Turning Points

Turning points, or inflections points, are crucial price points where the stock price begins to head in the opposite direction. If a stock price is declining, the turning point marks the bottom of the descent and if the stock price is increasing, it marks the top of the ascent.

Turning points is a theory based on Min-Max analysis. Barring bankruptcy, and any other unforeseen situations such as fraud like in the case of Enron and Worldcom, all stocks have a base price which can be determined by using the financial statements. Total share holder's equity, working capital, market cap multiple to sales, etc, can all be used to determine a stock's base price. Likewise, these ratios can also be used to determine a stock's top price based on the stock's historical averages and comparable against other companies.

In mathematics, most continuous functions have a min-max property. Stocks can be likened to smooth continuous functions, and in any stock chart it could be seen that these min max properties do appear in the charts. I think it is this belief that has shaped my investment philosophy.

As stated earlier, barring bankruptcy, I want to make a purchase at a min price and exit the position at a max price. Or alternatively, short a company at a max price and exit the position at the min price. This approach to investing implies the following:

• IPOs are avoided


• Research companies, such as bio medical companies with no financial statements, would be avoided


• Stocks making new 52 week highs and new 52 week lows would be avoided.

With regard to IPO's, there is no historical price pattern to base a min-max decision on. With respect to research companies, there is no meaningful financial information to compute ratios. And with respect to 52 week highs or lows, the max or min is yet to be formed.

This would imply that my investment candidates would consist of mature companies or new companies that have been trading for at least one year, and I should focus on companies that are range bound and have a well determined min and max.

This analysis would explain my continued persistence in buying companies that are dropping in price and selling near their min point, and my constant shorting of companies making new highs near their previous high point. While this may sound like a great idea, in general practice this is a recipe for disaster!

From a market perspective, it implies buying companies the market is shunning (i.e. RIMM, BBI) and shorting market darlings (i.e. AAPL, NFLX). From an economics perspective, it implies buying companies with decreasing market share (YHOO), and shorting companies with increasing market share (GOOG). From a financial perspective it implies buying companies with decreasing profit or even loses (AMD), and shorting companies with increasing profits (INTC). Overall it, implies being a contrarian!

Min-max is great for mathematics, but if applied literally to stock investing it leads to losses instead of profits. In reality one wants to ride the bull and short the bear. Literally this would mean buy at the max and short at the min! This is what actually works in real life. Old mins get breached and go lower, and old max get breached and go higher.

In a way, investing requires a lot of optimism. It requires blind faith to believe that something that is going up will continue to go up and something that goes down will continue to go down, which in our gravity bound world does not work all the time!

After all, this blind optimism leads to tulip mania, dot com mania and housing mania. All of these manias have at their heart the greater fool theory in common. As Charles Prince, the ex CEO of Citigroup once said, "as long as the music is playing, one needs to keep on dancing". So keep buying as long as one is not the greater fool making the last purchase at the highest price!

Is it possible to reconcile min-max theory with the market reality? Perhaps it is, and I need to give it some thought. Eventually min-max does work. Stock prices don't continue going up forever, and eventually, aside from bankruptcy, most companies do have a bottoming out price at which they either recover (AAPL, F, YHOO, EBAY) or get bought out by other companies (PALM, SUN). The secret of applying min-max theory to stock investing would be determining how to avoid companies that either go bankrupt (GM, BBI, LEH, WCOM, ENRON) or get take under offers such a Bear Sterns.

A Pattern Emerges

On Tuesday after the close, ADBE reported earnings. The earnings met and slightly beat the expectations. However, the company's forecast for the next quarter was lower than expected.

The stock tanked 20% at the open hitting a low of 25.81 on heavy volume, slightly dipping past its resistance price of 26. Shortly after making its new 52 week low, the stock price began to rise slowly, closing the day at 26.67. The next day the stock struggled to remain above 25.5. In the final hour of trading, along with the overall S&P index, the selling pressure increased and the stock dropped, closing at 26.41.

I followed the news and the price action for the those two days. On Wednesday, the day of the 20% drop, I read ADBE's SEC earnings report and focused on the balance sheet. I did a quick analysis and calculated different ratios: asset turnover, market cap to equity, working capital, and profit margin. By Thursday I had almost convinced my self that I wanted to buy the stock.

On Friday, the market opened very strong. Everything was going up. The durable goods report had been released that morning and, ex transportation, increased more than expected. Additionally, an influential fund manager was interviewed on CNBC before the open and he stated that now was the time to buy stocks. All of this pushed the market to close 2% higher.

During this intraday rally I decided that ADBE had to be in my portfolio. I took a 500 share position and liquidated NBG to raise funds for the purchase. Also, on Thursday, I had sold S and AONE to raise funds and ADBE took up most of those funds as well.

Today, my portfolio consists of a few stocks with concentrated positions. Ordered by decreaing percentage, they are SH (hedge), RIMM, ADBE, AA, VLO, BIOD, and EK. This is quite a marked difference from a month ago when I held several small positions on different stocks. In particular, all these stocks have something in common. All of them are previous high fliers that have fallen out of grace. Basically, they are contrarian plays. I buy stocks from the discount bin when the market decides that companies are no longer worthy of high multiples.

Through out this gradual portfolio shift, a pattern has reemerged. Concentrated positions on value plays. Try as I may, it seems that I always revert back to the same investing strategy. I have never owned a stock that is making new 52 week highs just about every week or that has gone up 10 fold in a year's time, like NFLX. I have to think why it is that I can not buy into growth companies WHILE they are growing. I need to go back and examine why this value investing strategy is so ingrained in me. Is it my education? Previous investing mistakes? Is it risk aversion? Could it be a combination of all these elements?

Investing is a very rewarding business when it's done well. But it's a game, and like any game I have yet to learn all the rules. And like other games, it's a game which causes a lot of introspection and a lot of self questioning. There is a pattern in my investing, and I need to figure out what drives it and why.

The Aftermath

RIMM opened near its after market close of 48.61. Immediately after the open, the selling pressure began. The stock finished the 10AM trading hour at 47.15 and meandered between 47.75 and 47.30 for the next few hours. I decided that I should not let this opportunity slip away, even though my current holding was close to 10% of my trading account.

I still had cash left in my main trading account, but to raise more cash, I sold my position on NOK and used all my cash to triple my RIMM position. I bought additional shares at 47.32, at what seemed like a great bargain. I entertained the idea of buying RIMM for my other accounts because I did not want to liquidate more positions. Fortunately, I stopped myself.

At the low of the session, around 3PM, RIMM traded for 46 - briefly going negative for the day. It closed at 46.64, nearly unchanged after reporting strong earnings. MY P&L took a hit because I lost some of my original gains. I now hold a RIMM position with an average price of 46.30, close to today's closing price.

Why did I increase my position to 23% of my account when my rule is not to exceed 10%? Because the fantasy of huge profits took over my will. I still expect RIMM to trade up to 56 in the near future. That is nearly 20% from where I bought my last position. I think that it will be very easy for RIMM to trade up to that level, even though today the price was nearly unchanged.

I rarely like to hold concentrated positions, but I concluded throughout the trading day that if RIMM goes down by 5%, my trading account will decrease by 1.1%, but my portfolio will only decrease by 0.65%, because RIMM is only 13% of my overall portfolio. I won't go broke even if RIMM decreases 10% from my average purchase price. It will hurt, but I won't be out of business. Six months from now, I do not want to see that RIMM increased to 60 and that I could have bought at today's closing price of 46.75. That would be too much of a regret!

The Earnings Report, the Fantasy and the Reality

RIMM reported earnings yesterday after the close. The EPS and revenue were better than expected. The Q3 forecast is also better than expected. The stock rose after hours to a high of 50.43 on heavy volume. After the earnings call, the stock stock lost a bit of its new found luster and settled at 48.50.

Throughout the post report hours I felt that I should have taken a larger position on RIMM, and I began to fantasize on my Excell spreadsheet about the money I could have made if I invested my entire portfolio on RIMM. That's investing for you - when you lose you regret the loss, and when you win you regret the missed profits!

That's one aspect of investing I have to get better at. I need to control the emotions of a loss and the regrets of not investing more when it's profitable.

Now the question is, do I hold on to RIMM, buy more, or sell what I own for a profit? That is the second aspect of investing I also need to get better at. I need to control the emotions of loss and regret and learn to reevaluate the position as though I did not already have an investment on the stock. To that end I dedicate the rest of this blog.

The EPS for Q2 is 1.46, and the twelve month trailing PE is 9.2. It's incredible that RIMM is being treated with such disdain. After all, isn't it one of the leading companies in the cell phone industry? With a 12 month trailing PE of 9.2, investors are basically saying that RIMM is no longer a growth company. Is this plausible? Well, the revenue growth is slowing even though the profits are quite robust. Is the market fearing that the revenue growth will stall and RIMM will lose out to APPL just like NOK, MOT and all the other once high flying telecom companies?

If the price and the PE is a sign of investor sentiment, then yes. RIMM is done as a growth company. Could it be true? Perhaps, but I think I will take my chances with an ex-growth company selling at a PE of 10 than a growth company selling for a PE of 30. And in case I am wrong? Well, I'm not investing my entire portfolio on it, despite of what my fantasy might be. So do I hold, sell or buy? At this point, my emotions tell me to hold even though my analysis says buy. Unfortunately, I am already at 8% of my account so no matter what my emotions or analysis says, I can not buy any more, as no single position should be more than 10% of my account.

RIMM, NBG and more SH

To practice what I preach is the way I like to invest. And that is exactly what I did by buying the above positions.

I bought RIMM because the price is entering a support area with a price range of 39 to 42. I could have waited for the price to get closer to 40, for another %10 decrease, but, with the earnings report only 2 days away, it seems that now is right time to strike.

As posted a day ago, the price forecasting illusion is telling me that RIMM will continue its downward spiral and that the support zone of 39 will not hold. However, from a probability perspective, I think that the probability of a price increase has gone higher at these levels. A bad Q2 earnings report and a bad Q3 forecast would probably result in in the price testing the resistance level of 39, for an 11% decrease. If on the other hand, the earnings report and forecast is better than expected, or not as bad as expected, then RIMM could rally to the 48 - 57 resistance level.

NBG follows a similar line of thought. I bought it at 2.36 after it announced a capital raise of 1.2B Euros. The price declined after the announcement, and it fell short of its 2.12 support price. Even after the capital raise, the stock is not decreasing past its support point. Is that a good sign? I don't know, but I think the probability of a higher price just improved.

And just in case all I am wrong in my analysis, I bought a little SH as a hedge. I did not hedge the entire RIMM and NBG position because lately these two stock have not been correlated to the market. But if the market were to take a sudden tumble, I want to protect myself at little bit. A hedged position is the only way I can sleep at night any more!

The Price Forecasting Illusion

There have been many times when I looked at a stock and noticed that the price was reaching a support level. On several of those occasions, I wanted to buy the stock but was afraid the support level would not hold and the price would continue to deteriorate. This happened with MOS, BP, NOK, VLO, ZQK and several others. In only one instance, with BP, the price did not hold at the support level and the price continued to decline another 20%.

A similar situation, but in reverse, has happened as well: I looked at a stock and saw that the price was reaching a resistance level, and I told myself not to buy it, but went ahead with the purchase because I expected the stock to break out of its resistance zone. Shortly after making my purchase, I watched the stock retreat from my purchase price, as though it hit a ceiling and could not go any higher, and proceeded to reverse its upward trend.

Why is it that instead of doing the first - buying at support, I do the second - buying at resistance? My explanation is price forecasting illusion. When a stock declines and comes into a resistance level, the mind focuses on the price down trend and projects further decreases as opposed to focusing on the probability that the price slide will cease. The illusion is created that the stock is being sinked by an invisible force and nothing can hold it up. The illusion of a lower price is created and the mind ceases on this and blocks it self from any action. It must be a survival mechanism of sort. After all, why buy the stock if it will continue to decline and go to zero because of the momentum it carries?

The opposite is also true. The mind anticipates the continued price increase, although the price is entering a resistance area. All stocks that continue their climb have to clear this resistance area, but very few do, or only do so after several attempts. Instead of focusing on the probability that the stock price will stall and reverse, the mind fixates on the recent price increase and expects the force which lifted the price to its current level to boost the price higher.

There has to be a way to disassociate the mind from the price forecasting illusion and help it focus on the potential price reversal. Perhaps the disassociation can be achieved by rephrasing the down or up price movement. To dissuade the mind from focusing on the price forecasting illusion, each day one should ask, "What is the probability that the stock will be higher than where it is today given where it has been in the past?". Then compare this self assessed probability, which is either decreasing, stable, increasing, with the actual price action of the following day. When the actual price action and the self computed probability are in sync then that is the time to act.

In other words, when the price enters a resistance area, after a protracted decline, wait for the area to prove itself out. The logic should flow as follows: If the price will reverse, then the probability of the price being higher is increasing with each subsequent price decline. If the price is higher on the next day, then buy near the support area price. Likewise, if the probability of the price being higher is decreasing with each consecutive price increase, and the next day the price is lower, then sell an existing position or short near the resistance area price.

The purpose of phrasing this way the movement of a stock price, is to train the mind to treat an increase or decrease in price in the same manner. The mind will focus on a positive thought (what is the probability of a price increase) and assign a strength factor to this thought (decreasing, stable, increasing)

Hence, instead of asking whether the S&P 500 is going to be down or up, I would ask, "Is the probability of a higher S&P 500 index decreasing, stable, or increasing?" By phrasing the price movement this way, I am training the mind to focus only on the strength of a one event, as opposed to forcing the mind to consider whether a down trend or up trend will be reversed.

September Has Arrived

The pundits foretold that September would be the decisive month. Summer lacked direction and commitment, and that it showed in the low trading volume. After the Labor Day Weekend, the professional traders would take over from the Junior traders and give the market direction. Either up or down, the month of September would set the tone for the remainder of the year. It's almost mid September and the pundits prediction is yet to materialize.

Now we are told to wait until the November midterm elections and, after this decisive event, the market will take off after a purported Republican win at the polls. I wonder what we will be told in November. Wait untill January when Q1 stats and December sales show the strength of the economy?

There does seem to be a lot of waiting in investing. Unfortunately, one needs to invest and then wait as opposed to wait and then invest. There is no reward for investing after the news is published. The real money is made by reading the tea leaves and placing a bet on a positive or negative outcome. Is investing then tantamount to gambling? Well, in a way, except that in gambling the house always wins, and in investing one may win too. In both cases, a choice is made and then the outcome appears.

For example, today I bought 1K shares of NOK because it had a appointed a new CEO. The embattled CEO will be replaced because he is costing NOK market share in the lucrative smart phone market. NOK is yet to develop a product to compete with all the shiny music and movie players posing as cell phones. I do not know if replacing the CEO will have an impact on the future of NOK. Currently in the U.S., NOK is an aging brand without much appeal to the young generation. Any device NOK introduces is likely to be expensive, and with $200 iPhones available in the market, NOK will have to develop a true killer product, which is very unlikely.

So why did I buy? Well, the new CEO is going to clean house and change the strategic direction of the company. Maybe the Android operating system will be adopted and NOK Symbian's experiment will be terminated. Building out Symbian and asking software houses to develop applications for it is a pipe dream. The market will not support more than two operating systems. NOK passed up the opportunity of buying PALM and, with it, eliminated the opportunity of relaunching its own operating system.

Maybe the new CEO will steer NOK into a new path, or maybe NOK will become the next MOT or PALM. The former being a market leader turned lagger, and the later a killer innovator turned prey.

In either case, I made my decision on two factors:
1) NOK stock price of $10/share is at value levels and its downside is $8/share
2) NOK has the potential of turning itself around and possibly regaining its post crash high of $20/share.

With a profit/loss ratio of 10/2 NOK should be a winner. So now I sit back and wait for the November elections and, thereafter, the pundit's prediction of what to wait for next.