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Keeping It Simple


The 'Hows' and 'Whys' Live from Ojai.


Our professors and partners have come from as far away as Australia to contribute their wisdom and guidance. Throughout the next two days we will be highlighting some of their ideas on managing risk and staying in the game as catalysts for discussion.


-My philosophy is as simple as it is effective: to identify an excess of sentiment regarding investor opinion on stocks and to measure the market's concurrence with said sentiment. Who is right about a particular stock, group or sector -- the bulls or the bears? My experience suggests that by answering this question, investors cannot only uncover opportunities otherwise unseen, but also can avoid the pitfalls of following too big a crowd.

-There are few ways to measure sentiment on a stock-by-stock basis. Erlanger Research has found normalized short selling statistics to be the best method for measuring investor expectations of individual stocks. Once an investor uncovers the sentiment picture surrounding a stock by examining the Erlanger Short Rank, the next step is to determine the market action of the stock. Erlanger Research has developed a series of models that use modern pattern recognition techniques to identify the relative strength or weakness of a stock's price action. If the Erlanger Short Rank shows heavy short selling but the Erlanger Technical Rank remains strong, the implication is that those short sellers are wrong. Often, when short sellers get caught in such a squeeze, the market moves against them (up) until they capitulate (evidenced by a subsided Erlanger Short Rank).

Key themes:

-07/27/05 - The current uptrend has taken its toll on short sellers. This month's short interest reports from the various exchanges show that as of the trade date of July 12th, short intensity levels have dipped to moderate levels.

Outlook for the financial markets:

-07/05/05 - Our 20-year Seasonal Cycle shows a broad peak around August 16, 2005. This is not only a peak for the period since April 15, but it also represents the beginning of an extended negative phase that ends in October 2006.

Thoughts on controlling risk and staying in the game:

-Know when you are in a crowd, and know when the market is moving against you: The WorldCom debacle cost investors billions of dollars. Investors could have made money on WCOM by owning it when short selling was heavy and price action in a long-term advance phase (i.e. above its monthly DMA channel.) Once short selling dried up - and especially once the price action turned negative, there were no technical reasons for being exposed to WCOM. The problem with risk management is that it is psychologically toughest to do the right thing at the right time. The proper time to own WCOM was when it was in a constant state of "overbought" and the fundamentalists were urging short sale recommendations. The time to not own WCOM was when it looked oversold (cheap.)

Select content:

-Erlanger Research Methodology
-Micron Case Study
-What is a Squeeze Play?

Outside reading:

-Interview by Kate Welling

If I could give one piece of advice to attendees...

-Keep it simple. Anyone who has a 76 factor model is in serious trouble. Try finding 76 factors that have some degree of independence. If you have a 38 factor model, and there were only 5 ways to interpret each factor (e.g. neutral, positive, negative, very positive and very negative), how many patterns would one have to recognize and interpret? (Answer: 364,000,000,000,000,000,000,000,000 - or 5 to the 38th power.) If you have only 10 factors, you need to be able to recognize 10,000,000 patterns! There isn't enough market history to allow for sufficient degrees of freedom for such complex models, a problem which is exacerbated given the non-linear nature of the market. I primarily use only 2 factors - price action and sentiment. It doesn't model all market action, but it's better than throwing darts.

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No positions in stocks mentioned.

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