Market Phase Analysis

These notes are a summary of the market phase analysis discussion in Colin Nicholson’s book: Building Wealth in the Stock Market.

3 Analytical Tools to determine % capital invested in Stocks:

1. Dow Theory Phase Analysis
2. Coppock Indicator
3. Trend Analysis of the market index

1. Dow Theory Phase Analysis

There are 3 bull and 3 bear market phases. The phase indicators/checklist for each Phase is described below.

Bull Market Phase 1: Reviving Confidence

• News about the economy tends to be negative
• Market expecting recovery
• Household saving ratio still high
• Interest rates still relatively low
• Private investors out of the market
• Market may ignore bad news
• Initial rise thought to be a bear market rally
• Disbelief turns to fear of missing out
• Market fundamentally undervalued
• Very few IPOs
• Inquiries into what went wrong
• Regulation is tightened

Bull Market Phase 2: Increasing Earnings

• Many companies announce increased earnings
• Good news is announced
• Employment picks up
• Household savings ratio falls
• More IPOs
• Significant market corrections end higher
• Fundamental values return to normal
• Sector rotation

Bull Market Phase 3: Rampant Speculation

• Significant fundamental overvaluation
• Interest rates relatively high
• Increased price volatility
• Many capital raisings
• Many IPOs, many without merit
• Private investors heavily in the market
• Day traders heavily in the market
• Increased use of debt and leverage by investors
• Much commercial building construction
• Someone builds “world’s highest building”
• Increased media coverage
• New paradigm theories advanced
• Market led by relatively few stocks

Bear Market Phase 1: Abandonment of Hopes

• Fundamental valuations will still be high
• Interest rates peak
• The economy is still strong
• Public see a buying opportunity
• Volumes fall; Buying is done
• Market may ignore good news
• There may be some shock news
• The public may also panic, triggering a crash
• Floats fail and are then abandoned

Bear Market Phase 2: Decreasing Earnings

• Earnings decreases announced
• Market ignores good news
• Former market leaders may fail
• A recession begins (and much discussion exists about when it started)
• Share rallies leading to further falls
• Few new floats
• The public loses interest
• Fundamentals return to reasonable levels (ratios look attractive based on past earnings)

Bear Market Phase 3: Distress Selling

• Significant undervaluation (Low price/earnings ratios)
• Unemployment peaks (high unemployment levels, with ruling party typically voted out)
• Many bankruptcies and failures
• Bad news is discounted (already built into price)
• Market is rarely in the news
• Low public interest and participation (brokers reduce staffing)
• Stock price charts show accumulation: stocks offered by general public to professionals in desperation with broad sideways formation

2. Coppock Indicator

• Momentum oscillator designed to indicate when it is time to buy long term holdings near the bottom of a bear market. This indicator measures changes in the speed of price changes in the stock market
• To calculate this:
  • Calculate the percentage change between the index value at the end of the current month and its value 14 months earlier
  • Calculate the percentage change between the index value at the end of the current month and its value 11 months earlier
  • Total the two percentages
  • Calculate a 10-month weighted moving average of the total of the two percentages
• Buy when the indicator turns up when it has fallen below the zero line. Use it only as a buy signal, and only in conjunction with analysis using other indicators

3. Trend Analysis of the Market Index

• A bull market is in place when the market rises higher than its previous peak. One of the following occurs:
  • The market is falling. It then rallies above the peak formed on the previous rally.
  • The market is falling. It then rallies, but does not rise above the peak of the previous rally. After forming a trough which is higher than the previous trough, it then rallies again and rises above the peak formed on the rally from the lowest trough.
  • The market is falling. It then rallies and declines several times, forming a trading range. It may have given several consecutive conflicting signals, which were quite quickly negated. Eventually, the market rallies above the highest peak in the trading range.
• A bear market is in place when the market falls lower than its previous trough. One of the following occurs:
  • The market is rising. It then declines below the trough formed on the previous decline.
  • The market is rising. It then declines, but does not fall below the trough of the previous decline. After forming a peak which is lower than the previous peak, it then falls again to below the trough formed on the decline from the highest peak.
  • The market is rising. It then declines and rallies several times, forming a trading range. It may have given several consecutive conflicting signals, which were quite quickly negated. Eventually, the market declines below the lowest trough in the trading range.

The two greatest sins that investors commit in the stock market

• Beginners enter the bull market much too late
  • If beginners enter earlier then losses would not have been as catastrophic
• Beginners fail to get out when the bull market ends
  • Holding on when bear markets occur create larger and larger losses
  • Beginners then sell out at horrendous losses
• The key is to start putting money into stocks when the risk is low, and be completely invested as early in a bull market as possible
• Then start taking money out of stocks as the risk becomes high and be completely out of stocks as early in the bear market as possible

Key Charts to Analyse

• Market P/E Ratio
• Market Dividend Yield
• 90-day bank bill rate
• Simple Moving Average (SMA) of new listings

Building Wealth in the Stock Market

These notes are a summary of Colin Nicholson’s book: Building Wealth in the Stock Market

Winners Think Differently – Important ways of thinking

• Forget how much was paid: Don’t anchor to prices paid in the past, but what the investment is now worth
• Don’t play with the “market’s money”: Paper profits are still your money
• Make it strictly business: Look at all investment decisions as business decisions and don’t invest your ego
• Focus on the bottom line: You don’t have to be right all the time. As a realistic investor, you can relentlessly cut non-performing investments to allow the few good performers to build into profits for your bottom line.
• Resist doing what seems natural: Don’t hang on to losses and persist with losing positions.  Quickly cut your losses.
• We can’t win if we lose too much: Preservation of capital is the overriding objective of any effective investment strategy
• Avoid magical thinking: There is no system that is foolproof
• Stop looking for a guru: There is no holy grail, nor perfect investment method
• Try to focus on the correct question: There aren’t right or wrong answers in investing. Investing is an art.
• Don’t be seduced by tops and bottoms: Have no expectations of buying at the bottom and selling at the top.
• Avoid making predictions: It’s not possible to forecast the future with any sort of accuracy
• Simple is better than complex: It’s the simple, big ideas that make a difference
• Act on what is happening, not what should happen: There will always be uncertainty and markets look at the future, not the past
• Become a serial decision maker: Analysis is only a starting point. The difficulty is in managing the investment and continuously making decisions on each investment position
• Never stop thinking: Winners tend to be original thinkers, accepting nothing on face value
• Realise that it will take time to learn: Count on a minimum of 5-10 years to learn the craft of investing

What is required to succeed as an investor?

• Knowledge: On markets, decision making, analysis and the great investors
• An investment plan: A clear and complete plan consistent with our personality, attitudes, beliefs and objectives
• Experience: It will take many years to learn
• Discipline: Developing faith and following our investment plan
• Patience: Have a realistic idea of what is possible and likely over time. Time and patience are needed.
• Winning Thinking: Investing is a game that is played in the mind

The risks to be managed

• Market risk: the risks associated with the overall market
• Specific risk: the risks associated with individual stocks
• Financial risk: the risk associated with borrowing money to invest
• Liquidity risk: the risk associated with the ability to quickly move into or out of an investment

Executive Summary of an Investment Plan

1. Policy

• Asset classes: Stocks (Australian) or cash
• Target rate of return: 12.5% pa
• Simple big idea
  • Buy stocks heavily only in bull markets
  • Only buy uptrending stocks
  • Build position if the uptrend is confirmed
  • Sell quickly if the uptrend fails
  • Any stock bought must be of investment grade and be cheap in fundamental analysis terms

2. Strategy: Managing Market Risk

• Getting into the market
  • As soon as the third stage of a bear market (distress selling) is detected, watch for stocks making new highs. Begin to buy them cautiously, increasing the proportion of capital invested in stocks to around 20%
  • When the Coppock indicator gives a signal, increase the proportion of capital that is invested in stocks to around 40%
  • As soon as there is a clear upward breakout from a broad trading range on the index, or the index starts trending up by moving above its last significant peak, begin increasing the proportion of capital invested in stocks to around 70%
  • After the first significant correction in the uptrend on the index is completed and the index moves above its previous peak, move to having 100% of capital invested in stocks
• Getting out of the market
  • Once the third phase of a bull market (rampant speculation) has begun, reduce the proportion of capital invested in stocks to around 70%
  • As the third stage of a bull market becomes more developed, gradually reduce the proportion of capital invested in stocks to around 30%, acting urgently if the market comes off a very strong peak
  • If the market index breaks down out of a trading range, or starts to trend down by moving below its last trough, sell any stocks that do likewise immediately. Do not replace them.
  • Worst performing stocks should be sold first – starting with stocks on which a profit has yet to be made. The sale of stocks according to the capital allocation rule overrides the uptrend rule for individual stocks.

3. Strategy: Managing Specific Risk

• Diversification
  • Invest at least 2% of capital in any stock
  • Invest no more than 6% of capital in any stock
  • Hold only 2 stocks in the same industry
• Position size
  • Maximum risk per stock of 0.5% of capital

4. Strategy: Managing Financial, Liquidity and Other Risks

• Gearing and leverage
  • Do not borrow money to invest in stocks
  • Avoid stocks with a debt-to-equity ratio over 60%
  • Do not invest in derivatives
• Liquidity
  • A stock must trade on most days
  • Look for sufficient volume to transact in one day
  • Hold only a few less liquid stocks at once
• Type of stock
  • Focus primarily on second-rank industrial stocks and producing miners
  • Only buy stocks making profits and paying dividends
• Long, short or both?
  • Long only
• Time frame
  • Aim to hold for months to years for dividends and capital growth

5. Tactics: Stock Selection

• Value model
  • Buy value model stocks breaking out of accumulation phases or in established mark-up phases
• Growth model
  • Buy growth model stocks breaking out of consolidation phases or in established mark-up phases
• Margin of safety: value model
  • Price/earnings ratio is significantly lower than the average price/earnings ratio for the market
  • Dividend yield is significantly higher than the average for the market
• Margin of safety: growth model
  • Price/earnings ratio is not significantly higher than the average price/earnings ratio for the market
  • Dividend yield is not significantly below the average for the market

6. Tactics: Managing Investments

• Initial purchase
  • Breakouts: invest a minimum of 2% of capital
  • Existing uptrends: invest a minimum of 2% of capital on seeing a new high for the trend
• Position building
  • Invest another 2% once the next trough appears to be formed
  • Complete building the position to 6% of capital once the peak after the breakout or the first buy is exceeded
• Selling rules
  • Buying into a breakout: situate the sell stop up to 2% below the accumulation or consolidation pattern
  • Buying into an existing trend: situate the sell stop up to 2% below the last trough that has been validated by a subsequent move above the peak that preceded it
  • As the uptrend unfolds: situate the sell stop up to 2% below the last trough as soon as it has been validated by a subsequent move above the peak that preceded it
•  Additional selling rules
  • Situate the sell stop level up to 2% below a substantial trading range that develops in the trend
  • Sell if the price forms a lower peak and then moves up to 2% below the preceding trough
• Profit-taking guidelines
  • Each time a stock grows to 12% of capital, consider reducing the holding to 6% of capital
• Re-entry guidelines
  • If a sold stock makes a new high for the trend, consider it for reinvestment using the usual rules and guidelines

Presentation Links

The following links provide a presentation summary of the above concepts – these should be attributed to Colin Nicholson at www.bwts.com.au

• Masterclass in stock selection: Presentation for workshop covering the above plan
• Stock selection: Managing risk, timing and value