Fortune Telling 101

This is by no means a comprehensive list, but it gives you some insight into the type of data the fundamental trader looks for in general. Often the fundamentals that affect a specific stock, industry, or sector are more common than those affect- ing the overall economy.

Let’s quickly look at an example from the pharmaceutical sector. What specific fundamentals and/or surprises might a trader be watching?

1. The sales of the company’s basic lines of drugs a. Strength

b. Profitability

c. Contribution to overall company health d. Competition

e. Time left on patents

f. Plan to protect the market when patents expire 2. Drugs or products in the pipeline

3. Pending drugs or products a. USDA approval pending b. Field test results

c. Competition

d. Market situation—sales penetration and earnings potential 4. Distribution

5. Reputation

6. Legal problems, like lawsuits and so on

Here again, this list is not comprehensive and would vary with the size and type of company that is being evaluated and tracked. For example, an option trader may pay more attention to small, one-product pharmaceutical companies because these are higher-risk operations. Regular investors shy away from them because it is usually boom or bust. This also means that the daily trading volume of regular shares is low. Thin markets make for explosive opportunities, meaning that these types of stocks potentially make major moves on low trade volume. Visualize toss- ing a rock into a puddle and another into an ocean—the former will make a big splash, and the latter goes unnoticed. Option traders who play long shots bet on these types of stocks limiting risk to the premium they pay for the option. If they are not sure the drug company will be successful in getting its product approved, they can buy both puts and calls, thus playing both sides at the same time. If the company is successful, the price skyrockets and the calls leap into the money. If the opposite happens, the stock price crashes and the puts are the right prescrip- tion. This type of trade is known as a staddle.

As you can see, with fundamental analysis, you must be looking in all directions at the same time. I often thought that if fundamental analysts chose a god to make

burnt offerings to, it would be Janus, the old Roman god of doorways, who had one head simultaneously looking in two directions. The analyst is looking one way to determine the size of the supply and the other way to gauge demand.

The strength of fundamental analysis is that it forces the trader to do a lot of re- search, so that he truly understands the entity he is trading. With a stock, the fun- damental trader knows what the company makes or does, how it ranks among it peers, who the key managers are, its relationship with its customers and competi- tors, and the detailed financial history and outlook. The company is real to the trader, not just a stock symbol, as is often the case with technical traders. This in- depth knowledge and understanding can also be a liability. Some traders, and more often investors, fall in love with their asset. They become loyal to it. This some- times prevents them from selling it when it becomes stodgy and uncompetitive. When you have spent a great deal of time studying, admiring, and owning a stock, it is often painful to cut it loose when it is has lost its usefulness. Maintaining your objectivity is a cornerstone of success.

A virtue of fundamental analysis is that it often signals a major move well in ad- vance of other analytical systems, such as most technical approaches. This allows the trader or investor to gradually become more and more aggressive as the trade develops. For example, an industry or company may be fading slowly over a pe- riod of years, but prices do not reflect the problems until they become so obvious that they are on CNBC. The meticulous fundamental analyst is aware of these problems well in advance and can build a large position in an orderly fashion.

The negative side is that fundamental analysis is weak regarding the timing of trades. If the analyst acts too soon, the option expires before the move material- izes. The trade must be rolled over into more distant months, at a cost of additional commissions. As you will see soon, technical analysis can help.

Here is an example. A fundamental analysis of a friend of mine, a few years ago, determined that the U.S. dollar was going to make a major correction to the downside. He studied the market and selected 10 major companies, mostly in the financial sector, that he felt were going to be affected if the dollar dropped by 20 percent or more. He began buying puts on these companies, 100 lots at a time for the next several months, until he had built a large position. It took several months for the dollar to fall because Japan and China defended it as they attempted to keep their exports flowing into the United States by keeping the dollar artificially high. They were buying dollars to keep the dollars higher than their currency and simultaneously dumping merchandise on the American market to keep their people working. Before the dollar collapsed, some of the puts approached expira- tion and were offset and replaced with new ones in a later month. The objective was to get the puts only a few dollars in-the-money and average $5 profit on each. On several thousand options, the risk-reward ratio was good, and the options were cheap.

Naturally, the risk was that after he had built up this huge position, the expected result, in this case the fall of the dollar, would not occur. It is always possible that all the options will expire worthless or have to be offset for less than the purchase price. And the trader must guard against two demons. First, the trader can fall in love with his or her brilliant analysis and not know when to cut the trade and sal- vage whatever is possible. Let’s call that demon hubris. The other one is despair. It causes the trader to give up too easily or too soon. The strength of conducting all the detailed fundamental analysis is that it gives you enough of an understanding of the overall universe of the stock that you can hold the line against these two fiends. By now you should be starting to come to the conclusion that trading is as much a mental game as it is anything else. If so, you are exactly right!

One final virtue of fundamental analysis is that the study you do on your pri- mary stock teaches you how the entire sector performs. This can lead to some dandy ancillary trades. These are sometimes referred to as sympathy trades. For example, your primary target is Intel. Some news hits the Street unexpectedly, and Intel pops. You missed that trade for some reason, but you know that the other stocks in the chip sector will move in sympathy. You immediately buy some in-the- money calls and profit from Intel’s move, but with one of its sister tech stocks.

Because of trades like this and all the specialized information a fundamental trader must have at his or her fingertips, it is common for these traders to become what is known as shepherds. Shepherds are traders who closely follow a manage- able number of stocks. Selecting just the right number of sheep takes experience and skill. The trader knows everything there is to know about the industry, the sec- tor, all the stocks composing the sector, and the specific target stock.

Before moving on to technical analysis, let me leave you with a few words of caution. Avoid myopic fundamental analysis. You must totally understand and an- alyze your target stock, but you must not suffer from tunnel vision. Do an analysis of the overall economy as a major part of your specific analysis. For example, your data indicate that a certain stock is poised for a major bull move, but the S&P is down big and heading lower. Earnings reports are dismal. Interest rates are search- ing for new highs. Housing starts are down. Get the picture? There is a bear mar- ket in progress. That does not mean that your stock cannot move higher vigorously, but it does argue strongly for caution. Nothing trades in a vacuum. Always put your analysis into the perspective of the overall economy.

It is also critical that you put your facts into perspective. Let’s think housing. You are convinced that many of the public homebuilders are about to make a seri- ous move north. Then boom! You see a headline saying that housing starts are ex- pected to be 10 percent lower. Should this stop you? Not necessarily if you are aware that even with a 10 percent drop, home starts will still be at near record highs. Just put every new fact that comes to your attention into perspective, and then, and only then, act.

When your analysis indicates a major bear move in your target stock, you hesitate because you think that there is only room for a small move downward, since the cur- rent price is almost equal to the book value. Your conclusion is that it cannot move below book value. My reply: “When pork bellies fly!” A famous trader and trading system developer named D. W. Gann once said, “Gentleman, it can always go to zero.” A lot of stocks trade below book value or some other value that is supposed to be etched in stone. If your analysis says it is going lower, believe your analysis. Of course, you might want to trade lightly, use a tight stop, or enter a position gradually. Always err on the side of caution, especially in the beginning, when you are at- tempting to understand and interpret the data accurately. Often the nuances of the data for certain industries are not well understood by the universe of traders. What may sound good at first may not be good in actuality. If your analysis depends on a weak jobs number and the month’s report is flat compared to last month, the ac- tual situation may be worse than it looks at first because of the number of people who dropped off because they quit looking for jobs. My point is that you need to understand the data completely and all the possible interpretations before reaching conclusions.

Always take seasonality into consideration. A key statistic may be lower or higher than you expected. But before you bet the farm, check out comparable fig- ures for the same period in previous years. Some retailers, for example, make over 70 percent of their profit during the Christmas season. Also, if you are missing a key piece of information, do not jump the gun. Wait until you have all the facts. Remember, a bus leaves this corner every 15 minutes—good trades are always coming down the pike, and the patient trader wins.