PRIMARY MARKET INDICATORS FOR GAUGING RISK

PRIMARY MARKET INDICATORS FOR GAUGING RISK

This chapter on the New York Stock Exchange (NYSE) Bullish Percent covers a critical area of investment strategy (see Figures 6.1a through 6.1c). It is critical that you grasp this concept thor- oughly. This index is our main coach and dictates our general market posture. Since my first book was published, our experi- ence with this concept has strengthened my conviction that this is the absolute best market indicator. This index, in combination with the Nasdaq Bullish Percent, has guided our decisions through the murky markets of 1999 and 2000 with flying colors, the bear market from 2000 to the end of 2002, as well as the bull- ish market we have had from 2002 through 2006. It continues to amaze me how effective this index is at alerting us to which team, offense or defense, is on the field.

It wasn’t until January 1987 that I began to fully understand what the Bullish Percent Index was all about. That was the month my partner, Watson Wright, and I started Dorsey, Wright & Associates (DWA). Before that, I was director of options strat- egy at a large regional brokerage firm. Although my department was self-contained, in that we did our own research and never pig- gybacked off the firm’s recommendations, we did use another outside service for our intermediate-term market outlook in addi- tion to the Bullish Percent Index. I am an adamant believer in the KISS principle (“keep it simple, stupid”), from investing to run- ning a company. When we started our own company, I wanted to

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Figure 6.1b NYSE Bullish Percent, 1986–2000.

Figure 6.1c NYSE Bullish Percent, 2000–2006. 180

Primary Market Indicators for Gauging Risk 181

stick with the basics, and this continued to draw me back to the Bullish Percent concept I had used previously. What we found is that when the market in general had an upward bias, the call rec- ommendations generally worked. When the general market was losing ground, the call recommendations did not work as well, but the put recommendations worked really well. In other words, we found that the first step in our game plan for investing was to determine the general direction of the market. Was the market supporting higher prices or not? It’s kind of like the tide going in and out in a marina. When the tide goes in all boats are lifted. Conversely, when the tide goes out, all boats decline.

This concept has been numerically quantified by several stud- ies including one by the University of Chicago and another de- scribed by Benjamin F. King in his book, The Latent Statistical Structure of Securities Price Changes. What these studies quanti- fied is that 75 percent to 80 percent of the risk in any individual stock is in the market and the sector. Only 20 percent of the risk in any individual stock is related directly to that issue. Therefore, as we began building our business, we put tremendous credence in the Bullish Percent concept to tell us whether the tide was rising or falling in the market, and this guided our recommended strate- gies in the market. It is now 20 years later and I am even more convinced this is the right concept to guide our broad market pos- ture. I have used this Bullish Percent concept now through every kind of market you can imagine in the past 20 years. We have suc- cessfully negotiated the crash and subsequent recovery of 1987, the recession and war in the Middle East during 1990 to 1991, the stealth bear market of 1994 and subsequent phenomenal bull mar- ket for the next several years, the bear market/Asian crisis of 1998, the bull market in indexes and bear market in stocks from 1998 to 2000, and the OTC meltdown of 2000, as well as the structural fair market or sideways market we have been in from 2001 through 2006. As the different types of markets have come and gone, I am even more impressed with how the Bullish Percent concept saw us through each market in fine form. Some markets are more volatile than others and require more vigilance, but they don’t dif- fer much from a football game. Some games are marked by many turnovers while others are marked by long periods of possession of the ball. Still other games are defined by how a certain team

182 Learn the Point and Figure Methodology

played defense. The stock market is the same way. Every game is different, but the process and rules of playing the game never change. It is imperative that you learn this concept well, and keep it in the forefront of all your market decisions. The Point and Fig- ure method of analysis is not a science; it is, however, an art. The more you use the Bullish Percent concept, the better you will be at interpreting it and thus better at the investment process. Remem- ber, you are an integral part of this whole program; nothing works without your involvement.

Do You Have an Operating System?

During the 1980s, the market pretty much went up. This decade made the reputations of many investment advisors and money managers, who then slipped back into obscurity in the 1990s. The decade of the 1990s ushered in a new breed of money manager. Many money managers in the 1990s had much in common with an eight-year-old snow skier—no fear. I remember financial tele- vision stations sporting fundamental analysts who had found new ways to evaluate companies that had no earnings, no hope of any earnings, and no real reason to even be listed on any exchange. This was one of the most amazing times I have seen in the stock market. If you asked an investor why he bought particular stocks, you would likely get the following response: “Because it’s going up.” Gravity eventually upsets a good thing, optimism quickly turns to pessimism, and those who were once considered heroes settle back to being mere mortals as their clients lose their shirts. I’ve seen this time and again during my career. As I write this, anything that smacks of oil or gold is, well, golden.

We primarily focused on the option stock universe in the 1980s, and to a lesser degree on the general market of stocks that did not have options attached to them. Stocks generally rose dur- ing this period, so the focus was on catching the next rising star. The 1980s were wild indeed. Things were popping, and the listed derivatives market was only about seven years old, having de- buted in April 1973. By the time the 1980s rolled around, options derivatives were the fastest game in town. If I were asked to de- fine that period with one word, it would be overleveraged. It

Primary Market Indicators for Gauging Risk 183

seemed everyone had a stake in the game. By 1987, the game had gotten easy and everyone, it seemed, had become comfortable with the state of the market. Rising prices translated into easy money in options. Until October 1987, that is. Once again gravity exerted its influence, and in one day the air came out of the bal- loon. Today, with the Dow Jones at about 11,500, a similar drop to that of October 1987 would be the equivalent of falling about 2,600 points in a single day. Can you imagine the field day the media would have with that magnitude of a drop? And we’ve al- ready been there, done that. One of the strategies that led to the one-day October 1987 decline was the misuse of put options that had a dampening effect on the options market. Put options can be viewed as insurance products. Buyers of puts are typically seeking insurance to hedge some market risk they are unable or unwilling to accept. The seller of puts on the other hand is contracting to provide the insurance the buyer is seeking. A put seller stands ready to purchase stock at a certain price for the life of the con- tract, no matter how far below that price the stock declines. This is similar to an insurance company insuring your car for the stip- ulated duration of the contract. The insurance company will make you whole if you have an accident. If cars never had any ac- cidents, the insurance business would be the greatest business of all—good premiums and no risk. Because stocks rarely had acci- dents during the early 1980s, investors decided to enter the un- derwriting business. You know what happens when everyone thinks some investment is too good to be true—it generally is. Well, in October 1987, every stock on the stock exchanges had an accident the same day. The casualty companies of the stock mar- ket (put sellers) all went bankrupt. I am referring to the investors who sold those puts that, up until October, usually expired worthless. This expiration month, they didn’t. From that day on, the options market changed.

This isn’t anything new. It’s been going on since the tulip craze in the 1600s. It happened again with Internet stocks in the late 1990s and early 2000. And I am sure it will happen in the future. You would think investors would learn from their mistakes or at least learn from history, but the conventional wisdom always seems to suggest that, “this time is different.” Most investors make the same mistakes year in and year out. Their biggest mistake

184 Learn the Point and Figure Methodology

is operating in the markets without a logical organized method of analysis. I see it day in and day out. So much information is avail- able today that investors are more confused than ever on how to manage their money. Most investors and brokers don’t operate in the markets with a defining process, an operating system if you will. However, a select group of brokers have taken it upon them- selves to see that they are well educated in this methodology. They have attended our Point and Figure Stockbroker Institute in Rich- mond, Virginia. These craftsmen brokers have a solid game plan for their customer that incorporates the strategies of wealth preserva- tion and wealth accumulation based on the Bullish Percent con- cept and associated Point and Figure discipline.

If I could impress on you one fact, it would be that at least 75 percent of the risk in any stock is associated with the market and sector. If the overall market is not supporting higher prices, very few stocks you own, if any, will do well. In the past, I spoke at the Yale Club’s annual Wall Street Night with Merrill Lynch’s direc- tor of Investment Strategy, PaineWebber’s director of Investment Strategy, Jim Rogers, Abbey Cohen, and some of Wall Street’s top economists. In all, some of Wall Street’s brightest people. The second year I was invited to speak I brought a chart I always use when I explain the Bullish Percent concept. This chart is a schematic of a football play we often see on TV during football games. This chart is my way of demonstrating how we view the market as a football game where the play shifts from offense to defense throughout the game. Once the other panelists had fin- ished discussing the market’s outlook, it was my turn. The first chart (Figure 6.2) I put up was a football schematic like the one John Madden writes on the TV screen with his grease pencil showing what just happened on the last play. This chart drove home the point I was trying to make that evening: The first thing an investor must know before investing any money is whether the offensive team or defensive team is on the field.

In a football game, two forces operate on the field at any one time, offense and defense. The same forces act in the marketplace. There are times when the market is supporting higher prices and times when the market is not supporting higher prices. When the market is supporting higher prices, you have possession of the ball. You have the offensive team on the field. When you have the ball,

Primary Market Indicators for Gauging Risk 185

Figure 6.2 Game plan.

your job is to take as much money away from the market as possi- ble; this is when you must try to score. During times when the mar- ket is not supporting higher prices, you have in essence lost the ball and must put the defensive team on the field. During such periods, the market’s job is to take as much money away from you as possi- ble. Think for a moment about your favorite football team. How well would they do this season if they operated with only the offen- sive team on the field in every game? They might do well when they had possession of the ball, but when the opposing team had the ball, your team would be scored on at will. The net result is your season would be lackluster at best. This is the problem most in- vestors have. They don’t know where the game is being played, much less which team is on the field. Let’s face it, most American investors only buy stocks, they never sell short. The market is fair. It has something for everyone. It goes up and it goes down. The NYSE Bullish Percent signals when the environment is ripe for of- fense or defense. I want to stress that there is a time to play offense and a time to play defense. You must know which is which.

How the Bullish Percent Concept Developed

The need for a soulless barometer started with Earnest Staby in the mid-1940s. He was thinking about the market indicators in existence and determined there was a problem that needed to be

186 Learn the Point and Figure Methodology

addressed. He reckoned that if one were to look at any chart of the broad averages, whether it was a Point and Figure chart, bar chart, line graph, or candle chart, they all looked bullish when the market was at its absolute top, and conversely, they all looked bearish when the market was at its absolute bottom. He deter- mined that we needed a soulless barometer that would guide us to become more defensive at market tops and more offensive at mar- ket bottoms. A contrary indicator if you will. Well, Earnest was not able to come up with this soulless barometer, but A. W. Cohen did in 1955.

What Cohen was trying to create was a market indicator that was bullish at the bottom and bearish at the top. Something that was totally contrary to how most investors operate in the mar- ket. Normal trend charts of indexes like the Dow Jones and the S&P 500 are always bullish at the top and bearish at the bottom. Thus, trend charts of market indexes invariably lead investors to buy at the top and sell at the bottom. Here’s how the Bullish Percent concept works. It is contrary and goes against the pre- vailing wisdom. Most market pundits think the Point and Figure method is a trend-following system. It is not that at all in the initial stages of investment. What this method endeavors to do through the Bullish Percent Indexes is to buy stocks when they are washed out and virtually everyone has denied them. Kind of like a value investor might operate, not the other way around. Although once a stock does make a move off the bottom and starts a long-term uptrend, it can be bought along the way. But the method tries to initiate the buying of stocks when they might be considered value stocks whose momentum has re- cently turned up for the better. If a stock is moving up off the bottom, as it gains sponsorship at the price of, let’s say, 40, it will likely be good at 45, 50, 60, or even higher. Remember stocks that are the first to double in a bull market are typically the first to double again. So this method of analysis is really a contrary investment style that turns into a trend-following style once the vast majority of stocks have moved off the bottom. Just because you did not catch a stock at the bottom doesn’t mean you are out of the ball game. I have always wondered why a value investor would not incorporate technical analysis in his decision making process. The value player suggests that the

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stocks that he buys will eventually be recognized as a value by other investors and as a result will have their price bid up. What if no one sees it like the value player sees it? I’ll tell you what will happen. The stock will go nowhere. Why not put the list of value stocks together and wait until the supply/demand rela- tionship of the stocks begin to change where demand is in con- trol. That would be an aces back-to-back trade, a whole lot better than Texas Hold ’Um Poker.

The NYSE Bullish Percent is simply a compilation of the per- centages of stocks on the NYSE on Point and Figure buy signals. Think back for a moment to Chapter 3. A bullish chart is one where the last signal is a column of X’s that exceeds a previous column of X’s. If you simply thumbed through all the Point and Figure chart patterns of the stocks on the NYSE and counted the ones that were on buy signals, then divided by the total number of stocks evaluated, you would have the NYSE Bullish Percent reading for that day. A sixth grader could do it. We have comput- ers that do the counting for us. Let’s say there were 2,000 stocks on the NYSE and 1,000 of them were on Point and Figure buy sig- nals. The Bullish Percent would be at 50 percent (1,000/2,000 = 50 percent). Each box constitutes 2 percent, and the vertical axes runs from 0 to 100 percent. That is the football field we are play- ing on. When the index is rising in a column of X’s, more stocks are going on buy signals suggesting sponsorship is increasing in the market.

Think about what actually takes place if the index is in X’s at 50 percent this week and over the next week rises to 52 percent. Changes in the index can only come from first signals that are given, not subsequent signals. What do I mean by first signal? Let’s say XYZ stock is on a sell signal, bottoms out after declin- ing, and then gives that first buy signal off the bottom. That sig- nal turns the stock from bearish to bullish (see Figure 6.3). It is this first buy signal that is recorded. All subsequent buy signals are not counted—one stock, one vote.

To be sure you understand how this index can move from 50 percent to 52 percent, let’s theoretically cut the number of stocks trading on the NYSE down to 100. Over the next week, 12 stocks experience a new buy signal like the one shown in Fig- ure 6.3, and 10 stocks experience new sell signals. The net result

188 Learn the Point and Figure Methodology

Figure 6.3 Bearish to Bullish pattern.

of the action for the week is net two new buy signals (e.g., 2 per- cent more stocks went on buy signals than went on sell signals). Remember that each box on the chart represents 2 percent, so a 2 percent net change in new buy signals allows the chart to rise one box. Think about the importance of what I just said. I get questions all the time about how this index correlates to the Dow Jones or the Nasdaq or the S&P 500. It doesn’t correlate at all. These indexes are either price weighted or capitalization weighted. In the case of the Dow Jones, the highest price stock has the most votes. In the Nasdaq and S&P 500, the stocks with the largest capitalization have all the weight. It can take only a handful of stocks to move these indexes. Let’s say IBM was bought out tomorrow 100 points higher than it is at today’s close. Do you think it would have an effect on whether the Dow Jones rose or not that day? It sure would. The Dow Jones Aver- age would rise today, but it would be only one stock that is caus- ing all the action. If the top 20 highest capitalization stocks in the S&P 500 went up sharply one day, the S&P 500 would rise as well. Now, what does this type of action do to a basic chart of these indexes? It obfuscates reality, that’s what it does. If IBM were bought out tomorrow 100 points higher than its close today, it would only count as one positive stock on the NYSE Bullish Percent Index. It would have virtually no effect on mov- ing the index. It is important to keep the Bullish Percent sepa- rate in your mind versus indexes that are a measure of performance of a handful of stocks. The Bullish Percent is an as- sessor of risk in the market, not performance. This is the main difference.

Primary Market Indicators for Gauging Risk 189 Why Use the Bullish Percent

versus a Chart of an Index

One of our clients sent us an interesting article by James Surowiecki entitled, “The Financial Page Markets Always Out- smart Mavens” (from the New Yorker, October 9, 2000). That arti- cle had an interesting take on the markets and long-term capital management. That firm had bond trader John Meriwether and some of the smartest minds on Wall Street, yet the fund managed to blow up. The author compares the TV show Who Wants to Be a Millionaire? with long-term capital. The premise of the show is simple. Contestants pick one of four answers to a trivia question, with the value of each question getting greater until they reach the final million-dollar question. A contestant who answers a question wrong is out. The show gives contestants three “life- lines.” If they are stumped on a question, they can use the life- lines to help them out. One lifeline is a 50/50, which takes away two of the wrong answers and leaves one correct and one wrong answer for the contestant to select from. Another lifeline is to call a friend to see if he or she knows the answer, and finally a contestant can poll the audience. To do this, each member of the audience keys in his or her choice for the right answer, then the computer displays what percentage of the audience voted for each answer. What the show’s producers have found is that when the participant phones a friend for an answer, the person is right two- thirds of the time. When the contestant polls the audience, how- ever, they are right nine times out of ten. So what gives here? Your super-smart friend is right less often than an audience of people who come from all walks of life and have diverse educa- tional backgrounds.

In short, you are more likely to find right answers from a di- verse group of people than from one person you deem to be ex- tremely bright and well rounded. As Surowiecki says in the article:

Long-Term specialized in esoteric trading strategies, which meant that most of the time there were relatively few people it could trade with. If you want to buy stock in Cisco Sys- tems, there are lots of folks out there who will sell it to you

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Learn the Point and Figure Methodology

at a reasonable price. But if you want to buy, say equity volatility (don’t ask), as Long-Term did, there are really only four or five dealers in the entire world who buy and sell this stuff. And they all know one another. These people may have been financial wizards, but, as Millionaire demonstrates, if you want to find the answer to a question—like “What’s the right price for equity volatility?” you’re better off asking a big, diverse group, rather than one or two experts.

Keep in mind that two of the principals of Comprehensive Capital are Nobel Prize Laureates.

You can test this phenomenon pretty simply with an old trivia game, “How many jelly beans are in the jar?” Surowiecki asserts in his article that a college professor does this with his classes and invariably the collective guess is within 3 percent of the actual number. At each of our Advanced Point and Figure Institutes, we conduct this experiment. We have an intern count out peanut M&M’s into a large jar and write down the number. Then, the eight people in the office guess how many M&M’s are in the jar. The results are essentially the same each time. In one of our latest Advanced Point and Figure Institutes, the average guess of the eight people who were teaching the seminar was 840. At the sem- inar, in which there were 80 attendees who all voted, the average guess was 1,398. Now, get this—the number of M&M’s was 1,396! We found it absolutely amazing that the group came so close. We took all the guesses and applied the statistical concept of a bell curve to it. What we saw was a perfect bell curve. There were some outlying guesses but the collective guess was right on the money. Again, the larger the sample, the better the average guess.

Norman Johnson, a physicist at Los Alamos National Labora- tory, quantified this hypothesis. He built a computer-simulated maze in which a person could navigate in numerous ways and tested people’s ability to get through it. Johnson took the sample group and found what he called the “collective solution.” In other words, he took the turn in the maze that the greatest percentage of people picked. This “collective solution” was just 9 steps long com- pared to an average of 34.3 steps the first time a person worked through the maze. Furthermore, he found the bigger and more di- verse the group, the smarter the collective solution was. As

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Surowiecki points out in his article, “The miracle of markets is that a hundred million ordinary people, just by going about their daily business, end up allocating resources much more efficiently than would five guys talking on the phone, no matter how smart those five guys are.” Or as Michael Mauboussin, the chief investment strategist at Credit Suisse First Boston, puts it, “The market is smart even when the people within it are dumb.” Does this speak in any way about the wisdom of the politicians we elect? Maybe the best way to solve world problems is through a collective vote of all Americans on the Internet. Hey, don’t laugh; it might solve the hanging chad and dimple problems in Florida. I’ll bet it could solve our energy crisis, too. The problem is it wouldn’t get any incremen- tal votes for politicians, so I’m sure it will never be tried.

Our Bullish Percent concept relies on the same approach as the jellybean, M&M, or maze tests. The larger and more diverse the sampling, the better or more accurate picture we get of risk in the marketplace. We view the Bullish Percent as “polling the au- dience” in the Millionaire show, while the most often quoted market indexes take the “phone a friend” solution. The audience members get it right more often than the phone a friend, and that is what we see with the Bullish Percent—it is better at assessing risk in the market than the indexes. Remember, it is the risk in the market we are assessing, not the market’s performance. Each week when we calculate the Bullish Percent reading we are in essence polling our audience, which happens to be the NYSE (or OTC) stocks. This audience of about 3,000 for each market is bet- ter at assessing risk than the top 20 capitalized stocks in the S&P 500 or Nasdaq 100. Remember, the bigger the sample size, the more accurate a picture you get. Each week, we ask the stocks comprising the NYSE (and OTC) what is the correct level of the Bullish Percent. Should it be 50 percent, 70 percent, 30 percent, or somewhere else? It is then up to us to interpret the reading and decide what type of strategies we want to integrate.

Mechanics of the Bullish Percent

Let’s go back to the mechanics of charting the index. We use the same three-box reversal to shift columns in this index as we do

192 Learn the Point and Figure Methodology

in the normal Point and Figure chart; however, we do not look for chart patterns in this index as we do in the individual charts that make up the index. We do, however, watch for Double Bot- toms and Double Tops. I’ll explain in a minute. Field position and the column you are in are the two most important consider- ations. Remember the only way to switch from one column to the next is through a three-box reversal. Since each box in the NYSE Bullish Percent is worth 2 percent, it would take a sum total of 6 percent net buy or sell signals to cause a reversal. Re- versing from one column to the next is tantamount to losing or gaining possession of the ball.

The chart is made up of columns of X’s and O’s with the verti- cal axes running from 0 to 100 percent. We think of this as a foot- ball field consisting of 100 yards. There are two things we try to ascertain with this chart: (1) Who has the ball (offense/defense)? (2) What is the field position (current level from 0 to 100 per- cent)? If you colored the area above the 70 percent level in red and the area below 30 percent level in green, these would represent the two extremes much like the end zones of a football field. The higher the index climbs, the more overbought it becomes because more and more investors become fully invested, and those in- vestors who are inclined to sell tend to hold off. The lower it drops, the more oversold it gets because more and more people who have an inclination to sell do, and those who have an inclina- tion to buy hold off. When the index is rising in a column of X’s, we say you have possession of the football. When you have pos- session of the ball you must run offensive plays. This is your time to attempt to score against your opponent, the stock market. When the index is declining in a column of O’s, the market has the ball and your job is to try to keep it from scoring against you. The numbers in the boxes on the chart represent months of the year, so you can see the time spent in a column of X’s or O’s is generally a number of months, not weeks.

It is important to fully understand this index, so let’s go back to our discussion about how the index rises and falls. It takes a net change in buy or sell signals to move the index. The mini- mum percentage move in the index is 2 percent to advance a box or decline a box. It requires a 6 percent net change between new buy and new sell signals to change columns. This 6 percent

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change is the critical part of how this index moves from column to column. Typically, I look at the index as a gauge of how many players are on the field. In July 1990, the Dow Jones was making all-time highs with the NYSE Bullish Percent Index at 52 percent. This showed that the Dow might have been at a new high but only 52 percent of the NYSE players were on the field. In other words, the NYSE Bullish Percent was at 52 percent and in a col- umn of X’s. One would have expected to see more than 52 percent of the stocks participating in the rally when the Dow was at new highs. This goes back to our discussion on how it only takes a few strong stocks to push and pull the index. A few weeks later, Iraq invaded Kuwait, and the same day the NYSE Bullish Percent re- versed over into a column of O’s, signaling investors had lost the ball once again. Those who heeded the signal avoided a major crunch in the market. The net result was the index declined to the 18 percent level in October 1990, which was the bottom. The first week in November the index reversed into a column of X’s signaling investors had once again taken possession of the ball. Those who were willing to listen bought stocks right at the bot- tom. Those who preferred to listen to the news media were ex- pecting a depression or worse. I am continually amazed with the accuracy of this index. It helps the investor understand the most important question in investing, “Who’s got the ball?”

NYSE Bullish Percent Risk Levels

There are six degrees of risk in the index similar to the different signals a traffic light can give. A. W. Cohen felt if the index was rising in a column of X’s and above the 50 percent level, the mar- ket was bullish. Conversely, if the index was declining in a col- umn of O’s and below the 50 percent level, the market was bearish. Earl Blumenthal fine-tuned the NYSE Bullish Percent to include 6 degrees of risk. Over the years of working with this index, I have found that field position and whether the index is in X’s or O’s is about as complex as you need to get with this con- cept. For this reason, I am leaving out the risk levels in this up- dated book. I have not found much use for them over the years, instead I have concentrated on column and field position.

194 Learn the Point and Figure Methodology

Earlier I mentioned that we watch for two patterns—the Double Top and Double Bottom. It is significant that when the Bullish Percent goes into a period of weakness (reverses into O’s) and then reverses up (into X’s), rises to the previous level that caused the supply to come in, and exceeds that level (Double Top). We would give added value to this condition. Conversely, I would say the same thing with the Double Bottom. Don’t try to think too deeply into it. Suffice it to say that when the Bullish Percent is in X’s below 50 percent the field position is better than when in X’s above 50 percent. When in O’s, the field is worse above 50 percent level than it is below 50 percent. It’s just logical. Keep it simple. Who has the ball and how is your field po- sition? That is the most important guidance the Bullish Percent can provide.

Lessons from the Bullish Percent

As mentioned, my conviction in the Bullish Percent has only grown stronger through years of experience with different mar- kets. In this new third edition, we have tacked on another five years of experience watching it guide us through even more mar- ket conditions and our own confidence level has just continued to build. You can gain this confidence level too by studying different market periods and how the Bullish Percent has reacted. If you take the time to read and study the market scenarios I am about to lay out, you will be miles ahead of the average investor in un- derstanding how the markets work.

1987—The Crash

I discussed the crash of 1987 earlier because the NYSE Bullish Percent Index saved our company and would have helped any in- vestor avoid the crash if he or she had been following it. We were only 10 months old at DWA and had just begun to acquire some clients. We had decided when we started the company that our main market indicator would be the NYSE Bullish Percent Index. That index was the soulless barometer we would hang our hat on. If it had worked so well since it was developed in 1955 by A. W. Cohen, and was well founded in the irrefutable law of supply and

Primary Market Indicators for Gauging Risk 195

demand, why should we look any further? On September 4, 1987, the indicator reversed into a column of O’s (Figure 6.4) and sug- gested we put the defensive team on the field. It was our Head Coach so we followed the signal without any reservation. From that day forward, our feature article in our “Daily Equity and Market Analysis Report” had to do with how to hedge a portfolio with options. The following month the market crashed, and I’ll be the first to tell you we had no idea the decline would be so se- vere. Nonetheless, those who chose to follow our recommenda- tions were prepared. The crash took no prisoners from our client base. This was a major confidence builder for us. We knew then, we were on the right track.

By the first week in November, the same indicator that had suggested defense on September 4, 1987, now suggested offense. This was just as tense as the sell signal the index had given us a couple of months earlier. All the newspapers, magazines, and TV shows were talking about depression, recession, 1929, no hope for Wall Street, and on and on. The media did their part in scaring in- vestors, right at the time our Head Coach (NYSE Bullish Percent) told us to begin running plays. It was a great example of how the market looks ahead. The Bullish Percent Index reversed up into a column of X’s and, once again, we knew of nothing else to do but follow it. Those who followed our recommendation to buy got back in right at the bottom. I must add there was no brilliance on our part for those calls on the market; it was the NYSE Bullish Percent that did it. We simply followed its guidance like football players follow the guidance of their coach. Ultimately, the most credit should go to the late A. W. Cohen for creating this index in 1955. Along the way, this method of analysis became a lost art that I revived in my first book.

After the crash, we put together a marketing piece consisting of excerpts from our report pre- and postcrash. This marketing piece, in essence, opened doors for us. From that day forward, the NYSE Bullish Percent has been the mainstay of our market indi- cators. I have written many articles on it, and each time I write about it I learn a little more. We have used this index to guide our intermediate market action for 20 years now. We have seen it work in bull, bear, and neutral markets. The more you learn about this index, the more confidence you will have in your day- to-day market operations.

Figure 6.4 NYSE Bullish Percent: 1987. 196

Primary Market Indicators for Gauging Risk 197 1990—Kuwait Invasion

We really need to begin the discussion of the 1990’s market by going back to 1989. In September 1989, the NYSE Bullish Percent hit 74 percent (Figure 6.5). Exceeding the 70 percent level put this important indicator into the red zone. In October 1989, every- thing changed. Six percent of the stocks on the NYSE moved from buy signals to sell signals and put the defensive team on the field. The initial move down carried the NYSE Bullish Percent down to 38 percent in a straight column of O’s. By March, there was a slight reprieve. The NYSE Bullish Percent reversed up from March until August when, on the day of the invasion of Kuwait, the NYSE Bullish Percent reversed down into a column of O’s, putting us back on defense. The thing about defense is you never know how bad it will be until it is over. For that reason, we al- ways take the posture that it is better to preserve capital and lose opportunity than it is to lose money. Opportunity is easy to make up, but money is hard to make up. A 50 percent loss in a stock means you have to gain 100 percent just to get back to even. The NYSE Bullish Percent just continued to experience more sell sig- nals and more sell signals until it was finally driven down to 18 percent in September. The Bullish Percent stayed at that level until November when it reversed up into a column of X’s. I dis- tinctly remember watching the financial news and hearing Alan Greenspan tell the American public that we were in a recession at the exact time our main market indicator was reversing up from oversold levels. The difference between economics and Wall Street is that economics reports on what is happening today, while the financial markets look ahead. The Bullish Percent was telling us that the recession was not just beginning, but rather it was nearing an end.

After the NYSE Bullish Percent reversed up from that 18 per- cent level to 24 percent, it rallied straight up to 70 percent. This is one of the few times the NYSE Bullish Percent has fallen to such an extremely low level and then rallied straight up to 70 per- cent. This is why we always take positions on any reversal from below 30 percent. Who knows when that move might end up going coast to coast? Usually we see an initial rally up off the bot- tom and then a retest that results in a higher bottom. When the

Figure 6.5 NYSE Bullish Percent: 1989–1990. 198

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NYSE Bullish Percent reached 70 percent, the risk management process started all over again. This points out how the Bullish Percent is an oscillator and not a trend chart, and why you cannot compare it to an index like the S&P 500. Keep the concept of a risk assessor firmly in your mind as you evaluate this chart.

1994—Stealth Bear Market

The market of 1994 has been dubbed the “stealth bear market.” The indexes were holding up, coming in even for the year, but the sector rotation in the market was unbelievable. As one sector was getting hit, another was recovering from its sell off; the ef- fect of this was to cancel each other out in the broad market in- dexes. However, the individual stocks and many investors did not fare as well. The market during 1994 was one in which you came into the office and sat down and crossed your fingers that it wasn’t your stocks that got taken out behind the shed and shot. The reality of the market was that 80 percent of the stocks on the NYSE were down 20 percent or more at some time during the year. The NYSE Bullish Percent was in a column of O’s for eight months out of the year (Figure 6.6). That means for two thirds of the year we were playing defense. In 1994, the NYSE Bullish Per- cent started out the year at 66 percent. Is this good field position or bad field position to start out the year? Bad field position. By the end of the year, the NYSE Bullish Percent was at 32.1 per- cent. You might ask, “Why wasn’t the Bullish Percent lower than 32.1 percent if 80 percent of the stocks were down 20 per- cent or more that year?” The reason is that many sectors bot- tomed at different points in time. Some sectors, like drugs, bottomed out in the spring; others like technology, bottomed in the summer, and yet other groups bottomed out in December. While some sectors were moving to sell signals, others were moving to buy signals, and those buy signals had the effect of canceling out some of the sell signals, thus keeping the NYSE Bullish Percent from getting down to a reading of 20 percent or lower. Nonetheless, what was the field position going into 1995? Good field position. In 1995, the NYSE Bullish Percent and other indicators had us playing offense for 70 percent of the year (36

Figure 6.6 NYSE Bullish Percent: 1994.

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weeks out of the year, the NYSE Bullish Percent was in X’s), and certainly the market did quite well with the Dow Jones up 36 percent. In 1996, it was a similar story as the NYSE Bullish Per- cent was in X’s 39 weeks that year, 75 percent of the time. The S&P 500 was up 20 percent that year. In 1997, the NYSE Bullish Percent was in a column of X’s for 35 weeks or 65 percent of that year, and in general, it was another good year for stocks, except for the Asian crisis, which hit in October 1997. Before the mar- ket crumbled from the Asian crisis, the NYSE Bullish Percent gave us notice having reversed in O’s from the 72 percent level. That reading of 72 percent was the highest for the NYSE Bullish Percent since 1987.

1998—Indices versus Stocks

The year 1998 showed another major change with respect to the NYSE Bullish Percent (Figure 6.7). What I find so interesting is that there are always different catalysts that seem to make the market rally or stumble, but that doesn’t matter to the NYSE Bullish Percent. Those catalysts are always rooted in the supply- and-demand relationship in the market, and that is what the NYSE Bullish Percent is designed to measure. I’ll never forget the 1998 market. By April of that year, the NYSE Bullish Percent had risen to 74 percent. We began to see selling pressure build up as more stocks were going on sell signals versus buy signals. A change definitely was in the offing. Reversals from above 70 per- cent are particularly concerning. On April 1, 1998, we wrote in our daily research report, “It Wasn’t Raining When Noah Built the Ark.” I saw this euphemism on the marquee of a Baptist church as I was going to lunch one day. I felt as if the Pastor had put it up there for me to read. We always keep our eyes on that marquee as we drive by because the Pastor of the church is incredibly creative with respect to his euphemisms. This one hit me right between the eyes because it was perfect with regard to what the market was on the verge of doing. We needed to have our professional clients begin to think about what they would do to protect their clients when this index moved to defense. Our intention was to get our clients to begin considering risk management/damage

Figure 6.7 NYSE Bullish Percent: 1998. 202

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control—what to do when things go wrong. We could see the Bullish Percent was close to reversing to defense. It was like doing lifeboat drills on a cruise ship. The first thing you do when you embark on a cruise ship is participate in lifeboat drills that deal with what to do if the ship begins to sink. Our outlook was the same. Plan what to do if the market begins to sink so your portfolio won’t go down with it.

By May 13, 1998, the NYSE Bullish Percent Index had re- versed to a column of O’s signaling defense. The index then marched straight down to 16 percent, which is an extremely washed-out condition. In July of that year, the Dow Jones rallied to all-time highs, as did the Nasdaq, NYSE, and S&P 500. The trend charts of these indexes looked very good, but the reality of the situation was that more sell signals were piling up while a handful of stocks pulled these indexes to new highs. It was as if the generals were in the battle but the soldiers had left the field. Those who followed the Bullish Percent Index were dead on the money, playing defense while others who followed the trend charts of these indexes were on the wrong road with the offen- sive team on the field. This “major” rally that took these indexes to new all-time highs only lasted two weeks. Shortly after the highs were made, the market caved in. Or, should I say, those in- dexes caved in. The market had been declining since April 1998. As mentioned, the Bullish Percent eventually went down to 16 percent before we experienced a reversal during the month of September.

2000—The Two-Sided Market

The year 2000 was interesting, indeed. The NYSE Bullish Percent had been making lower tops since its peak in 1998 at 72 percent, and by February 2000 the NYSE Bullish Percent had fallen to 32 percent, just above the green zone or low-risk level (Figure 6.8). Then in March 2000, the NYSE Bullish Percent reversed up on the exact same day that the OTC Bullish Percent reversed down into O’s. We had a situation in which we went from offense to de- fense on the OTC Bullish Percent while going from defense to of- fense on the NYSE. In March, we also saw some of our other

204 Learn the Point and Figure Methodology

Figure 6.8 NYSE Bullish Percent: 2000.

Relative Strength (RS) indicators turning positive on the NYSE while turning negative on the OTC market. This call kept our clients underweighted in the OTC stocks and over weighted in NYSE stocks while most of the investing public was doing just the opposite and getting killed. As mentioned, the years 1995 to 1997 saw the NYSE Bullish Percent in a column of X’s 70 plus percent of the time, keeping the offensive team on the field for those stocks for three quarters of the game. During 1998 and 1999, though, it was a different situation. During those years, the NYSE Bullish Percent was only in X’s about half of the year. In other words, we had the ball for 50 percent of the game and the market had the ball for 50 percent of the game. That’s why

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it was so hard to make headway in the NYSE stocks during 1998 and 1999. But in 2000, we saw a switch back to investors having possession of the ball for 75 percent of the time. Here is the reason for this. The RS of small-cap stocks overtook that of large-cap stocks. This was the first change in the market favor- ing small-cap issues in many years. Since the capitalization- weighted indexes are all driven by the handful of stocks with the highest capitalization, this change was imperceptible to the uninitiated. Over the previous years it was the big-tech names that drove the “market.” Stocks like Microsoft, Sun Microsys- tems, Cisco, and the like were the locomotives that pulled the market up. Now it was the little guys, who never have any votes in the capitalization weighted indexes like the Standard & Poors 500 that were taking over the show. In fact, I remember in July 2001, I was on FOX Cavuto on Business when Neil Cavuto said, “Tom, everyone I talk to tells me they are losing money in the market. How can that be when over half the stocks that trade are up not down?” Well, this was a change in leadership in the market that the media totally missed. The media primarily looks at indexes like the S&P 500 and Dow Jones. If these indexes are going down, then in their eyes the market is not doing well, but in this situation the small-cap stocks were doing fantastic while the large stocks that gener- ally pull the indexes up and down were losing sponsorship. The next five years through mid-2006 were marked by the advance of small-cap stocks.

During the dot-com craze, we saw an increase in the volatility of the NYSE Bullish Percent indicator, especially the OTC Bullish Percent. Some of this can be attributed to the advent of the Internet craze and technology stock proliferation. Over the past 50 years, there have been times when the index has only changed columns two times a year, like 2003 and 2004 when it changed direction four times. So far, five months into 2006, there is only one column of X’s but volatility in this index is not unprecedented. From 1960 to 1965, the index averaged about six changes a year. That was dur- ing the close presidential race between Nixon and Kennedy. There was reason to believe there was voter fraud in that election. The Daley political machine was involved. During that span of years,

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1960 to 1965, we witnessed the Cuban Missile Crisis, the Bay of Pigs incident, and the assassination of President Kennedy. The volatility in the NYSE Bullish Percent ebbs and flows. After the year 2000, when so many investors were absolutely and unequivo- cally wiped out as the Nasdaq dropped 50 percent from its high and that is over twice the percentage associated with a bear market, the volatility in the bullish percent charts came back to a more normal range. What we have learned is that volatility doesn’t matter. Some- times volatility increases significantly and other times it is less but the one constant is the Bullish Percent concept is still the best method of evaluating the markets, hands down!

9/11/2001

This is a day we will all remember. The day America was at- tacked by terrorists who hijacked and flew two airliners into the World Trade Centers. This act of terrorism caused the markets to collapse. The market did not open back up until September 17, 2001, and by September 21, a mere five trading days later, the Dow Jones Industrial Average had lost 1,543 points or 16 percent of its value. Many investors headed for the hills and sold every- thing that wasn’t nailed down. Since this chapter is on the NYSE Bullish Percent, the question is “How did this index react during this sharp decline in the Dow Jones?” The answer can be found by just looking at the chart. You will notice that the NYSE Bullish Percent had us on the defense since June of 2001 (Figure 6.9). Any one who had taken the signal and was operating in a wealth preservation mode went through the attack in relatively great shape. The market had already been in decline when the attack happened. In reality, the attack actually created a bottom in the Dow Jones. It’s major events like this that make investors “throw the baby out with the bath water” and often mark the bottom of the market. The problem is, who rings the bell that the bottom has been reached? For us the bell ringer is the NYSE Bullish Per- cent. On October 11, 2001, the NYSE Bullish Percent reversed up. What many investors thought would be a long-lasting market de- cline was only a one month phenomenon.

Figure 6.9 NYSE Bullish Percent: 2001.

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208 Learn the Point and Figure Methodology 2002—No Place to Hide

Just nine months after the NYSE Bullish Percent had reversed up from below the 30 percent level, in October 2001, our Main Coach was once again knocking at the door of the red zone (Fig- ure 6.10). From the reversal up to X’s in October 2001 at 34 per- cent, the NYSE Bullish Percent marched unwaveringly ahead and by April 2002 was at the 68 percent. You know, there’s an old market adage that says “sell in May and go away” and what strikes me as I look at the chart of the NYSE Bullish Percent is the frequency of the numbers 2, 3, 4, 5 (for February, March, April, and May) when the NYSE Bullish Percent is nearing the red zone. Be that as is may, we defer to the chart and let it tell us when the time for defense is. In 2002, the time for defense was June 3rd. That is when the defensive team came on the field and boy did our team take a lickin’ during the market’s possession of the football. It seemed like the market scored against us at will. By July 23 the major indices were down 20 percent or more and the NYSE Bullish Percent had moved coast to coast, now resid- ing at 24 percent; even lower than the 9/11/01 lows of 28 per- cent. In 2002, there was no place to hide as just about every stock took it on the chin. In fact a look at the DWA sectors dur- ing that time period show that 68 percent or 27 of the 40 sectors we follow were down 20 percent or more.

In August 2002, the NYSE Bullish Percent saw 6 percent of the stocks move from Point and Figure sell signals to buy signals and reverse this chart up into a column of X’s and suggest that you bring the offensive team back on the field and the field posi- tion was ideal, below the 30 percent mark. The NYSE Bullish Per- cent had an initial move up to 42 percent and then reversed down into O’s but this is not unusual (Figure 6.10). In the instances where the NYSE Bullish Percent has fallen below the 30 percent level and reversed up, we have seen the NYSE Bullish Percent re- verse back down and make a higher bottom (or even level) in half of those occasions. But what is interesting is that while the major indices usually make new lows, the NYSE Bullish Percent makes a higher bottom. In October 2002, the NYSE Bullish Percent fell back to 24 percent to test and hold its July low levels while the Dow Jones moved through its lows like a hot knife through butter

Figure 6.10 NYSE Bullish Percent: 2002. 209

210 Learn the Point and Figure Methodology

falling past those July 2002 lows of 7532 to 7197. But because half of the time the NYSE Bullish Percent doesn’t give us another chance, we have to start moving money back into the markets on that initial reversal up. Remember, since 1955 there have only been 18 instances where the NYSE Bullish Percent has moved below the 30 percent level. That’s only about once every three years we get the opportunity to buy at very depressed levels. Of course, without a soulless barometer like the NYSE Bullish Per- cent, we would have no idea of when supply had dried up and de- mand moved back into the equation.

2003—Who Would Have Guessed

In March 2003, the NYSE Bullish Percent was residing at the 36 percent level (Figure 6.11) and as a nation we found ourselves heading into war with Iraq. Just as we were entering that war, the NYSE Bullish Percent was reversing up to a column of X’s and putting the offensive team on the field as of April 2, 2003. The market in general was taking off quickly and conventional wis- dom was that the rally shouldn’t last too long. We were just com- ing out of three consecutive years of the S&P 500 posting losses (−10.13 percent in 2000, −13.04 percent in 2001, and −23.37 per- cent in 2002). Everyone’s mentality was that this rally wouldn’t last, we’re in the middle of a bear market. But that kind of think- ing can only get you in trouble. Think about this situation for a second. You pull a quarter out of your pocket and toss it in the air. You have a 50/50 chance of heads coming up. Now let’s say that you toss that coin three times in a row and tails comes up each time. Does that mean you have a better chance of tails coming up again? No. However, our minds might fool us into thinking that was the case by weighting the most recent action more heavily. However, if you continued to toss that coin for say 500 times, I bet that you would find that heads comes up about 50 percent of the time and tails comes up about 50 percent of the time. In 2003, so many investors found themselves not believing their indicators because the recent market action had swayed their beliefs or the geopolitical situation made it seem implausible that the market could experience a rally.

Figure 6.11 NYSE Bullish Percent: 2003. 211

212 Learn the Point and Figure Methodology

What happened in 2003 was the NYSE Bullish Percent stayed in X’s for almost a solid year not reversing into O’s again until March of 2004 and the S&P 500 was up over 26 percent during that time while the S&P 500 Equal Weighted Index was up over 46 per- cent. The NYSE Bullish Percent rallied to 86 percent before it re- versed into O’s. That reading of 86 percent was the highest reading for the NYSE Bullish Percent since 1982. If you had asked me when the NYSE Bullish Percent reversed up in April 2003 if I thought it would go over 80 percent, I would have guessed not but that is one of the beauties of the system. It forces us to keep the offensive team on the field as long as we have the football. Just because this indicator nears the 70 percent level or even exceeds it doesn’t mean you sell and move the defensive team on the field. What is does mean is that risk is higher at these levels so you ready the defen- sive team and select more conservative offensive plays.

2006

This actually brings us to the status of the NYSE Bullish Per- cent as I write this third edition. I want you to view the NYSE Bullish Percent chart from the top in 2004 at 86 percent to January 2006 (Figure 6.12). Actually, since the beginning of January 2006, the chart has only tacked on one more box but the Dow Jones is up 600 points through May 10. What you will see is a case where the generals are the only ones fighting the battle. The Dow Jones, in May, was within a hair of going to a new all time high and the cover of major financial periodicals flashed “Dow 12,000.” As quickly as the Dow Jones had moved up to test those old highs, it has come down and actu- ally reversed down into a column of O’s putting the defensive team back on the field. When I look at the NYSE Bullish Per- cent that is producing lower tops as the Dow Jones neared a new high, it reminded me of another time in history—1987. This condition will be resolved one of two ways. Either the broad market begins to gain sponsorship and the Bullish Per- cent Index rises and broadens out, or we suffer a broad market decline. I just don’t see it happening any other way. As you know by now, we don’t predict, but it will be fun to watch

Figure 6.12 NYSE Bullish Percent: 2006.

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how it unfolds. Depending on when you read this book, you might already know.

When the Bullish Percents get near or moves above the 70 percent mark, the availability of demand to push the market higher is diminished. An advisor calls their customer with a great idea. It’s the newest widget-making company that will change the semiconductor industry. Your customer replies, “I love the idea. What should I sell to buy it?” If you sell a stock to buy another, supply and demand cancel each other out. One day you start to sell but decide to keep the cash from the sale in your bank account. You don’t replace those sell tickets with buy tick- ets, and that’s what causes the Bullish Percent to reverse down. It’s like a pressure cooker when you’re above 70 percent. The top on the pot is rattling with the steam underneath. One day the steam gets to be too much and the top blows off. We don’t know what the cause will be. It may be the Asian crisis again or it may be another type of international crisis like the Iran nuclear bomb situation, or it’s oil moving to $100 a barrel, or the Fed chairman raising interest rates and tightening the money supply. We never know what the cause will be. What we do know is that the risk is high at these levels and we must govern ourselves accordingly.

What does “govern ourselves accordingly” mean. It can mean many things to many people. For those of you who are profession- als in the investment business, this is NYSE Rule 405: Know your customer. What is right for one person may not be right for an- other. There are many right answers. If you are unaware that the indicators are in high-risk territory, you might just continue to buy stocks with unbridled enthusiasm; the financial news media certainly will foster this enthusiasm. It’s in their best interest that you remain enthusiastic about the markets. That way you keep tuning in. Most of us, though, would not take that tact. Here are some ideas that might make sense in market conditions when this index is at high levels. This is the type of commentary we provide in our daily reports:

• Do nothing.
• Tighten up stop-loss points. As stocks start to give sell sig-

nals, you ensure that you don’t give back too much of your profits. You might choose to just take partial positions off the

Primary Market Indicators for Gauging Risk 215

table on the sell signal, but by doing that you have taken some

defensive action.

• Take partial profits. One thing you might consider is selling a

  third of your position if you are up 30 percent or more. This gives you staying power with the rest of your position to han- dle a correction. The money you free up acts as a hedge and then you have that cash to reemploy once the indicators sug- gest you have a good buying opportunity again. As well, tak- ing partial profits will keep one stock from becoming too large a portion of your portfolio.

• Sell calls against partial or total positions. This takes the sell decision away from you. You take in premium, which acts as a hedge against you, and you sell at the strike price. If the stock doesn’t get called away, you keep the premium and can rewrite the calls. With this strategy, you must be willing to have the stock called away. If you are not willing to have the stock called away, then you’re a closet naked writer.
• Buy protective puts on particular stocks. Let’s say you own Exxon Mobil (XOM). The stock is at the top of its 10-week trading band, the weekly momentum just flipped negative, and the sector is extended and the next support is the 55 area with the stock currently trading around 65. You or your client might be willing to accept the risk down to 60 but after that want someone else to carry the risk. You might choose to buy a six-month-out put struck at 60. That gives you (or the client) the right but not the obligation to sell his stock at 60 anytime between now and expiration no matter where XOM is trading. If the stock does in fact fall, you can always take the profits on the put and hold the stock, too.
• Buy protective puts on a portfolio. Ask anyone if he or she owns a put and the answer would likely be no. Ask the same people if they own a home or a car and you get a resounding yes. If you own a home or a car, you own a put. You own in- surance on your home and car. Every six months, you send the insurance company a check to protect you for the next six months should there be an accident. Many people have portfolios worth more than homes and yet they don’t even think to buy insurance on their stocks should there be an ac- cident in the market. Let’s say you have a portfolio worth

216 Learn the Point and Figure Methodology

$250,000 of blue chip names. Your client says he can handle a 5 percent drop in the market but after that he wants some insurance. The S&P 500 (SPX) is currently trading at 1265. A 5 percent drop in that index would bring it down to 1200. One way to hedge the portfolio is to buy puts on the SPX struck at 1200. Each put that you buy protects $120,000 (1200 times 100) of the portfolio. To hedge a $250,000 portfo- lio, you would buy 2 puts. The price you pay for the puts is like the car insurance premium you pay every six months to your insurance company. You hope you don’t have to use it but if you do, you’re sure glad you have it. Also, you don’t have to buy protective puts on the whole portfolio. You can hedge just a partial portfolio.

• Buy only half positions here and average in the other half on a pullback. This allows you to at least get your foot in the stir- rup in case we don’t get a pullback. If the stock does pull back, then you can average in lower.
• Buy calls or leaps on stocks you want to own. Let the pre- mium you pay be your stop-loss point and come back at expi- ration and see how you stand. The important thing to remember here is not to over leverage. If you normally buy 500 shares, only buy 5 calls; don’t over leverage by buying 15. Keep the rest of the money in a money-market fund.
• Buy an Exchange Trade Fund (ETF) that holds the stock you are interested in owning. It will give you more diversification with less volatility. Let’s say you are interested in buying a particular oil stock. You can buy an ETF that is simply a bas- ket of oil stocks. This way instead of buying one fish, you buy the whole school of fish.

  There are lots of ways to take a more defensive stance. What makes you different from the competition, or other investors, is you have a game plan. You have a soulless barometer to tell you what plays to run.

  This is the type of research we put out each day. We try to make sense of the indicators. We never anticipate the anticipa- tors; however, when we see changes in the offing, we discuss what to do if the event does in fact take place. We always try to have the moves we would make in the chess game laid out for us

Primary Market Indicators for Gauging Risk 217

ahead of time so that we don’t act like a deer in the headlights when the change does take place.

Every few years, the NYSE Bullish Percent gives us some real opportunities by declining below the 30 percent level. It doesn’t happen every year, but when it does, be prepared to buy. The last time it was below 30 percent was in 2002. It’s now 2006. Could we be in for a great opportunity with the index working its way back down below 30 percent this year and on this reversal down into O’s? Depending on when you are reading this book, you might already know. But like I have said many times in this book, we don’t anticipate. We change the players on the field when this indicator tells us to.

The OTC Bullish Percent Index

The OTC Bullish Percent Index is important because of the plethora of high-tech, over-the-counter stocks we deal with each day. Chartcraft began the OTC Bullish Percent in 1981, and the same rules of reversals, box sizes, 70 percent high risk, and 30 percent low risk all apply to this one as well. On our web site (www.dorseywright.com), we now have Bullish Percents on virtu- ally every country that has a stock exchange in the world—from Tel Aviv to London to Australia to Shanghai you can follow the same concept on any country.

The OTC Bullish Percent Index is a compilation of the per- centage of Nasdaq stocks that are on Point and Figure buy signals (see Figure 6.13). The OTC Bullish Percent Index can give you a great deal of insight into what the technology stocks are doing. In 1982, the small stocks bottomed out much earlier than the large- cap stocks. By the time the big-cap stocks were ready to go in Au- gust 1982, the small stocks were already up 70 percent. The chart is read the same way as the NYSE Bullish Percent Index. When the index is rising in a column of X’s, you have the football and should be running plays (buying stocks). Conversely, when it is in a column of O’s, the OTC market has the football and you should be more concerned with defense (protecting your portfolio). The best sell signals come from above the 70 percent level and the best buy signals come from below 30 percent. Much of the time

218 Learn the Point and Figure Methodology

the truth lies somewhere in the middle. Notice also the OTC Bullish Percent bottomed at the 22 percent level three years in a row, 2000, 2001, and 2002. Since 2003 we have also seen the OTC Bullish Percent make lower tops, like the NYSE Bullish Percent, but we have also seen it make higher bottoms. Like the NYSE Bullish Percent, the OTC Bullish Percent hasn’t seen the 30 per- cent level or lower, the green zone, since 2002 so it’s due. This Bullish Percent Index can be an important clue when evaluating the risk in the market.

The Nasdaq or OTC stocks have become much more impor- tant than they were years ago. When I was a broker in the 1970s, these stocks were considered poison. They were the lowest rung of the ladder and always considered high risk. Now we have Nas- daq stocks in the Dow Jones. Some of the largest cap stocks that trade are in the Nasdaq. I must say though, they are still volatile and in many cases are not suitable recommendations for investors who have a low risk tolerance. In the latter part of the 1990s, many investors who barely understood the mechanics of invest- ing had totally overleveraged their whole portfolios with Internet stocks. The media as well as Wall Street analysts had convinced them these stocks could only go up. In the end, many investors lost over half of their retirement funds in these “never decline” stocks. Closely watching the markets is a great education in in- vestor psychology.

From 2000 to 2002, most of those stocks didn’t go up, they blew up. I’ll tell you something else. Just go back and view some of the recommendations by Wall Street fundamental analysts on these Internet stocks when they were at their absolute highs. You will break out in a cold sweat when you see the adoring reports at the top. I’ll bet Google still has them archived. Goldman Sachs took the stock Ask Jeeves Inc. (ASKJ) off their recommendation list after the stock dropped from 59 to 4. That’s only a 93 percent decline from recommended to off recommended. They rated it Market Performer. I guess if the market moved up 20 percent from there, ASKJ would have risen 20 percent. Of course, at 4, that would be 80 cents (ASKJ was acquired by IAC/InterActiveCorp in 2005.) During this same time, Goldman took E-Toys off its recom- mended list when the stock declined under 1. This is why the technical analysis coupled with fundamentals is so important.

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220 Learn the Point and Figure Methodology
POINTS AND FIGURES BY DORSEY, WRIGHT MONEY MANAGEMENT

We are trained from birth that obedience to proper authority is right and disobedience is wrong. That essential lesson fills parental lectures, the schoolhouse, children’s books, Sunday school lessons, and is carried for- ward in the legal, military, and political systems we encounter as adults. Notions of submission and loyalty to legitimate rule are accorded much value in our society.

In many cases it makes great sense to comply with the wishes of prop- erly constituted authority. Those in authority often have superior knowl- edge and judgment.

However, problems can arise if we stop thinking for ourselves and blindly trust the authorities. Furthermore, what if the authority is mis- guided? Let’s consider an example from a facet of our lives where author- ity pressures are visible and strong: medicine. Physicians possess large amounts of knowledge and influence in the vital area of health and hold the position of respected authorities. The medical establishment has a clearly terraced power and prestige structure and various health workers understand that the MD sits at the top. Yet, even with these knowledge- able authorities calling the shots, the application of medicine still has its challenges. A study done in the early 1980s by the U.S. Health Care Fi- nancing Administration showed that, for patient medication alone, the av- erage hospital had a 12 percent daily error rate! A decade later, things had not improved: According to a Harvard University study, 10 percent of all cardiac arrests in hospitals are attributable to medication errors. Com- menting on those examples, Robert B. Cialdini, PhD points out in his book, Influence, problems arise when those lower in the hierarchy stop thinking for themselves. In his book, Cialdini cited the strange case of the “rectal earache” reported by two Temple University professors, Cohen and Davis. A physician ordered eardrops to be administered to the right ear of a pa- tient suffering pain and infection there. But instead of writing out com- pletely the location “right ear” on the prescription, the doctor abbreviated it so that the instructions read, “place in R ear.” Upon receiving the pre- scription, the duty nurse promptly put the required number of eardrops into the patient’s . . . well, you can probably guess where!

Cialdini, also cited an experiment conducted on five classes of Aus- tralian college students, in which a man was introduced as a visitor from Cambridge University in England. However, his status at Cambridge was represented differently in each of the classes. To one class, he was pre- sented as a student; to a second class, a demonstrator; to another, a lec- turer; to yet another, a senior lecturer; to a fifth, a professor. After he left the room, each class was asked to estimate his height. It was found that

Primary Market Indicators for Gauging Risk 221

with each increase in status, the same man grew in perceived height by an average of a half-inch, so that as the “professor” he was seen as two and a half inches taller than as the “student.”

Wall Street has seemingly crowned a multitude of authorities. Some may justly deserve our attention, others do not. It is worth asking our- selves who or what has the most influence on our investing decisions. Is it the CEO of the company in which we are considering investing, our firm’s chief investment strategist, a market commentator, or other authority fig- ure? Is their influence on our decisions due to their status or to their abil- ity to add real value?

For the technician, there is only one authority: the almighty price! In price there is knowledge. Objectivity is key to investing and price is only influenced by supply and demand for the stock. Price determines trend and RS and is, in our estimation, the legitimate authority.