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August 15, 2007 � Issue #334

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Market Efficiency Portfolio
August 15, 2007
By 
Van K. Tharp

I am now looking at why the portfolio was not as profitable as I would have liked. Last month we showed that if we had only entered our long positions, and done so with simply a 25% trailing stop, we would have performed quite well with our portfolio. We were up 24.6R with an expectancy of 0.98R and a standard deviation of 1.15R. We would have still been in most of our positions (at least as of the July update), but probably would have been stopped out of many of them since the July issue. The efficiency portfolio on the long side with a simple 25% trailing stop works (as I proved in my Market Mastery updates in 2001-2 during the last major bear market phase).

This month I want to look at the short side, which was somewhat of a disaster. Table 1 presents an overall summary of our short positions that we took.

Table 1: R-multiples of our Short Positions

The expectancy of our R-multiples was a disastrous negative 0.29R. We lost money on 15 of 20 short positions or 75% of the time. In addition, Deluxe Checking (DLX), which we shorted, was one of the top gainers of the last 12 months reaching a high of $44.95. 

But perhaps the situation with the shorts is not nearly as bad as it might seem. Let�s assume that if the stock moved against us by August 10th, we would have gotten out at a 1R loss¹, but otherwise we would have held each position until August 10th. And, since we sold JRCC short two times, we�ll only hold that position once. These data are given in Table 2. 

Table 2: Price Changes on August 10th

Using this method of analysis, we can see that 10 of our 19 negative efficiency stocks were down from the time we bought them until August 10th. In addition, 7 of those 10 were down by more than our initial risk. In fact, based upon this analysis, we�d be up about 11R by August 10th. Our maximum possible gain is 4R, and with that notion in mind, two of four of our selections were huge gains (i.e., they went down a lot). JRCC, SCT, JRC, and FMT were great shorts. So 20% of the stocks we selected to go short produced the huge down moves we were expecting. However, 15% of the stocks also produced huge up moves (DLX, MLS � which was bought out on August 3rd, and ERES). Furthermore, in shorting, our downside is limited to 4R.

This analysis, however, doesn�t exclude the winners that would have been stopped out. Table 3 compares a 25% initial stop with the maximum adverse excursion. This analysis turns four of our winnings into 1R losers. Notice that we now only have 7 winning stocks remaining in our portfolio. We lost LEE (a 1.29R gain), HOV (a 1.93 gain), GYS (a 1.22 gain) and CHS (a 0.10 gain).

Table 3: Largest loss versus our initial stop

And that�s not the only problem. What if we had had a 25% trailing stop? What would that have done to our big winners? We already know that JRCC actually gave us two large gains because we were stopped out at one point and got back into it. 

SCT was no better. We shorted it at $15.70. It fell to $6.72, but then almost doubled to $11.50, before falling to $3.70 on August 10th. 

And FMT was also no better. We shorted it at $13.72. It fell to $5.63 on March 3rd. It then rose to $13. 80 on May 31st before finally falling to $3.96 on August 10th. 

In other words, our huge gains on the short side are all stocks with tremendous volatility. These stocks might eventually go to zero, but we�d have to tolerate huge fluctuations to our portfolio in order to do so.

My conclusion from the short side analysis is that shorting based upon efficiency does not work. Yes, it gives us a reasonable chance of capturing some stocks that may eventually go to zero. However, with a 25% stop there is not enough profit potential to make the stock worth shorting and the potential volatility on the way down is way too high.

The building stocks are a good example. They are a disaster and we managed to short HOV when it already looked like a disaster. However, after we�d shorted it, the value players were saying it was a good buy (e.g., Steve Sjuggerud was recommending them again to his True Wealth subscribers). And they did stage a significant rally before going down even more. Unfortunately, we didn�t make money with HOV.

My conclusion is that the only way to find good shorts would be to find highly desired stocks that have broken out of a trendline. Let�s look at a long term chart of HOV to see how that might work. This is shown in Chart 1 below. In early 2005, the investment everyone wanted to be in was real estate and home builders like HOV were hot stocks. HOV reaches a high of 73.4 in July on 2005.

Chart 1: Three Year Chart of HOV

Notice that HOV breaks its trendline at about $60 within a month or two of the July high and falls to about $43. It then has a nice upward correction to about $55 or or about 22%. A 25% trailing stop would have protected us here and kept us in the position. It then falls down to about $25 and then corrects back up to about $38. This second upward correction lasts nearly five months and amounts to a gain of 52%. With a 25% trailing stop, we would have been stopped out at about $31.25. But that would have given us a gain of about $28.75 per share which isn�t too bad. We probably could have shorted it again when it broke the correction trendline at around $31. And with HOV now at around $14 that again would be a nice gain.

Originally, I was going to do a three part analysis of the results. Part 1, which we looked at in July, was to see what happened to the positive efficiency portfolio. My conclusion was that the original positive efficiency trading method with a 25% trailing stop works quite well. It didn�t work for us because 1) we had much tighter stops and too many reasons to exit and 2) we combined both longs and short into the portfolio.

In this issue, I concluded that shorting negative efficiency stocks doesn�t work even with a 25% stop because 1) there is not enough profit potential on the downside and 2) there is too much volatility in the stocks that we correctly select as big losers. In addition, our negative efficiency stocks have already moved down significantly before we select them and value players among mutual funds like to buy stocks that are strongly depressed. For example, we bought HOV (in the chart above) just before people decided that the home buyers might again be a value play. But for those who like to short stocks, especially when the stock market starts going down, my guess is that shorting highly overbought stocks (with high PE and lots of psychological hype) will probably work as shown in Chart 1.

I was also going to do an analysis of the largest gainers over the past year to determine why we didn�t capture them. However, I�ve decided to skip that analysis for two reasons. First, the positive efficiency method works to my satisfaction the way I originally designed it. We probably didn�t capture some of the biggest gainers because I frequently had over 100 stocks to select from to add one or two candidates to the portfolio. The best stocks easily could have been among the many I didn�t select. Second, remember that our positive efficiency stocks have already moved up a lot by the time we select them. DLX, which we shorted, was one of the best performers, but we wouldn�t have spotted it until it had made much of its move.

As a result, because many of you have said you have gained a lot from my analysis, we�ll start a new portfolio in September. This time we�ll do a $100,000 portfolio. I�ll devote half the portfolio to finding positive efficiency stocks just using 25% trailing stops. And it now looks like we might be doing that in a bear market. And I�ll devote the second half to finding good shorting candidates from strongly hyped stocks with high PE ratios that have broken trendlines.

Thank you to all of readers who offered me feedback and opinions on continuing the portfolio. I couldn't personally respond to each of you, but your comments, insights and feedback were very valuable. If you'd like to see a very small sampling of some of the comments, click here.  

Until the September issue, this is Van Tharp.

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

1 Here we�re only out on stocks that did not show a profit on August 10^th.  This does not include stocks that might have stopped us out but then went up.  That is considered later in the analysis

September Workshops

Trading Tip

Market Mayhem � What to Do in Volatile Non-Directional Markets

by D.R. Barton, Jr.

Thanks once again for all of the useful links and e-mails that keep coming in!  If you haven�t sent your favorite sites in yet, please see my e-mail address at the bottom of the article.  We�ll continue our look at no-cost but useful Internet sites in future articles.

Today, I think it would be useful to talk about the volatility explosion that we�re in the midst of with the major market indexes.

Like most shorter-term traders, I keep a close eye on market volatility.

My favorite tool for measuring volatility is the Average True Range (ATR).  The standard setting for this is 14 periods.  And by this measure, the volatility is at its highest levels of the last five years for the S&P 500, the Dow and the Nasdaq indexes.  The Russell 2000 is at its highest level of the past seven years.

Since the end of July, when the market was making new highs, volatility has much more than doubled.  And despite the market being generally down since that time, we�ve really entered a non-directional sideways period.  Big up day. Big down day. Lather rinse and repeat.  There's lots of movement but neither side can get any real momentum going.

So what does this mean for us as traders and investors?

The quick answer has two components:

1. Volatility will contract sooner rather than later.

2. Price is clearly being manipulated by the world�s central banks' intervention as the U.S. Fed, European Central banks and others keep injecting more funds into the market. Therefore, discerning a clear price direction is a real crap shoot.

The longer answer is that markets never fair well during credit contractions.  And this contraction has some added issues of extreme over-leverage from the real estate bubble.  So prices should really be correcting much more than they have.  But the central banks keep injecting extreme liquidity and have done so for the last two weeks.

The market is still acting badly with new monthly lows hit on Wednesday afternoon; however, the game may not be over if the central bankers really decide to open the liquidity spigots.

Day traders are thriving on this added volatility.  Our Day Trading Workshop with Brad Martin next month should be really interesting and I hope many of you can join us!

Longer term traders may not have been overly affected yet if their stops have not been hit.  However even long-term investors in any market that is associated with the sub-prime markets have taken a shot directly on the chin.  Make sure that your stops are in place and be very wary of �bottom fishing� (looking for values assuming that the bottom is in place) in this market environment.

Swing traders have particular challenges when volatility expands so rapidly.  Normal ranges and standards get violated much more easily in markets that have such big day-to-day movements.  The best systems I�ve seen either stand aside in such markets (making fewer or no trades) or have adaptive indicators that take volatility into account.  If you are getting whipsawed in your swing trading, it would be best to wait on the sidelines until some of the excess volatility is reduced. A good rule of thumb is that if the S&P 500 daily ATR drops back below 20, systems should start to return to normal.  (That would put us back into the higher end of the volatility range for the last few years).

Keep sending in your favorite web sites to [email protected] .  And let me know if you�ve found this discussion useful! Until next week�

Great Trading!

D. R.

About D. R. Barton: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world.

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine.

Melita's Inspirational Corner

Freedom Fighters

by Melita Hunt

As we continue our journey of self-discovery and self-work, one of the words that I hear often is �freedom.� We trade the markets, toil so hard to make money and work our little tooshies off, to eventually get ourselves to this blissful state of �freedom.�  But what does it really mean to obtain freedom? And what if it isn�t obtainable because you already have it?

I used the phrase freedom fighters as the heading because that is an oxymoron if I ever heard one. Should the word �freedom� really be so closely linked to a word that conjures up thoughts of conflict, rebellion and force? Maybe it should�

The dream of financial freedom, freedom from work, freedom from responsibilities, freedom from restraint, freedom from our kids, freedom to do as we please, freedom to travel, to rest�. Oh, the joy of eventually being free. Can�t you just taste it?

Is it possible?  Is it realistic? Or is it really just an exhausting, ongoing battle (i.e. fight) to get there?

And is the fight in your head, in your environment or is it other people and the �system� that we live in that makes it so hard to be completely free? 

If you are not experiencing freedom, then who or what is stopping you from your freedom? Who made the choices that put you into ANY situation that you are in now whether you perceive it as good or bad? And be careful how you answer this because if you don�t honestly answer �I did,� then I recommend that you take a look at that because there is some real work to do in any area that you believe someone or something else is controlling.

In my world, freedom lives hand in hand with personal responsibility. If we truly believe that we are responsible for our own lives (and if you don�t believe that, then this work is probably not for you), and you do not experience freedom, then perhaps a change of perspective is in order. What does the word freedom mean to you?

What have you �made up� about freedom and what it needs to look like? I ask once again, who are you blaming for the perceived lack of freedom in your life? (This could be yourself.) And what are you willing to do about it?

The wonderful family therapist and theorist Virginia Satir lists the five freedoms as follows:

1. The freedom to see and hear what is here, instead of what should be, was or will be.

2. The freedom to say what one feels and thinks, instead of what one should.

3. The freedom to feel what one feels, instead of what one ought.

4. The freedom to ask for what one wants, instead of waiting for permission.

5. The freedom to take risks on one�s own behalf, instead of choosing to be only �secure� and not rocking the boat.

And here are the three that I added:

6. The freedom of knowing that every choice is one's own.

7. The freedom to accept or forgive the choices that one makes.

8. The freedom to just feel free.

I believe that we all have complete freedom to do whatever we want, whenever we want. We just need to recognize the choices that we are making and whose rules we are playing by. Ultimately, we are the ones that create the chains and limitations that bind us by buying into the rules, conditioning and beliefs that we think will protect us. And we are usually doing this unconsciously. 

So take a good look at your life.

What does freedom mean to you?

Is the dream of freedom something that is �out there� in the future, is it still something that you are trying (which is just another word for struggling) to obtain?

I am going to ask you to come from a different perspective. Let�s stop �thinking� about freedom for a moment and just be free.

Right now, in this moment, do this very brief exercise:

Take a big deep breath and relax your face, your tongue, your neck, your shoulders, your torso, and your legs.

Imagine that all aches and pains have just left your body (and for a moment let them go, just release them out through the floor).

Take another deep breath.

Imagine that your brain has gone on holidays (let all thoughts, worries, concerns just drift away as though there is a hole on the top of your head and they are flowing away).

Take another deep breath.

Imagine that your body is as light as a feather - feel a tingling sensation in your toes and your fingertips.  

Take another deep breath.

Imagine that you are floating.

Imagine that your body has disappeared and that you are just air.

Imagine that you are completely free.

Now come back to Earth�

So for a fleeting moment, how did that feel?

Although we used our head, we used it for imagining instead of thinking, and I am sure that some of you were able to completely let go and free your body and mind. This could be called experiencing freedom.

Funny huh? 

If you now reread this article you may recognize that when we "analyze" freedom and think about it too much, we can get ourselves tied up in knots and feeling heavy about it versus just choosing freedom (and yes, it may take some practice and that's ok). 

Could it have something to do with �being� rather than doing?

I�ll let you get back into your head to ponder that�

See you next week.

You can contact Melita at [email protected]

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Happy Birthday to Van!

August 15th is Dr. Tharp's Birthday. 

Best wishes for a great year ahead.

Fun Facts: In the Zodiac Van is a Leo. According to the Chinese calendar he is Year of the Dog. So, it's only fitting that this year his wife is giving him a new puppy! The new addition to the Tharp family arrives next week.

Email Van A Happy Birthday Wish

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