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Tharp's Thoughts Weekly Newsletter

September 19, 2007 — Issue #339
  
New ETF and Blueprint Workshop Discounts Expire Next Week
Article

A Look at Stock Data, by Van K. Tharp Ph.D.

Trading Tip

The Market Always Has Another Trick — Prepare for the Unexpected, by D.R. Barton, Jr.

Melita's Corner

Photos From our Dinner Party at Van's Home

New Workshop Added

 

$700 discount off ETF or Blueprint Expires Next Week


Exchange Traded Funds (ETF)

Three Day Workshop

October 8-10 Raleigh, NC


NEW One-Day Excel XLQ System Programming Class

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October 11 Raleigh, NC


Blueprint for Trading Success

Three Day Workshop

October 12-14 Raleigh, NC

(NOTE: These workshop dates were changed since we mailed a printed schedule. Always double check on-line).

Feature

A Look at Stock Data

By

Van K. Tharp Ph.D.

I’ve just spent two days with Bob Spear, the developer of the software Trading Recipes which I used in the 1980s and early 1990s. I really liked Trading Recipes for a couple of reasons:  1) the programming was fairly simple; and 2) it allowed many forms of position sizing.  IITM used to sell it, but we stopped in the mid 1990s because it was a DOS based program in a Windows world and it looked like it would be a long, long time before a Windows' version would appear.  So, I was happy when I recently discovered that Bob now has a Windows' version called Mechanica that does many of the things I was hoping for in terms of position sizing.

Anyway, I went to visit Bob with the idea that I might be able to use Mechanica in the monthly portfolio research and perhaps even do some testing with it.  My goal is to develop rules for a long portfolio based upon the efficiency screen and using 25% trailing stop and for a short portfolio, using a breakdown of an efficient stock.  Bob has agreed to help me with both tasks and I'll be keeping you up to date on how that progresses.

That’s the good news.  The bad news is that our initial research won’t be done in time for this newsletter.  As a result, I thought I would touch on some of the data problems that we are having with stock data.

Data Can be a Real Problem

Most people think that if you buy the right stock, you can hold it forever and make a fortune.  But that is not true.  Just to illustrate that let’s look at the most important US stocks that make up the Dow Jones Industrial Average.  The average was developed by Charles Dow in 1896.  At the time, it only consisted of 12 stocks.  In 1916, the average was changed to 20 and in 1928, during the roaring 20s bull market, it was changed to 28.  But let’s take a look at the original 12 and see what’s happened to them in a little over 100 years.  Could you have bought any of them and just held them for 100 years?  For many, you’d have done fairly well.  But some of them have disappeared.  Table 1 shows the 12 original Dow stocks and what’s become of them over the last 111 years.

Notice that North American, U.S. Leather, and American Tobacco are totally dead.  Thus, an investment in 3 of the original 12 stocks in the Dow Jones would have disappeared on a buy and hold decision.  Six of the 12 were absorbed by other companies and three (General Electric, National Lead, and Laclede) are still around in some form.  This simply illustrates how many changes occur to major companies.

Table 1: The 12 Original Dow Stocks

Original Dow Stock

What’s Happened in 111 Years

General Electric

Still part of the DOW 30, although it was taken out and then replaced.

 

American Cotton Oil Company

Distant cousin to Best Foods, which was bought out by Unilever.  Traces also remain in CPC International.

 

American Sugar Company

Now part of Amstar Holdings.

 

Chicago Gas Company

Absorbed by People’s Gas and now part of Integrys Energy Group.

 

Distilling & Cattle Feeding Company

Now part of Lyondell Chemical Company (I was also told it was part of Quantum Chemical).

 

National Lead Company

Now NL Industries.

 

North American (Group of utilities)

Broken up in the 1940s.

 

Tennessee Coal Iron and Railroad Company

U.S. Steel

U.S. Leather Company

Dissolved in 1952.

 

U.S. Rubber Company

Became Uniroyal, which merged with Goodrich and was bought out by Michelin.

 

American Tobacco

Killed by antitrust legislation in 1911.

 

Laclede Gas Light Company

The Laclede Group

 

The big averages are simply like mutual funds.  The bad ones get dropped out and new, powerful stocks are added.  For example, in 1999 Chevron, Goodyear, Sears, and Union Carbide were dropped from the DOW and replaced by Microsoft, Intel, Home Depot, and SBC Communications.  In 2004, International Paper, ATT, and Eastman Kodak were removed and Pfizer, Verizon and AIG were added.  And then, ironically, in 2005, SBC communications absorbed ATT and changed its name to ATT, so ATT is still part of today’s DOW, but it is different.

Between 1999 and 2004, several stocks in the index merged and/or changed names: Exxon became Exxon-Mobil after their merger; Allied-Signal merged with Honeywell and kept the Honeywell name; JP Morgan became JP Morgan Chase after their merger; Minnesota Mining and Manufacturing officially became 3M Corp; and Philip Morris renamed itself Altria.  In some cases the company changes dramatically (e.g., Exxon-Mobil) and in some cases the name just changes (e.g., Atria).  But all of this can wreak havoc on anyone trying to do historical testing.

Bob and I were originally going to do our study of efficiency stocks on the S&P 500 data.  However, the S&P 500 changes several times each year and there can be as many as 50 additions/deletions each year.  For example, Microsoft was added to the S&P 500 in 2000.  Our database, which included S&P 500 stocks from 1985 through 2005, included Microsoft from its inception as a listed company in 1986.  Thus, we could say we were only trading the S&P 500 as efficiency stocks, but we weren’t.  Instead, we were trading the 2005 version of the S&P 500.  Thus, we might catch this great stock like Microsoft in the late 1980s and make a fortune with it.  The only problem is that Microsoft was not a part of the S&P 500 until 2000.  And many of the stocks that were part of the S&P 500 are no longer part of the database.

This is called the survivorship bias in data.  Only those stocks that survive are contained in the data.  Those that go bankrupt or are absorbed by other companies are not included.  There are databases that include the data of companies that disappear up to the time they disappear, but those databases cost a small fortune.  My understanding is that a database of fundamental stock data (with no survivorship bias) can cost you well over $100,000.

Even our portfolio from July 2006 through August 2007, which included 44 positions, has 3 stocks that disappeared.  Those were FAL, AETH, and MRCY.  The survivorship bias with stock data is huge, which is another reason that most people can only test the way I did with the model portfolio.

And look what happens when a company gets absorbed by another company.  Its chart looks like the one below of Myogen.  It showed up as a very efficient stock because of the huge data gap and then the very quiet steady movement after the gap.  This happened because it was announced that Myogen was to be acquired by another company.  As a result, the price gapped to near the acquisition price and then stayed there until it was acquired.  It stayed at the acquisition price until it disappeared and it also looked very efficient.  But that’s not what I want in an efficient stock.

Other Data Problems

Other gaps sometimes occur because 1) stock splits are not accounted for in the data or 2) perhaps dividends are not adjusted for in the stock data.  All of that also wreaks havoc on any sort of historical testing, which was one reason that I chose to test the portfolio as I did in Tharp’s Thoughts.

There are basically two types of stock data.  One type is acceptable for screening.  If you want to screen all listed stocks for those making new highs or those above their 200-day moving averages, then it’s possible to get data that will do that.  However, many of these data sets are replete with errors.  They are fine for regular screening, but they are useless for historical testing.

If you want to do historical testing, you must get data that has adjustments built in for dividends and for stock splits.  And even when you find this data, most of it still has the major problem that I mentioned earlier with the survivorship bias.

Another problem you face is huge gaps in stock data that appear historically.  For example, I found the following gap in Alnylam Pharmaceuticals (ALNY) that occurred in mid July.  Chances are there was a major news announcement that produced it, but I couldn’t find the source of what was happening easily by looking at the companies news – and that was only a few months ago.  What if it happened 15 years ago?

These are just a few of the data problems that one will have trying to test  stock market systems.  And we haven’t even touched upon programming software issues, problems trying to program what you want (e.g., stocks going up in a smooth line) into the software, etc.  So most of the time, testing by making trades the way I did in the model portfolio is the only way to test. 

[Editors note: To review past model portfolio updates go to our newsletter back issues list and scroll through the list. They are usually titled Efficiency Portfolio Update or Market Efficiency Portfolio. Click here to see back issues.]

 

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

 

Trading Tip

The Market Always Has Another Trick — 

Prepare for the Unexpected

by D.R. Barton, Jr.

The market can surprise us at any turn – even if precipitated by outside events.  And this week we had a confluence of events that lit a fire (whether temporary or longer term) under the market.

Let’s look at a little bit of background to this week’s market gyration and then talk about some implications for traders.

There was, in a sense, a real prelude to the very large market reaction – a lineup of three big events that created an even bigger move than may have reasonably been expected.

First, the easy one -- it’s option expiration week.  And Friday (9/21) is one of the four days a year that make a “triple witching” day – a day when stock options, futures options and futures contracts all expire on the same day.  And that typically means extra volatility.

Add to this the problems at English bank Northern Rock, where folks were lined up to get their money out Friday and through the weekend.  Then the Bank of England blinked – and created a de facto English version of the U.S.’s  FDIC (Federal Deposit Insurance Corporation).  Prior to this event, the BoE was adamant about not bailing out institutions who were taking larger credit risk.  This week, they changed their tune and actually created an FDIC-like guarantee for essentially all bank deposits in order to stop what was, in reality, a run on a single troubled, albeit large, bank ($230 billion balance sheet).

And lastly, as most folks know, the Fed lowered both the federal funds rate and the Fed’s discount rate by half a percent (50 basis points).  For clarity, the “surprise” 50 basis point cut back on August 17th was just to the Fed’s discount rate.

The discount rate is the rate at which member banks may borrow money directly from the Federal Reserve. The federal funds rate is the overnight lending rate that banks charge each other and is notable because it has a bigger influence over the amount of interest consumers must pay for various types of debt, such as credit cards, home equity lines of credit and auto loans.

Enough of the background. What does all this mean?

First of all the market saw this as a decisive action by the Fed and reacted in a bigger fashion than most could have foreseen.  The Dow had its biggest up day in four years.  But this greater stretch, as we pointed out above, was not solely a reaction to the Fed move, but also a reflection of the volatility that was infused by a triple witching option expiration week and a sign of relief that the Bank of England stopped – at least temporarily – a bank destabilization that could have turned ugly in a hurry.

Where are the lessons and pointers for traders and investors?

These type of volatility stretching events push us back to a common theme – traders need to prepare for the unexpected.  And in this market, the main issue that we have to deal with as traders is the spikes in volatility that we’re seeing now.

And we need to prepare for that in two ways – the first and foremost is to protect against big losses.  But the often overlooked issue is how to take advantage of volatility that waxes and wanes.  (Take Tuesday 9/18 for example – a very low range day that has to signal more volatility to come.)

As my good friend and fellow instructor Christopher Castroviejo said today, “This was a horrible week for ‘can’t lose’ strategies!”  Folks selling naked option call premiums, or working strangles have had a tough go.

Yesterday, in our one-day swing course, 34 of us watched as some consolidation breakout players got filled on the short side in the S&P e-mini just seconds before the Fed announcement and then got annihilated (there’s just no other word for it).

Folks who love fading gaps have to be careful in this environment; today’s gap in the indexes (9/19) had a high probability of going further up versus closing, for example.

We’ll be discussing how to avoid a majority of these traps and how to set yourself up to really use volatility as your ally in the newly scheduled “Professional E-Mini Futures Tactics” workshop on November 10-12.  I’ll be joined by market maven Christopher Castroviejo for this course that had the highest attendance of the year back in March, so be sure to join us!

Keep sending in your favorite web sites to drbarton@iitm.com.  And let me know if you’ve found this discussion useful! Until next week…

Great Trading!

D. R.

About D. R. Barton: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world.

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine.

Melita's Inspirational Corner

Melita is out this week so we'll just share some photos with you from the dinner at Van and Kala's home following the Day Trading Workshop this week. It was a great workshop and a very nice gathering with friends old and new.

 To see a few photos from the evening, Click Here...

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