Mousetrap 2/18/2012

Condition Bear Market Rally
S&P Target 1020
Small Portfolio IAU & XLF 13.54%
Hedge XLU -2.53%

Position Date Return Days Call
SE 6/27/2011 16.97% 236 Hold
CLH 7/6/2011 22.11% 227 Hold
GCI 7/14/2011 9.85% 219 Hold
CSGS 10/3/2011 28.32% 138 Hold
NLY 10/25/2011 1.59% 116 Hold
DD 10/27/2011 6.45% 114 Hold
KBR 10/27/2011 13.22% 114 Hold
VG 10/27/2011 -27.97% 114 Buy
TTM 11/30/2011 61.53% 80 Hold
BT 1/4/2012 8.95% 45 Hold

S&P Annualized 1.65%
Small Portfolio Annualized 18.81%
Mousetrap Annualized 21.09%
Hedged Annualized 17.58%

The Mousetrap is maintaining a comfortable lead over the market averages, which are more oversold than they have been since the week before the 2010 flash crash.

All I can do about short term timing is shrug my shoulders. This is still registering as a Bear Market Rally on my models, so something isn’t adding up. Fundamentalists will point to high earnings, and I’ll point to a plunge in capital equipment purchases in the 4th quarter GDP report. Capital Equipment are things industries buy to expand and maintain their productive capacity. By NOT buying equipment, earnings reports become artificially inflated.

Imagine if you knew your take home pay was going to be slashed next month – so you stop going out for dinner this month. THIS month your bank account looks fantastic! But it’s only looking great because you are battening down the hatches.

But the immediate future is not what I wanted to talk about.

What I wanted to talk about is what I’ve BEEN talking about in a few conversations this week: things that don’t work well together.

There’s a study I read about a totally random trading system. The system used a trailing stop loss, cutting off losing trades and letting winning trades run. The system actually worked, with one exception: stocks chosen for fundamental value caused the system to lose money.

In other words, a blind chimpanzee could pick stocks better than Warren Buffet on this method.

There’s a dirty little aspect to fundamental investing – it’s almost always wrong immediately after you invest in the stock.

Let’s look at something simple like a price to earnings ratio. If a stock has a price of 15 dollars and earnings per share of 1 dollar, it has a P/E of 15. Typically something with a P/E of 5 to 15 is a decent buy, as long as everything else about the company is sound. But we’ll keep it simple. For the past year the stock has been running earnings per share of 1 dollar, but THIS quarter they took an earnings hit and only earned 50 cents a share. Suddenly that P/E of 15 is now a nose bleed of 30. The stock price plummets as people dump the shares. It goes from 15 to 10 in two days!

The CURRENT P/E is still 20 even after plunging to 10 dollars.

But the 12 month TRAILING P/E is averaged over 4 quarters. So the 12 months trailing P/E is actually 11.43.

Who’s right? Depends on how long you plan to hold the stock. If you generally hold for a few weeks it’s still a bad stock. If you generally hold for a year it’s probably a good stock. SHORT TERM it’s too expensive. LONG TERM it’s really cheap.

In other words, short term traders could be shorting the stock and long term traders could be buying it long – and they could BOTH be right.

The point is this: if you are using a fundamental filter to select stocks (as this model does), using stop losses will practically GUARANTEE a loss. These stocks are selected with a goal of holding for a year. They won’t always make it that long, but that’s the goal. In the short term, they will typically lose money.

Can’t really be helped, although I’ve worked to minimize that “feature.”

The market is filled with two different kinds of traders: momentum and mean reversion. Momentum traders are technical traders looking for young trends to ride. Mean reversion traders are fundamental investors looking for old trends that have exhausted themselves. While a momentum trader won’t know when the current trend will end, a mean reversion trader won’t know when the next trend will begin. The momentum trader often uses a trailing stop loss to exit when the trend ends. A fundamental investor can’t do that, because he’s always hopping into the last part of a trend that’s going the wrong way – waiting for the next that will come sooner or later.

We’ve all met that “perfect” couple made up of a fantastic guy and a wonderful woman, who are a disaster together. It’s not enough to know fundamental or technical tactics that work in isolation. We have to have a strategy that combines tactics that work TOGETHER, and avoids tactics that do not.

Tim