12. Buying and holding growth stocks – unless they’re rigorously researched – is potentially disastrous. Few companies can keep growing strongly. The huge winners are offset by the huge losers and the rest usually give back their big gains over three to five years. Use charts to take profits and get out.

13. Many good buys come after the stock is up more than 100 per cent

14. Big winners often have strong earnings growth now, but relatively lower earnings forecast growth. E.g. annual EPS might be up 150 per cent, but analysts are forecasting the next year’s EPS to rise 30 per cent to 40 per cent. Analysts are conservative and often underestimate future profit growth.

15. IPOs can be huge winners, but the best buys time is usually after it has traded for more than six months, or three months at the very least

16. Almost all stocks you buy will go higher than the price you sell out at

17. Some institutions are often selling at the best time to buy. While you want them on side – witnessed by an increase in volume — some funds will be selling for a number of reasons that don’t necessarily mean it’s a bad stock. They might be rebalancing, or selling based on valuations etc.

18. Strong stocks are usually trading above their rising 50-week moving average

19. The best time to sell a profitable position is when it falls below the last resistance level, or when it makes a climax top

20. Trading is a messy business: You’ll make heaps of mistakes: sell out too early, buy too late. The only key is to learn from your mistakes and persist. That also means you have to survive, so don’t bet too big and cut your losses.

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Traditional aggressive growth trading usually means buying stocks hitting new highs.

The problem is that every hedge fund and momentum shop in the world does that. So it’s always good to be looking for alternatives.

You buy recovery growth stocks when they are trading 30 per cent or more off their highs (usually all-time or 52-week highs). 

Richard Driehaus has a small-cap recovery fund that has performed exceptionally well. (Note that his small cap recovery fund has significantly outperformed the mid-cap one. I suspect that’s, in part, because there are more inefficiencies at the smaller end of the market).

I’ve been trawling through Driehaus’s recovery trades and here are a few things I’ve learnt:

* He buys recovery growth stocks when they’re bouncing off their 50-week moving average

* He buys recovery growth stocks after they have fallen sharply then formed a base — or sideways trading pattern — for at least six months

* Some recovery growth stocks have had a few years of price underperformance — forming a long shallow base — and are now starting to rise

* The companies usually have posted a poor quarterly earnings report where growth has slowed or they’ve made a loss. But recent profits are surging back and forecast growth is also strong

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A bear market, or correction, is a great time to do this.

I did it last week and I’d equate the value of the exercise to reading 20 top trading books, or sitting down with an awesome mentor.

It helps to have good records. I have every trade pasted up in a big art book, including fundamentals, state of the market and charts. If you’re not keeping these types of records you should start today.

I trade with an aggressive-growth strategy, which most of the lessons apply to.

Here are the first 10 lessons from my review (they are in no particular order):

1. The best time to buy aggressive growth stocks is at the start of a bull market when most people aren’t looking

2. The best time to buy during a bull market is just after a market correction. So use corrections to look for opportunities and don’t panic

3. The best stocks have surging current earnings

4. Don’t get too hung up on earnings for the past three to five years. As long as growth is accelerating now it’s fine 

5. Turnaround/recovery growth stocks are as good as stocks that haven’t had a set back

6. Don’t buy stocks with a 50-day moving average that has been rising for a long time – it’s probably due for a correction that will shake you out

7. The best time to buy a stock is when the stock has traded sideways (based) and the 50-day moving average has flattened and is starting to rise

8. Tight price action (low volatility) in a base before moving to a new high is as important as any other technical criteria

9. Don’t be afraid to buy stocks with no earnings, but that has a hot new product and with a strongly performing share price

10. A correction to the 50-day moving average is not a high probability time to buy a stock; unless it is the first time after a breakout from a base

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But what on earth is going on?

After his first implosion, you would think he’d learnt his lesson.

Clearly, Niederhoffer is playing out some psychological dramas that is difficult to understand.

This is a general observation, and not a direct commentary on Niederhoffer; but it is seldom recognised that psychological issues can manifest themselves in business and finance.

It annoys me that we focus on drug, alchohol and gambling additions, but there is little focus on addiction to business success.

Financial disasters, broken relationships and damaged children are all a result of men seeking riches to cover up their shortcomings, rather than facing them.

The problem is business and trading are respectable activites; that doesn’t make them any less dangerous as an outlet for screwed-up people.

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The sub-prime debacle is a classic case of Fed mismanagement.

First it pumped money into the economy after the dot-com bust to supposedly avoid a recession.

That extra money — and rock-bottom interest rates — distorts normal financial decision making: banks lend more to low-quality borrowers.

Now the Fed is slashing rates to avoid the impact of that sloppy lending, which its own actions encouraged.

As Greg Mankiw highlighted, Jon Stewart posed a great question to Alan Greenspan: “Why do we have a Fed? Why do we have someone adjusting the rates if we’re a free-market society?”

Greg Mankiw, one of the world’s leading economists, is honest enough to say his profession has no answer. 

“We economists have rigorous and fundamental theory to explain why we have environmental regulation (externalities) and to explain why we have antitrust laws (market power), but there is no consensus about what market failure calls for the existence of a central bank,” Mankiw said.

How weird: one of the most powerful economic levers and we don’t know why on earth it should exist.

One problem is that a lot of economists know the Central Bank’s actions are mostly harmful; but they haven’t come up with a suitable alternative; or at least successfully sold an alternative.

The world’s greatest monetary economist, Milton Friedman, said: “…One unsolved economic problem of the day is how to get rid of the Federal Reserve…”

Friedman was dead right to argue Central Banks should be scrapped. But he failed to propose a good alternative: his money growth rules never really caught on.

At an intellectual level, Friedman’s desire to do away with Central Banks needs to be re-energised.

We delude ourselves that we live in a free-market economy.

What is free-market about a bunch of smug nerds setting interest rates and determining the course of a nation’s business?

I once hung out with some central bankers: they had weird rules like old-timers wore their ties well above their belly buttons; the young turks wore theirs hanging below their crotches.

Jon Stewart’s question was good, but he was asking the wrong person.

Alan Greenspan is probably the most over-rated person in the history of mankind. He’s an Ayn Rand acolyte but spent his life thinking he was smart enough to manipulate free markets.

It’s about time that people stood up and said: we don’t want our lives manipulated by a bunch of bureaucratic central bankers who know nothing about capitalism!

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But it did it’s best yesterday to get some after a big rise on higher volume.
It’s not a perfect set-up: volume wasn’t massive and the 50-day MA is sloping down.

But it is likely the start of an interesting move; while it may not be wise to jump in fully, it’s time for a nibble at least.

Here’s a look at the chart:

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I believe in jumping on a trend and riding it till the end; though I incorporate fundamentals, which is a anathema to hard-core trend followers.

But right now some of its legends are doing it particularly tough.

The first was John W. Henry and now Bill Dunn, both poster boys for trend followers.

These guys have generated big returns in the past and experienced huge volatility. But they’ve always bounced back.

As Michael Covel notes in a recent post, Bill Dunn’s drawdowns has been going on for an unprecedented number of years.

It must be terrifying for them: they’d be asking whether the market changed so their method is redundant?

These guys maintain that trends will always remain in the market; sure they disappear sometimes, but they always come back eventually.

I suspect the market hasn’t changed this time as well. What they’re going through is simply a once-in-a-lifetime funk.

The likes of Henry and Dunn have taken big risks and used concentrated leverage. If you do that over a long period of time, then sooner or later you’re going to be caught by the mother of all drawdowns.

Everyone knows that to get higher returns you have to take on more risk. What most of us can’t accept is that you’ll eventually have to live through that risk. 

From this perspective it’s probably a good time to buy trend followers; at the bottom of their most brutal drawdown. Not that I’d have a clue how to go about that!

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He made two salient points: sometimes we just lose passion for trading; and that many traders are deluded by desires for quick, easy riches.

“What makes it (trading) a fantasy is that it is an effort to achieve success without such effort,” he said.

I suspect these two issues are linked: when traders realise they won’t get rich overnight they often lose interest.

I’m sure many traders simply drift off having found other challenges, higher (expected?) rates of returns elsewhere, etc.

For the ‘fantasists’ trading can be dangerous. Some waste years and huge sums using trading to try and escape character flaws and the brutal realities of working for a living.

But it’s not all bad news. The irony is that while many trade to try and solve personal issues, trading can also shine the spotlight on our biggest weaknesses.

Most advanced traders know that success comes from having an edge, good risk management, and psychology. They also know that only your own hard work and attitude determine success.

When traders work that out, it forces them to look inward for causes of problems (and success), rather than blaming others. This can trigger an amazing journey exploring psychological weaknesses, strengths, quirks etc; basically you get to know yourself better and learn to accept responsibility.

So even if I drift away from trading it won’t have been a waste of time: the rewards it has delivered me in non-monetary rewards far outweigh any financial gains. Far, far greater!

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Another tool I’ve come across to help analyse broader market risk is the Gordon equation, which allows investors to roughly calculate the expected return of the market in the long term (30 years +).

William Berstein highlighted the equation in his book,  The Four Pillars of Investing. A google search doesn’t provide many good references about it. But the equation was pioneered by University of Toronto professor Myron Gordon.

Basically it rearranges Irving Fisher’s ‘discounted dividend model’, which says a share is worth the present value of its future income stream.

The equation is simple: Market return = dividend yield + dividend growth.

If the market dividend yield is, for example, 4 per cent and compounded dividend growth rate was also 4 per cent, then expected long-term return is 8 per cent.

“The Gordon equation is as close to being physical law, like gravity or planetary motion, as we will ever encounter in finance,” Bernstein said.

Slot in the figures for your country. If you assuming a bond’s long-term market returns is the coupon rate, you can then compare it with expected returns from equities and adjust your portfolio accordingly.

A central message from the equation is that after strong market gains, expected returns fall. That may seem obvious, but it’s easily forgotten.

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I like to see the market displaying upward momentum, which hopefully lasts, before buying.

So when is there enough momentum to jump in after a market correction?

I look for:

- Momentum or growth stocks beginning to break out of bases
- Major indices trading above their 50-day moving average
- The number of new 52-week highs becoming significantly larger than new lows
- A major accumulation day (ie, a big rise on higher-than-average volume) during the rally
- Weekly MACD in buy mode

The most important thing I’ve found is there’s no need to rush straight back in after a sell off: you have to be patient.

Fortunately, if you wait for the market to heal itself a bit and create some set-ups there’s usually heaps of opportunities — hopefully much safer ones — still left.

Based on current market action, where does this leave me? Largely on the sidelines: the major indices are showing no signs of momentum … yet.

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