The basis of the bourgeois life is innovation. McCloskey’s work makes a lot of reference to Joseph Schumpeter, the Austrian-born economist. Schumpeter theorized that the entrepreneur is the central player in capitalist economies; their innovations drive relentless growth and also create the business cycle.

Schumpeter coined the well-known phrase ‘creative destruction’: entrepreneurs innovate and create new products and enterprises. That spawns imitators and eventually booms. The destruction comes both when the boom busts, but also the destructive impact of innovation on existing businesses.

What has this got to do with trading?

It got me thinking that aggressive-growth/momentum traders are essentially riders of the gales of creative destruction.

The goal is to seek out innovation; to buy entrepreneurial companies that are growing rapidly and changing people’s lives; companies that have created innovative new products and services. Google is a prime example; it is creating new products, but they are also destroying old ones like newspapers.

We can identify the innovators by accelerating growth in earnings and sales. Genuinely successful innovators are producing sales and are not just speculative like most biotechs, tech companies and mining explorers. The fact that something big is happening shows up in their strong price action.

But as Schumpeter noted, innovators eventually lose their edge when they stop innovating and when others adopt their creations. So aggressive growth investors have to be mindful that growth stops; you have to be prepared to hop off before things – company performance and the general market – implode.

It’s a tough thing to do. But it’s also worthwhile. Aggressive growth investors are partners with entrepreneurs, allocating capital to them when they are growing fastest and need it most. It is a crucial role in entrepreneurship and innovation – the essence of capitalism which has pulled most of the world out of extreme poverty.

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As a result Driehaus’ strategy of focusing on companies with strong earnings growth and strong technical action has meant its funds have lagged indices since the rally began.

“Whether these strong performing stocks were re-priced upward to reflect reduced probabilities of bankruptcy or appreciated because they were trading at levels beneath their intrinsic values, it is not uncharacteristic for our strategies to underperform in this type of environment,” Driehaus said.

It helps explain why many aggressive/growth momentum investors can’t find as many opportunities as they’d like, which is proving extremely frustrating. Particulalry, as Driehaus says, there are “many reasons to be incrementally more positive on equities”.

It’s interesting to note that Driehaus isn’t changing their strategy, but will ride it out:

“Though frustrating, this is not the first period where our investment approach has been “out of favor.” Through experience we have learned that the best approach to take in such periods is to continue to implement our investment philosophy and to resist the temptation to chase returns by investing in weak fundamental companies and stocks with unattractive technical charts.”

It’s good to know I’m not the only one frustrated by this environment.

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While many people assume trading is about getting rich/making money, which it no doubt can be, if approached correctly, it’s one of the best tools for self development.

I’ve been a reporter, columnist, jackaroo, cleaner, dish washer, student, publisher, editor, etc. But nothing (apart from having a child perhaps) has forced me to face up to who I am – my strengths and weaknesses – like engaging with markets have.

I like trading to be a lonely activity; just me against the market. I make all the decisions and take full responsibility for mistakes etc. In that way I also get direct feedback on me. There’s no one else to blame!

Trading does two things: firstly, gives you feedback on yourself, both positive and negative. If negative, you obviously then have the option of changing yourself.

The tricky thing I’ve found is that most of the negative feedback doesn’t mean you should change yourself, but that you should accept who you really are.

Learning style is part of getting to know yourself better; and perhaps accepting that you actually may not be who you think you are, or who you think you want to be, because of parental expectations, or teaching by a guru, etc.

As Dr Brett says, traders get into trouble when there is a mismatch between how they approach the market and how they optimally process information.

I grew up in a very aggressive, action-oriented, entrepreneurial family. My father would yell “don’t just stand there, get into it.” The problem is I wanted to stand there and analyse the situation; see the bigger picture, change things etc.

I noticed this conflict in trading. A part of me was saying “don’t just stand there, get into it” and TRADE. It associated action with success.

But the real me was detached and analytical. As I said in my last post, whenever I tried to be ‘action man’ I’d lose money and clarity. I chose to accept I wasn’t Mr Action and as a result have become profitable.

When it comes to process information and learning, I’m mostly analytical. But I also have a very strong visual element to my learning. I’ll read stuff then draw up diagrams, flow charts and models.

It probably explains why I’ve gravitated to the style I trade: aggressive-growth, trend following with market-timing overlay. It combines fundamentals (analysis) and technicals (visual).

I actually started out learning value investing, which is pure analysis. But I couldn’t get a picture of what was happening visually. I couldn’t stand buying a stock and not knowing if it was going down, up, or sideways. I needed charts.

It also helps explain my timeframe. Too short a time frame and I lose analytical clarity. Too long (buy and hold) and the visual element becomes annoyingly irrelevant.

As an aside, among professionals there seems to be a bias against visual trading. In part it’s to do with governance: how do you explain to someone allocating assets that you “just sort of know” when to buy stocks, or to aggressively buy one particular stock, because of a pretty pattern?

But I’m convinced that among conventional fund managers particularly, it is actually what separates many of the good guys from the pack – the years of looking at charts. As Richard Driehaus says, “I look at the total image. It’s more the visual impression than whether the stock breaks a particular point.” He’s one of the few to admit he makes decisions partly on “visual impression”.

Accepting how you process information — rather than how someone else says is the best way — should pay off.

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If you don’t have a clear understanding of what you hope to achieve in terms of holding periods, it’s easy to get knocked off course by ever-shifting markets.

One of Ed Seykota’s trading rules is to “keep your mind and spirit clear”. Having clear time frames is an important element of this.

The problem is that when it comes to momentum/aggressive-growth/CANSLIM trading, many time frames work. You can day-trade breakouts, hold them for a few days, shoot for 25 per cent profits over a couple of months, or try and ride the entire trend.

Some people have the ability to shift between timeframes; for example, swing trading bear market rallies, then holding longer during bull markets.

Unfortunately, I’m no good at doing that.

My time fame is long-term. When I buy a stock, I plan to hold it until the trend finishes. That often means holding it for a year or longer.

Why do I do that?

Firstly, it’s largely to do with my personality. I’m probably a more considered person. I’d prefer to make one good decision and let it play out over a longer period, than make a series of short-term decisions.

I’ve tried making short-term decisions. A part of me is jealous that I can’t be a more action-oriented short-term trader. The frustrating thing is that I can see short-term opportunities, but I can’t take them.

When I try to take short-term opportunities, I just get confused. I lose my analytical clarity, or as Ed Seykota might say, “my mind and spirit become cluttered”.

I need to be detached from the action.

The best illustration of this was when Nicholas Darvas had success trading the market by receiving short telegrams around the world with nothing else but price movements. He reasoned that if he traded more often and got closer to the market he’d be even more successful.

Darvas started trading from a Wall Street broker’s office. But rather than make a killing, he totally lost his ability to see the market clearly. The numbers and movement stopped making sense. He lost his cold, analytical, detached view and started trading like a drunken sailor and lost a big chunk of cash.

Longer-term trading is also more cost effective. Costs often make the difference between beating the market or not. In Australia, if you hold for more than a year, your capital gains tax rate is halved. I spend little on broker’s fees and don’t need expensive trading software.

I also usually get extra returns from dividends, which does make a difference to the bottom line.

Being a longer-term trader has strategy implications. To hold a winning stock you need to know three things are in your favour, which gives you confidence to hold on.

The first is momentum; the stock has been going up and is likely to continue in that direction. The second is the company’s fundamentals indicate it is doing well; the third is the condition of the market. As Jesse Livermore said “general conditions” were his best ally.

As I’ve mentioned before, I can hold a stock that goes up 20 or 30 per cent and watch most of those profits disappear on a retracement and not sell out. Because I know things are in my favour.

It means that when conditions are sub-optimal, I have to let opportunities go.

Bear market rallies are sub-optimal. They fail to meet the three conditions above: they’re led by stocks reversing downtrends; fundamentals of these stocks are often weak (they’ve been plummeting for a reason); and the market is not strong.

Watching opportunities go can be frustrating, but until conditions are right, and the right stocks are setting up, I can’t take positions and have the faith to be able to ride them to the max.

I can only do this by knowing, understanding – and having faith in – my timeframe.

Colin Nicholson has one of the best illustrations of timeframes I’ve read. Based on his definitions, I’d fall into the active investor camp.

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Green Mountain Coffee Roasters (GMCR), which is in the news at the moment after a big earnings result, is a classic example of what I was talking about.

While I don’t trade the US market, I still analyse it because it is usually correlated closely with the Australian market. (Though at the moment the US markets are outperforming the Aussies and seem to be throwing up much better momentum opportunities)

GMCR came up on my US momentum screen, but I first noticed it because it was Driehaus Capital’s Small Cap Growth Fund’s biggest holding. As mentioned, looking at what the best performing aggressive-growth stocks own is a good screen.

Looking at the chart above, by February/March, GMCR had put in a big 100%-plus move since October last year — a period of around six months.

This is where people find momentum trading difficult. Looking at the chart at the start of March, it’s natural to think - ‘how on earth could this go up any more?’

But it’s probably only then that I would get interested because the 50-week moving average is starting to tick up, which can be seen in the weekly chart below. The stock was also close to its 52-week high of $45.

It had all the classic tells of a momentum stock: a huge prior move over six months, a rising 50-week moving average, and close to, or at, its 52-week high.

It also had surging earnings and sales growth.

The sideways or consolidation period in price from February to mid-March provides what I call a “defendable position”.

I’ve given up on being too fussy about specific chart patterns (though a text-book one is always nice). What I want to see is a consolidation pattern below which I can put a stop.

The consolidation represents accumulation of stock by big funds and if the price falls below that I know something has changed and those guys are bailing and I want to as well.

But risk/reward is also important. The main characteristic I want in the consolidation is tight price action which indicates institutions are absorbing stock. If the pattern and daily price action is too big and volatile — or sloppy — it means the stop has to be too far away from my buy point which is a move above the consolidation.

The buy point for GMCR would have been when the stock broke above the high reached at the start of February this year.

What would I do if I owned GMCR now after the big move. Start fretting!!! Is it a climax top? I don’t know. Ahhhhh.

I hate when this happens. You get a big move up, but it’s a long way down for the next ‘defendable position’.

My system calls for me to move stops up after the price moves above each defendable position (as explained in The Only Profit-Taking Rule You’ll Need). But sometimes it’s not clear cut.

This is where I tell myself I’m ‘earning my keep’: when a stock makes a big move it requires a ‘leap of faith’ and courage to let it retreat and build another basing/consolidation pattern. But you have to do that to ride the big trends.

Some choose to take partial profits after a big move, which is another good option, but I’ve never done that. Basically, there is no easy answer.

I suspect I would move my stop up to just under $50 and let the stock play out. I know you’re giving up all that profit, but that’s the risk you take to get the big gains.

I know this post could appear as a ‘coulda, shoulda, wouda’ post if I traded the US market. But GMCR is a nice illustration of a momentum stock.

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In situations like this it’s probably good to remind yourself of your edge every now and then. In my case it’s momentum – buying stocks that are already moving strongly.

As I’ve written before, momentum is an anomaly in the stock market that doesn’t conform to the Efficient Markets Hypothesis – ie it’s possible to beat the market buying momentum stocks. What’s more, despite it being well known, it doesn’t seem to have been arbitraged away.

So I’m chasing momentum.

Obviously momentum primarily refers to price: stocks prices that have been going up tend to keep going up. But do we buy stocks that have been going up after a day, a week, a month, three months?

Most research suggests that momentum is only significant based on gains over the past 6 to 12 months; ie stocks with big gains over the past 6-months or year or will tend to persist in going up.

This explains why many of the best aggressive-growth traders aren’t afraid to buy stocks that have made big moves.

In my review of my last bull market performance, I mentioned that many – if not most – of my most profitable trades were stocks that had already made gains of 100 per cent or more.

I’ve found that stocks really only have momentum when they are trading consistently above their rising 50-week moving average. That usually only happens after the stock has already made big gains.

Stocks with real momentum also tend to be trading close to, or at, 52-week highs. Again, they usually only get there after substantial gains.

Based on the above, screening for momentum stocks is also fairly obvious: biggest 12-month gainers and relative strength, stocks trading above rising 50-week moving average, stocks hitting 52-week highs.

But research also shows that in addition to price momentum, there are other characteristics of stocks and the broader market that help with momentum:

- High price-to-book value
- Accelerating earnings
- Upward profit guidance revisions
- Increases in analyst profit forecasts
- A bull market (which is why momentum traders also need a market-timing strategy)
- Industry momentum

All this has implications for a suitable strategy for the current market: most of the gainers at the moment are beaten down stocks reversing (at least in the Australian market). Yeah they’re on the move and have been for the past three months or so, but they don’t have real momentum; it’s a crap shoot.

It requires patience to wait for the market to heal and momentum stocks to set up. It’s also important to remember that, as Gil Morales has noted, sometimes we can start a bull market, but the momentum stocks only begin to move seriously some months later.

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For a while I tried to “muscle through” the dips; ie I’d tell myself to be strong and adopt an aggressive posture. But in the last few weeks I tried something new: I’d just try and relax when I experienced a dip.

An interesting thing happened: the dips still happen, but they don’t last as long; I also seem to explode out of them when they end. There are other benefits: I can run longer and faster and my running style overall is more fluid and relaxed. It’s clear now that I was wasting an enormous amount of energy fighting the normal rhythms of jogging.

THE POWER OF FULL ENGAGEMENT

Recently I’ve been thinking a lot about cycles, their benefits and how to handle them. One of the reasons is that I’m re-reading The Power of Full Engagement, an ebook I downloaded years ago by performance psychologist Jim Loehr.

The book has a simple thesis: we need to focus on managing our energy; not our time. Energy – physical, emotional, mental and spiritual – is used optimally in waves or cycles, with energy expenditure balanced with periods of rest or energy renewal. “We are oscillatory beings,” he says.

That may seem obvious, but as most of us know it’s easy to end up ‘flat lining’. We’re all so busy, it’s easy to forget to schedule in breaks – or what Loehr calls ‘strategic disengagement’.

Loehr says a good example of cycles is in tennis. He found the top players created rituals between points that served as rest periods where energy levels were rejuvenated. Elite players over a long match were able to perform at higher levels because they were constantly recharging.

CYCLE TIME FRAMES

Cycles occur in all time frames: daily, weekly, monthly, annually and even longer periods. Every trader should analyse what they do at all those time frames to see if they are using energy optimally and to schedule in “strategic disengagement” rituals.

At the daily level, a few things I’ve done are to alter my diet, and working and reading habits. I realised one bad habit I’d developed is eating a sweet snack for morning tea. It meant I’d get a short lift, but then get a nasty blood-sugar crash. I’d lose energy between the morning tea and lunch periods and become very unproductive. I’ve also learned to schedule in more breaks; that’s simply a matter of getting up and walking around, and doing some deep breathing every 40 to 60 minutes.

As Loehr says, managing mental energy is also crucial. As an information junkie I had a tendency to read even during breaks: either mindless surfing on the internet, or reading books, particularly trading books. My brain never really got a break. I now ban any non-fiction reading after 6pm and try and get away from the computer during breaks.

At a longer time-frame I’ve realised how important it is to plan holidays properly. We’ve always had a rough idea of when we’d go on holidays, but lately it’s been coming down to taking a break when we’re exhausted. It would be much better to, say, plan to work for 11 weeks, then schedule in a week’s holiday after that. With maybe a smaller break somewhere in there as well.

I’ve found that accepting cycles is actually psychologically liberating. There is nothing more draining than looking forward and seeing never-ending activity. As Loehr says, life should be a series of sprints, not a marathon.

CYCLES AND SHORT SELLING

The stock market is another obvious place where cycles are important. One thing I’m curious about is people who have longevity in trading; ie are still trading in their 50s, 60s and 70s.

One of the keys is they seem to engage in ‘campaigns’ – they prepare for a certain market scenario, when it arrives they go full throttle, then when the conditions stop they retreat into the less strenuous activity of waiting and preparing for the conditions to return.

That, of course, is easier to do as a private trader. A hedge fund trader can’t wait out a bear market for a year or two in cash. Yet that’s what many of the great private traders, such as William O’Neil, do.

I think this is perhaps one of the major reasons for not short-selling – at least during a bull market. Combining long and short selling effectively means a trader is constantly at war; or flat-lining. That obviously is the whole basis of short selling: to try and remove the market’s natural fluctuations.

But from a performance perspective, it removes the natural engagement, disengagement nature of market cycles. Of course, a viable option when both buying and shorting is to schedule in breaks. But that’s easier said than done; when you have tool available, there’s a tendency to use it when you can. (One caveat is to being long-only, is that you need a profit-taking or market-timing system).

From my own perspective, looking back at past bull markets, my failure to accept corrections as part of the normal bull movement probably affected my performance. My system was to be long and leveraged, but then try and quickly go short when we entered a short-term correction.

Short selling did limit my equity drawdown somewhat. But I’m now convinced I should use those corrections to look for opportunities on the long side, rather than frantically trying to avoid a bigger drawdown. The constant activity meant there was no natural cycles or breaks, which resulted in me being ill-prepared and defensive when the market moved out of the correction and made another big leap.

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But yesterday the NASDAQ officially made a higher higher: it closed at 1670.4 points, above the previous significant high of 1665.6 points, as you can see on the daily chart below (click on thumbnail).

Below we can see it from a longer-term perspective on a weekly chart.

What does this mean? It gives an indication of the strength of this rally and the healing being done in the market. My concern is that the NASDAQ’s uptrend isn’t being confirmed by the S&P500, though that may change. Also, as we can see in the chart below, volume has been light.

As I’ve mentioned before, a suitable strategy at this stage may be to take, if you can find them, limited stakes in aggressive-growth stocks that meet criteria including explosive or accelerating earnings and that are hitting or close to hitting new highs.

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As I said in yesterday’s post, one of the signals we’re in a bull market is when we begin making higher highs and lower lows. I’ve found that ‘drawing the flamin thing’ on weekly charts helps to get a good perspective on where the market’s at.

Looking at the chart above (click on thumbnail), it’s clear we’re some way from an uptrend — and therefore new bull market — with the S&P500.

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The question remains: how do we know if we’re in a new bull market?

It’s pretty simple: when both short-term and long-term market indicators are bullish.

Short term indicators might include: the market trading above its 50-day moving average, gains in the market on strong volume, and the daily and weekly MACD indicators in buy mode.

Long-term indicators might include: the monthly MACD in buy mode, the market trading above its 50-week moving average, new 52-week highs higher than 52-week lows, and the market in an uptrend; ie making higher highs and lower lows on a weekly chart.

The problem is there is often considerable time between when the market rallies, which makes the short-term indicators bullish, and when the long-term indicators turn bullish.

By definition both bear market rallies and the start of the bull market begin with the short-term indicators turning bullish, like they are now.

So what do we do? Do we wait for the long-term indicators to turn bullish before buying? That is certainly a valid option. The risk is you give up early gains of bull moves; the reward is that you avoid being sucked into lots of bear market rallies.

Another option is to phase into the market. An example might include:

1. Increase market exposure to 15 per cent to 30 per cent when the market:

- Makes a strong volume move during the early part of a rally (similar to a William O’Neil follow-through day)
- Trades above its 50-day moving average
- The weekly MACD turns bullish

2. Increase market exposure to 30 to 70 per cent when the market:

- Begins making higher highs and lower lows on the weekly chart
- New 52-week highs are greater than new lows
- The monthly MACD turns bullish

3. Move to 100 per cent (plus) exposure when:

- The market trades above its rising 50-week moving average

If this strategy is applied without discretion – particularly at the start of a bear market – you’ll be sucked into plenty of bear market rallies, though with less exposure.

This is where Dow Theory and cycle phase analysis becomes so important. It provides a tool to indicate that there is a greater probability of a rally turning into a bull market.

By phase analysis I mean, for example, using the three phases of Dow Theory, which I’ve discussed in the previous few posts.

For example, when we enter Phase Three of a bear market, ‘distress selling’, we know the chance of a rally turning into a bull move is greater.

When we decide we’re in Phase Three and the market rallies, we look for aggressive-growth stocks hitting new highs. We take some positions, but limited to, say, 15 to 30 per cent of the portfolio.

The usual rules apply: adhere to strict risk management (ie risking no more than 1 to 2 per cent of your portfolio) and cutting losses quickly. There is every chance that it is another bear market rally that could fail quickly.

Often I find that my system is in Phase Three and it rallies, but there is little or nothing to buy; ie no company with accelerating or explosive earnings growth whose share price has had strong price momentum and is hitting new highs. Finding suitable candidates is the final filter that overrides everything.

Dow Theory is subjective. But trading isn’t about knowing what will happen, it’s about examining the environment we’re operating in, weighing the odds and adjusting strategy accordingly.

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