What To Do When 'Big Ifs' Rule

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Includes: EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, UPRO, VFINX, VOO
by: Victor Brown

Summary

Highly volatile markets are fraught with high risk but wide betas offer big opportunities.

A proven methodology and discipline are required to successfully profit from uncertain market conditions.

Protecting gains and losses from wrong buys is a must.

The world economies have been tossed around in turbulent waters and there seems to be no end in sight. Politics, effects of terrorism, shifting alliances, and many other factors contribute to the degradation of consumer confidence resulting in corresponding behaviors of goods and service providers. Conditions can change relatively fast and an investor gets exposed to decisions involving many "ifs". One needs to have the right tools and discipline to successfully navigate through the cloudy layers. At any point in time, within the financial arena, exists gems for the plucking by the informed. It is with this perspective that one can harvest profit with the right approach.

The whole market is the fish bowl. Inside it are stocks, ETFs, ETNs, and Funds of every color. One can posture that the fish bowl offers diversities and a degree of protection. My posture is that in tumultuous markets, one can succeed more readily by investing with a more focused knowledge. Using this approach, I favor individual stocks… and will discuss common stocks over preferred for simplicity sake.

Following a system with a disciplined mindset is the key to success, along with the realization that whatever system there is, no one can hit transactions with 100% certainty. Benchmark a success rate over 55% and year endings will be fine.

The system I propose will sound like it has been around, hackneyed and old hat. The metrics are, but the synergy explored among them is the key. The system simply is to trade with three legs in the tripod. These legs are Fundamentals, Technicals and News.

Fundamentals

The Fundamental metrics define the health of a business. Starting with a healthy choice is always a better route to profit.

  • Morningstar Rating (MR) of four and five,
  • Debt to Equity Ratio (D/E) of no more than 0.3, and
  • Free cash flow of positive and preferably increasing value

The Morningstar Rating of no less than four assures going long on a well-valued stock with the probability of stabilizing toward its fair value (a rating of three stars) higher than investing in a lower star rating. This is buying at a discount. An MR of five is a better discount.

The D/E of no more than 0.3 shows that the entity is not overburdened by debt and owned by the debtors. Zero debt is also not as good as it shows a lack of investment for the future but it is better than more debt that exacerbates failure if conditions go south. A D/E of 0.3 is a good balance. Growth companies may have higher ratios but this exception requires a deeper analysis on a case-by-case basis. For now, do not over think. I suggest sticking to choosing stocks with no more than 0.3 D/E.

Free Cash Flow (FCF) is a measure of a business's ability operating leverage to cover running its short-term operating costs. Beware of companies with high D/E and negative FCF. This condition is getting close to a kiss of death. Choose to invest in a company with positive, FCF, better yet, if the FCF is higher than the previous year.

Now that we covered the three Fundamental metrics, it is critical that the synergy among these metrics is positive, i.e. the stock meets all the minimum requirements. Knowing this threshold helps reduce guessing but a self-discipline to stick to the system is mandatory if one is to succeed.

Technicals

After choosing a stock that is healthy and has met the Fundamentals, it is important that an investor buys low and sells high. My proposed metrics provide a system of making this action more objective and timely. The metrics indicate when the probability of a stock price going up or down is maximized with risk reduced. After all, investing is really a game of winning the odds.

I use two primary charts and a secondary one of Technical metrics.

The first primary chart positions the stock price within the Bollinger Band supported by the median. Buy when the price is at the bottom and sell (set tight stops) when at crest. The direction of the median is important to note.

The second primary chart I use is a combination of Moving Average Convergence and Divergence (MACD) and a Moving Average. This chart confirms upward and downward trends with the crossovers between the two metrics.

The secondary chart I use is a crossover pattern of Divergence/Directional Moving Indicators. This chart expands close and asymptotic trends shown in the second primary chart. This secondary chart also shows the strength of the trend. Thus, it opens up interpretation of the second primary chart. This secondary chart is to be used only if interpretation of the second primary chart is difficult due to the asymptotic trend shown.

After zeroing in on well valued and sound stocks, the Technicals indicate the right action to take… go long, hold or go short.

News

Alas, these days when communication is instantaneous, news about stocks do affect an investor's action. This part of investing is the toughest one to filter and measure but one must take it into account when effecting a trade.

When a stock becomes a candidate for trade, it is highly recommended to use "LIMIT" to go long and "STOP" to protect gains and prevent big losses on wrong buys.

Summary

Having a proven system and the discipline to stick to it is a key to getting ahead in a rocky market and economic conditions. Observing the synergies among the Fundamentals, Technicals and News outlined above increases and investor's success while lowering risks. I realize that more details will amount to a lengthy article. The details are covered in my book "Simplified Stock Trading Techniques That Work". In this book is also a table for beginners to quantify their ratings of the various metrics and come up with threshold numbers to guide trading actions. This table quantifies chart interpretation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.