The Master Trader: Birinyi's Secrets to Understanding the Market

Preface

This is not a book about making money in your spare time, nor does it contain formulas that will allow you to retire early or double your money over the next two weeks. There are no guaranteed recipes for success or easy roads to riches.

Warren Buffett once said about life, or maybe it was the market, that the key was to make a large snowball and find a steep hill. For investors today, both professionals and individuals, the reality is not only that the hill is getting steeper but that it is increasingly uphill.

For a variety of reasons, including technology, communications, regulatory changes, and the like, investing is getting more complex and with complexity comes increased difficulty. Regulators and legislatures would like you to believe that rule changes, new instruments, and other developments have made life easier for the individual. I've disputed that from day one and our research and experience regularly highlight the failings of their conclusions.

Exchanges are no longer quasi-public institutions, but are now busi­nesses. And like all businesses, they have to compete with one another. Brokerage firms' primary focus is on their own, not customers' activity. Stockbrokers have been replaced by financial advisors whose focus is on funds and instruments that provide continuous income to themselves—as opposed to buying a stock that you may hold for five years and that would therefore never generate commissions after day one.

Funds engage in marketing rather than markets, and while I do believe that some of the criticism of professional managers is unwarranted, their failing to adapt and adjust will continue to result in mediocre performance, which is still rewarded with seven-figure compensation.

At the same time, the individual can no longer count on employee pension plans. Now IRAs and 401ks have shifted the burden to the employee and very few individuals have the wherewithal, the education, or even the time to run the financial maze.

This book details many of these issues. It should make you aware of some of the issues every investor faces (including professionals who are sadly unaware of many of them as well). Among our recommendations is education, including reading both current and historical articles and ­writings. The Money Game by Adam Smith, the 1967 bestseller, must be at the top of your reading list.

If money is a game, then like all games there are winners and losers. Hopefully, you will emerge a winner by understanding the reality of today's markets and being aware of the landmines and pitfalls. It is not necessarily a guide to making money but should illustrate what you must do and consider to avoid losing money.

It is also intended for the sophisticated or professional investor. Sadly, one of the characteristics of money managers today is their disregard for the market itself. No longer are ticker tapes a critical input, trading feedback is nonexistent, and history is seldom incorporated or interrogated.

Peter Lynch once suggested that poker was a useful ingredient in the investment process and I would argue that it has been more useful to me than my graduate studies. I have addressed some of the issues that should be incorporated in the investment process:

If futures are down 1 percent, what is the market likely to do that day?

A stock reports good news after the close and trades up 10 percent; what will happen tomorrow?

What is the best measure of investment sentiment?

Unfortunately, going forward is going to be even more difficult. Issues such as computerized trading, fragmented markets, unregulated blogs, and commentary will continue to obfuscate the investing landscape and investors' lives will become even more difficult.

Having lived in New York City for many years, I never got into golf. Nevertheless, I think that game and the market have some parallels. Very, very few golfers become scratch or even one-handicap players. But someone with a 10 or 12 handicap can enjoy the game, hope to break 80 one day, and play at various courses around the world.

Very few individuals will ever beat the market. Remember that in June 2013 the very best golfers in the world played the Open at Merion and no one beat the benchmark! Most individuals must play the financial game, and hopefully we have outlined and highlighted some of the rules. One which you should tape to your computer was a banner in the Financial Times in the summer of 2012:

Wall Street Always Wins

CHAPTER 1

Technical Analysis: Fuhgeddaboudit

I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer.

—Warren Buffett

There are three roads to ruin: women, gambling, and technicians. The most pleasant is with women, the quickest is with gambling, but the surest is with technicians.

—Georges Pompidou

Admit it. You were as surprised as I was to find that the former President of France said something about technical analysis. Perhaps it illustrates that individuals who have even a casual interest in the stock market are more likely using a technical approach of some sort. Usually it comes via charts because charts, tables, and graphics are, after all, part and parcel of our daily life. It is easier to show a chart on CNBC, Bloomberg, or in BusinessWeek than GM's balance sheet or income statement. Most market letters are technical in nature, claiming to provide guidance and clarity by reducing all required inputs to a simple, concise graph or table.

Unfortunately, neither life nor the stock market is that simple. We contend after years of analysis and experience that technical analysis does not work.

It is not predictive, it is not consistent, and it is not analysis. While we may not go so far as to compare it to a snake oil salesperson or three-card Monte players, in the ultimate test—making money—it fails.

It fails for a variety of reasons. To begin, it is not a discipline. Unlike the more traditional, fundamental analysts who begin with the economy, examine industries, and eventually look at individual stocks, the technical tool kit is a vast array of approaches and ingredients.

At one recent seminar, the speaker provided a list of technical elements:

This list is by no means complete. Over the years, the stock market has been forecast by astronomy, musical lyrics, any number of statistical/mathematic approaches, and, lest we forget, the Super Bowl. We would be remiss not to mention an article in Playboy: "How to Beat the Stock Market by Watching Girls, Counting Aspirin, Checking Sunspots, and Wondering Where the Yellow Went" (July 1973).

In mid-2010, investors were warned about the ominous signals coming from the Hindenburg Omen:¹

Over the past week, the amount of media coverage given to a rather obscure conglomerate of technical signals called The Hindenburg Omen has been extensive . . . it is supposed to be a very bad sign for the stock market.

The word crash is frequently found in the Omen forecast.

A Wall Street Journal blog later reported Yep, it was a dud, and the market, rather than crashing, cracking, or correcting, gained 22 percent through year end (see Figure 1.1).

Figure 1.1 S&P 500: 2H 2010

Source: Birinyi Associates, Inc., Bloomberg.

INDICATORS: PICK ONE, ANY ONE

The technical analyst/chartist has therefore an abundance of options. Our contention is that too often the facts or indicators support a conclusion; if the indicator changes, no problem, another approach (bearish or bullish) or indicator is inserted.

One approach that we would endorse is to have a consistent process, perhaps beginning with an analysis of the 30 stocks in the Dow Jones Industrial Average (DJIA). A manageable sample that could be regularly analyzed and then supported by some of the other elements listed previously.

Unfortunately, one such exercise only reinforces our argument that technical efforts are of little value. Some years back, Barron's asked three chartists to review the 30 individual stocks that comprise the DJIA:

The first reported that it was indeed a classic long-term bull and expected 2,410–2,825 for the rest of the year with an upside target of 3,400–3,425 possible over the next twelve months.

The second was a bit more cautious: supporting one more move into new high ground with the possibility of a more serious down turn in the Spring.

The third felt that eighteen names were bullish with six others neutral. During the current quarter . . . test the Dow's intraday high of 2,745. After that could rise above 3,000 in the first quarter of the next year.

Unfortunately, for investors and analysts alike they were woefully wrong.

October 12, 1987

Analyzing the Dow

Three Top Technicians Size Up the 30 Industrials

Figure 1.2 illustrates and articulates one of our concerns regarding the approach: Technicians have a disappointing record at critical junctures. This applied not only in 1987 but regularly and, sadly, increasingly so.

Figure 1.2 DJIA: 1987

Source: Birinyi Associates, Inc., Bloomberg.

The 1987 Crash marked the end of the great Volcker rally, which began August 12, 1982 and saw the S&P gain 229 percent. At its birth, at another critical juncture, the technical community was also AWOL. It is interesting to review the mood of those times, while the stock market was technically, in a bear market, it was to be a relatively mild decline (losing 24 percent). But the economy was in a recession (which ended in November 1982) and a number of economists suggested that depression might better describe the landscape. Inflation made investors wary of bonds, even as the 30-year Treasury was yielding 14 percent.

The inflation concern was dramatized in the infamous BusinessWeek cover, The Death of Equities, shown in Figure 1.3.

Figure 1.3 BusinessWeek Cover (August 13, 1979)

Used with permission of Bloomberg L.P. Copyright © 2013. All rights reserved.

Ironically, the magazine was not an inflection point or buy signal, as it was actually published during a bull market (see Figure 1.4).

Figure 1.4 S&P 500: 1974 Bull Market

Source: Birinyi Associates, Inc., Bloomberg.

Less notorious was Forbes' response with their cover Back from the Dead? (September 17, 1979).

While the rally's catalyst was Dr. Henry Kaufman's comments on August 17, 1982, the market had actually bottomed the previous Thursday. Over the intervening weekend, a lengthy New York Times article detailed the views of several technical analysts:

Dark Days on Wall Street

The long bear market seems to be entering its final phase. The end could be violent but also cathartic.

A prominent technician argued that the market must first capitulate . . . a time when everybody simply gives up. He suggested a final sell-off could come by November, maybe sooner, and the next six months would be critical.

Joe Granville, the most visible member of the community, suggested 550 to 650 by January.

On Tuesday, August 17, the DJIA rose 38.79 or 4.9 percent and traded 92 million shares (the average of the previous 50 days had been 53 million shares). On August 18, a new record, and the first 100-million share day saw volume rise to 131.6 million shares. Despite the gains and activity, chartists were generally unimpressed:

. . . the Dow could well break its '82 low.

. . . an even lower Dow reading, about 680, is anticipated by the end of the month by Justin Mamis, a well-regarded technical analyst.²

One month later, John Schulz wrote a piece for Barron's on September 13, 1982:

Messing Up the Tea Leaves, Where Technical Analysis Went Wrong

Why did so many pros fail to see it coming? Technical analysis must shoulder much of the blame . . . [technical analysis] offered monumentally bad advice just when—for perhaps the first time in modern history—it finally proved decisively instrumental in shaping majority opinion.

Schulz wrote that the technicians were unanimous in their view that a bottom would be accompanied by waves of massive selling. Cash was not at expected bear market levels, and sentiment readings likewise failed to reflect an overwhelmingly negative view. He also suggested that the bearish indicators had become too popular and accepted and therefore discounted.

1990: ANOTHER OPPORTUNITY MISSED

If the chartists were negative in 1982, their attitude in 1990 was even more pronounced (see Figure 1.5). Following Saddam Hussein's foray into Kuwait on August 2, 1990, the market took a sharp, concentrated dive that many expected to be protracted and painful.

Figure 1.5 S&P 500: 2H 1990

Source: Birinyi Associates, Inc., Bloomberg.

Since the decline was event-driven and abrupt, one cannot fault analysts—technical or otherwise—for failing to anticipate the drop. But their reaction afterward is further evidence of our concern that at critical instances, the approach is unsatisfactory:

Analysts Are Reading Their Charts—And Weeping

With virtually every major indicator pointing south, the market slump may stretch well into next year. . . .

How low is low? Some see the Dow touching bottom at 2,200 . . . or 1,700 . . . or 1,444.

BusinessWeek, October 8, 1990

A Bear-Market Rally? It Sure Looks Like One

. . . watches for three signals that would indicate more than just a bear-market rally. Right now he can't detect evidence of even one. . .

Jack Solomon, technical analyst at Bear Stearns, puts things bluntly. The first rallies don't hold. Sell them . . . it's a trap.

Wall Street Journal, November 21, 1990

Analysts: Shades of Nostradamus

On December 24, 1990, after the market had gained 11 percent off the bottom, Barron's interviewed four analysts.

The first expected a slide toward 2,400 and then a modest recovery to 2,700–2,800. The second was looking for gains late in 1991 after trading to the 2,100–2,200 level. Analyst number three also thought 2,100 was the next stop followed by a rally to 2,700.

The fourth was the most bearish (2,000, maybe 1,900) and then trade in the range of 2,000 to 3,000 over the next four or five years (see Figure 1.6).

Figure 1.6 DJIA: 1991

Source: Birinyi Associates, Inc., Bloomberg.

At the end of the year, the best we can say about these calls is that they tried (see Figure 1.7).

Figure 1.7 DJIA: 2H 1991 through 1995

Source: Birinyi Associates, Inc., Bloomberg.

The Market May Be About to Start Acting Ugly

. . . technicians are widely predicting grim tidings for the market . . . some analysts are warning of a possible reprise of the events of 1987.

The market traded a bit lower in November/December (–6.9 percent) so once again the bears were in full cry:³

Watch Out for Falling Bulls

Wall Street's technicians are trumpeting a horrible crash—again.⁴

(These articles were full-page features, not small, insignificant stories relegated to the bottom corner of a page.)

We cited Mr. Buffett earlier. One indicator that is often cited is the weekly sentiment of the American Association of Individual Investors (AAII). Figure 1.8 shows the chart for the 2009 bull market.

Figure 1.8 AAII versus S&P 500

Source: AAII, Birinyi Associates, Inc., Bloomberg.

Figure 1.9 is the same chart but inverted. As the gentleman from Omaha said . . .

Figure 1.9 AAII versus S&P 500 (Inverted)

Source: AAII, Birinyi Associates, Inc., Bloomberg.

NOTES

1. Michael Kahn, Taking Stock of a Scary Market Signal, Barron's, August 8, 2010.

2. Dan Dorfman, Stock Rally Washed Away, Daily News, August 27, 1982.

3. Gary Weiss, The Market May Be About to ‘Start Acting Ugly,' BusinessWeek, August 4, 1991.

4. Gary Weiss, Watch Out for Falling Bulls, BusinessWeek, December 15, 1991.

CHAPTER 2

The Failure of Technical Efforts

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

—John Maynard Keynes

The obvious question is why, given the resources and talents of so many, does the technical approach (in all its manifestations) apparently fail to provide guidance and illumination. As we suggested earlier, the abundance of approaches under the technical umbrella provide a salad bar of indicators and tools from which an analyst can choose to support a conclusion.

In addition to a lack of discipline and coherence, technical analysis—in our view—fails for reasons that include:

Amazingly, a lack of analysis.

Most analysts didn't, and don't, understand the market.

Not recognizing the changing nature of the market, the industry, or the environment.

Commentary rather than tangible advice.

It is both surprising and disappointing to find that little analysis and rigorous testing have been undertaken on the various indicators that analysts incorporate in their efforts. Earlier we cited John Schultz's concern that the prevailing opinion at the 1982 bottom required a massive sell-off or, as it was later termed, capitulation.

But why? The previous significant bottom, December 1974, was not accompanied or characterized by investor flight (see Figure 2.1). There was no discernible increase in activity as volume remained about average throughout the entire quarter. Did no one consider that in their strategy?

Figure 2.1 DJIA Volume 4Q 1974 (Shares, M)

Source: Birinyi Associates, Inc., Bloomberg.

Or, we might examine the popular and oft-quoted weekly survey of advisory services, which is tracked and provided by Investors Intelligence.

This indicator is considered a contrary one arguing that if too many individuals are positive, who is left to buy? Also, it suggests that there is the madness of crowds and this is one method to identify when that tipping point has been reached. Like many theories, the logic is impeccable but this is, after all, the stock market.

Historically (back to 1963), the most positive readings of the survey were January 16, 1976 and January 23, 1976, with 81 percent of the respondents bullish, a year the S&P was to gain 19 percent (see Figures 2.2 and 2.3). Later in that same market it was more useful. At the beginning of 1979, investors were bearish as the S&P traded to 100 before staging a rally that was to take it to 130. But as the market rallied, so did investors. We might also note that the volatility of the results is unsettling.

Figure 2.2 S&P 500

Source: Birinyi Associates, Inc., Bloomberg.

A LACK OF ANALYSIS . . . (AGAIN)

Another favored indicator is the number of stocks above their average price of the last 200 days, or roughly ten months. This indicator occurs as the result of many stocks having had a substantial move. The assumption is that it is more likely that the market will pause or slow down than continue higher. It, like other indicators, creates what is commonly termed an overbought condition. Conversely, when relatively few stocks have done well, a rally is more likely, creating an oversold condition.

The latter is actually true; when relatively few stocks (by this definition) have done well, it suggests that most stocks are doing poorly. Indeed this is the case. As shown in Table 2.1, there have been (in the past 20 years) six instances when only 20 percent of the S&P names are higher than they were—on average—200 days ago. If we measure from when we first breach that measure, in five of the six instances, the market, as we might expect, rallies. It rallies despite the fact that the readings may go lower. In January 2008, at the low, only 1 percent of the S&P 500 names were above their 200-day average.

Table 2.1 S&P 500 Performance After It First Crosses Below 20 Percent

As shown, buying when this indicator is oversold is not only profitable, it is very profitable. To illustrate how much so, we might at this point interject our 5 percent rule. Over the past 100 years, the DJIA has had an average annual price appreciation approximating 5.5 percent. In Table 2.1, buying in August 1998 led to an almost 22 percent return in six months or what would have taken, on a historical basis, four years to achieve. As the cliché goes, that works for me.

What then happens when a large number of stocks are overbought? Using 80 percent as a threshold or indicator of an overbought market, we might expect a correction or consolidation as shown in Table 2.2. In fact, the market becomes even more overbought and six months out has gained well over 6 percent.

Table 2.2 S&P 500 Performance After It First Crosses Above 80 Percent

Thus, buying when the market becomes oversold is, not surprisingly, a profitable strategy. On the other hand, buying when the market is overbought is similarly profitable.

At this point, we might introduce a market axiom:

The market is not symmetrical.

If an indicator suggests higher prices, the reverse of that indicator does not necessarily suggest lower prices.

Our analysis is limited to the past