company’s fixed assets. So if it bought new machinery last year that is expected to last for ten years, one can expect the value of that machinery to depreciate over the period. For that reason, company is supposed to set aside money to take into account this depreciation so that it will have the cash to replace the machinery when necessary. So you will need to look at what depreciation rate a company is using. If the depreciation rate appears too low, then you can safely assume that the company is not putting enough cash aside for future purchases of new plant. That will then impact its profits in the future. You should compare an individual company’s depreciation rate and period to that of its industry average. If it is too far adrift, that should raise a flag as it is probably getting boosted current earnings but will suffer at a later stage.

Lastly, we want to look at a ratio that some of the most famous value managers view as important. This is the Net Asset Ratio and whether a company is trading at a premium or discount to its net assets.

Although we can look at many measures of valuation, some of which are too obvious to have been included in this article, perhaps one of the best is the Net Asset Value as it is difficult to manipulated.

The calculation is simple, take the company’s total net assets (total assets less current liabilities, long term creditors, preferred stock and intangible assets) and then divide by the number of shares in issue.

If the figure you calculate is less than the price of the company’s shares, then it would be considered to be trading at a premium to net asset value (NAV). If the figure is higher than the share price, then it is considered to be trading at a discount to the NAV.

What a value investor will be looking for are companies that are basically good businesses, pay consistent dividends and yet are trading at a large discount to their NAV. Consider this; if a company went into liquidation today and it had to be sold off in order for shareholders to get their money back, you would want those assets to be worth more than the share price wouldn’t you? After the assets had been sold, shareholders would know they could get their money back.

If, however, a company was trading at a premium to its net assets and then had to be sold, shareholders wouldn’t stand a chance of getting all of their money returned because the assets were not enough to match the share price. Caution should be used when looking at NAV. Some companies may be trading at a discount to it today, but what if they had to write off machinery due to technological change?

This happened to many engineering companies when new technology improvements caused them to have to write off their plant and so all of a sudden, they weren’t as attractive from a NAV point of view. You want to ensure that not only is a company trading at a discount to NAV, but it also has a competitive edge and solid growth prospects based on its product range and equipment.

BRINGING IT ALL TOGETHER

By looking at the many fundamental ratios and figures, we are hoping to find quality companies that have good growth prospects and yet are currently considered cheap. This can be more difficult in practice because although you can often find undervalued companies, they will be that way for a reason. They could have poor management, under-perform their industry sector, be discounted because of the nature of their business, plus many more reasons.

However, you can often find a company that has simply been overlooked by the investment community in their search for more ‘exciting’ stocks. This is when you can find yourself a stock that is currently cheap but has a good future ahead of it. Along with that should be increasing dividend payments and an elevating share price.

Like we stated in the first part of this article last month, companies with high levels of cash can be very attractive. As long as they have a solid management on board, you should be confident that they will either put it to good use or return it to shareholders through dividends.

Also, when looking at undervalued companies, sometimes the value of their stock or assets can increase. This can be true for building companies and mining operations where the price of the mined product is rising (such has been with gold, silver etc over the past few years). Just a couple of months ago we discovered a mining company whose assets under the ground were worth many times what its market cap was valued at.

Although many fundamental ratios can be found on websites and paid for analysis platforms, crunching a company’s accounts will give you more information than you can otherwise gather. For long term buy and hold type investors, this type of analysis can prove valuable to the future success of your portfolio.

Warren Buffet always looked for companies that were trading at discounts to their net assets and this strategy, combined with other fundamental research has served him well.

Good sites for fundamental information include reuters, Bloomberg, zacks, yahoo and even comdirect based in the UK.

Darren Winters

Simple use of Elliott Waves by Darren Winters

To many people, the title of this article could be seen as an oxymoron. That is because Elliott Waves are considered difficult to interpret by the average investor. Well, we couldn’t agree more! However, if you can learn even their basic function, it can help with your analysis of where a stock is going to move in the future.

A single article such as this can’t possibly give you a complete understanding of Elliott, so we would recommend the book, ‘The Elliott Wave Principle’ by Robert Prechter and AJ Frost. Alternatively, if you want to learn it’s best application, Steve Copan is putting his master works together in his ‘market matrix’ which you can register your interest in by going to www.activetech.co.uk.

THE BASIC STRUCTURE

The ‘Wave Principle’ was discovered by Ralph Nelson Elliott who found that “crowd or social behaviour trends and reverses in recognisable patterns.” Elliott found that the stock market moved in harmony with some mathematical models found in nature. From this, he was able to develop a system of market analysis. Elliott identified thirteen patterns or waves of movement that could be applied at different time scales.



In the markets, momentum takes place over five specific waves. In figure 1, three of these waves form the underlying direction and are known as ‘impulse’ waves (waves 1,3 and 5). These waves are separated by two countertrend waves (waves 2 and 4).

Impulse waves will always consist of five sub waves in structure whereas corrective waves generally have a three wave structure. Looking at figure 2, you can see that after a five wave sequence has completed, it will correct via what Elliotticians call and ‘ABC’ correction. Once this correction has completed, another 5 wave sequence can commence.

It is worth noting that although a correction has three waves, wave A can have 3 or 5 waves within it; wave B has only 3 waves; and wave C has 5 waves.



A basic rule which is extremely useful to know is that wave 2 cannot retrace more than 100% of wave 1. So if you look at figures 1 and 2, you will see that wave 2 does not fall below where wave 1 started. Also, wave 4 cannot retrace more than 100% of wave 3. Again, you will see in the diagrams that it has not fallen below where wave 3 started.

PSYCHOLOGY OF EACH WAVE

Possibly the most important part of Elliott waves is understanding what the general market sentiment or psychology is like at each stage. The diagram below illustrates what the sentiment picture will be like during each wave.



The bottom of the 5 wave structure is usually accompanied with bad news or a recession, depending upon which timescale you are looking at. Wave 1 is named as the rebound from these undervalued levels. Wave 2 re-tests the lows although does not carry through to new lows. At this point, investors still believe the market is going to go lower. Wave 3 is the powerful wave where the strength of the market is improving along with the economy. By the end of this wave, most investors now believe the market is going to continue going up.

Then wave 4 comes which is seen as a disappointment putting some investors off the market. At last comes the final advance with wave 5. At this point, the majority of investors have accepted that the markets are going to continue heading up, after witnessing the previous moves. Sentiment can reach bullish extremes at the end of this wave.

Using this in real life, if you look at a chart of the S&P 500 which starts in early 2003, you will see that wave 1 moved up from the lows in March, then wave 2 retraced back in April. Wave 3 carried through to the June highs with wave 4 ending in October. Finally, wave 5 finished in March of this year at 1163.

SUMMARY

I have been limited in what I can explain due to the fact that Elliot Waves would need the entire content of the newsletter to explain. However, if you can take a 2 year chart of a stock or index, you can probably start to recognise where the impulse and corrective waves occur. By doing this, you may see where the future larger moves may be coming. It is well worth you investigating this fascinating form of analysis further.

Darren Winters

Make the trend your friend by Darren Winters

History shows that the markets are usually in trends. By classifying the current trends and then applying other technical, sentimental and fundamental variables, you can build a picture for where the future trends may be.

We are all taught when we start investing that we should not try to catch the proverbial falling knife. That is to say, if a stock is heading down, don’t try to catch the turn. The opposite is true in a rising market, many short sellers have been caught out trying to catch a down turn in the fortunes of Ebay’s stick!

We can understand why traders try to catch bottoms and tops in stick prices, but we should also be aware that when a stock or market is trending, that trend can often last longer then you might think. I know of traders who had been trying to short Ebay for 2 years it was only recently that they dropped from $100 to $71 by which time they have given up missing the move!

The old cliché “ the trend is your friend” is widely accepted by most technical analysts as being very important because generally, once a stock is moving in a direction, it will have momentum behind it. Understanding the long, medium and short term trends is possibly some of the most useful knowledge and investor can have. Also, this can apply to a short term trader as well as a longer term investor as we shall see.

TRENDING TIME FRAMES

Let us first make it clear that looking at trends helps us see the past, not the future. For instance, just because we have seen xyz stock in an uptrend for 6 months, doesn’t mean that it will continue. Assessing the current trend only helps us to make a start at building the larger picture for the future. Having said that, once you know where we have come from, it makes the process of predicting where we are going that much easier.

How often have we been told to cut our losses and let our winners run? If you have invested into a stock and it is performing well, why sell it? Once a trend has been established, it is pointless closing your position until you are stopped out.

Short term traders hare only going to be interested in the near term trend. However, longer term position traders and investors may be more interested in the medium and longer term timeframes. I also like to be aware of what I would call the super long timeframe.

Under the Dow theory, a short term is based on days going into weeks; a medium term is over a period of weeks to months; long term is months to years and super long term is two or more years.

For example, if we analyse the current trends for the S&P 500, we could use this information to help us make trading decisions. (Note that using trend classifications alone is a dangerous practice and should be used in conjunction with other analysis).

So looking at the chart of the S&P at the time of writing this, the short term trend is most certainly up with the rally that started with a double bottom on the 13th August. Then looking at the medium term trend, it can still be argued that it is down since the highs made earlier in the year. Possibly a break above the declining trend line would reclassify that trend. Then if you look at the long term trend, it is still most certainly up ( based on taking the two low points of Oct 2002 and March 2003). This is because of the rally of 2003. So far this year, the medium term down move could be argued as merely a pullback in the dominant larger trend.

However, I like to also look out a bit further to see the super long timeframe. Zooming out on the chart, you could still argue that we are in a long term downtrend because of the series of declining tops etc.

Now just because the super long term frame is currently down, doesn’t mean that the market has to carry on moving that way. Similarly, the long term trend which is currently still up doesn’t have to remain that way either.

CLASSIFICATIONS

In order for the long term trend for the S&P to change, it would have to decline past where normal pullbacks can occur. For this, you should look at where this trend started back in October of 2002 and its recent peak in April of this year. You should them look at Fibonacci retracement figures for what could constitute a normal pullback. This could come down as far as the 61.8% and yet still remain in the uptrend. However, should the S&P start to fall below this retracement level, we would then re-classify the long term trend. This way, with all time frames, we can start to build a picture of where the dominant trends are in which to start to work out the future direction of the markets.

CONCLUSIONS

Trend followers can make a comfortable long term success of their investing by ensuring they stay on the right side of the trend. It is just up to you to pick your time frame. If you are only interested in the long term trend, you may not be interested in the short term gyrations of the markets. It would only be when the long term trend looked like it was going to change that you would want to jump ship and close positions.

So are we in the midst of a trend change on the long term time frame from up to down? Or has this year been a pullback in a continuing bull market? Obviously no-one knows the answer to these, but by studying stock market history, fundamentals, and market sentiment, it can certainly help you prepare for which direction the long term trend is going to be. And if we know what it is, do we really care what direction it will be?

For further reading on trend analysis, we recommend 'The technical analysis course' by Thomas Meyers

Darren Winters

Making use of consolidation patterns by Darren Winters

Almost every time a stock makes a move higher or lower, at some point it will stop and consolidate. A consolidation occours as investors digest the recent price movement and contemplate whether to sell or buy as these noew prices. It is only when enough investors (volume) make a collective decision that the stock will move once more.

Consolidations come in various guises and are well worth learning about. We constantly use them for our analysis in the weekly update where we are looking for shorter term movements. Consolidations occur in all time frames, from a one minute chart, up to a monthly chart. If you are a regular investor who likes to hold a position for several days or longer, you should be keeping an eye on the 15 minute, hourly and daily charts.

You can see some very clear consolidations vuild on a 15 minute and houlry chart that are not evident on the daily time frame. For this reason, having access to intraday charting software is important.

I have drawn a number of consolidating patterns that we frequently see in the markets. Firstly, at the top, I have drawn a rectangle. In an uptrend, this is deemed to be a bullish pattern and in a downtrend, it is bearish. Like most consolidations, we usually wait for the breakout of the pattern before making a trade.

Once a pattern has started to form, it is useful to place some trend lines on the support and resistance areas so the you can define possible breakout points. For a rectangle, it is very obvious where the breakout points will be. We would look for a move on increasing volume in order for us to enter a trade.



The next chart is a flag pattern. In an uptrend, these are considered bullish vice versa. Bullish flags like the one shown are characterized with lower tops and lower bottoms, with the pattern slanting against the trend.



The final chart is a bullish pennant where the tops are getting lower and the bottoms are getting higher. In this situation, we would look for a convincing break out of the pattern to give us our trade.



It is worth noting that rectangle can last for a considerable period, but flags and pennants tend to last a much shorter period relative to the time-frame you are looking at.

EXAMPLE

The following examples on a daily chart of the S&P are clear flag patterns. When you look at smaller time frames you will notice consolidations forming even more frequently.



It is worth noting that youy should not religiously look for the patterns shown on this page. There are many more consolidation and continuation patterns that can be seen on the chart. ALso, just because a stock is n0t making a perfect patterns, it does not mean it is not consolidation. Any period of congestion after a large move is basically a consolidation.

The basic premise is that if a stock moves higher and the consolidates near the highs, the chances are it is building for another move higher. The alternative is true on the downside.

TAKING ADVANTAGE OF THEM

Personally, I like to wait for a breakout of a consolidation to occur before I enter a trade. I can do this by one of two ways. Firstly, by setting price alters with my onlime broker to notify me if a stock breaks through a key area. I would then go in and place a trade after assessing supporting volume and other indicators.

Alternatively, I could plave stop orders to automatically enter me into a position should these be triggered. It is probably best to start off by setting price alerts and then manually placing a trade when the break has taken place.

Some option speculators, including ourselves on occasion will place straddles to take advantage of the impending move. These have to be entered before any breakout had taken place and I would suggest you read out back issues to learn more about these.

If you have a charting package, it is well worth spending some time looking at consolidations as they can produce some excellent profitable trades.

Even as I write this, there is a lovely consolidation on the 30 minute chart of the Dow. Looks like a trade needs to be placed!

Darren Winters

Technical Analysis by Darren Winters

Talking about breakouts makes me think of my favourite Foo Fighters album track where David Grohl is singing about wanting to ‘breakout’ of the relationship he is in. I guess it’s not dissimilar to a stock that is trying to breakout of a trading range it’s been in or above a key resistance level!

Breakouts can form the beginning of an exciting new rally for a stock or alternatively, the start of a large downward leg. There are simply too many types of breakouts to go through each one individually, but if we give some examples, you should be able to get a feel for how they develop out of a multitude of chart patterns. We will also cover the ‘false breakout’ that can often leave inexperienced traders scratching their heads.

CONSOLIDATION BREAKOUTS

Consolidation patterns come in many forms, but some of the strongest patterns that develop out of a consolidation are perhaps ‘flags’ or ‘pennants’. We have covered these patterns in previous editions of the newsletter so wont go into long winded explanations at this point.

Essentially, consolidations occur when a stock has been trending in one direction or another. For example, if a stock has been rallying, it will get to an area of resistance where sellers enter the market and halt its advance. At this point, the stock starts to move in a sideways direction where the number of sellers matches the buying pressure. Once all the selling has taken place and if there are still buyers, the stock can then start to rally again.

It is at the point when a stock ‘breaks out’ of this consolidation pattern that traders can take advantage of the next rally leg.



The chart above shows a classic example of a stock forming a flag before breaking out to the upside. Of course we can see the opposite of this bullish formation in down-trending markets. It is worth noting that you want to see an increase in volume on the breakout to help confirm the move. If volume starts to fall, you may want to tighten stops or even close part of your position. Sometimes a stock may come back down and ‘retest’ the area that it broke out from so it is worth bearing this in mind.

The best way of trading breakouts is to get plenty of practice first. Using your charting software, flick through as many charts as you can, searching for these consolidation patterns. You can then look to see how each stock reacted to the breakout and what happened to the volume. These breakouts work best in strongly trending markets.

FALSE BREAKOUTS

Although we see breakouts occurring all of the time, so too are false breakouts. When you consider the number of traders who are well aware of consolidation patterns and waiting for a breakout, you also have to be aware that market makers can have fun with these.

Let’s assume a market maker has some very large institutional sell orders coming in on a stock that is just sitting below a key resistance level. It would be very easy for that market maker to start pushing the price up above the key area to entice buyers into the market. This surge of buying can then enable them to fill their large sell orders for the institution and thus the price comes crashing back down.


Watch for a breakout on light volume, or a shooting star candle as this can tell you all is not well.

Both genuine and false breakouts can be taken advantage of. Watch volume to give you confirmation of any moves and watch for non confirming indicators should a breakout turn out to be false.

Darren Winters

Strategies for spreadbetting by Darren Winters

As more and more of our subscribers are turning to spread betting, we thought we should cover some simple mechanics that will enable you to trade more efficiently. The beauty with Spread betting is that it caters for a broad cross section of investors. You can start trading with as little as 50p per point or as much as £1000 a point depending on your capital and experience.

For those who have never spread bet before, you buy and sell in just the same way as you would with an online stockbroker. The difference is that you are betting on the future direction of a particular stock as opposed to actually buying or selling shares. You have to decide how much you want to bet per point of movement in the underlying share. So for example, let’s assume you were going to spread bet the FTSE 100 index which currently trades at 4,770 for £1 per point. If it moved up to 4,780 you would make £10 and the reverse if it moved down 10 points.

Now there are some elements of spread betting that are worth considering when investing using this platform.

PHASING PROFITS

We have always been advocates of ‘letting your winners run’ when trading in the markets and this can be done whilst spread betting too.

In order to do this, you need to place a minimum of £2 per point on a trade (assuming the spread bet firm’s minimum bet is £1). Now we would not recommend this strategy if you do not have a lot of funds in your account or are still building experience. The reason for this is that although £2 per point doesn’t sound like much, you only need to take a few losses at this level and you could be down a couple of hundred pounds.

Anyway, by placing a £2 bet on a stock or index, when it has moved into a healthy profit, you may want to take some money off the table. You can do this by selling just £1 of that bet. So for example, You bought the FTSE at 4700 and it moves up to 4760. So after the spread of 5 points, you are up 55 points or £110 on your £2 bet. In order to take some of the profit off the table, you place an order to sell £1 of the FTSE at the new market price, thus banking £55. You can then allow the remaining position to run further if it carries on moving up in price.

You can move your stop higher which will protect your remaining position but at least you don’t feel the pressure to have to bank some gains. Obviously, if you bet more than £2 per point, you could stagger your trade even more as you gradually realise profits.

KEY ENTRY LEVELS

If you, like us, want to see a stock move through a key level before entering a position, then utilising certain orders can be of great value.

For example, if you believe that the S&P 500 is getting close to a key resistance level, you may not want to buy unless it manages to break through it first. So you can use a ‘buy stop’ order to buy the S&P when it reaches a certain price. If it doesn’t manage to break through the resistance, your order doesn’t get filled and you cancel it.

Alternatively, let’s assume you think that if the S&P breaks through a key support level, then it will go much lower. So this time you would enter a ‘sell stop’ order to sell the S&P if it breaks below the support level.

This type of trading gives you plenty of time to undertake your technical analysis and identify key support and resistance levels. A classic example of this was when the S&P broke through the key 1131 resistance level at the beginning of November. It brought more buyers into the market which kept the price moving higher. Obviously you can get false breakouts but very often, a move through a significant level will bring about a continuation for a period in which a quick profit can be taken.

ADDING TO POSITIONS

We never advocate adding to a losing position in order to average down, but adding to a winning position is perfectly acceptable in our view. Let’s assume that you have entered a position which you are now up 50 or 100 points on. The stock is in a confirmed trend now and could still have much more to run. Well, you can add to your position in order to take advantage of further movement in the stock in the current direction.

If you had gone long on the stock, you would now simply place a new buy order at the current price in order to build your position (although you may want to wait for a pullback first). This will have the effect of increasing your average entry price so you will need to raise your stop in accordance with that. Now that you have added to the position, any further upside in the stock will give you even more profits. Bare in mind that you should not add any more than what your original bet was.

Alternatively, if you had sold short the stock and it had moved down 50 or 100 points in your favour, you would now add to the position by placing a sell order at the new lower price. Remember in this scenario to move your ‘buy stop’ lower.

These ideas are simple, but we utilise them in our own trading frequently in order to maximise our returns.

Darren Winters

Should we set profit targets? by Darren Winters

Many investors like to have a complete plan of how they are going to trade and what profit they would like to make each month. It’s easy to understand why; many courses and books discuss making 5% a month or 20% a year or whatever figure they choose to aim towards. Even we have discussed the power of compounding in the past and shown what a return like 5% a month can do to a portfolio over just 3 or 4 years.

The problem with planning profits in advance is that you can’t rely on that steady rate of return, so is it even worth setting such goals? To give you an example; would you rather have profits over three months of 10%, 10% and 10%? Or would you prefer to take a more unpredictable scenario of –10%, 50% and 28%?

Assuming the target of 10% for three months and you started with £10,000, your capital will have compounded to £15,208. But if you had opted for the more unpredictable returns, your capital will have grown to £17,280 even though you lost money in the whole of the first month.

LET THEM RUN

The key here is to let your winners run. If you exited a trade just because it met a price objective, it could have continued going in the right direction and thus, an even more profitable trade was closed early. Think of it this way, why would you want to exit a trade at a 10% profit when it could go on to make 60% or 100%?

Now we are not saying wholeheartedly that you should not set price/profit objectives, we do this all of the time with our trading. But if a trade gets to a target area for you, you may want to close half of the position to lock in profits along the way. By doing this, you have the best of both worlds. Part of the gains are banked whilst you still give the position room to run further if it wants to.

If you consider that stocks trend 80% of the time, once you have gotten onto that trend, why would you want to totally jump off? I guess you could have a very slow moving stock and you may want to move into something that has the potential to move quicker. But if you know a trend is in place, you should certainly try to stick to it. As an example, lets say you believe that the dollar will fall in value against the pound over the next year to over $2.

Once you have identified your entry point and the trade is moving in the right direction, there is no need to exit. You can take profits off the table along the way, or even add to your winning position using your paper profits as collateral. The way to do this is that as you move your stop/loss behind your trade, you would be locking in profits anyway so a strategy could be to add to the position periodically.

Knowing that stocks trend for 80% of the time and go nowhere for the remaining 20%, it allows traders and investors alike to make small losses when a market is in a trendless environment. Subsequently, it enables them to more than make up for those losses when a larger trend gets underway.

An essential part of trading trends is being prepared to weather small losses or occasional sideways moving markets. If you do not think you could cope through these periods, you will never be able to stick to the right strategy.

Because no traders can predict what is going to happen next week or next month with 100% accuracy, it is not easy to know whether you are in a trend or if a stock is about to move sideways. For that reason, what appears to be a trend can fail. As a result of this, every buy or sell signal that you see using your strategy should be acted upon. If you try to second guess which trade might work out and which won’t, you could miss the trades that make sizeable profits.

THE BENEFIT OF HISTORY

By ensuring that you trade all buy and sell signals that are created using your strategy (whether it is one each week or only one every 2 months) you ‘know’ future profits will be generated. Just back test your strategy and see how it would perform over time. It only needs to win 50% of the time in order for it to be successful. The key is to only take small losses on the occasions the strategy doesn’t work.

By back testing your strategy, you should be able to work out what is the best stop/loss to employ by identifying the point at which the strategy is going to go wrong. Any charting software with end of day data will allow you to back test any strategy you wish.

SUMMARY

Profitable trading and investing is all about letting your winners run, not cutting them short just because a profit target has been met. Even day traders will use this strategy in their intra-day trading, albeit on a shorter time scale.

As usual, the most important thing to do is to keep moving your stops up to lock in profit and also to sell part of your position once your original profit target has been reached. As shown earlier, the less consistent approach actually yields higher returns over the long run.

Darren Winters

Put/call ratios - how to really use them by Darren Winters

Long time readers of my articles will know that we often refer to something called the put/call ratio within our work. We refer to it in our analysis of individual stocks each month and almost always use it within our analysis of the indices.

Put/call ratios are an excellent measure of investor sentiment and can help us identify imbalances that are likely to reverse soon and also trends that may last for some time. This ratio is merely the number of put contracts on a stock or index, divided by the number of calls. The resultant ratio helps us to see if there are a higher number of bearish or bullish investors on a particular stock.

When there is an excessive amount of call buying (bullish bets) made on a stock that is rising, the chances increase that any future buying strength will have dramatically reduced and that a reversal is at hand. When there is an excessive amount of put buying (bearish bets) made on a stock that is falling, selling strength will have reduced and a rally could soon take place.

When we see an extreme in one of these conditions, it is highly likely that a reversal is at hand. For example, if the majority of investors are bullish, there is little chance that any more money will come into a stock because most of the buying has already taken place. In the opposite case, when there has been an extremely high put/call ratio (high amount of puts), investors have already sold much of their stock positions and so any slight increase in buying strength will overwhelm the remaining sellers and start pushing the price up.

A put/call ratio of 1 would tell us that for every one put buyer, there is a call buyer. Now although at first interpretation you could argue that this is surely an even match, it is in fact considered bearish. The reason for this is that investors are normally optimistic towards stocks and thus the ratio should be naturally more biased towards having more call buyers. Therefore, for most stocks a put/call ratio of 0.5 could be considered even. However, many Nasdaq stocks naturally tend to have a higher put/call ratio due to investors still being bearish on these stocks since the dot.com bubble burst. In order to really know what the average ratio is for a stock, you will need to take a look at its history.

APPLYING THESE RATIOS

Lets assume that a stock has been rising and that because of this, investors were increasing the numbers of calls they were buying in anticipation of even further price rises. You would need to look for a point when the ratio started to reverse. This could be at one of two points. The first reason could be that the ratio has reached a level that had previously marked a stock price high. The second reason could be that the stock is reaching a price level where there is a very high amount of open call interest. That could provide a natural resistance barrier for the stock as sellers of the options start short selling stock to ensure it doesn’t get above their optimal strike price.

However, you could see a situation where a stock price is rising and yet the put/call ratio is rising i.e. although the stock is going up, investors are placing bearish bets against it. This is the classic analogy of a ‘market rising on a wall of worry’. So investors aren’t convinced that the stock will continue to rise. In this situation, investors will very often be disappointed and some of them will give up the game and join the party, thus providing more buying strength to the stock.

It would only be once these bearish bets had subsided that the stock would then start to head lower. A classic example of this is with the Nasdaq exchange traded fund, the QQQQ after it had made its final lows in March of 2003. The put/call ratio was well over 2 which meant there were two put buyers for every one call buyer. But as the markets began to rally during the course of that year, the put/call ratio remained high on the QQQQ, helping to fuel the advance. It was only once optimism started creeping back into investors, that the ratio started to decline in 2004. And what happened? The market started to fall!

A very recent example of the put/call ratio at work is again evident in the QQQQ. Over the past week, the stock has found price support at $36. From looking at the put/call ratio, we can see that the peak level of put open interest is right at the $36 strike price. So the stock found support just where the highest number of puts had been bought.

So there are many ways in which you can use put/call ratios in your trading;

1. You can track the ratio on a chart to see when it reaches an extreme that has previously marked a high or low in the stock price.



2. If it is falling as a stock is rising, then this is bearish for a stock as investors are too optimistic—watch for a reversal in the ratio.



3. If it is rising as a stock is rising, then this can be bullish for a stock as investors are too pessimistic.



4. Look at where the most number of puts and calls are bought as these strike prices will offer both support or resistance to a stock—as shown in the example with the QQQQ above.

You can get all of this information by going to www.schaeffersresearch.com and clicking on the quotes and tools tab.

Darren Winters

The country with big potential by Darren Winters

We have covered this country on a number of occasions in the past, but until now we have been reasonably cautious on investing there. Some of our reservations are starting to subside as the country continues to become more investor friendly.

The country I am talking about is India. A few facts before I carry on; -

• India has a population of around 1 billion people. 31% of whom are under the age of 14; 50% under 25; and a massive 85% under 45. The median age is just 24
• India has some huge reserves of natural resources, it has the fourth largest reserves of coal, it also has large reserves of iron ore, manganese, mica, bauxite, titanium ore, chromite, natural gas, diamonds, and petroleum. It is currently the 24 largest producer of crude and has a number of majors exploring for new deposits.
• The GDP has grown by 6.8% per year since 1994. In 2004 this was 6.1%
• 23.8% of GDP is invested, compared to around 16% in the US and UK, and a massive unsustainable 46% in China.
• 50% of the GDP is earnings through service industries.
• Inflation is currently running at around 4.2%.
• The overnight interest rate is 5.1%

A friend has been travelling back to India for many years. Every time he returns he is more enthusiastic about the country’s developments. There are signs that there is some true wealth coming to the country, brought about by the huge service and Information Technologies and foreign companies that are keen to take advantage of the potential market.

It is far from a bed of roses, some 66% of the population work in agriculture that are operating at subsistence level meaning that many families are living below the poverty line. The country’s infrastructure is overloaded and often in poor hape and there is still a significant amount of state owned companies that are not efficient.

That said labour costs whilst still rising, are running at only 50 pence per hour (US$0.85). This ensures that the country’s corporates have a significant competitive advantage in some sectors. As highlighted in the proportion of the country’s GDP, the emphasis is on service rather than just goods.

The country’s political environment has been relatively stable since independence. No one party has complete power, which may explain why the pace that legislation is changed is quite slow. With regards to the international relations, we have witnessed improvements with India’s neighbours Pakistan and Russia.

Of the three key emerging markets of China, Russia and India, the latter has the most entrepreneurial population. It is within the culture to trade and make a profit. It has a rapidly increasing number of middle classes, who are building bigger businesses. Whilst India has one of the highest levels of illiteracy, those that do go on to college are almost guaranteed a job in one of the many Business Process Outsourcing companies or within IT.

India’s financial system is well developed having a large and active domestic retail and institutional investor base. The National Stock Exchange of India has around 800 companies listed and the Bombay stock market has a listing of around 6,000 companies. The banking system is stable having just 3.5% of non-performing loans.

One rather amazing statistic is that only 10% of India’s economy is dependent on international trade. This ensures the country is far more stable in the event of a major global turndown than many of its competitors. Whilst buying around one fifth of the worlds gold, they have not had the same impact on other commodities in the way China has. This may well change as they go about improving their over burdened infrastructure.

There are some significant business empires that are continuing to grow. Amongst these are Tata and Mittal. We covered the latter in a recent newsletter. Tata is a conglomerate of around 80 companies, which is a model of how some of the larger empires are developing.

Some may have heard of the name of Tata, it was building the City Rover, which was re-badged and sold in England. Tata also owns huge tea plantations in addition to Tetley, which it acquired to gain more up-stream control of its tea business. I think Rover may have been better off in their hands as they have just released a small sports car that has stole the attention in the Geneva motor show.

There are a number of ways of investing into some Indian companies. They are far from risk free but may offer rewards that reflect this. We generally prefer to buy stocks via either the UK or US stock markets. An alternative to risking your money in any one stock may be to invest in a trust fund. We know of a couple if you’re a high net worth investor. There is of course the likes of Aberdeen New India Investment Trust amongst others.

So in summary the outlook is significantly better than when we last looked. It is not all smooth running as any western turn down may also affect India. The infrastructure is far from great, but as this is improved so to should the economy

Regards Darren Winters

The lazy mans way to riches by Darren Winters

Who ever said trading was difficult? The purpose of this article is to show how, using some simple criteria, you could invest over the long term without having to watch your stocks day-in, day-out. This is written for those readers who have no interest in short term trading and are happy with making profits over a period of years as opposed to months.

I have chosen two variances of the same strategy on two different stocks; one has been around since the early 20th century, the other floated 5 years ago. Because of this, I have run the tests back to the year 2000, but from looking at my screens, the strategy would have worked whenever you had started it.

I noticed this buying and selling strategy when looking at XM Satellite Radio for the January edition of the newsletter. The simplicity of it involves buying or selling a stock when its bar moves above or below its 200 day moving average. I had to be strict with the testing and so had to wait until the bar was not touching the average before buying or selling. I chose to enter the trade at the end of the trigger day, so that I was getting one of the worst prices available. That makes this exercise more realistic in terms of its success rate— you would have been more profitable in reality than I was in this exercise.



STRATEGY 1

This strategy was applied to General Motors stock. I started with the entry signal which was when the bar clears the 200 dma. However, It was my exit strategy that was adapted to ensure greater success. The reason for this is that all stocks behave differently in relation to their respective 200dma. Some stocks will bounce off it violently whereas others will break though, only to then fall back below again. GM is in this category of stocks. If I had applied a straight forward ‘buy when the bar clears the 200dma and sell when it breaks back below,’ I would have been whipsawed frequently and barely made a profit.

So what I did was to tighten my exit strategy in order to lock in profits. This was achieved by using a Time Segmented Volume (TSV) indicator with an 18 period setting. Accompanying this was a 10 period moving average—both of these were set to ‘simple’.

The TSV will often get you out of a stock before it has turned against you in earnest. So, on the occasions when a stock was moving up through the 200dma, once I had entered the trade, I would watch the TSV for my exit. As soon as the TSV crossed below the 50% horizontal line in its window on my charting software, I would sell. Generally, this would ensure I would exit a trade with a profit.

Once I had closed out of a position, I would have to wait until the bar crossed through the moving average before making my next trade—this could sometimes mean I was out of the market for several month at a time before the next trade was set up.

So, the criteria for this trading was that if the bar was moving up through the 200dma, I would buy once it had cleared it (see diagram). Then I would sell when the TSV moved below its 50% mid line. The opposite is true when selling short; I would sell when the bar cleared below the 200dma and then close the position if the TSV moved above its 50% line. I also had a stop loss in place which was set at 5% so that was the maximum I could lose on any trade.

This strategy turned £10,000 into £25,197 from April 2000 to September 2004 which is when the last trade was closed. So over four and a half years, it gave a 150% return and there were only 12 trades in that period—an average of just 3 trades each year!

STRATEGY 2

If you thought the first strategy was straight forward, this one is even easier. This was applied to XM Satellite Radio (XMSR). Instead of using TSV for the exit signal, we simply used the 200dma. For example, after the bar had closed above the 200dma as in the diagram, I would wait until it closed back below it to close the trade. The difference with this strategy is that I would always be fully invested because as soon as the stock had closed back below the 200dma, I would close the original position and then immediately sell short.

I still had a stop loss of 5% on every trade but other than that, would obey the rules set out in the diagram on this page; whether the stock was moving up through the 200dma or crossing down below it. The result for this stock was that £10,000 turned into £109,810. That gave a total current return of 1088% between October 2000 and present. This stock produced 9 clear trades over the period. See my note to the right of this column

Regards Darren Winters

The next hot energy source by Darren Winters

The world is demanding more energy. With expected population growth to reach 8 billion by 2025, we will continue to put more of a strain on our natural resources. Currently, 28% of the world’s population use 77% of the world’s energy production. What is going to happen as emerging nations demand more? With the huge growth in countries such as China and India, there will not only be increased demand for electricity, but for cars and therefore oil too.

This demand is asking a lot of governments around the globe, who are looking for cleaner forms of energy production than traditional fossil fuels.

Some questions that need answering are; what are our electricity requirements? What forms of generation are available to us? Which combination of energy supply will provide our needs with maximum security and least harm to the population and environment?

In order to answer these questions, we need to first explore the fundamental backdrop to the vailable energy sources. We then need to look at the reasons why uranium could see increased demand that would propel it’s price five fold from where it currently stands. Added to that, we will show you companies that would stand to benefit from any underlying price increase in this controversial metal.

AVAILABLE ENERGY

Let us first make it clear; there is plenty of energy available to us, ranging from solar, wind and waves, hydro, and fossil fuels. It is estimated that we have enough coal to last more than one hundred years although it is obviously not environmentally friendly. So it is not a matter of the world not having enough resources for electricity production, but which resources pollute less and reduce global warming.

Fossil fuels have been an excellent form of energy and coal was the first to be utilised in order to increase our standard of living. The problem today is that a 1000 MWe coal fired station produces 7 million tonnes of carbon dioxide each year and 200,000 tonnes of sulphur dioxide which are a major source of atmospheric pollution. Other waste products from the burning of coal include 200,000 tonnes of fly ash which contains toxic metals including arsenic, cadmium, mercury plus carcinogens which can cause cancer.

This is an environmental nightmare when compared to nuclear power, according to the World Nuclear Association. Compare that to a nuclear powered station that re-processes 97% of it’s waste. The remaining 3% needs to be isolated for a long period although because of it’s small amount, it is easily manageable.

Solar power is not yet ready to be a viable clean alternative to coal although with nanotechnology, it’s use will certainly become more widespread in the future. At present, it is intermittant and inefficient. Solar power generation gets interupted by clouds and night. It is also presently inefficient in converting incoming radiation into electricity (only 20%). While sunlight may be free, the capital, energy and material costs of conversion, maintenance and storage are very high. The best purpose for solar power at the moment is in direct heating.

Another widely discussed alternative is hydroelectric power. Granted it is cheap for those areas that have plentiful water but building dams can have a negative impact in that they require the flooding of land upstream and populations have to be moved. Considering hydroelectric power accounts for nearly 20% of world electricity production, it is certainly a viable source in locations where it can be developed. The only problem now is that most of the world’s suitable sites have already been used.

As for other alternatives such as wind, tidal and geothermal electricity generation, although they are without a doubt useful sources, they are limited in their use for creating mass power.

DEMAND

The world’s demand for electricity is currently increasing at a rate of 2.6% per year. In the US we have recently witnessed the problems associated with excess demand on the grid, blackouts in both California and New York.

As countries like China continue to demand more electricity, this has to be met with power stations. They are presently building one new nuclear reactor every year and will continue to do so.

This increased demand by Asian economies is not just limited to electricity production. We have seen crude oil trade at $55 in recent months and these price rises have also been mirrored for gas, coal and lastly, uranium. Uranium has increased from around $7 per pound in 2000 to over $20 per pound today.

If you compare it’s price with it’s high in 1979 of $43, you can see that it is still far below those levels. In fact, if you account for inflation over time, in today’s money, that translates to over $100 per pound! Supply Cameco, the world’s largest uranium miner estimate that uranium demand should average 194 million pounds per year until 2012. According to the World Nuclear Association, supply is running at 135 million pounds per year. The difference is currently made up from surplus supplies like weapons conversion and old stockpiles.

Now there is no lack of supply in the world, but mining it out of the ground is another matter. There are many countries with large uranium reserves but they lack the resources to start mining. Even if they did, it takes about ten years to bring a mine online. These countries include Russia, Kazakhstan, Nigeria and Uzbekistan who also have a great deal of political instability. Just look at what the disruption in Russian oil supplies has done for the price of crude this year—the markets don’t like uncertainty.

A major factor influencing the future price of uranium is the inelasticity of demand relative to price. We currently only have one year’s worth of uranium stockpiles. As supply becomes tight, the utility companies tend to hoard uranium which then increases it’s price as there becomes such a small amount of supply.

Mines only produce a total of 79 million pounds of uranium each year. Considering demand is 194 million pounds each year, mines will need to significantly increase production in order to meet that demand. Like I have already said, some of that demand is met through weapon conversions, but that is only about 50 million pounds. Therefore, mines would need to increase production by around 65 million pounds every year. The only way that is going to happen is if prices rise significantly in order to make new mining projects worth while developing.

As a result of this supply/demand fundamental backdrop, one can assume that the price of uranium, like so many other energy sources, is going to rise significantly over the next several years. We may even see it trading at new all time highs.

The way to exploit this and gain leverage against it is to invest into the mining companies that have the major uranium mining rights around the world. Fortunately, there are only about eight major uranium miners who mostly work on deposits in Canada, Australia, Namibia and Niger.

MINING COMPANIES

The largest producing uranium companies include Cameco, ERA, WMC, Cogema, Rio Tinto and Anglogold. Cameco is like the Newmont Mining equivilant of the gold miners. It is the only pure uranium miner that fund managers can invest into because it has enough liquidity. The problem with Cameco is that it currently trades at around $95 a share on the New York Stock Exchange which makes it an expensive share to hold for the average investor.

However, there are plenty of alternatives that can give you exposure to this part of the mining sector. We covered one such company in last month’s edition of the newsletter. Anglo Pacific currently trades at around 92 pence a share on the LSE and owns shares in a small uranium miner. It’s share is fairly slow moving so is more of a longer term holding for any portfolio.

Anglogold, who also have exposure to uranium mines in South Africa, are traded on the NYSE and are currently fetching around $38 a share. We have covered this company in the past and from a technical perspective, it made a nice 50% retracement this year from it’s entire move up from 2001. It is now trending higher.

What I want to cover here though is companies that offer real leverage for long term speculators. These are the sort of companies that are very cheap, but offer the potential to make ten times your initial investment. Having said that, they should be considered high risk, and therefore speculative. However, for investors willing to put a small amount into them and hold for several years, they could do well.

One junior mining company that offers this type of potential leverage is Strathmore Minerals which is a Canadian miner listed on the Torronto Stock Exchange. This stock has increased by more than 100% since the summer and now trades at C$1.60 a share. It’s ticker simbol is STM.V. It has a strong management team with the recent appointment of Bob Quartermain who was previously with Silver Standard—a company we have also featured. This is certainly a speculative play and investors need to undertake full research on this, or any other stock we have featured. It’s website can be found at www.strathmoreminerals.com.

SUMMARY

There is certainly a very good fundamental argument for continued strength in the price of uranium over the coming years. This will benefit the mining companies that we have shown who from a market matrix point of view, should remain in a bull market for many years. To undertake more research, I would recommend going to the World Nuclear Association site at www.worldnuclear. org.

Regards Darren Winters

Trading in oil by Darren Winters

With oil remaining in the $50 area it is not surprising that we have had a number of readers asking us how they can benefit from this. Another key question has been surrounding whether you can trade oil companies on the basis of the price of oil, much in the way we do with gold companies.

We should put out a public wealth warning here, in that whilst oil prices may go up buy quite a lot more, they are currently running at close to all time high prices thus we could have a proper retracement. Remember the dot-com boom drove investors into what was already an overpriced market, just so that they could be in the action. As I alluded to in the opening article, the price of oil may be high because it suits some economies for it to be so.

If you prefer to follow fundamental information or use it in addition to technical analysis you may find good quality data is hard to come by. The biggest problem that even the market analysts have, is finding good quality, accurate, timely information. I guess the other side to this, is that you are not at much of a disadvantage as a private investor.

As most suppliers are very secretive about how much they are actually producing due to their different quotas, particularly in OPEC, it is difficult to even guess what the total output is. As for purchasing this is equally as difficult, as countries such as China do not necessarily want the World to know how dependent they are on others.

What it has come to, is that investors tend to look at the weekly releases from the US oil reserves released by the Department of Energy, which are available at 15.30 (10.30 US Eastern Time) on a Wednesday (Thursdays on a bank holiday week). As the United States now use somewhere in the region of 25% of the worlds oil production, their stocks are key to whether they need to increase or decrease their purchases. This is probably one of the biggest movers of the oil price on a regular basis. If you look at a chart of the cash price of oil you will see that for months now, Wednesdays are traditionally the most volatile on the market, followed by Thursdays as traders continue to digest the news.

INVESTMENT OPPORTUNITIES

There are numerous ways in which you can invest in oil, here we look at a few of them.

If you’re a qualified investor you can actually buy into an exploration project. Having been to several investment conferences in the US, I have been offered numerous opportunities for a share in a new drill. Whilst these are given tax breaks for US citizens, they are just extremely risky as whilst each company is trying to convince you that they will find oil, there are absolutely no guarantees for the well being viable, if it is not dry. Be prepared to lose all of your investment.

Dealing in futures contracts is probably the most common and most direct method of trading oil by institutions and more sophisticated investors. Due to the risk involved and relatively large sums of money needed it is not for everybody. We have covered the topic of futures in detail in other articles so will not go into detail here.

As an alternative to trading futures, you can trade options on the futures. Whilst this requires less money, the risk is equally high if your buying options and potentially unlimited if your selling them. Of course there are some great profits to be made if you know what your doing. Again this is a whole topic on its own.

A safer alternative may be seen as investing into Oil Companies themselves. However, we are quite cautious here, as you must take into consideration a whole raft of factors when deciding which one to invest in. You may of heard of a company called White Nile, it was set up by an ex England cricketer. Frankly this company sums up all that is bad in small exploration companies and investor madness. It has one field that is unproven yet people have been putting money into the stock as if it was a done deal. The big companies are not clear of controversy either, Shell managed to grab the headlines for far too long due to the overstated reserves.

We are cautious with trading oil companies purely on fundamental information. Even with oil at $50 plus per barrel, this does not mean all companies will get that amount for what they are pumping. You need to take into account the quality of the oil and location of the reserves. Of course they will still get more as even lower grade crude will rise in line. In the longer term you should also note that with oil at a higher price, more projects become viable increasing the amount of oil available. As more wells are drilled this brings more oil to the market thus reducing the price.

It is not always the oil companies themselves that are the best investment. Some of the supply companies and refineries we have featured in the past have seen some awesome increases in their share price. Tesoro Petroleum (Refiner) was featured around 12 months ago, it is now up 87%.

Looking forward it is important that you take into account what price the company is using to forecast future earnings. If is only around $30 a barrel, there could be some good earning surprises (for the small investor) leading to an increase in share price.

There will undoubtedly be a correlation between the price of oil and stocks although we would remind you that this can mean the stock may fall as
well as rise.

Regards Darren Winters