You know you are a Permabull when……

• each time the market declines you declare it a “healthy pullback”
• sideways moves are actually just the market “taking a breather” or a “pause”
• missing earnings estimates is ok as long as management confirms next quarter’s guidance
• bad guidance is ok as long as last quarter’s earnings beat estimates
• you criticize any analyst that downgrades your stock from “Strong Buy” to “Buy”
• you applaud poor economic results as good for the market because this time they will cause the Fed to stop raising rates
• any negative market commentary is evidence of a huge “wall of worry” that the market needs to go higher
• you plead that a 10% decline is a “great buying opportunity”
• you blame any market decline on short sellers who just don’t understand
• oil declines to $60 and you expect that will cause the market to head higher
• oil increases towards $70 and you point out how the market has been able to absorb higher oil prices
• you quote the cliches “history repeats itself” for positive things and “it’s different this time” for negative ones
• an inverted yield curve doesn’t concern you at all……

“How do I know when to sell a stock?” That’s a common question that most investors struggle with and one that I am asked quite frequently. One technique that I use to change signals is “expected value” - a concept borrowed from basic probability theory that is defined as the sum total of all possible outcomes times their related payoffs. Simply put, if I think a stock has a high probability of going up but the expected gain is relatively small while the risk to the downside is high, I will make an exception to my normal procedures and change the signal to Down before I have any firm evidence in the form of weakening fundamentals or technicals. The most frequent situation that benefits from this kind of analysis is when a stock has gone on a nice run and you start having that nagging fear that you should get off the joyride before it gets ugly. Some people call it taking money off the table or profit taking, but I just call it a normal part of portfolio management. So even though it’s impossible to get all the probabilities and payoffs perfectly thrown into a formula, I recommend that you do some quick expected value calculations in your head and keep a close eye on your other fundamental and technical factors.

Last week, I kept hearing how the market was stagnant because everyone was waiting on our new Fed chairman’s first report to Congress. Then we had yesterday’s move and it was clear that not everyone was waiting. It looked like the market was set up to either continue yesterday’s trend or reverse it in dramatic fashion. I was looking forward to hearing what all the anticipation was about. It turned out to be no new news - no surprises. After listening to the statements, questions and answers, the market didn’t react significantly in one way or another. I had hoped for more, but I guess I should look at it as a positive that nothing he said contributed to an erosion of yesterday’s gains. Expectations for interest rates prior to the speech were consistent with his testimony and the treasuries have held relatively constant. If there had been any hint of a pause in rate hikes, the market was primed to jump. No such luck and now we can hopefully get back to trading.

$600 or $2000 for a share of Google? Price targets seem to have become popular again, but not at Hedgefolios. The only targets I find interesting are ones that are below the current market price. The last time targets were as much in the news as they have been lately things didn’t turn out so well. I remember targets like $1000 for Qualcomm, $600 for Yahoo and who can forget Blodget’s call of $400 for Amazon? Just pull up the last quotes for each and you have to wonder why investors bought into the concept last time and more importantly, why are they buying into them again? People have an amazing ability to put unquestioning faith into a number just because it’s written down. That’s just the way it is.

Theoretically, there is merit to price targets because they should be based upon quantitative measures. Just take your best estimate of future earnings per share multiply that by a PE ratio and out comes a price target. For value investors that like to create intrinsic value measures to help with stock selection, this is a familiar process. Unfortunately, the reality is that most price targets are more about marketing calls than they are about portfolio management. However, even if they are based upon math, targets provide no long term benefits to increasing the value of your portfolio. You may use targets and your portfolio may go up, but I question any correlation between the two.

One thing that bugs me about targets is that they usually have the phrases “long term” or “12 month” attached to them. Yet, in reality, the main effects of publishing targets are found in the very short term - like the day of the announcement and maybe the day following if it is surreal enough to get others to comment on it or offer competing numbers. To me, predicting stock prices 12 months in the future sounds like predicting the weather 12 months from now. There’s a small chance you will get it right, but that doesn’t mean your analysis had anything to do with it. You can predict things like that for tomorrow or next week or maybe get close for a month, but that’s where the believability of relying on data to predict the future trails off. As it relates to individual stocks, there is too much that can happen over any extended period. In general, 12 month targets rely heavily upon an assessment of what market sentiment will be to create the relevant PE at that time. In the words of Secretary Rumsfeld - that is just “unknowable.”

Calculating the performance of a price target forecast is almost impossible as they rarely achieve the current published figure. It seems that each time a stock approaches, the target is moved. This moving target phenomenon should give you reason to ponder how you can use them either for selection or portfolio management. Some advisors suggest that you should sell a stock when it hits or exceeds the price target you established when entering the position - others suggest moving the target. If you don’t rely on targets in the first place, you won’t have to follow either suggestion.

Ever since Ben Graham and David Dodd published Security Analysis in 1934 and founded fundamental analysis, stocks have typically been categorized as Value or Growth. I am not ignoring other terms such as Core, Blend, Deep Value, Absolute Value, Relative Value, GARP or Momentum, but those derivations are much more difficult to quantify and mean different things to different investors. So, for the sake of simplicity and clarity, I have always focused on Value and Growth and finding ways to make those two definitions more relevant.

When I set out to build Hedgefolios, I wanted to use terms most advisors and investors were familiar with. However, I also wanted to bring my own perspective to the site and have unique terminology that would create meaningful standards that could be used to build and manage portfolios. The greatest example of this comes in the form of Hedgefolios’ style definitions.

I have always been critical of defining a stock as either Value or Growth without being able to provide an additional (and quantifiable) measure of the degree to which they were one or the other. When you look at the Russell and S&P/Barra Style Indices, you’ll see that stocks have an “either or” definition of Value or Growth. Here’s where my concern comes in - consider two stocks on a spectrum, one called Value and the other Growth. The Value stock has fundamental measures that place it just to the left of the Value vs. Growth threshold (say the 49.99th percentile) and the Growth stock is just to the right of the threshold (say the 50.01st percentile.) While the stocks are relatively the same, they obtain two different definitions and yet, stocks that are much further apart on the spectrum (but on the same side of the threshold) have the same definition. The Hedgefolios methodology for determining each stock’s Style was constructed to address this issue and provide more detailed choices. As a result, Hedgefolios offers Eight Degrees of Separation within the Value/Growth spectrum.

At the far left of the Hedgefolios spectrum and in sequence moving to the right, the definitions are:
High Value, Mid Value, Low Value, Value Blend, Growth Blend, Low Growth, Mid Growth, High Growth.
When you use the Evaluate Section of Hedgefolios to identify stocks that meet your Style criteria, you can focus on the traditional terms of either Value or Growth. If you select Value, you will receive all stocks in the Hedgefolios universe that were High Value, Mid Value, Low Value or Value Blend. If you would like to refine that search and drill down deeper, you can select one of the 4 subcategories of Value and only receive those stocks. The same can be done for Growth Stocks. Furthermore, if you are interested in stocks that show fundamental measures of both Value and Growth, you can select Blend. Within blend, you have 2 subcategories, Value Blend and Growth Blend, as these are stocks that are near the Value / Growth threshold but have a slight bias towards one or the other discipline.

As I have mentioned in the post entitled “It’s Fundamental”, Hedgefolios uses a multivariate and standardized analysis of 6 fundamental measures to create a score for each stock that is then compared to all the other stocks in the universe. These composite fundamental scores are then placed within one of the eight subcategories of percentile ranges along the Value / Growth spectrum.

During the first week of each month, I analyze key fundamental measures of each stock in the Hedgefolios Universe and assign definitions of the general criteria that most investors use to construct their portfolios - Size, Style and Income. While Russell reconstitutes its growth and value indices once a year and S&P/Barra does it twice, Hedgefolios does it monthly to recognize the changes that occur with a stock’s relative size, style and yield during 6 or 12-month periods.

For Size, all stocks are assigned a definition of Large Cap, Mid Cap or Small Cap based upon individual market caps relative to the total market cap for the Hedgefolios Universe. For Income, dividend-paying stocks are divided into thirds and assigned Low Yield, Mid Yield or High Yield definitions. About half the stocks covered by Hedgefolios do not pay dividends and are assigned a definition of No Yield.

Creating Style definitions is a more complex process than the Size and Income methodologies. Rather than relying on 1 or 2 variables to determine whether a stock should be considered Value or Growth, I use 6 fundamental ratios (Price-to-Earnings (Trailing), Price-to-Earnings (Forward), Price-to-Book, Price-to-Sales, Price-to-Cash Flow, and 5-Year Expected Earnings Growth). Employing a multivariate approach is particularly important for the stocks that may not have a ratio that can be calculated given that it is common to have no PE. In those cases, the composite style score is determined by adding each of the 6 variables that does exist and calculating a simple average. To make sure that each variable can be fairly compared to all the other stocks and all the other variables, they are standardized into a numeric value from .0001 to 1.0000.

Okay, so the Greenspan era is over (finally) and we had another rate hike on Tuesday to make 14 consecutive increases. “Don’t fight the Fed” - right? We’ve done pretty well by my calculations. Since the FOMC started this sequence on June 30, 2004, the fed funds rate has increased 350% and the S&P 500 was up 13%. That is interesting given that I keep hearing how Wall Street is betting on stock prices heading higher once the Fed stops raising rates. If the market went up when rates were going up, why is it now true that it will go up when rates don’t change? Don’t get me wrong, I am not ignorant of the economic theories and effects of interest rates on equities, but I am trying to make the point that markets can go up with rates going up, staying flat or going down. Similarly, the market can go down under all the same scenarios.

I am intrigued by how certain most experts are that increases are ending now that Bernanke is running the show. Seems to me I have been hearing some very smart people that I really respect saying that Greenspan was done several times over the past year. They were wrong then, and I am not sure they are right now. In the category of “Be Careful What You Wish For”, Ned Davis Research just released a study this week that said the market is typically down in the 3 months, 6 months and 1 year following the end of an increasing rate cycle. According to their research on the S&P 500 since 1929, the market was down 64% of the time for the 1-year period after rates stopped rising. Even though I am leery of such statistics, it should give people a rational perspective to evaluate whether the market needs rates to stop for it to continue its upward trend. To me, the Davis research doesn’t guarantee the market will decline this year but then again…… what evidence do we have that rates are going to pause this year? AND to take an even more provocative stance, what assurance do we have that once Bernanke stops - that the next move will not be to raise rates once again?

What we all know is that the market and certain industries are definitely affected not only by what really happens to rates, but also what everyone hopes or expects will happen whether they are right or wrong. I am not suggesting to ignore rates, but I am suggesting that it’s nutty to put too much emphasis on it. We can go up or down regardless of the direction of rates - we’ve done it before and we’ll do it again.

Now that January is over it is time to comment on the January Barometer - the concept that the market’s performance is indicative of what WILL happen for the remainder of the year. By the way, it’s not the same as the January Effect which many people like to confuse interchangeably. Like other historical observations that somehow become “indicators”, the January Barometer is fun to look at, but I really hope that no one actually uses it to place any trades or risk capital in any way. In fact, I am at a loss to figure out how relevant these things are other than as filler for newspapers, financial tv programs and other media.

Typically, we start hearing about the January Barometer on the first trading day of the year and then we evaluate it increasingly as the month expires. I’ve noticed that if the Barometer is positive, Permabulls love to use it to “prove” their point. When the January Barometer is negative, they bring out a myriad of exceptions to say why the indicator should be given an exception for that year. Strangely, I rarely, if ever, hear bears reference the Barometer regardless of whether it is consistent with their view. Since 1950, the Barometer has been correct 44 out of 56 times (or 79%) which is a pretty great winning percentage for the investing world. However, it was wrong in 2001, 2003 and 2005 (or 40% correct) which is NOT a pretty great winning percentage for the most recent 5 years. I have no idea how it will do this year, but it will not pressure any signals at Hedgefolios, and I hope it doesn’t change what you do either.

Since I am on the topic and the Superbowl is a few days away, I find the Superbowl Indicator equally fun to look at and important to ignore. The same goes for the Hemline Indicator, the Presidential Cycle, the Year 5, the “Sell in May and Walk Away” strategy, etc. If you are interested in these novelties, I highly recommend reading the Stock Trader’s Almanac and then hopefully you will put it away and get back to evaluating market strength, sector strength, economic reports, geopolitics, earnings reports, fundamental valuations, technical indicators, and all the other things that are definitely relevant to what affects stocks for the rest of the year.