Technically Speaking, February 2007

Recently, a member suggested that we feature interviews with successful technical analysis practitioners on how they apply technical analysis to make money in the real world. MTA affiliate Matt Caruso agreed to conduct interviews and prepare this feature. MTA President Phil Roth took some time to talk about his day job in late December. Part II of this interview will be published next month.

Matt Caruso: What is your professional job description?

Phil Roth: Well I’ve been an analyst my whole career, this is my 41st year right now. I’ve been on the sell side with major brokerage firms for most of my career; 11 years at Merrill Lynch, more than 11 years with the E. F. Hutton/Shearson combination, more than 11 years at Dean Witter/Morgan Stanley, and now I’m with an institutional firm and all we do here, is institutional research. So I have a much smaller audience, but an institutional audience. My job is three fold: to have a market view and make stock suggestions to our own people; try to bring in some business from my old contacts at previous firms; and try to increase business with the firm’s present customers by adding technical research.

M.C.: Do you work only with stocks, or also futures or options?

P.R.: Our business here is equities and options. What I follow and I’ve always followed primarily is the equity market and I make my suggestion strictly in equities, both long and short ideas. I follow all the markets though to do my analysis of the equity market. I follow bonds, commodities, and currency but I only provide ideas in equities. Our people on the desks, since we have very astute option people here at Miller Tabak, they often translate my ideas into some kind of options strategy.

M.C.: How pronounced do you find the effect from the futures and currency markets is on your equity predictions? Do you find those markets to have a large affect on your analysis?

P.R.: Well I do a top-down versus bottom-up kind of analysis, so intermarket analysis is part of the top-down. For example, if interest rates are rising and oil prices are rising, I probably want to suggest oil stocks and not utility stocks. So I start with a top-down, the top-down tells me what kinds of stocks make sense, the top-down tells me about how attractive stocks are relative to other forms of investments like bonds. Then I look at as many individual chart patterns as I can as often as I can, I guess I monitor about a thousand stocks every week, to see if I’m getting the same message or a different message. Sometimes I will see changes starting from the macro, sometimes I will see it starting from the micro. I always compare one to the other to make my judgment. Commodities and bond are very important because there are stocks that are commodity sensitive and stocks that are interest rate sensitive. The currency situation is different obviously; you can have a strong market with a week currency and a strong market with a strong currency. It’s a little harder to incorporate, but international flows are huge these days by the standards of what they were 10 or 20 years ago. Therefore you try to have some judgment about foreigners’ attitudes towards the US – do they want to buy U.S. financial assets or not. Right now for example I think we’ve had a weak dollar and it’s at least as far as domestic US investors go they’ve interpreted it as sort of a positive, a mild positive, it’s certainly a positive in some multinational earnings. But if the dollar got weaker and you had more emotional markets, foreigners might perceive the currency risk as too great and might dump it. You certainly have to watch it and I think an acceleration of dollar weakness could be an important negative if it happens and it’s possible.

M.C.: What specific technical tools do you apply when looking at your charts and making your analysis?

P.R.: I follow four kinds of indicators. The first kinds are trend and momentum indicators. This is sort of traditional stuff so I’m looking at the price indexes, breadth, volume, and relative strength. I usually do my trend and momentum work from inspection of bar charts.

In other words, I do not really use tools like stochastics, and MACD and RSI and all of those momentum tools. I do that by inspection. I look for changes in intra-day volatility and changes in volume to make my judgment about the strength or weakness of a trend. Moving averages I use as kind of guides, but again it is primarily from my subjective evaluation of changes in volatility and changes in volume. That’s the frst kind of indicators, trend and momentum. Those kinds of indicators tell you the direction the markets are moving and the force behind the move, is it accelerating or is it decelerating?

But those kinds of indicators don’t necessarily tell you very well where you are in a trend. To get some handle on that I look at many sentiment and supply/demand indicators. That’s really my love, my love is markets psychology and trying to analyze how bullish and how bearish the different market participants are. The most important technical precept to me is that investors make bottom and traders make tops. I mean that investors, people that are motivated by price and value, are the kind of people that are likely to buy in a weak market or in adverse conditions because they have a long term view, they look beyond the short term uncertainty. Traders on the other hand are motivated by the trend and they’re bearish if the trend is weak and bullish if the trend is strong. So what tends to happen is that at turning points it takes traders an amount of time to change their opinion because nobody recognizes the change in trend immediately, trends don’t change immediately. So as a trend goes from up to neutral to down, it tends to catch the traders bullish a little too long. The same thing is true on the downside, it takes them a while to recognize a turn from down to up and so they tend to be bearish at bottoms.

So I’m looking for indicators that measure the attitudes of investors and indicators that measure the attitudes of traders. When looking at traders I look at options data, put/call ratios, put/call ratios on volume, put/call ratios on premiums. For short selling indicators I look at polls; Consensus, Inc. polls, Investor’s Intelligence polls. Those polls are basically traders polls, and all those kinds of indicators tend to be reasonable good contrary indicators.

For investment attitudes, there are people with long term horizons. Normally when I say that people think I am talking about the institutional money manager, but I am not. I believe institutional money managers have a relatively short term horizon. People with long term horizons are corporations themselves, so if corporations are buying back more stock then they are issuing, that is very bullish for me because that means the supply of stock is actually contracting and it means corporations think their stock is cheap and they obviously have a very long term view. Insiders have a good record of buying their stocks when their stocks are cheap. So I pay attention to the relationship between corporate buy backs and new equity financing, and I pay attention to insider activity. Those are the kind of indicators that are in that sentiment and supply/demand category which are the second and third kinds of indicators I follow.

The fourth kind which we touched on at the beginning is intermarket analysis. The change in valuation of any alternative to equity will affect the supply and demand for equity. If bonds go up and down in price it changes the supply/demand picture for stocks. As commodities go up and down it changes the supply/demand picture for stocks. I follow them in the order in which I mentioned and the importance is in the order in which I mentioned them. The most important thing is trend and momentum, then sentiment and supply/demand, and then intermarket analysis.

One observation I would make is that a lot of people try to analyze market psychology and make a market judgment based on that alone and I think that is a terrible trap because indicators of sentiment and supply/demand are only important insofar as they occur against a certain trend backdrop. In other words, it is a mistake to say that everyone is bullish therefore I’m bearish, and you hear that all the time. Well that’s nonsense because during a strong trend everybody gets the idea and everybody is right for a while. It’s when the trend falters and the traders stay bullish that you get an important message. So you cannot use sentiment and supply/demand indicators or for that matter inter-market analysis in isolation. You must start with an assessment of the trend.

M.C.: Very interesting. You also mentioned that you use subjective analysis. Is there any mechanical system you use as well as a filter in your work, or are you purely subjective?

P.R.: The only thing that is mechanical is how I get some of my ideas. I need to figure out what the strong stocks are and what the weak stocks are, and you can’t look at everything everyday. So I do look at the new high list and the new low list, I want to know where the relative strength and relative weakness is. That doesn’t mean that I want to buy a stock simply because it’s on the new high list but I’m probably going to be bullish rather than bearish on such a stock. That’s how I get some ideas. However, I do not have any mechanical buy or sell signals. I think if I were a trader rather than an analyst I would apply more systems like that but since I am an analyst and I do not manage a portfolio or manage money I can afford to be more subjective in how I do things. I am concerned with the relationship between risk and reward when I make a recommendation. If I am suggesting something for a short term trade, what I mean by that is a couple of months horizon, I’m always looking for at least a 2:1 profit-to-risk profile and I’m looking for a more than 10% profit potential. Let’s say I’m looking for a 15% potential, I want to control my risk to half of that, 7%. On an investment basis, if I’m suggesting something for a longer term, six months or more, then I’m looking for at least a 3:1 profit to risk profile and I’m looking for a bigger return. I’m looking for 40 or 50% and I’m willing to take a 10-15% risk. Those are some of the parameters I’m using. Also, the risk levels always come from some chart point. If I can’t identify the risk clearly from some chart point, or there is no reasonably close risk level, I don’t use the stock. I’m not going to buy something simple because I think the trend is up. I have to be able to quantify what the risk is and it has to be from some reasonable point on the chart, a support level or a trendline or something like that.

M.C.: Do fundamental or economic factors affect your technical view or recommendations?

P.R.: Only in one sense – I am always interested in seeing if there is some consensus about the fundamentals because then we can see how the market reacts to that. If there is some consensus and we can get a good sense that there is a consensus, then that notion is probably discounted in the market and I’ll be looking for the opposite to pan out. But, no, I do not apply fundamentals at all. We have fundamental research here and my job is not to bump heads with the fundamental analysts. So I’m not going to emphasize stocks we have a different opinion on simply because it would be stupid from a standpoint of trying to do some business. I try to support the fundamental analyst. That doesn’t mean I’m going to prostitute myself, if I have a different opinion I say it. But I’m always going to try to emphasize the points of agreement just from the standpoint of doing business.

M.C.: As you said earlier, you really love the sentiment and supply/data figures because you like analyzing market psychology. Do you find that your own psychology or you own emotions at times affect your analysis?

P.R.: Absolutely. It’s the hardest thing for an analyst to do in my opinion is to stay objective. I don’t even manage my own money for that reason. I want to stay as objective as possible so my own money is managed. I have found that I make the most mistakes, or the biggest mistakes, when I think I know why something is happening. If I’m making my judgments strictly from the chart and am paying no attention to why a stock or the market is going up or down, I’m going to perform relatively well. If I think I know why for example, interest rates are behaving well I may want to buy stocks. Well if interest rates start performing poorly and then the market keeps going up, you’re saying, “What the heck is going on?” So staying objective is very important and it’s difficult and I think the biggest problem I have is everyday taking a look at things and everyday making a new judgment and trying not to be influenced by my own opinion. The hardest thing for anybody in making money in the markets is to admit you’re wrong and it’s the thing you have to do all the time. I make lots of mistakes and as long as they’re little, that’s no problem. Everyday you have to say, that stock I suggested yesterday, if I hadn’t suggested it yesterday, would I want to suggest it today? Everyday you want to force yourself to take a fresh look at things and not be affected by your previous opinion. It’s difficult but that’s what I try to do.