In fact, I do not think that you should drive yourself crazy trying to figure out whether there are current surpluses of buy and sell orders. This kind of
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analysis can—and therefore should—be automated with the use of a com- puter. If you go this route, you should devote a certain amount of time on a schedule of your own choosing—every month, week, day, hour, or minute (God forbid!)—to figuring out what the market is trying to tell you.
Broadly speaking, the market is trying to tell you one of two things:
Either the market is selling and the price has gone down, or the market is buying and the price has gone up.
And even more broadly speaking, your response should be to travel with the herd: Buy or hold if the market is buying, and sell if the market is selling.
The buying and selling method just sketched out is called a filter. It takes market behavior at face value and sends buy and sell signals accord- ingly. How, exactly, does it work? You define what constitutes an upward trend—say, a 5 percent upward movement in a particular period of time—
and you buy into that upward trend. When a stock peaks and begins mov- ing in the opposite direction (down!), you watch closely to see if it hits your predetermined downward-trend number (which could again be 5 percent).
If and when it gets there, you sell. Then the game starts all over again: You determine the bottom of the valley and start buying again when the next upward trend establishes itself.
On the “long” part of this strategy, there are two signals: the upward-trend buy—which decides when you move in—and the trailing sell orderor stop- loss—which is the drop you will permit in price before cutting your losses.
On the “short” part of this strategy, things are reversed. The downward- trend sell may be the same signal as the trailing stop-loss of the long part of this strategy. When applied “short,” a trailing stop-loss applies when the stock price goes up. The two percentages for upward-trend buy and trailing stop-loss need not be identical.
The “long” part of this strategy succeeds because more often than not by the time the automatic trailing stop-loss has been triggered, the price will still be higher than the price you paid when you bought on an upward-trend buy.
The reason why the filter strategy works should be intuitively clear:
There is an intentional asymmetry built into the way that profit and loss are dealt with. As we have seen, there is no cap on profit, but there is a set floor on allowable losses: the trailing stop-loss.
Let me hasten to add, however, that although the basic tenets of the fil- ter system—let your profit grow; cut your losses—are logically compelling, this is no guarantee that people will embrace them. Why? First, because people are not logical. We humans are slow to embrace our successes and quick to defend our mistakes. “Don’t get out too soon,” we tell ourselves
on the ride up. “Don’t worry, the price will be back,” we reassure ourselves on the long slide down.
These psychological observations are not original to me, by the way. In his 1930 publication, The Art of Speculation, Philip L. Carret remarked on
“. . . the timidity of the average trader in the face of a profit, [and] his [or her] stubbornness when faced with a loss. The explanation is probably to be found in the tardiness with which the mind adjusts itself to changing ideas of value.”5
And second, there is an enormous amount of propaganda to the con- trary. Many of the players in the game—corporations and financial advi- sors among them—have a stake in the “buy, hold, and buy more” strategy.
Mutual fund salespeople tell us to “dollar cost average,” which means put- ting the same amount into a bad market that you put into a good one. This is presented as the prudent, long-termapproach to investing. I say that it is silly on the face of it.
The highly respected economist Burton Malkiel describes the filter method in A Random Walk Down Wall Street. He first remarks that the method is “very popular with brokers” but then immediately derides it:
“When the higher transaction charges incurred under the filter rules are taken into consideration, these techniques cannot consistently beat a policy of simply buying the individual stock (or the stock average in question) and holding it over the period during which the test is performed.”6
I grant that constant trading to track tiny fluctuations of the market up and down will wind up costing the investor a certain amount in commis- sions—although the cost of the average commission is far less today than it was even a decade ago. And yes, the effectiveness and efficiency of the method depends on multiple factors above and beyond transaction fees:
what level of upward trend you move on, what level down from the peak you place your trailing stop-loss, and so on.
Malkiel’s preferred alternative of “buy and hold” is demonstrably worse, however, because it can only work in a bullish market (that is, when things are headed upward). When things are headed in the opposite direction, you definitelyshould be willing to pay a few extra commissions to unload plum- meting stocks.
And yes, to determine which decision levels stand to optimize capital gains, professionals perform elaborate computer simulations, trying out var- ious combinations of values for “upward-trend buy” and “trailing stop-loss”
over the past history of the stock. Getting access to this expertise can be very expensive. I maintain, however, that to work reasonably well, the fil-
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ter method requires only the application of some good old-fashioned com- mon sense. Since your buy and sell signals are triggered automatically by stock price levels, you will not need the (expensive) advice of any broker or financial advisor. Use a deep-discount brokerage—and the lower the transaction fee, the better.
So why does Malkiel try to dissuade investors from using the filter?
“The individual investor would do well to avoid using any filter rule,” he writes, “and, I might add, any broker who recommends it.” Myself included, I suppose.
The only explanation that I can offer is that Malkiel believes that it would damage the market if too many people used this trading method simultaneously. If a large number of investors used the filter in concert, it certainly would amplify market movements and add volatility. Drops in price would encourage moreselling—and additional drops in price. Con- versely, overheated buying would trigger more overheated buying.
For that type of amplification to be noticeable, however, large numbers of buy and sell orders would have to be identical. Practically speaking, this will never happen. Investors necessarily will have different thresholds for trend buying and trailing stop-losses based in part on what commission fees they are charged on trades. In addition, their time horizons will differ—from the individual investor’s month to the intraday trader’s minute.
And by the way, why is it your responsibility, or mine, to make up for market shortcomings that are created indirectly by earnings-obsessed com- panies? Why should wetake the hit? Why shouldn’t we look after our own interests as carefully as the corporations, brokerage houses, and exchanges look after theirs?
All I know—and I know it from personal experience—is that the filter strategy serves disciplined investors extremely well. In the early 1990s, I designed an automated system based on the filter strategy for a French com- modity and trading advisors firm, and its overall rate of return was sur- prisingly high.
The filter strategy works. And—speaking directly to the underlying theme of this book—it is an effective way to deal with earnings-obsessed companies that may not have their investors’ best interests at heart.
In Chapter 7, which focuses on the specifics of the Enron death spiral, I will draw on some of the information presented in this chapter and show what happens when an aggressive (and increasingly desperate) company sets itself up as a market maker in an OTC exchange.
LESSONS FOR THE INVESTOR
Buy and hold as long as there is a renewable surplus of buy orders over sell orders.But sellwhen there is evidence of a renew- able surplus of sell orders over buy orders. In other words, go with the crowd. Do not be afraid to sell when the time comes.
Other investors’ motives are not pertinent.Do not worry about them; you can’t figure them out in any case. Only their disposition to buy or to sell is relevant to you.
Institutional investors are the source of most buy and sell orders.To find out about surpluses of buy or sell orders, track the behavior of institutional investors using appropriate subscription services.
Explore the appropriateness of a filter strategy for your invest- ments.If it feels right, use it.
In any case, buy or hold if other investors are buying (because the stock price is going up); sell if other investors are selling (because the stock price is dropping).
Only buy the services you need.Buy and sell strategies that are dictated by stock price level should be pursued using deep-discount brokerages. Keep your commission costs down to keep your prof- its up.
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How Enron Got
Earnings-Obsessed
I have always tried to do the right thing, but where there was once great pride, now it’s gone.
—From the suicide note of JOHN CLIFFORD BAXTER, Enron’s former vice chairman
We humans are optimistic creatures. We believe in outcomes that we want to believe in despite all kinds of compelling evidence to the contrary. For example, we believe today (or at least many of us do) that inflation is a thing of the past—that we have vanquished it and put it to rest forever. This is absolutely, positively not the case. And yet, we go on being optimistic.
At the turn of the century, similarly, we believed that recessions were a thing of the past. In a chorus led by Federal Reserve Chairman Alan Greenspan, we celebrated the constant rise in productivity due to the com- puterization of business and agreed that this meant the “death of recession.”
After all, by 2000, the economy was in the eighteenth year of a bull mar- ket. This time, certainly, the bear was not hibernating but was properly dead.
Down at Enron’s headquarters in Houston, there were powerful people who shared in this optimism. Some time in 1999, these people—and perhaps
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a number of more cynical colleagues who saw no reason notto go along with the optimists—began devising business policies that would onlywork in a bull market. From 1999 on, Enron’s business could only operate in an environment where the price of its stock was constantly moving upward.
Was this so wrong if the bear was dead?
How culpable was Enron?
Was it optimism or cynicism that got Enron into the mess that ultimately destroyed it?