The averages most people use are the 50 and 200 day.  As a rule of thumb, if the 50 is above the 200, long term uptrend.  If the 50 is below the 200, long term downtrend.  I myself prefer to use the 17 and 43 week moving averages, with the same rules in terms of short average above long average, or vice versa.  This gives us the following picture:

The 17 week moving average is above the 43, so that indicates a long term uptrend.  Essentially, this is telling us that the bear market has ended.  The question then becomes, is now the time to buy, or is waiting for a pullback a better call?  If a pullback were to start tomorrow, I’d estimate it goes to around 900, because that’s where the last low was, and as such, the strongest area of support.  If you’re a long term investor, the difference between getting in at 900 and 1000 is more significant then it may sound.  If it goes to 1600 over the next 5 years, then getting in at 1000 means a 60% return, getting in at 900 means a 77.8% return.  Annualized over 5 years, the difference is getting 9.8% annually, vs. getting 12.1%.

So for long term investors, what’s the move… buy or wait for a pullback?  The first thing i look at here is the short and intermediate term trends.

The 20 day EMA is above the 50 day EMA, so the intermediate term trend is up.  The 20 day EMA has an upwards slope, so the short term trend is also up.  What does this tell us about a pullback?  It tells us that we’re not partway through one - if we were, waiting till it ends would be the correct move.  Yet at this very moment, the market is moving up.

In terms of how this affects our long term investment choices; buy or wait for a pullback, it comes down to these options:

1.        If we wait for a pullback, the market will most likely continue rallying for another 2 weeks, and the pullback may not even take it to the current levels.  If we get in even higher, our returns will be lower.  Waiting is the higher risk move; either we get higher returns if the pullback comes sooner, or lower returns if the pullback comes later, and doesn’t bring us beneath today’s levels.

2.       Long term, we’re almost assuredly profitable if we buy here, based on the long term trend.  Buying now looks to be a safer move then waiting for the pullback.  In a long term uptrend, almost everything goes up, and now’s the time to be buying.  We may be buying at a more expensive price then is absolutely necessary, but now that the market has shown itself to be up trending again, it’s time to be buying equities.

So that’s my analysis for the long term portfolio.  What’s the right move for traders?  I’d stay long as long as the market is above the 20 day moving average, and exit if the market spends 2 days under the average.  Best guess at holding period with that scenario is a week to a month, if the market continues its current trend, there is definitely the potential for significant profit; if the market decides to pullback, the fairly tight stop should get you out without big losses.

This chart shows the SPY, an etf that tracks the S&P 500 index.  We’ve had quite the run since march, but that run seems to have fizzled out.  The 20 day exponential moving average is now moving essentially sideways, with a slightly downwards bias.  This overall shows neutrality in the short term trend - that is, days to weeks.  The 20 day EMA is above the 50 day EMA, indicating that we’re in an intermediate term (weeks to months) uptrend, but the flat 50 day EMA also shows that its not a strong uptrend.  Trend wise, we’re pretty much neutral.  Unlike the march-june timeperiod, we’re no longer in a trending market.

So we’re in a trading market then.  With that in mind, important considerations are support and resistance, and if we’re oversold/overbought at the moment.  There is clear resistance at 95.50, and with today’s rally to 94.15, that is definitely the most important level to have an eye on.  Besides that resistance, there’s also some weaker, less significant support around 93.00.  Far more important then that support level is the one at 87.75, as its been tested many times over the last year, and has held more consistently.  Based on support and resistance levels, the favourable trade seems to be a short @ 94.15. That allows for a tight stop loss, (95.65 means approximately $1.50 at risk), while allowing for strong profits if you aim to close the short at 88 (6.15 profit).  Reward:Risk ratio of 4.10.  Not to shabby.

Condition wise, we’re neither overbought nor oversold at the moment.  Most recently, we were overbought near the last set of highs, but the NYSE BP index has been falling recently, indicating bearishness.

Overall, my current stance is leaning towards bearishness.  The market could go higher, but for traders using tight stop losses, the market is saying to be bearish.  For the momentum players out there, its fairly neutral indicating you shouldn’t be in the market until it has some clear direction.

To find these companies, I used a combination of fundamental and technical criteria, searching for the best companies in a decent technical position.  Here are the companies I uncovered.

1.        Research In Motion (RIMM) - $83.45 per share

I talked about THIS one extensively in a prior article.  Its up a couple percentage points since then, but hasn’t encountered any big movement yet.  What it comes down to is that this company is fundamentally strong; it has a good debt position, it has strong revenue and earnings growth, and the company has a large cash position.  It basically has everything I look for in a company, and is trading at a PE multiple of about 25.  I see the multiple going to 30-40 after the recession, on top of much higher earnings, so this stock is definitely going up in the long run.

2.        Shanda Interactive Entertainment (SNDA) - $63.32 per share

This company deals in the Chinese online gaming market.  I’m sure you’ve heard in one newsletter advertisement or another that china is big, and you may even have read them talk about the gaming industry over there.  Although I wasn’t trying to target Chinese Gaming specifically, this did come up in my stock scan.  Here we have another strong company.  First off, this company has almost no debt.

Second off, comparing the latest quarter to the one a year ago, they had revenue growth of 42%, and earnings growth of 34%.  Pretty spectacular given the generally lacklustre earnings most companies are getting lately.    Finally, they have the advantage of being in China, where the economy is still growing, and so demand for their products is increasing, instead of going down.  For the low PE multiple of 23, this stock could easily take off to much higher levels in the coming years.

3.        Netease.com, Inc. (NTES) - $38.10 per share

Have you ever noticed that when one company is doing well in an industry, others in the industry also tend to succeed?  Its because conditions in the industry broadly help many companies do well, and perhaps that explains why this company made the list.  This company also deals in the Chinese online gaming market, and product-wise, is very similar to Shanda, number 2 on our list.  Also a company with very little debt, its revenue growth numbers came in at a paltry 20% comparing this quarter to the one a year ago, although earnings were actually up 55%.  With no debt to speak of and a growing market, I can’t really see any serious impediment to this company’s success.  Its currently trading at a PE multiple of just 19.  Like the other companies on this list, I think you can make a killing if you hold it for a while, as people will eventually see a company that’s growing earnings at a lightning fast clip, and give it a PE multiple of at least 30.  Factoring in the ever increasing earnings and this could easily double or triple in the coming years.

4.        Transcend Services Inc (TRCR) - $13.30 per share

This is likely a company you’ve never heard of.  With a market cap of just 113 million, it’s a very small company.  As google finance puts it, they “provides medical transcription services to the healthcare industry”.  To be honest, I’m not 100% sure what exactly that means.  What I do know is this; Sales in the most recent quarter vs that quarter a year ago were up 28%.  Earnings were up 18%.  They’re in the healthcare industry, so they won’t get hit by discretionary spending issues if the consumer gets beaten too hard by the recession.  They have very little debt, with a debt to equity ratio of just 2.35%.  They also trade with a PE ratio of just 19.  Given they’re strong revenue and earnings growth, and their healthy debt situation, I wouldn’t be surprised if that increased to 25 in the near future.  As the economy recovers, and hospital budgets go up, its entirely possible that they’re earnings and revenue growth will accelerated, and they’ll do even better then that.  I like to play it by the numbers, and the numbers say this is a solid company to be buying into.

5.        SOHU.com Inc (SOHU) - $69.26 per share

Once again, we’re back to china and the internet.  As google finance puts it, “Sohu.com Inc. (Sohu) is an Internet company in China, providing Chinese with news, information, entertainment and communication [...]Its advertising business comprises brand advertising and sponsored search services. Sohu’s non-advertising business principally includes online games and wireless value-added services.”  This is startlingly similar to numbers 2 and 3 on the list, and just goes to show you how strong this industry is.

My stock screener came up with 8 companies total, 3 of which were trading OTC.  Of the remaining 5, 3 of them were in the Chinese gaming industry.  Amazing.  In terms of the actual company, its a familiar story.  Sales up 37%, earnings up 108%, and no long term debt.  A company like this should fairly be trading at a PE multiple of 30 right?  In my wildest dreams, perhaps just 20, offering an absolute monster of an investment likely to deliver fantastic returns.  Yet sometimes fact is stranger then fiction.  This company is trading at a PE multiple of just 14.84.  For a company that operates in a growing market, with growing revenues and earnings, and no debt, that’s an amazing deal.

So those are the 5.  Research in motion, Shanda, Netease, Transcend Services, and Sohu.  What are the important trends here?  For one thing, 3 of the 5 are based in china, and part of the Chinese gaming industry.  This may be because I was screening for companies that increased revenues year over year, and china’s economy didn’t slow - it merely grew at a slower pace.  That being said, it still points strongly to china as a good place to invest.  These are also all traded on the NASDAQ, which has been outperforming of late.  Perhaps this is a good demonstration as to why?

So those are the 5 growth stocks I’d buy and hold, based on a pure-by-the-numbers approach.  The recession hasn’t slowed down these companies, as growing revenues and earnings have demonstrated.  Yet the recession has taken down their stock price, giving opportunistic investors a great entry price.  While we’re likely approaching the end of a bear market rally, these companies should hold up better then most in a downturn, and should produce returns far in excess of the market should it continue going upwards.

Of course, if you want to supercharge your returns, you could use a long term option strategy like the one mentioned in one of my older articles on stock option strategy…

You may have heard of the phenomenon known as the triple leveraged ETF.  This type of ETF aims to mimic 3 times the daily performance of a sector or index.  The most popular are probably FAS and FAZ, offering triple the performance of the financial sector, and inversely triple the performance on a day to day basis.  This means that if the financial sector goes up 1% in a day, FAS will go up 3%, and FAZ will go down 3%.  That being said, this correlation doesn’t work in the long term.

If Financials go up 5%, then down 5%, then up 5%, then down 5%, then for arguments sake, up 0.5% to get them back where they started, then the assumption many will make is that the triple leveraged ETFs will ALSO be exactly where they started. Yet this is not so;  the performance of FAS would be up 15%, down 15%, up 15%, down 15%, then up 1.5%, for a total loss of 3%.  The performance of FAZ would be down 15%, up 15%, down 15%, up 15%, then down 1.5%, for a total loss of 5.9%.

Both the ETF that goes up as financials go up, and the ETF that goes down as financials go up, ended up down with the same price action.  This is because of a small mathematical hiccup in the compounding, and is the reason why both ETFs state many times, very boldly in the prospectus, that these are intended as a daytrading vehicle.

If you don’t think it adds up, consider this.  FAZ and FAS were both launched on the same date around $55 per share.  At the time of writing, FAZ is trading at 4.96, and FAS is trading at 9.71.  Also of interest is the fact that the underlying index is down, yet the bullish triple leveraged etf outperformed the bearish triple leveraged ETF.  Another compounding hiccup.

The fact of the matter is that given any amount of volatility, these triple leveraged ETFs are quick to fall.  This is why they are recommended as daytrading vehicles only.  Thing is, I’m not a daytrader, so now I’m wondering, what’s the best way to use these things?

Their characteristics

-They get slaughtered by high volatility, and sideways markets

-They come in both the bull and bear variety

-Low volatility DOESNT benefit them (they won’t outperform due to low volatility, they just won’t underperform as badly)

-They have wild daily fluctuations


So what’s the best way, aside from daytrading, to use them?  The answer is to short them, because of their natural, mathematical tendency to go down.  Yet the wild fluctuations are likely to produce excessive volatility, and some excess losses to.  How to solve that problem?  That’s actually fairly easy.  Just short both the bullish ETF, AND the bearish ETF.  That way, one of the ETFs will be ahead at the end of EVERY day, and over the long term, you should see very high returns on both.   An example; FAZ and FAZ both started at 55-60.  They are now at about 5 and 10 respectively, after 7 months.  Shorting both would have led to 92% and 83% gains.  While they are something of a best case scenario, as there have been giant rallies, giant pullbacks, and massive amounts of volatility over that 7 month period, that just goes to show you what these things can do.

The thing you have to watch out for just shorting both of them is getting wiped out by short term swings.  Without frequent rebalancing, the direction that goes up in the short term could lead to the position sizing being highly skewed (a short position becomes a larger and larger position as it goes out of your favour, smaller and smaller as it goes in your favour).  If you DO frequently rebalance, the excess commission costs could damage the portfolio, although it WOULD give you a systematic way to pyramid your profits (the rebalance would involve covering shares on the losing position, and shorting more shares of the winning one).

Definitely a high maintenance strategy.  The alternative would be to use put options on both ETFs.  The downside here is that the high implied volatility cuts into profits.  This could be offset by using a vertical spread, not unlike the ones I discussed in my article, “the vertical leap”, the one difference being you would buy the higher strike option, and sell the lower strike option, making it bearish.  That would offset the high implied volatility, while still staying true to the basic idea.  As an added plus, it greatly limits the amount of risk you take on while waiting for the mathematical compounding effect to do its job.  That being said, its not really ideal if your not confident trading stock options.  Its also not ideal in the less liquid option markets, for although the options for FAZ and FAS are fairly liquid, other triple leveraged ETFs don’t necessarily have the option liquidity to support such a setup.

So what are some ETF pairs that this could work on?

So there laid out is a nice arbitrage-esque strategy designed to take advantage of volatility in the markets.  Personally, I think for the lower volume pairs, shorting both pairs, and rebalancing every 2 weeks would be the best strategy.  For the higher volume pairs, a 2 strikes OTM vertical spread with max profit of at least 80% expiring 9 months to a year out would be my favourite play.

Now one thing that you should keep in mind is that this is much closer to a buy and hold play then a short term play.  If you hold for a long enough time period, then the strategy is almost guaranteed to pay off, based both on empirical results, and the effect of mathematical compounding.  However, in the short term, this strategy is bound to lead to some losses, those losses of which have the definite potential to be large losses.  If you’re going to try this strategy in your portfolio, please keep the amounts risked very small, and approach with caution.

Personally, if I was to use this strategy now, I would use either financials, or technology, as they are likely to be the most volatile over the next year, and volatility is where the returns from this strategy come from.  Emerging markets would also be a good possibility for this strategy.  In terms of the triple leveraged treasuries; I frankly have no idea how well it would work, but feel free to weigh in with your opinion.

So what do you think; we know buy and holding won’t work with these leveraged ETFs, but how about a short and hold?  Does the idea have potential?  What are your thoughts on rebalancing?  Leave your comments to discuss!

Post Discussion EDIT: So as many of you have pointed out, its very difficult to find shares to borrow to short these ETFs with, and if the broker has low inventory of the ETFs, you also run the risk of having the position closed at a bad time. With that in mind, the major options become a) Using Puts to take advantage of a downside move, and using a vertical option spread to take advantage of the downside move. I’ll go over using options for a bearish position in the near future, but in the meantime, for those with a solid amount of options knowledge, what are you thoughts on that?

What’s the better economic-recovery play?

These companies were both major media darlings before the recession, posting strong revenue and earnings growth, and sporting sky-high PE multiples.  Yet with the recession, many stocks got CLOBBERED, and these companies are now both trading at a PE of around 22.  So the market is pricing these companies similarly; is the market right to do so, or is there hidden value in one of these companies?

Looking at their PE ratios of 22ish, there are two ways the companies can go up in value.  They can make more money, driving up the E side of the equation, or sentiment towards the company can improve, driving up the ratio itself.  Since sentiment is also based on earnings, earnings are definitely the most important variable here. 

So it wins revenue growth wise, where do they stand on earnings growth?  It’s all about the bottom line right?  Well AAPL managed to grow its earnings 14.84% over that time span.  Once again, this is a lot better then the vast majority of companies, whose earnings have in fact fallen throughout this recession.  How does RIMM compare?  Well as you may have guessed based on the revenue numbers, RIMM beat apple squarely in terms of growth here as well.  RIMMs earning growth clocked in at 25.88%, falling significantly short of their revenue growth, but still trumping apple by a fair margin.  Assuming the recession doesn’t get significantly worse, the fact that these companies are both growing earnings at such a fast pace indicates they are likely to continue that trend well into the future.  Neither of these are exactly discount-brands either, so coming out of the recession, they’ll have the added benefit of selling to an expanded market of consumers, which should give them a short term boost in earnings and revenue growth.  That said, have to give it to RIMM on this metric as well; its growing earnings faster then apple is.

So they’re making money hands over fists.  Wheres the risk?  Looking at their debt situations, they’re in fairly good shape.  AAPL and RIMM have current ratios of 2.46 and 2.29 respectively; This means that they have over $2.00 of cash and assets that will soon be converted to cash (eg: inventory) for every $1.00 of short term debt.  In other words, no real short term debt risk.

Are they sitting on piles of long term debt?  Not at all!  In fact, both companies share the remarkable property of not having any long term debt.  On top of that, they both have very significant cash positions.  AAPL is sitting on 25 billion in cash and short term investments (total assets = 43 billion), while RIMM is sitting on 1.5 billion in cash and short term investments (total assets = 8.1 billion).  That being said, keep in mind that to keep their current ratios healthy in the 2-3 range, they’d have to keep most of that cash on hand and not spend a significant portion of it, so they aren’t quite at a stage where they’re likely to be using that cash to enhance shareholder return.  The large cash position is more a margin of safety type deal.

A good short and long term debt position then.  What else could threaten the stock price?  If this recession gets a lot worse, they could go from fast growing companies to slightly contracting companies.  While this may only lower the Earnings portion of the PE ratio by 5-10%, the big loss would be caused by a drastic fall in the PE ratio.  A company that is contracting may only get a PE ratio of 10-15, and if people don’t believe the company will be able to grow earnings in the future, a PE ratio of even lower then that is possible.

Looking at AAPL, I can see a quarter with decreased earnings as a possibility, although the fact remains that after the recession ends, there is likely to be a large boost in revenues.  This common knowledge is likely to keep AAPL at a fairly lofty PE ratio.  If an earnings report comes in where AAPL DID lose ground compared to the quarter 1 year prior, then that’s when I’d begin getting worried, as its likely to cause the PE ratio to fall significantly, and that would have a massive effect on the stock price.

Now examining RIMM, I don’t envision them running into that problem.  With such strong revenue growth, it is bound to continue into the next quarter as well.  Even if they don’t come out with earth-shattering numbers like their previous 84% growth in revenues, it’s almost a given that revenues will be up, and earnings will be up.  With that in mind, the biggest risk; a drop in PE ratio as the market factors in the possibility of very low future earnings growth, is practically eliminated.  RIMM definitely scores the upper hand here.

That being said, If this recession ends up going longer then people expect; instead of a recovery in 2010, it lasts as long as 2011, 2012, or further, all bets are off.  In that kind of situation, the prolonged and continuous job losses would eventually impact the markets for both of these companies products to the point where earnings would definitely come in lower, the PE ratios would definitely drop drastically, and an investment in either of these companies would definitely lose money.  Yet if you agree that we may see a recovery by the end of next year, then AAPL and RIMM have some definite potential.

So where do I see AAPL and RIMM going?  Well at this point, I’d say that RIMM has without a doubt the better prospects between the two.  Assuming a non-Financial Armageddon scenario, then this is how I see the situation.  Within a year of the recession ending, the market is likely to push stocks that are growing quickly back up to a PE ratio of at least 30-35, for a gain of 36-59% (from the current PE ratio of 22).  If a strong company like RIMM also manages to increase earnings another 20% by the end of that year, then that would increase the overall stock price by 63-90%, which would put RIMM at 118 per share conservatively, up to as high as 136.  Of course, earnings growth of higher then 20% will put the stock price up possibly higher then that, and if the market is more optimistic, that also could lead to a higher PE ratio then the range given above.

So is now the time to buy these companies?  Not quite yet.  The market has had an enormous rally over the last couple months, and is due for a pullback in the nearby future.  The technology sector overall is currently in an overbought state, according to the BP chart, so we should wait for a reversal before trying to get into these 2 stocks.  In fact, i wouldn’t be at all surprised if the dow went back down to 7400 or less..  But when it does, these are definitely 2 stocks to keep on your watch list, for as the recession fades, these stocks are likely to be among the top performers.

So what happens next?  After this rollercoaster ride of a sector, what’s likely to happen next?  There are a couple key ways we can predict that, but keep in mind that the point of technical analysis isn’t to be 100% sure of the direction; the idea is to get a good idea of what is most likely to happen next, and capitalize on the opperunities the market gives you, while keeping your risk in check.  With that said, lets take a look at the technical picture.  Basic technical analysis, step 1 is to identify support and resistance levels.  Key support levels seem to be 11.20, and 9.80.

XLF is an etf representing the Financial Sector. Seen on the chart are two support levels, and the 50 day moving average. The RSI and MACD are also shown

Looking at the chart, it’s clear that the financial sector is sitting at support.  The question now is if the support will hold.  If it goes lower from here, the next major support level is 9.80, followed by the 50 day moving average.  If it falls as low as 9.50, I would definitely be shorting it based on the support at resistance levels, but until then, there is a strong chance of it continuing its move upwards based on support and resistance.  Although not shown on the chart, the 200 day moving average is also a big factor, as it currently sits at 13.29.  This is major resistance, and the last pullback was on a bounce off that moving average.

There is another indicator that says its likely to go down from here, and that is the Bullish percent index chart.  The bullish percent index chart recently changed from a column of Xs to a column of Os, and it did this while overbought.  This is the strongest sell signal a bullish percent chart can give, and if I was long the financial sector, I would definitely take that as a sign to get out.  Looking to other indicators, the RSI is declining from a fairly high level, and a bearish MACD crossover seems to be occurring.  These are also bearish signals

Given these signals, I would recommend beginning to build a short position on financial stocks.  Start with a small position, and pyramid your profits by adding to your position if it goes in your favour.  For a reminder on how one pyramids their profits, take a look at the stock trading strategy article i posted about a month ago.  In a case like this, I’d also recommend a tight stop, as there is some support, and it could easily move against you.  If XLF tops 12.25, its time to get out, although more conservative traders may set it tighter still.  The time span on this trade is looking like it should make the move in about a month, although it’s crucial that you keep an eye on indicators like the BP index when looking for an exit signal.

That being said, its important to note that the last time financials gave a BP chart sell signal, it turned out to be a head fake, and people shorting on that signal would have lost money.  Still, this signal is right far more then its wrong, and traders should keep that in mind in the coming weeks.

In my previous article on stock trading strategy, I showed you how to use relative performance to decide what sectors you should be buying and selling.  In this article, I’ll show you how to use a little-known tool to call reversals in the major economic sectors.  What is this little known tool?  Its called a Bullish Percent Index, or BP Chart.

A BP Chart basically charts the percentage of stocks of a group that are going up, vs. Down.  It does this by looking at Point and Figure buy and sell signals. (A stock is on a Point and Figure buy signal if its latest price movement took it above the previous high, whereas a sell signal if it took it above the previous low.)

When examining a Bullish Percent Chart, the important things to look at are: the direction it’s moving in, the current level, and past times its been at its current level.  The direction it’s moving in is given by looking at the column furthest to the right.  A column of Xs denotes that its currently moving up, whereas a column of Os denotes its currently moving down.

With that in mind, here’s the interpretation.  If the BP chart is above 70, its overbought, if its below 30, its oversold.  The strongest sell signal is it reversing from a column of Xs(going up) to a column of Os(going down) from above 70, because that shows that it went from the bulls being in control of an overbought market, to the bears being of an overbought market.  Similarly, a reversal from Os to Xs under 30 would be a strong buy signal.  Between 30 and 70, the most significant thing is which direction its going; up or down, Xs or Os.  If its going up, you want to be bullish, if its going down, you want to be bearish.  Fairly simple right?

The column farthest to the right is Xs. This is a buy signal. Its above 70, so its already overbought. Conclsuion? The SPX index is currently a hold. Keep an eye on it, when it reverses by 6 points, its time to short.

The one thing you want to keep in mind is that if it’s in an overbought or oversold condition, that in and of itself isn’t enough for a signal.  Don’t consider it a buy or a sell, because while it may be very oversold, markets can stay in an overbought or oversold situation for a long time.  Waiting for the reversal is absolutely essential in cases where the sector is in an overbought or oversold BP position.

The only question left is where to find bp charts?  The best place I’ve found to find bullish percent charts is at stockcharts.

So if I’m looking to find out what sectors are a buy and a sell at the moment, I go to that website listed above, and first I’d scroll down, looking for anything reversing in the overbought or oversold areas.  If I don’t find anything, then I’d look to relative strength to find 3 or 4 sectors to go long or short on.  Finally, I’d then use the BP charts to confirm the signal.  Only buy when multiple indicators tell you to buy, and only sell when multiple indicators tell you to sell.  Doing this insures your always in the best sectors at the right time, and that’s how money is made in the stock market.

The vast majority of your returns are determined not by what stocks you choose to invest in, but what industries you choose to invest in.  With this in mind, one of the key things you should be doing when investing is deciding what sectors you think will do the best.  How do you do this?

Determining what sector should do well is actually a fairly simple task.  It’s all based on the observation that markets trend.  Day to day fluctuations may be fairly random and unpredictable, but the effect of those day to day fluctuations on the stock price over a period of months is generally consistent, weather it be up or down.

An easy way to see if you should be long or short a sector is to pull up a chart for an ETF representing that sector.  Ask yourself this question: is it up or down from 2 months ago?  Is it up or down from 6 months ago?  Is it up or down from a year ago?  The direction over the last 2 months is the short term trend.  For position traders, people whose holding period is less then a month, that’s the ideal direction to be trading in.  The direction over the last 6 months tells you the intermediate term trend.  If your usually holding period is 1-4 months, then the intermediate term trend is more important.  The direction over the last year is the long term trend.  If your usual holding period is 6 months to a year, its the long term trend you need to pay attention to.

The goal here is to buy things while they’re going up, and short things that are going down.  To accomplish this, we judge the relative strength of different sectors.  While this used to entail looking at numerous charts individually, calculating the percentage increase or decrease over the aforementioned time periods, and comparing them, it’s been made easy by technology.

Viewing this, its easy to see that the top performers over the last 2 months have been consumer discretionary, industrials, materials, and financials.  The worst performers have been utilities and health care, and consumer staples.  You always want to trade in the direction of the trend, and the short term trend tells us that we should be buying technology stocks, materials stocks, and financial stocks while selling utilities stocks.

Before making the trade, you should always check the next highest time frame as well.  The short term trend is saying long consumer discretionary, industrials, materials, and financials, and short utilities and healthcare, and consumer staples.  What does the intermediate term say?

Relative Performance over last 6 Months

The intermediate term chart is clearly telling us we have a downtrend.  Most things are down, but we do see that consumer discretionary and technology stocks have also been doing well over longer time frames.  Although financials are a good bet based on the short term trend, the intermediate trend is saying sell.  When you have conflicting signals, the best bet is to make no bet.  Finally, utilities, healthcare, and consumer staples are down over the intermediate trend as well.  They’re down in the short term trend, and the intermediate term trend, so shorting utilities, healthcare, and staples would be a good call (for a short term play).  Based on this, I’d be bullish on technology and consumer discretionary companies, while I’d be bearish on utilities, healthcare, and consumer staples.

Some rules of thumb

*The trend is your friend.  Trade in its direction

*If you’re holding for a couple weeks up to a month, you want to use the short term trend.  This is found by looking at the last 3 months of price action.  If your holding for a couple months, then you want to use the intermediate trend.  This is found by looking at the last 6 months of price action.  If your holding for 6 months to a year, then you want to look at the long term trend.  This is found by looking at the last year of price action.

*Always look for confirmation in the next highest level.  If the short term trend says buy, look at the intermediate term trend for confirmation.  If they conflict, then the trade is too risky.

For this kind of trading, ETFs are a very useful tool.  Here is a table containing the ETFs tracking the sectors above

This type of analysis is useful not just for sectors of the economy; its also useful for analyzing countries as well!  Here are the tickers for various countries and their ETFs.  By putting in these tickers, you can create a performance chart based on countries instead, and use that to compare international markets.

The key to beating the market is to invest in the right places, and by using the relative strength techniques in this article, your well on your way to doing so.  Relative strength isn’t the only thing to keep an eye on.  You should also keep an eye on bullish percent indexs, which will be covered in the next article.  They allow you to take advantage of reversals in sentiment, and are the best way to effectively quantify if a sector is overbought or oversold.  Relative strength helps to identify the trend; bullish percent indexs help to time entries and exits.

Without further ado, the company.  Its DryShips Inc (DRYS), and here’s the relevant information. (In millions)

As you can see, revenue has been increasing rapidly on a consistent basis, a very good sign.  In 2007, they had 582.6 million in revenues, which translated into an EPS of $13.40 per share.  Yet in 2008, they had almost double the revenues - 1080.7 - and yet posted a loss.  Why is this?  I looked into it, and it appears they made an aquisition, and part of that aquisition involved a loss of “goodwill” of 700 million.  As the company put it in its quarterly report, “Included in the year ended December 31, 2008 results are a non-cash loss of $700.5 million or $15.71 per share related to impairment of goodwill associated with the acquisition of our wholly-owned subsidiary Ocean Rig ASA”.  If that cost weren’t there - and it won’t be in future - the company would have made closer to $7.50 per share.  According to the annual report, if all unusual expenses were excluded, the EPS would have been $11.35 per share.

So what is likely to happen next year?  Well, given its acquisitions, there isn’t reason the believe that revenue will go down, its “unusual expenses” should practically disappear, and with those changes, it should be looking at a profit of at least $8.00 per share, and likely closer to the 10-15 range.  So a company that will make $8.00 per share, and has been growing extremely quickly, how much is that worth?  Given its strong growth, a conservative PE ratio would be 15, for a stock price of 120.  Coincidentally, 120 is very close to the pre-recession high for this stock.  If we assume it will make 11.35 for 2009, the same as it would have made for 2008 if not for those unusual expenses, then a PE ratio of 15 puts it at 170.

So whats the stock trading at now? 10.75 per share.  If it goes even halfway to the conservative valuation of 120, then its at $60 per share, for a 458% return.  If it goes all the way, as i believe is a definite possibility, returns in excess of 1000% are completely possible.

But it wouldn’t be the full story without looking at the risks.  Most analysts are giving it a sell rating.  Their estimates for 2009 revenues range from 771 million to 1010 million, expecting an average of 832 million.  I wouldn’t say that’s so negative, given its 43% higher then its 2007 revenues.  Yet these analysts are expecting an average EPS of $1.85, although this number ranges from $0.81 to $9.70 (apparently, i’m not the first to deduce that they’ll do very well next year) depending on who you ask.  Interestingly, one year ago, they were expecting EPS of 15.92 for 2009.  Perhaps they didn’t look deeply enough into the unusual expenses?  Before the unusual expenses popped up, they were saying almost 16 per share, now the company posts a loss (only after unusual expenses) and they’re saying 1.85?  I think they’ve made a mistake.

The other big barrier for this company is debt.  It currently has a current ratio of only 0.39, which is absolutely terrible.  Its Debt:Equity ratio is 172%, which means it is mostly debt-financed, also a negative in this situation.  That being said, the industry debt:equity ratio is 155%, and the industry current ratio is 1.11.  In most cases, those ratios alone would make me very wary of investing in DRYS, but with its strong earnings potential, and it being so undervalued at the moment, i think its a reasonable risk to take.  With a current ratio so low, they will probably have to convert some short term debt into long term debt, which may be hard during the current economic environment (although the fact that they’re profitable means they are almost sure to succeed).

The other potential issue is that they may issue more shares to try and lower their debt:equity ratio, which would be a bit dilutive, and may take the final EPS figures down 20-25%.  Overall though, i would be very surprised if 2009 EPS numbers came in under $6, and that would translate into a stock price of at least 60.  Recessions offer many opportunities to buy undervalued companies.  Now is the time to start looking for these opportunities.

Think i’ve missed something?  Have another company you feel is about to take off?  Post in the comments section!