TSX TrendWatch Weekly

WEEKLY REVIEW… Another up week: +3.1% last week on the S&P/TSX Composite Index and +4.4% on the S&P/TSX Venture Index. That brought our %-Up reading in the chart below back up to 76%.

Nine of the ten sectors have positive trend values now, with FINANCIAL SERVICES leading the way.  That sector has been in the top 5 trend-wise for 20 weeks now. CONSUMER STAPLES was the worst performer last week, although it fell just -1.7% on the week and it’s trend value is just barely below zero at -0.1%.

The weekly price moves on the major US indexes were similarly positive overall, and volatility (as measured by the VIX index) continues to drop.

As usual, you can find the winners and losers among sectors and within each sector in the DATA & CHARTS workbook.

EXIT STRATEGIES…  Those of us holding Cott shares (BCB) were in for a nasty surprise yesterday (Monday). The share prices of the soft drink maker had been on a nice smooth upward trajectory for quite some time. It was a dream pick based on our relative trend analysis™ (RTA) methology, which is the core of our investment approach.

The quarterly results were announced yesterday and the numbers were excellent. Earnings easily beat street expectations at 48 cents per share, compared to a loss of 3 cents per share a year earlier.  Analysts had expected just 15 cents per share in profits for the quarter.

Revenues declined slightly, but were due to currency fluctuations.  Excluding the impact of foreign exchange conversion, revenues would have been up 2.3%.

So, did share prices surge?  Nope. By the end of the day they were over 20% lower.  Why?  Well, all it took was for the CEO to say the the numbers might not be as good through the rest of the year, due to Coke and Pepsi cutting their prices.

We’re content that we’re still up +15% from our purchase 12 weeks ago, but we were a whole lot happier when that number was above 40% last week.

Invariably, there will be situations like this, but it does remind us that every investor should have an exit strategy… whether for an individual stock purchase or for getting out of the equity markets entirely.

Opinions vary on what such a strategy should consist of, but we have some suggestions for you to consider.  These tips may or may not have helped in the Cott situation, but I’ll have more to say about that later. (BTW, long-term buy/hold investors are doomed to lose anyway, so this section won’t apply to them.)

1. Stops… This is the obvious one.  Decide at the time you buy each stock, how much you’re willing to lose if it turns out that you’ve made a bad choice. If you’re trading online, or even dealing with a full-service broker, you can enter a stop-loss order. If the trading price falls and hits or drops below that level, your shares are sold at the then-current bid price (i.e. it becomes a market order). The downside of this automated approach is that in rapidly falling markets and with stocks that have minimal trading volume, your order could be executed well below your stop-loss price. For that reason, many traders use “mental stops”. They’ve still picked their exit price when their shares fall, but manually enter their order as a limit order close to where the stop is hit. That naturally requires more time to follow your stocks and price moves… i.e. you need to be available to act.
2. Targets… You can do the same thing on the upside. Just after your purchase you can enter a limit order to sell your shares if they’re up a certain amount.  If I had been optimistic enough to think that Cott shares would climb 30-40% in a couple months, I could have set a target there, and would have had my shares sold two weeks ago at least.  Unfortunately, I didn’t.  I tend to go with the old adage… “cut your losses, but let you profits run”.
3. Floating Targets and Stops… This is a compromise strategy, which we find more attractive.  You still set an initial actual or mental stop, then move it up now and then (assuming the shares move up right away from your purchase price). Using a fixed percentage loss is generally better  than a dollar amount, but you’ll still need to convert that percentage to a dollar amount to adjust your stop. Floating targets make less sense if you want to let your profits run, but occasionally a rumour of a rich gold deposit or successful drug trial will affect a stock’s price dramatically and it’ll spike upwards until the rumour is dispelled. In cases like that an automated target limit order will let you take some nice profits before the story evaporates and the price falls again.  It’s rare but it could justify that strategy for you.
4. Trend Tracking… Again, vigilance is required, but if you have adopted our approach of screening for and buying stocks with attractive, consistent trends, you can monitor those trends from week to week at our web site after your purchase. Inevitably, at some point the consistency value will start dropping as share prices become more volatile. Then, as prices start to top out, the trend value will ease off too.  That is another good time to sell. The alternative is to hope that the trend will be restored, but hope is not going to change reality.

Generally, I like to use a combination of #3 and #4, with a bit of intuition thrown in. I generally don’t use automated stops and targets, but adjust my stops regularly in a spreadsheet and enter a manual limit order when it looks like I should get out. I track the highs and lows of my stocks after I buy. Every day or two, I’ll have a look at current prices and reset new highs or lows if either previous high or low has been breached.  My “mental stop” then is always relative to the latest high as I carry out my tracking. As I mentioned, I like to let profits run, so I’m less likely to enter a target limit order… unless intuition tells me that this stock has risen too far too fast.

I can’t leave this topic, though, without warning you that you should use percentage stops on a sliding scale, depending on what you paid.  I’ve seen all too many so-called experts telling people to set an automated stop-loss order at, say, 5% below purchase price. That might make sense with a $100 stock price where that would be $5 below purchase price.  Try that with a $10 stock (i.e. a -5% or 50 cent loss) and there’s a good chance that your sell-order will execute before the end of the day and you’ve lost the stock you just bought at a discount.  Try the 5% rule with a $1 stock (i.e. -5 cents), and your stop-loss order will likely execute the minute you hit your enter key. It’s a fact of life that the cheaper the stock, the higher the volatility, and the more risk you have to be willing to take when setting your stop.

The only rule-of-thumb that I’ve seen on this is setting your stops based on the square-root of the stock price. In the example above, if you were willing to risk 5% ($5)  on a $100 stock, you should approach a $10 stock (square root of $100) with a risk expectation of 25% (5% squared) when setting your stop (i.e. a loss of $2.50/share). Scale that down to a $1 stock, and it’s so close to double-or-nothing, that you might as well forget about a stop.

It’s not that simplistic in real life, but that’s how you should consider how much you’re willing to lose before setting a stop-loss order (especially one that is automated). Otherwise, you’ll only be making your broker happy with all the commissions you’re generating for him.

As for #4, I track the trend and consistency values after my purchase. Let’s say I bought a stock with a +5%/week (10 week exponential moving average) trend with 70% consistency. There are no hard-and-fast rules here, but if I were to see consistency drop to 20-30% when reviewing my weekly data, I’d keep a closer eye on it. Then if the trend value were to then slip down to 1% or less, I’d probably sell.

With both of those tactics in place, I rarely lose significant money on my trades unless I don’t monitor them regularly.  Unfortunately, I’ve had a few of those hits recently.
Now that brings us back to Cott and my 20%+ loss yesterday.  Neither strategy would have done me much good if you’ve been following what I’ve said so far. But what if I added a new strategy that says “sell the day before any earnings report”?  I’ve been looking for some academic research on this but have been unsuccessful so far.

Anecdotal evidence tells me, though, that more often than not, shares prices are far more likely to fall than rise on any earnings report. Nowadays, many investors “sell on the news” whether good or bad, and that obviously drives prices down.  And, even if the news is outstanding, but there is a warning that the picture ahead isn’t totally euphoric, the sell-off is even worse… as per the Cott announcement Monday.

So why not sell ahead of every earnings announcement?  If nothing catastrophic occurs price-wise, you buy back in at the end of the day of the announcement or the next morning.  And, if something catastrophic does happen, and you personally think the price hit was overdone, you’re getting back in at a much lower price for (hopefully) another ride up.

This was totally unheard of even 5 or 10 years ago, since commissions were much higher and flipping stocks was extremely expensive, unless you had a huge account. That’s not true anymore.  Although I’d like to see zero-commissions like in the currency markets, I would have preferred to give up $20 ($10 out, then $10 back in again) in my Cott example, than to lose a big chunk of the 40%+ gain I had. It’s certainly something I’ll be considering in the future, especially if I can find some academic evidence to back this up.  It also means tracking the specific dates of all earnings reports for stocks you own.

I’ll keep you posted if I find anything else to share on this topic.