Stick With Strength to Beat August Heat

In ancient cultures that lacked the benefit of calendars and patio lights, the shortening days as winter nears were met with terror each year. To compensate, the most contemplative hunter-gatherers from the frozen steppes of Russia to the steamy highlands of Mexico created all-powerful deities to whom they could pray for relief -- a ritual that, in some cases, included the sacrifice of virgins.

The same pagan horror seems to beguile investors at the onset of August each year as they ceremonially slit the throats of thousands of innocent stocks, despite evidence that they'll just have to buy them back by October -- and probably at higher prices.

To bring some sense and science back to the temple, I spoke with a couple of professional tape worshippers in Minneapolis and New York who have lived through more seasons than they care to count -- Edward P. Nicoski, chief technical analyst at US Bancorp Piper Jaffray, and Chrystyna Bedrij, chief investment officer at Griffin Securities. Both had the same admonition to private investors trying to play along at home this summer: Stick to a single strategic plan -- mostly price momentum, with a little value tossed in for good luck -- no matter what the thermometer reads outside. (I'll start with Nicoski's views today, and follow up with Bedrij next week.)

Beyond Simple Valuations

Nicoski began his Piper Jaffray career as a mainstream securities analyst. He gradually gave up on that dark art, however, when a deep understanding of balance-sheet fundamentals just didn't help clients in the bear market of 1973-74. "Some of the companies that analysts insisted had the best fundamental stories took a decade to recover their 1972 values," he recalls. "And it will happen again, as a whole host of highly regarded stocks will never recover their 1999 values."

He believes that the problem in 1973 and 1974 was that the methodology of assigning values was too simplistic. "If a stock sold between 15 and 30 times earnings and it got down to a 15x multiple, we called it a buy. And, if it was down to 10x, it was a strong buy, and, if it was down to 5x, it was a super buy! And that's when the fundamentalists gave up. The average stock lost two-thirds of its value by the end of 1974."

Nicoski says he began to sneak technical analysis books into his briefcase, and before long, his "uphill battle" to gain respect for research on price and volume action led him to make a single observation that rules his view on stocks to this day: "The key to success for investors is to understand relative strength."

He notes that even as tech stocks languished in a bear market from 1969 to 1974, other groups, like oils, surged to new highs. In the 1980s, the strong stocks were foods and drugs, as gold and other commodities languished. In the 1990s, it was back to technology. Buy strength and sell weakness, he says, and you will seldom go wrong.

Indeed, the quantitative analyst believes private investors today should stock up to 75% of their portfolios with issues that are outperforming the market and put the final quarter in deep-value stocks that are emerging from long periods of consolidation. To sum it up in a catch phrase, he believes in breakouts and bases, and shares this view in a monthly report published at the excellent Piper Jaffray stock-analysis site, GoToAnalysts.com.

Nicoski breaks his work into two parts:

The Microgroup Project, in which he refines a universe of 6,000 stocks into 500 narrow industrial groups, and assigns each group and stock a "TechniGrade" based on performance relative to its peers. This, he says, helps him see trends just as they emerge.

Moving Average Cycle Evaluation, or MACE, which helps him focus on how each of those 6,000 stocks is trading relative to its own recent history. He prefers issues that are trading above their four-week, 13-week and 26-week moving averages, but divides his entire universe into six groups: possible, confirmed and well-defined uptrend; and possible, confirmed and well-defined downtrend.

Once he identifies outperforming stocks in outperforming groups, he often adds one more trick before narrowing down his buy list: He determines which of these names are trading at the low end, or at least the median, of their historic six-month or 12-month price momentum. Most large companies' shares, it seems, trade at some steady ratio to their prices six months ago. When the ratio expands to two or three times its long-term average, he believes the stock has become overbought; when the ratio shrinks more than normal, the stock has become oversold.

You can plot this six-month price momentum oscillator yourself, by the way, if you're handy with a spreadsheet. Here's how:

Visit the charting area of MSN MoneyCentral Investor, run a five- or 10-year chart, then use the File/Export feature to send daily or weekly prices to a spreadsheet on your personal computer.

Six months above the last price on your table, start a column that divides the price in each row by the price six months earlier; that's your six-month momentum ratio. Do the same in the next column for the 12-month momentum ratio.

If you're extra handy with a spreadsheet, next use the Insert/Chart/Custom Types control to generate a "Lines on 2 Axes" chart to plot these ratios against the stock price. (It helps to change the X-axis scale to logarithmic.)

You'll see that the table and chart reveal the oscillation between times when the stock rose or dipped very much above or below its average 26-week and 52-week momentum ratios -- call them the M26 and M52 -- and what happened next.

I won't vouch for the predictiveness of this oscillator, but it does at least show that very often a stock is in its normal six-month and 12-month momentum ratio zone even near new highs -- as EMC Corp. (EMC) is today. Nicoski cautions that the method is mostly used for forecasting where stocks will be a year from now, not tomorrow, and that the best conditions arise when historically strong stocks' ratios both dip below 1.0. "My clients are mostly large institutions, and they are looking for inflection points that are meaningful -- not where they can get a few points in a month."

Tech Stocks Not Yet Out of the Woods

Putting all these techniques together to make a broad market call, Nicoski believes tech stocks overall won't be out of the woods for a while because -- though many have been hammered -- most are not oversold compared to their prices a year ago. "We've had a huge bounce, but, in some cases, that's all it was. There's a very limited number of technology groups at new highs," he said.

Among the current MACE uptrenders, he likes education-services stocks like Apollo Group (APOL), Career Education (CECO) and Learning Tree International (LTRE). In health care, he likes generic drug makers like Alpharma (ALO) and Barr Laboratories (BRL).

As for safely picking value stocks emerging from long-term bases, Nicoski suggests you stay away from recently crushed tech stocks and instead picture this cycle of infamy and redemption:

• Annihilation. A stock gets killed in a single day or a couple of weeks, usually resulting from news, such as a bad earnings report.

• Overselling. After a few weeks or months, the stock's six-month and 12-month momentum oscillators sink below 1.25 or 1.0.

• Consolidation. The stock moves sideways in a trading range at identifiable support for a long time -- and that's six to 24 months, not three weeks.

• Re-emergence. The stock's relative strength vs. the market improves even though the price appears to be mostly flat.

The analyst cautions against getting involved in a value stock until it powerfully pushes through its multiyear downtrend -- to make it simple, its 200-day moving average. "Where you get mixed up," he says, "is when you try to force something that's not there. And I think that's going to happen a lot this summer. A lot of false movements is what building a base is all about."

He sees quite a few stocks and groups that meet these criteria. They include hospital management companies HCA-The Healthcare Co. (HCA) and Tenet Healthcare (THC), health-management organizations like Oxford Health Plans (OXHP), drug wholesalers like Cardinal Health (CAH), thrifts like Golden West Financial (GDW) and Washington Mutual (WM), soft-drink companies like PepsiCo (PEP) and Coca-Cola (KO), real-estate investment trusts like Essex Property Trust (ESS) and shoe companies like Nike (NKE).

I'll track all of these ideas over the next year and let you know how they turn out. Next week: Chrystyna Bedrij's turn.

At the time of publication, Jon Markman owned or controlled shares in the following equities named in this column or listed in the SuperModels portfolios: ADC Telecommunications, Amdocs, Cisco Systems, Digital Lightwave, Kopin, Maxygen, Microsoft, Nokia, Nortel Networks, Oracle, Qualcomm, Siebel Systems, Superconductor Technologies and Xcelera.com Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He welcomes your feedback at [e-mail].

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