In the table below you will find every stock that was currently featured by CANSLIM.net in the prior month.

Two-Year Trends in Sector Rotation - Richard W. Miller, Ph.D. Founder TripleScreenMethod.com

I’ve said here several times that as much as three-quarters of any stock’s price movement results from a combination of market conditions and specific sector strengths. Obviously, any strategy used to pick stocks—especially in this market—should involve an analysis of sector performance. That’s what I want to talk about today.

In the August 2005 issue of Canslim.net News, I provided an initial assessment of month-to-month sector rotations. I followed that with an update on my further research in the January 2006 issue. I’ve now finished over two years of data collection and want to provide further insight into the market rotation cycles of 31 market sectors (806 month-to-month rotations in 2004, 1,612 in 2005 and 806 in 2006). It’s these macro rotation cycles that drive the market from one group of stocks to another, regardless of company fundamentals. This year, the Energy Sector has rotated into favor, pulled back, then rotated into favor again. Now, it’s behaving differently.

As I discussed earlier, my approach uses Markov Chain Analysis (MCA). One starts by defining the states of the system under study, and I’ve defined four (called quads) based on sector returns over the combination of their past one- and three-month performances: “I” (both returns negative), “II” (1 month positive, 3 month negative [breaking out]), “III” (both returns positive), and “IV” (1 month negative, 3 months positive [pulling back]). MCA enables me to assess transition probabilities among the four states on a month-to-month basis. The resultant probability matrix can then be used to answer questions pertinent to the trader: Is it more profitable—have a higher probability of success—to buy good stocks in poorly performing sectors (quad “I”) or good stocks in the best performing sectors (quad “III”)? If my stock is in the Energy Sector and today that sector lies in quad “II” (performed well over the past month), where’s the most likely quad to find it in next month?

Chart I shows the 2006 month-to-month rotation cycle for the Energy Sector. Red circles identify monthly performance rotations over the past month, e.g., the encircled 4 represents April 2006 1- and 3-month performances.. Notice, energy has spent most of 2006 in quad “III,” i.e., producing a positive performance over both the last month and the last three months. When it’s pulled back, i.e., fallen into quad “IV,” it was buyable earlier in the year, i.e., it continued its multi-month bullish run again into quad “III.” At the end of the year, energy finds itself in quad “II,” and the natural question becomes: Where now?

Chart II shows how DRQ, an Energy Sector member, changed over the year. The encircled points correspond to those in Chart I.

All well and good, but how does one use this information? The question of most interest concerns the probabilities with which these sectors rotate among quadrants. That is, if I’m interested in a sector currently in quadrant “II”, what are the chances that it will continue to do well and find itself in quadrant “III” next month? Or, on the other hand, fall into a more negative quadrant “I”? Too, do sector rotation probabilities change over time as market health and the business cycle evolve?

The table addresses the second question, showing probabilities for transitions from one quad to another over the last three years. For example, in 2004 there was a 0.36 probability that a sector in quad “I” would find itself there in the next month (0.36 probability in 2005 and 0.53 in 2006).

The gold areas highlight the most favorable transitions. A sector finding itself in quad “II” (positive performance over the last month but negative over the last three months) might continue its positive performance and remain in quad “II” or move over into quad “III.” In 2004, there was only a 0.41 probability of that happening, but in 2005, that rotation became much more likely (0.74 probability), though this year it’s less so (0.53 probability). A consistent rotation over the years has been quad “III,” remaining in quad “III,” and quad “IV” moving back into quad “III.” Month 3 in Chart I, for example, shows this rotation cycle for the Energy Sector. It’s a behavior typical for a strong performing sector consolidating itself in a pullback then resuming its bullish run.

Two qualifications to bear in mind: (1) this analysis assumes no difference in the behavior of individual sectors, i.e., all are equally likely to make the same type transitions; (2) a few of the transitions are difficult—though not impossible-- e.g., the quad “I” to quad “III” transition, i.e., from a state where both one and three month performances are negative transitioning to one where just the three months performance is negative. The above matrices are best used to find new opportunities and to assess holdings and their likelihood for change. Presently, the best sector-related opportunities come from pullbacks into quad “IV” entries into quad “III.” Energy has entered uncharted waters for the year. According to our probabilities, it’s likely to fall into quad “I” from here.

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Technical Action Spelling Possible Trouble for Universal Stainless -  Frank E. Testa 

The chart pattern of Universal Stainless (USAP) caught my eye as several fascinating developments have arisen since early June.  The stock has carved out what I would call a "triple top" at the $30 area, while forming a flawed double bottom (the second low did not undercut the first low as we expect from a proper double bottom) near the $22 area.  In addition, a doji candlestick (a stock opens and closes unchanged but trades in a wide span during the session) surfaced on July 25^th to halt the latest attempt to overtake resistance.  A doji represents a period of indecision among investors with the bulls unable to propel the stock higher, while the bears failed to push the stock lower.  The stalemate of this magnitude often times is a precursor to a change in trend when it occurs after an uptrend (as in the case above) or in a downtrend. 

Based on the choppiness of the overall market, the appearance of a doji, and staunch resistance at the $30 level, odds favor a retest of the double bottom.  An investor looking to take advantage of this situation might short the stock at its current level and place a protective "buy stop" order just above resistance near $30.60.  Thus risking $2.59 a share, or 9%, for a potential reward of $6, or 21%, should the stock revisit the $22 mark.

Frank E. Testa has earned his Chartered Market Technician (CMT) designation and is a Vice President & Chief Technical Analyst at CapitalBridge. Frank is a devoted practiitioner of the CANSLIM methodology and a regular contributor to CANSLIM.net. In addition, Frank is the author of "Candlesticks: Shedding the Light on Pattern Analysis" and developer of the Power Point and Figure Charting Method that was published in "The Journal of Technical Analysis." Frank can be reached at frank.testa@cap-bridge.com.

Wiegert Wisdom - Investing On The Rebound - Mr. Charles Wiegert

It has been quite a while since I have penned some material for CANSLIM.net, but I offered the idea of an article and the drowsy reluctance won over common sense.  So hopefully I will provide some helpful insight and keep you awake for the better part of 10 minutes.

For the past 15 years I have worked in the securities industry, but on the not-so-exciting-side of compliance.  The folks in compliance are the behind-the-scene operators of all brokerage firms.  It was somewhat boring and paper-intensive, with momentary lapses of jubilee, but more than anything I had the opportunity to pay attention to the whole picture.  I have seen the guts of the regulators changing the marketplace and rules while firms, traders and clients alike have reluctantly adapted and ultimately changed their strategies.

Over time I also developed certain traits in my own investing lunacy.  I started simple (buy low/sell high and being a bit conservative) while maintaining a certain style and discipline, although I would often gaze over the fence and notice the investors, traders and representatives “working” their strategies to what appeared to be tame successes with the occasional “I bought it on a hunch and now it’s up 17 points” stories.  It occurred to me that one “style” of investing which may work for one person may be completely wrong for the next person down the street, or perhaps when both styles are acceptable it’s not recognizable.  I have determined that investing not only requires discipline, but also the ability to be a chameleon and somewhat diversified in your strategy.

Ahhh yes and I finally I get to the point of this story… throughout the years I have learned to love the earnings season.  It seemed that regardless of the markets or economic situation, you could always count on earnings to give an extra boost of excitement to investing.  However, over the past couple of years I’ve become a bit skeptical in the anticipation of earnings, but with a renewed sense of mining for gold.  For the purposes of this article I will focus on Alcoa (AA), Neoware Systems (NWRE) and Baidu (BIDU).  Each of these stocks is different in their stature as far as longevity, sector, and performance, but have a common underlying story with respect to their earnings. 

• On July 10^th Alcoa (AA) was trading in the $33-range when they announced a second-quarter net income of $744 million; 85 cents per share or an increase of roughly 62% from $460 million (52 cents per share) a year ago.  Revenue for the three months ended (June 30) rose 19% to $7.96 billion from $6.69 billion in the same time-frame from the previous year.  The income from their ongoing operations totaled $752 million; the 6-month figures were staggering and these numbers were some of the highest in the history of their company.  Five years ago this announcement would have sent the price of the underlying stock flying three or four points higher.  Instead, the reverse effect happened, and the stocked gapped down the next day by almost 5%.  Since then the stock has been treading water in the $29-range.  This is disappointing to say the least for an investor.  There are other underlying sub-stories behind the company’s performance with respect to the market, but with numbers like these – it is a bit surprising
• On June 29^th Neoware Systems (NWRE) announced that their revenue for the June quarter was effected by “lower than expected sales to certain existing customers in the U.S. and Europe during the last two weeks of the quarter.”  The company went on to say that its “sales growth from new customers did not increase enough to offset these lower than expected sales to existing customers.”  This sent the stock into a free-fall from the $22 range to the $12 range in a manner of minutes.  Prior to that, the company announced on April 27^th that their numbers across the board were higher, which included higher operating expenses, and the stock took a 6-point dump.
• And just a few days ago, on July 28^th Baidu announced that their profits (385% increase) and operating revenues (175% increase) skyrocketed from the previous year, but the net result of the per share value was not enough to keep investors satisfied and the stock plummeted from the $90-range to the mid-$70s and it is still trending downward.

So, you get the picture.  While these are only a few examples, there are many more companies with similar stories.  You may be thinking that I am a sore investor, or that perhaps I had over half my net worth in these stocks before they were taken behind the woodshed to have the snot kicked out of their price.  Although I have owned the aforementioned stocks (and profited), I was out before the bottom became soggy and dropped out.  I also intervened and jumped in after the earnings announcements and was fortunate enough to make a few bucks on the rebound.  In my view, the announcement by each of the aforementioned companies was not so staggering that it should have caused the stock’s price to drop in such dramatic fashion.  However, it seems as though the investing public is a bit too skittish today, and perhaps being part of the “herd” is commonplace in investing.  I am also sure that there were other underlying stories to each of these companies, and perhaps some would say they were a bit “overbought”.  But it leads me back to the whole idea of the earnings season; by nature I am a pessimist, and it has taught me to pay attention with a different directive.  It is always fun to buy or own a stock that has a positive earnings announcement and see it prosper, but if you keep your eyes open and have a quick trigger finger – you can stand to make a few bucks on the rebound when certain companies have taken a jolt.  All-the-while, the same basic philosophies of investing are still in play, such as following strong companies that are entrenched in their sector, with solid fundamentals, but when they announced their earnings – they were brought to their knees.

Editor's note: Volume and volatility often get extreme near earnings reports, as we frequently have noted. Charles obviously isn't feeding our members something from the standard CAN SLIM(R) menu, but we appreciate his contribution to this month's issue and we will surely be hearing more from him.  Some might consider his input this month as support for the notion that for every buyer there is a seller, and there are many contrasting views in the marketplace.  Let's just be clear about one thing - it is always important to limit losses at 7-8%!

Most recently, Mr. Charles Wiegert was the Vice President and Chief Compliance Officer for National Alliance Securities in Dallas, Texas; an institutional fixed income firm. He began his career in the securities industry 15 years ago and has worked in various compliance and operational related capacities. He earned a double major in Economics and Management and an Associates degree in Banking & Finance from Northwood University. His securities licenses include the Series 7 (General Securities Representative); Series 24 (General Securities Principal); Series 53 (Municipal Securities Principal); Series 63 (State Agent Exam) and the Series 65 (Investment Advisor Exam). He recently entered the world of independent consulting, providing ideas for corporate development; compliance solutions and advice on behalf of broker-dealers within the securities industry.

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