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This is the second part of a three-part interview series in which I sit down with Dr. Christian Kacher, former portfolio manager for William O’Neil + Co., managing director of VirtueOfSelfishInvesting.com, and chief investment strategist for MoKa Investors, LLC.

Ward: Going from being a trader who was using O’Neil’s system on his own to being in that “inner circle,” what stood out to you most?

Kacher: Bill hand-picked his guys based not only on their prior track records, but also their discipline and their dedication; in other words, their attitude. You have to have both to be successful consistently. He watched for that. So when I was brought into the “inner circle,” as they called it, he didn’t tell me what to do. He just gave me some money and said go compound it. I loved that freedom. In fact, I would say in all the years that I traded for him, not once did he ever say or even hint at how I should be trading. He knows how fragile a trader’s psychology is.

This will sometimes present difficulties when you’re running public money. They might not have the tolerance for drawdowns and will start calling you, asking all kinds of questions. I had a policy where I would not take a client’s money if I thought they would not be able to stomach some major drawdowns. I use 1999 as an example. That was my best year. In my O’Neil firm account, I think I was up 568% or 581%, something like that; the thing of it was, in the second and third quarters it was extremely volatile while the markets moved higher. Kind of like a worse version of what we saw in, say, 2004 to 2007, where the markets were quite compressed yet still making headway. So you call it a bull market but it’s sloppy. 1999 was an amplification of that. I found my drawdowns from peak to trough were over 50%. Yet I was still able to score that high return. Again, trend following systems are going to have high drawdowns when you get these exceptional circumstances.

The second and third quarters of 1999 are, I can fortunately say, just about the only time I’ve seen a six month period like that, one that was that treacherous. Then again, I’ve seen 2004 to 2007, which was treacherous in its own way. That said, I’ve figured out novel ways to deal with those kinds of compressed market environments. After creating what I call “trading refinements” to the system, I was able to achieve a triple digit return in 2006, for example. I figured out ways to buy inside of a base, what I call buying “in the pocket.” Now, the O’Neilian system says to only buy on the breakouts because you don’t know how long the stock is going to base for. I found ways, however, using the price/volume action, to buy within the base that gives you a high probability advantage if you buy at that critical “pocket point.” It often precedes the breakout at the pivot point.

It was a very powerful finding that I made in 2005, almost by necessity really, because in 2004 and 2005 I was not happy with my returns. So 2006 ended up being a triple digit year. Now being able to buy in the pocket, when the market starts to trend I can get onboard winning names before they breakout, double up on the breakout and, as the stock starts to move higher and higher, buy more as the stock maybe pulls back to the 50 day moving average and provides another entry point. I don’t like buying on weakness, but that’s purely my trading personality. Some people are great at it, but I find what works for me is buying on strength. So if the stock traces back to the 50 day, if I see what I call a “volume signature setup,” then that might offer an entry point into the stock on strength.

Ward: What percentage of the position are you buying in the pocket?

Kacher: It depends. If I’m running an aggressive account, it’ll probably be a 5-10% position. Then I can double that up on the breakout. If you take your typical conservative account, I would probably initiate about a 4-5% position in the pocket. Then I would double that on the breakout so that I would have about a 10% position. If the stock works out, then that 10% grows relative to the size of the portfolio. If I do end up buying a third, fourth or fifth time on the way up, I also keep the stock’s stops very tight on that buy extended from the base. I’ll usually use the 10 day moving average as a stop guide, but I use the 10 day in my own proprietary way. So if that buy doesn’t work out at least I reversed it at a minimal loss and I still have my core position. A lot of these stocks, though, I want to give more room than just the 10 day. I might want to give it room to the 50 day, but I’ve worked out all kinds of sell rules that seem to statistically hold up.

Ward: Gil trades in and out of about 5 to 10 stocks in his concentrated portfolio and 20 to 30 stocks in his diversified portfolio. Do you operate in the same way?

Kacher: Interestingly, my trading personality has never changed. A trading personality is like a fingerprint and everybody’s is different. Even when I had only a tiny bit of money I enjoyed holding 13 to 16 positions in a good market. Sometimes more but generally not less. Bill and I used to have these discussions, he used to argue that I’ll never get the kind of returns that he gets because he’s concentrated in only the best stocks; I would argue that not only can I get as good or better returns but I have less risk. I’m always diversified. I also argued that there were enough good names that emerge as the market progresses that you can always be force-feeding money into at least 13 to 16 different names. That’s certainly been the case this decade. Late 2006 and 2007 are a testimony to that.

Ward: Good-natured banter with Bill O’Neil.

Kacher: Yes, it was great. Those were magical times for me. He would call me to get my views on the markets on a regular basis. He also had an open door policy where I could call him at home or walk into his office anytime and rap about the markets. I should say, that debate we had was a really constructive, friendly debate. I would remind him of things like how in 1997 he was so piled into this one stock that when it gapped down unexpectedly he reversed all his profits for the year. So I think by August or September he was flat. Now because he is such a great investor he wasn’t down for the year even after that catastrophe. Hats off to him.

Nevertheless, it works better for me to know that I’m diversified. If, God forbid, I have a stock that gaps down, I only get a slight haircut in the portfolio performance. Incidentally, that’s why technical analysis is so essential. If you know how to properly analyze a stock, in virtually every case you will see the warning signs before the gap-down. In fact, I keep a database of stocks that have gapped down without any warning. To me, that’s a death sentence. I’ve always managed to get out of stocks that hit my sell points and then you see the gap down. And I would point out, regarding that database, that there’s only about 5 or 6 stocks in there that hit new highs and then gapped down the very next day, which is a shocking thing to see happen. I would also add that, of those 5 or 6 stocks, half of them were in biotech.

Ward: How about your operations on the short side?

Kacher: Shorting has more risk, simply because the emotion of fear is much more visceral than the emotion of greed. You can certainly see that in stock charts, which are human nature on parade. When a stock goes up, it usually goes up in a fairly orderly way, even the more volatile semi-conductors have an orderly rhythm to their ascent. However, when a stock comes off, there’s so much more volatility associated with the pattern that shorting is almost a swing-trader’s game. I don’t know anyone who can initiate a short position and just sit on it for 3 to 6 months. There’s been plenty of opportunity, for instance in 2000 to 2002 and 2008 to present. But I don’t know anybody who’s made a killing on the short side by sitting on a position for a long time.

The one exception to this rule, in terms of return percentages, is Gil Morales. He did incredibly well in 2001. He was up about 185%, I believe, just by going short. But, again, it wasn’t by sitting in names for 6 months. It was getting in at the right time and then getting out when he had his profits. And 2001 was obviously a treacherous market. That 185% is just absolutely amazing.

Ward: You’ve always been interested in commodities. In Kevin Marder’s book, “Conversations with Top Traders,” you explain that when you were 11 years old you would paste the precious metals’ spot prices in a notebook. What are your present thoughts regarding commodities?

Kacher: I think there are opportunities in commodities for four reasons. First of all, you have the China factor. They are going to be the leading economy in the years ahead. They have already shown the demand they can exert, as we had a commodities bull market from 2002 to 2007. That demand is not going to go away. In fact, it could potentially grow even fiercer. Secondly, countries around the world, the United States especially, are printing money at an alarming rate. It seems the only thing Bernanke really knows how to do is print money. The U.S. is not the only guilty party, but this rampant printing press dynamic that is happening around the world is obviously going to be favorable for the price of hard goods, such as commodities. Those are my two primary reasons. A third reason is that agricultural supply, I believe, is at a 20-25 year low. So those are the three reasons I’ll give for now. There is a fourth but I’ll save that for my website.

Ward: Do you almost view the Chinese indexes as leading indicators to our own markets now?

Kacher: These are going to be the leading indexes. China’s a volatile market, as we saw how far the markets pulled back in 2008, but I believe it’s going to do what it did in 2005 to its peak in late 2007. It well outperformed the U.S. markets. The U.S. markets might move 5-8% on an intermediate term uptrend, but the Chinese market will go up three times that in the same timeframe. In fact, I’m looking at the FXI right now. It went from about 18 to about 73 in just about two and a half years. That’s tremendous. The world is already showing signs of beating to China’s drum rather than to America’s drum. The U.S. is still the world’s number one economic power, so it still has huge influence; however, that influence has already begun to wane. But that’s a whole separate interview right there (laughing).

In a nutshell, the U.S. is the world’s largest debtor nation. These first world countries, many of them are debtor nations; some of the emerging countries and some of the far eastern countries are creditor nations. China has trillions in sovereign wealth. It doesn’t take a rocket scientist to know that is a huge bat they can swing. Money tends to flow toward opportunity. I believe China is the best bet. India is interesting, too, but it has its share of problems that might keep it mired for a little while. Still, I wouldn’t be surprised to see India pull out of the most critical of its problems in, say, 5 to 10 years.

Disclosure: No positions

Please read: Interview With Dr. Christian Kacher (Part 1), Interview With Dr. Christian Kacher (Part 3)

Source: Interview With Dr. Christian Kacher (Part 2)