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Tharp's Thoughts Weekly Newsletter

September 26, 2007 — Issue #340
  
New ETF and Blueprint Workshop Discounts Expire Today, September 26
Article

Deeper Understanding of the 1-2-3 Model: A Conversation with Van Tharp, by Van K. Tharp Ph.D.

Trading Tip

Systematic Trading – What Does That Mean for You?, by D.R. Barton, Jr.

New Addition Emini Workshop added to the November Line-up
Melita's Corner

Follow Your Bliss, by Van Tharp

New Workshop Added

 

$700 discount off ETF or Blueprint Expires Today


Exchange Traded Funds (ETF)

Three Day Workshop

October 8-10 Raleigh, NC


NEW One-Day Excel XLQ System Programming Class

Free for ETF Attendees

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

Deeper Understanding of the 1-2-3 Model:
A Conversation with Van Tharp

By

Van K. Tharp Ph.D.

In our book Safe Strategies for Financial Freedom, Steve Sjuggerud presented his 1-2-3 model as a guide for when you should and should not invest in stocks.  I currently update you on that model once each month in Tharp’s Thoughts and I’ve gotten lots of questions on the model.  I’ll have a new update for next week so this is a good time for me to answer some of those questions here.  To get the best understanding of this model, if you have not done so already, read Steve’s original thoughts in Chapter 5 on pages 65 – 74 of Safe Strategies for Financial Freedom.

Question:  What’s the least confusing aspect of the 1-2-3 Model?

Steve did extensive research on conditions in which the stock market performs well and he found three that he likes. We don’t get many questions on the first one, "Is the market acting badly?" so I’ll deal with that first.  When stocks are going up, we expect that to continue and when stocks are going down, we also expect that to continue.  Steve basically picked the 45 week moving average as his barometer and he found that when stocks were above the 45 week moving average, they returned 12.6% per year and when they were below it, they lost 1.2% per year.  As a result, the first barometer is to determine whether they are above or below the 45 week moving average.  If they are below, then it’s one strike against us and we cannot be in Green Light Mode.

Question: The next part is “Is the Fed in the Way?”  What does that mean and how do you use it?

It really means “Is the Federal Reserve tightening or lowering interest rates?”  When interest rates go down, corporations can borrow much more cheaply and use it for expansion.  As a result, it’s good for the stock market.  In addition, people are less likely to put their money into bonds (when interest rates are low) because their return is lower and this is also good for the stock market.  Steve found that when the Federal Reserve is not in the way (i.e., they are not raising interest rates), that stocks make 10.9% per year. But when the Feds are raising interest rates, stocks only return 1% per year.

Question: But what does “in the way” mean?

Steve defined “in the way” as the Feds raising the discount rate within the last six month period.  If they haven’t done anything in the last six month, then they are not considered to be in the way.

Now there are several aspects of this that probably confuse people.

Question: When interest rates go down, isn’t that good for bond holders?

Yes, it is good for people who already hold the bonds because the value of the bond will go up.  For example, if you buy a bond for $1000 paying 8%, then you should get $80 per year in interest rates.  But if interest rates go down to 4%, and you are still getting paid $80 per year, then your bond is really worth twice as much and so it should be priced at about $2000. That is, 4% (the current rate) of $2000 produces the $80 per year that you are getting.  Thus, if you are holding bonds, it is good for interest rates to go down.  People certainly won’t be selling their bonds under these conditions.  But once interest rates are low, it’s not good for bonds because 1) you can get better returns in the stock market and 2) interest rates could go up, which would decrease the value of your bonds.  Thus, when interest rates are low, people put their money into stocks rather than bonds.

In other words low interest rates are good for the stock market.  High interest rates that are starting to go down are not necessarily good for the stock market; expect that people tend to anticipate what will happen to stocks in the future if interest rates continue to go down. 

Question: But you don’t measure long term rates, like the rates on bonds, do you?

No, we don’t look at long term interest rates, we look at the Federal Reserve discount rate.  And this rate could go up or down without affecting long term rates significantly.  There usually is some relationship, but the last time the Fed raised rates, it had little impact on bonds – long term rates stayed low and that was generally good for stocks.

Question: But shouldn’t lower rates then lead to the stock market performing well, which is not seen in reality?

Steve’s research covered over 100 years, and generally when interest rates go down the market improves.  However, that action doesn’t always happen immediately.  Sometimes rates have to become low (not be going down) for the impact to be seen in the stock market.  For example, during most of the decline seen in 2001 through 2002, the Federal Reserve was lowering the discount rate, but the market was still going down.  However, once rates became low, as in 2003, the market took off.  Thus, the relationship is not always clear.  However, one exception does not invalidate the rule.  Generally, when the Fed is lowering rates, the stock market goes up.

Question:  What do you mean by number three: Are stocks expensive?

Expensive really means with respect to earnings.  This is measured by the price-to-earnings ratio of the S&P 500.  Steve found in his research that when the PE ratio is above 17, that stocks only make on the average 0.3% per year.  But when the PE ratio is below 17, stocks make 12.4% per year. 

Question: But haven’t you said that we’re in a secular bear market for the next 15 years or so and that PE ratios will continue to fall during that time?

I have the most difficulty with this aspect of Steve’s model for the following reasons:  First, Steve only did his research on a 75 year period, which is not enough.  However, he probably couldn’t find data before the 75 year window.  And second, we are in a secular bear market.  In secular bear markets, PE ratios keep going down (even if stock prices go up).  And secular bear markets usually do not end until PE ratios get in the single digit range.  When we reach a PE ratio of 17 on the S&P 500, which is where we are right now, we still have a long way to fall to get to single digit PE ratios.

Question:  An inflationary bear market seems to be a more conventional interpretation as inflation means higher interest rates and low performing stocks.

I tend to agree with you.  But actually PE ratios can go to single digits while stocks could easily double or triple in price with high enough inflation.  For example, let’s say the S&P has a price of 1500 and a PE ratio of 30.  That means the average S&P 500 stock earned about $50. Then for the next 10 years, inflation eats into the value of the dollar and it’s now only worth 10 cents.  Let’s also say that company earnings keep up with inflation and the average S&P 500 stock now earns about $500.  And that PE ratios are now just under 10.  That would put the S&P 500 price just under $5000.  Thus, price will have gone up more than 3 times.  But PE ratios are now in single digit ranges.  And the inflation adjusted price of the S&P 500 is now only about $500.  Thus, prices can definitely go up while PE ratios go down.  

Question:  Hasn’t that been happening?

Yes, in 2003-5, the prices of stocks have generally been going up.  But during that time PE ratios continued to fall.  It’s exactly what I expected.  And the dollar has also fallen with respect to other currencies (i.e., which is a different sort of decline from inflation).  In 2003, for example, the dollar fell about 40% versus the Euro while the S&P 500 only went up about 17%.  That’s a real loss when measured on an international basis.

Question:  So what’s the overall interpretation of the 1-2-3 model?

When you only have one of the three factors in your favor, Steve considers it Red Light Mode.  Stocks, according to Steve’s research, return a negative 9.7% each year.

When you have two factors in your favor, Steve considers it to be Yellow Light Mode.  Stocks return 10.7% per year.

But when all three factors are in your favor (i.e., prices are above the 45 week moving average, PE ratios are below 17, and the Fed is not raising interest rates), then stocks return 19.5% per year.

Question:  Do you really believe that?

The model provides a good overall framework to guide my thinking, although I think the sample size could be a lot bigger.  I’d be much happier with the results if they were based upon 300 years of research, but we just don’t have the data.

In addition, I expect PE to be below 17 for much of the next ten years or so, but I don’t expect it to be a great climate for the stock market.  We could have green light periods that are not so great simply because of the secular bear market.

Question: Do you really believe that we’re in a secular bear market?

Yes, I believe that, but it is simply a belief supported by 200 years of research.  It’s just a concept that guides my thinking, just as the 1-2-3 model is a concept.  The market will always be the final answer in telling us what it’s going to do.  It doesn’t care what you or I believe.  And that belief (again it is also a belief) is probably more useful than either the idea of secular markets or 1-2-3 models.

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

Systematic Trading – 
What Does That Mean for You?

by D.R. Barton, Jr.

 

This past weekend, I had the chance to meet some incredible new folks and also spend some time with old friends at the workshops in Raleigh,NC

And, we certainly had some very interesting discussions.  One theme that kept re-appearing on the radar screen was the topic of systematic trading.  It was clear from the heated debate that BELIEFS play a huge role in our understanding and implementation of systematic trading.

So I thought it would be helpful to share some useful beliefs about systematic trading that might guide expectations and actions as folks design and implement their trading strategies.

First of all – we need a working definition of systematic trading.  My belief is that systematic trading is any trading strategy that follows a defined a set of rules.  I can hear the cringes out there now, so bear with me while we explore some of the subsets of systematic trading.

Purely computerized trading.  By way of definition, this is any strategy that can be programmed and executed via computer.  For some diehard adherents, this is the only “true” systematic approach.  But this is a very constrictive and less useful belief about systematic trading.

Mechanical trading.  In this subset of systematic trading, the rules are completely mechanical (all decisions are either “yes or no”).  But some of the rules may be difficult or impossible to program. In this style one may ask a question like, “Is there news on this stock?” or "Has Market Profile shown time/price contraction or a similar rule that is tough to program?"  However, those questions can have a binary “yes or no” answer, making the system purely mechanical in both design and application.

Now we need to stop and add a definition -- one that makes mechanical traders wince.  A rule can be a decision that requires trader input.  And to be honest I know many more traders who have rule-based systems that aren’t purely mechanical than those that are (more on this next week).

What’s an example of a rule that isn’t mechanical?  There are plenty. What is the current market sentiment?  How is this sector doing compared to three others?  How does this pattern compare to the last time I saw it?

Hybrid mechanical / rule-based trading.  I added this category, which is a combination of mechanical rules and rules that require a trader’s input, because lots of traders use this style of systematic trading – more than any of the others.

Rule-based, non-mechanical trading.  Here is the style where a trader follows rules, and follows them every time, but those rules aren’t a mechanical set.  My belief is that most successful intuitive traders fit into this category.  They have rules that they follow, but they just haven’t formalized them in a way that a linear/logical thinker would understand.

Next week, we’ll look at the pros and cons for each of these styles of systematic trading.  Until then…

Great Trading!

D. R.

About D. R. Barton: D.R. will be presenting his upcoming “Professional E-Mini Futures Tactics” workshop, November 10-12.

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. You may contact D.R. at drbarton@iitm.com.

New Addition

E-mini Workshop Added to the November 2007 Line- up!


How to Develop a Winning Trading System That Fits You

with D.R. Barton and Chuck LeBeau
Nov 3-4-5

Peak Performance 101

with Van Tharp
Nov 7-8-9

Professional E-Mini Futures Trading Tactics

with D.R. Barton and Christopher Castroviejo
Nov 10-11-12

 

Melita's Inspirational Corner

Melita is currently relaxing and following her bliss as she travels in the western USA. She will be back next week to resume her column. This week we'll share a classic tip from Van Tharp.

Follow Your Bliss

by Van Tharp

Author and teacher Joseph Campbell in his The Power of Myth documentary described the message of “follow your bliss” to be his ultimate teaching for any of his students.  In a real sense, it’s like a message from God.  If you do what you love to do, then you are probably doing what the universe intends for you to do.

A few years ago I had a client who had joined the Super Trader program because he wanted to start trading with a solid foundation.  However, he had made very little progress toward where I expected him to be at the end of his first year and I advised him to take a break from the program.  He still needed to accumulate trading capital.  He didn’t have a business plan for trading and he didn’t have a trading system.  Instead, he was busy building a house and investing all his time and capital into that house.  The house was a childhood dream, but he was not happy.  He wasn’t happy with his work even though it was paying him a substantial income.  And he was not happy with his schedule, which was driving him to exhaustion and left him little time to develop a trading business.

During our last consulting session prior to the sabbatical, I suggested that he meditate on two topics—what he loved to do and what he was attached to in his life.  What he loved to do was important because it gave him signals as to what he really should be doing with his life.  For example, did he love his house so much that he was willing to spend the next 20 years at a job he hated just to pay for it?  If trading was so important, was he willing to do whatever it takes to make it a reality, including sell his house to get trading capital.

These issues are examples of conflicts that most people face throughout their lives.  And the way to really solve such conflicts is to go with what you love to do.  If you don’t love what you do, you’ll face tremendous stress and possible burnout.  If you love what you do, then you’ll have the energy and excitement to make what you want a reality.

Here are two exercises that are helpful.

Exercise 1

Spend about 30 minutes meditating. Quiet your mind and let your thoughts come and go. Afterwards write down a list of all of the things/activities you really love.  What really turns you on?  Making such a list could be very powerful and sometime can literally change your life. In my work with so many traders over the years I have seen this happen again and again. 

Exercise 2

Spend another 30 minutes meditating. Then make a list of the things in your life to which you are attached—things that are really important to you.  Your attachments are probably your UN-doing, so this list is important.  They are your undoing because you will do unpleasant things to keep them.  Yet one day you must give up all your attachments.

Now, notice if there are any of your attachments that are so important that you would be willing to make you spend 20 years of your life doing something you hate.  Also notice if some of your attachments are making you spend time now doing what you hate.

Once you’ve finished those two exercises, spend some more time in meditation and design your life around doing what you love.  It’s a very simple exercise, but it is guaranteed to change your life if you are unhappy.

 

Feedback

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