Timing is everything – and a brief trading lesson

Don’t believe anybody that says that market timing is not an important element of successful investing. Timing is a crucial part of it – basically you have to know when to buy (identifying when the prices are low) and know when to sell (identifying when the prices are high). I have historically found it more difficult to know when to sell than when to buy, presumably because markets crash quicker and harder than they go up. I have been actively working on this part of my investment experience for the past few years. I still do not feel comfortable with my exit tactics.

It is a very, very frustrating part of investing when you know you had the timing correct, but were unable to execute on any trades. Two days ago, on May 25th, I wrote:

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

I had placed a smattering of orders, starting at roughly 3% below the May 25th market close, but they probably won’t be executed now since the markets seemingly have reversed. I wanted to get about 10% equity exposure to the fossil fuel industry and I only have about 5% exposure on the debt side. Since the whole Canadian crude market has skyrocketed in the past couple trading sessions, I’m going to have to re-evaluate the short-term entry or hope for one more shock-wave coming out of Europe (which would be nice). My general thought is that while I don’t believe in the “10% of your portfolio in Gold” inflation-hedging technique, I do solidly believe that having a claim to future cash streams from Canadian oil and gas companies with significant reserves will be a good capital preservation technique over the long run – at least until crude prices rise to the point of unsubsidized alternative energy production costs.

After describing my inability to execute on what should have been a short-term winning trade, now is the time for a trading lesson to describe why the process I employed is correct.

Whenever I place orders, it is always with limit orders, and broken into price increments that are scaled below the initial point. I very, very rarely buy at the ask and sell at the bid unless if dealing with illiquid securities and somebody posts something juicy.

As an example, if a share is trading at $10/share and I was interested in purchasing 1,000 shares and thought market volatility would take it roughly 10% below current price levels before bottoming out, a simple execution would be to break it into five branches, such as the following:

Buy 200@9.80, 200@9.60, 200@9.40, 200@9.20, 200@9.00

The total cost of the order, excluding commissions, would be $9,400; a lot cheaper than just putting in an order for 1000@10. However, the cost of such a decision is that you may not get your desired quantity (or any at all) if there is not sufficient volatility in the marketplace. In the case of my fossil fuel equity trades, this is exactly what happened – market volatility took the market price up and not down as I expected.

Inherent with the breaking of such orders is the assumption that you don’t know what “the bottom” will be. I have learned many times over that predicting the exact bottom is impossible and that breaking orders into smaller quantities is the best way to capture value from this admission.

Using a real brokerage (e.g. Interactive Brokers) keeps trading costs of breaking orders into small bite-sized amounts cheap; a price-making order on the TSX incurs around 52 cents of commission for 100 shares. The increase in commission is inconsequential to the likelihood of saving capital costs with the lower-priced purchases. Even using a less sophisticated brokerage, you can still obtain significant price savings.

This same heuristic can also be employed with an exit of a position.

Note that it is very easy to modify this into a workable algorithm. When working with institutional quantities (e.g. millions of dollars), you typically employ algorithms to randomly time entries and exits depending on ambient market conditions and the volume seen in order to get the best execution on the entire order. When working with large amounts of dollars, masking the intention of your order is critical in order to be able to successfully accumulate or distribute share holdings.

One major advantage a retail investor has over the institutions is the ability to get in and out of positions with the click of a mouse button, as opposed to employing complex algorithms to do the same over the period of days or weeks.

Apple vs. Microsoft

It was only a couple months ago that I wrote about how Apple and Microsoft’s market capitalizations are closing in on each other.

Today, Apple for the first time has a market cap higher than Microsoft, at $222 billion for Apple and Microsoft at $219 billion.

The real issue with the two companies is that Microsoft is really living off of its legacy product lines (Windows and Office) while Apple has come out with a huge stream of technological innovations, mainly the iPod and iPhone product lines (which secretly get the users to lock into their business model, similar to how software in the 90’s was “for Windows” only).

At this time, I don’t see how Microsoft can demand a market premium for its position – on the retail end, Windows has not fundamentally changed in 15 years (Windows NT 4 was the quantum leap product, and Windows XP was a great retail refinement of the Windows NT core). Microsoft Office has not fundamentally changed since the release of Office 97; everything else subsequent has been cosmetic in nature. With competitors chipping away at the cost premium that Microsoft charges (typically to large-volume corporate licensees), their ability to extract margin out of the marketplace with upgrades and obsolescence upgrades is limited. Microsoft will continue to produce cash like no tomorrow, but it is tapped out in terms of growth. Microsoft shares, as a result, trades like it – analysts expect $2.31/share in FY2011, while the stock price is $25.01/share – a yield of 9.24%.

Apple, on the other hand, has plenty of room to invade the computer marketplace, and combined with their mobile device market seemingly can command a high premium and has room to grow. As a result, they are given a premium in the stock market – analysts estimate $15.42/share in FY2011, on a stock price of $244.11/share – a yield of 6.32%.

Although Apple has competitive issues (i.e. Google is trying to invade the territory), it remains to be seen whether it can keep Google and other competitors at bay. Certainly its marketing arm continues to create users that have an almost religious-like adherence to its products.

I don’t have a position in either company and don’t plan on establishing one.

Flight to safety

The US held a 2-year treasury bond auction today and some $42 billion was awarded at a yield to maturity of 0.769%.

In Canada, the 2-year government note is trading at 1.69%.

I can’t think of a single rational reason why a retail investor (that has a lot less than $42 billion in the bank account) would want to purchase these types of securities when there are relatively risk-free alternatives (such as “near guarantee” GICs and corporate bonds of issuers that would only default in the event of an economic apocalypse).

Canadian oil companies

In today’s trading there are a few oil and gas companies that are tripping my price range thresholds – i.e. they might be worth further research and consideration.

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

The impact of touting a stock

Jim Cramer is very well known to anybody in the financial domain as a former hedge fund manager, but also a hothead on CNBC television hosting a daily show called Mad Money, where he praises and pans every stock on the book. He knows, and the audience should know that his show is purely for entertainment value (Cramer is really an excellent host that seems to never run out of his child-like adrenaline surges), but a whole bunch of amateurs take him seriously.

It used to be when his show came to the air that whenever he made recommendations that the stocks would go up, significantly, in after-market trading, only to recede to their previous levels a couple days later. Traders would usually target this phenomenon and try to capture the demand by short selling and taking profits later.

If anything, it was a very fascinating exercise of how sharks try to eat fish, akin to a poker game – that type of stock trading was definitely zero-sum, and Cramer had the ability to attract a lot of amateurs that were also trying to make the fast dollar off of each other. It was undeniable that in the first few months of the show, Cramer had the ability to move stocks and somebody was probably able to consistently take advantage of it (e.g. being associated with somebody directing or producing the show, for example).

So it was with interest when a fellow named Controlled Greed, who has 5,514 subscribers according to Google Reader, on May 22 mentioned that he took a position in the previous week some illiquid smallcap company (XETA). It has a market capitalization of 39 million and an average volume of 6,700 shares or roughly $25,000 traded a day.

Most notably, on no news, the stock opened up Monday about 5% on 1900 shares. So his article did attract a few market buyers, which I found to be fascinating.

My econophysical studies of situations like these suggest that “immediate popularizations” of stocks has an impulse function effect on the share value, but the value of the impulse declines substantively as the value of the popularization exponentially decays, and eventually reaches a null point (where it is indistinguishable from background noise) a few days later (the decay rate being variable). But you have to wonder how many of those 5,500 readers now stick XETA on the watchlist, waiting for some sort of substantive news. I will not. One of my rules is that by the time you read about any obscure stock pick on any popular medium, it’s already too late.