The TSC Streetside Chat: John Bollinger of EquityTrader.com and Bollinger Capital Management

There's a tendency among many people (some of whom write for TheStreet.com) to view all technical analysis in the same, derisive light. The chartists, they argue, are the numerologists and phrenologists of capital markets, and should be taken about as seriously.

There are certainly some technical analysts who live up to this reputation, folks who will drone on about the importance of the number three, or the significance of a 45-degree angle on a chart (change the scale, buddy), or will tell you about the significance of a head-and-shoulders pattern in the Federal Reserve's target rate. Hello?

But then there are people like John Bollinger, who heads up EquityTrader.com and Bollinger Capital Management. (He also invented Bollinger Bands, a charting tool that comes with most analytical software.) For Bollinger, a chart isn't some world within itself, which moves according to its own, inherent laws, but a reflection of investor psychology, a look into the market's Rorschach.

Nor is Bollinger doctrinaire. He's going to think about the fundamentals. He's going to look at what's going on in the market and consider what the chart says about that. Technician? Fundamentalist? The lines get blurred. "I'm neither," says Bollinger. "My religion is success, you know."

Bollinger stopped by the offices of TheStreet.com recently to talk about how he views the market and what he thinks about the market now. Participating in the chat were Aaron Task, David Reilly, David Shabelman, Justin Lahart and Tom Lepri.

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TSC: A lot of times, people think that technical analysis is mumbo-jumbo, some sort of voodoo. It seems that sometimes technical analysis is very good at gauging the psychology of the market, but it also seems that some of the things people are doing just don't work very well. What do you consider good technical analysis, and what do you consider bad technical analysis?

John Bollinger: Yes, it's like anything else, as you point out. There is good and there is bad. There are some technicians doing things out there that I think are ludicrous.

There are other technicians doing things, I think, that are very informative, and very cogent, and very important. Unfortunately, that fact has been recognized over the years by both the academic community and the street community. So great portions of what were once technical analysis have been made off with by other groups and renamed. A great portion of what was once technical analysis is now called quantitative analysis. "Psychology is the technician's job. We are nothing more than practicing psychologists, except the market is our patient."

So there has been a tacit admission on the part of many players of the value of technical analysis. In doing so, the technician has been marginalized a little bit, because such large, important blocks of the craft of being a technician have been co-opted.

To me, you hit the nail dead on the head in your question. Psychology is the technician's job. We are nothing more than practicing psychologists, except the market is our patient. All we are trying to do is get in touch with the prevailing psychology and the prevailing trend of that psychology, and trade in accord with it.

To a lesser extent, we try to identify areas where that psychology might change and reverse, and to transition from long positions, short positions or vice-versa at those times. But, the bottom line of the practice, as practiced in ways that I recognize, is that it is primarily a psychological approach.

TSC: You said there were some forms of technical analysis that had utility that some of these others don't have, that had less utility.

John Bollinger: You're trying to get me in trouble! There are, essentially, two approaches. There is the internal structure, the internal order of the markets approach, which I think is ... I don't know if it's worthless, but it's worthless to me. I am unable to practice that approach. Then there is the psychological, the understanding of investors and what motivates them and how they act, how they're likely to react to the data that they're presented with. That's the area that I like very much.

The internal order of the universe, the conspiracy theories -- my favorite one is back from the '50s, you know, the specialist is out to kill you. All of that, to me, was completely ludicrous. The internal order of the structure, conspiracy theories, I think really have no useful place, at least in my work.

The rest of this stuff can be extremely useful on the analysis of price, as it relates to supply and demand, the analysis of volume as it relates to how people are motivated to transact, why they might be motivated to transact. These things, I think, are very important and can really add value to a portfolio. And that's what we're talking about here, is adding value to a portfolio.

TSC: How would you gauge the psychology of this stock market today? What do you think is going on?

John Bollinger: Actually, I think the psychology of the stock market today is fairly good, on average. There's obviously a pretty big split.

There are times when the market's pretty cohesive, and people pretty much share the same opinions for a long period of time. I don't think we're in that now; I think there's a much more diverse sampling of opinion at the present."It's the longest, most powerful bull market that has been known in modern times ... after the current round of tightening ... we'll probably see it continue."

I think the primary idea here is the demographic idea. I think a lot of Americans are at the height of their productivity, or at least within shooting distance of being at the peak of their productivity, and they recognize that the time is going to come at some point, and they're seeking to prepare for that.

Obviously, what I'm focusing on is this bulge of people coming through, the baby boomers, but I think that psychology affects younger people just as dramatically. There's a basic [feeling] that Social Security either won't be there, or won't be meaningful to them when they retire, and so they feel that they need to provide for themselves and that equities are the best way to do so.

I think that's the major force behind this huge expansion in the bull market that we've seen and is now 27 years old. It's the longest, most powerful bull market that has been known in modern times. I suspect that after the current round of tightening on the part of the monetary authorities, we'll probably see it continue.

TSC: In the shorter term, do you expect a period of strength here?

John Bollinger: No, in the shorter term is that diversity, that broader diversity that I alluded to. I think we really had a speculative blow-off in the first quarter of this year. We saw a classic speculative bubble, and I think it's going to take a long time to unwind that.

A 40% drop in the Nasdaq over a six-to-eight week period certainly was enough damage from the price perspective. If we go back and examine past bear markets, we're right in the middle [range] of what one would expect. Almost precisely in the middle, actually.

But I don't think enough time has passed, so really we're in a trading-range environment. It's going to be a big trading range, because the moves coming into it were big moves. I think that trading range will prevail into the fall, and I think the market is essentially what we call trying to look across the valley. "We'll rally a bit here, into the middle of the summer, then work our way back down to the bottom of the trading range and prepare ourselves for the fall trench."

They see the Fed tightening, they see the economy starting to weaken, and they're hoping that the Fed won't become obsessive. That it will stop at a reasonable time and that the economy will simply slow, and strengthen again. And the stock market is trying to look towards that strength on the other side of whatever economic weakness there is.

I think that right now is a pretty good time for stocks. I think we'll rally a bit here, into the middle of the summer, perhaps, then maybe work our way back down to the bottom of the trading range and prepare ourselves for the fall trench. And I think, completely, it will be very important to buy the fall trench this year.

TSC: What would you say, short term, are the key resistance levels for the major averages this year? Do you think we'll revisit the old highs?

John Bollinger: You know, it's a very diverse environment out there, that's the interesting thing. I think it's unlikely that, in this range, we'll revisit the old highs in the Nasdaq, but the Value Line has already clicked a new high. That, again, is another reflection of this diversity that we're seeing here. I think that some averages will actually manage to eke out new highs, perhaps meaningful new highs, in certain sectors, the OSX [the Philadelphia Stock Exchange Oil Service Index] and the XOI [the Amex Oil & Gas Index]. The gas index [the XNG], too. Those three might well make meaningful new highs.

The more democratic indexes, like the Value Line, stand a very good chance of making meaningful new highs. The cap-weighted indexes are going to have a much harder time. I think we're shifting towards smaller stocks here. It's a natural rotation. We've had our big-cap binge largely for this portion of the cycle, and people are focusing on small-cap growth here.

In general, I think the name of the game is earnings visibility. People have been pretty burnt here in companies that had earnings promise, but no actual earnings, and now, the salve for those wounds is 42 cents this quarter, 48 cents next quarter -- a nice, understandable earnings progression that they can look forward to. The flip side of that is for people who are going to explore -- I won't say riskier, but more aggressive ideas -- I think that the area that they're going to explore is small-cap growth.

TSC: Can you be specific on what [small-cap] stocks you think look attractive right now?

John Bollinger: I'd prefer not, in the small-cap area, because it's a little tougher, but I think there's a trend out there that people can exploit, where there is liquidity, and we're not playing the who's going to mark the stock up higher tomorrow morning game.

We're seeing a rotation away from small, and if you look at the indices, that rotation is very evident. The best performing index out there, today, is the S&P Mid-Cap."It's like a python eating a pig ... The lump moves through the python."

And what's happening is that managers, professional managers, are rotating out of big-cap; they're slowly making this transition and buying smaller and smaller and smaller and smaller. It's like a python eating a pig, or something. The lump moves through the python. It's very useful for the average investor who's going to have a very, very hard time picking the right individual companies to use these indices that allow you to participate in there.

We have a meaningful position in the S&P mid-cap spiders, plenty of liquidity there, easy to get in and out. Several of the big mutual funds companies have taken the Barra Indexes, where they've split them into the growth of value components. So you can buy mid-cap growth; that's the place to be right now.

As that cools down, the place to be after that is going to be small-cap growth. And, frankly, for most investors, the index approach is going to be far more viable, because information is much harder to acquire about small-cap growth stocks than it is about mid-cap or large-cap.

TSC: Where should single and individual investors look to see that the pig is passing from the mid-caps down to the small-caps?

John Bollinger: I think very, very simple analysis works here. Ratios, S&P 500 to the mid-cap, mid-cap to the small-cap -- there are two ratios that you can keep.

What I'm looking for is a period of out-performance of the smaller stocks, so I take the mid-cap divided by the S&P 500 -- the S&P 400 divided by the S&P 500 -- and when that line starts to turn up -- and it's been turned up now for quite some time -- that tells you that money is flowing from the big-cap area into the mid-cap area. Same thing, take the S&P small-cap and divide it by the mid-cap, and when that line turns up, then you see the money moving further down the python.

Actually, in this case, the mid-cap, I'm not certain that you'll have to leave the mid-cap this cycle, because portfolio managers need liquidity, and they're going to find more liquidity in the mid-cap stocks than they are in the small-cap stocks, so I think you're going to see a continuing flow of money towards mid-cap, and you may never really have to feel obliged to actually move from mid-cap into small-cap."They're going to have to go profitless over rough, washboard-like circumstances ... before that sentiment is quelled sufficiently for it to be the base for another leg of expansion."

TSC: There still seems to be some evidence that the speculators, for lack of a better word, are still out there. Is that something that's just with us now, or is it something that you worry means we're going to have another blow-off?

John Bollinger: They're two different things. I think the increased volatility is a fact of life and you better get used to it; it's particularly driven by the speculators. I think there are many competing and very powerful forces out there. I think the level of participation is very high. [There] is a wide diversity of opinion being expressed, and I think all those factors add up to more volatility.

To answer the other segment of the question, I don't think that the beating the Nasdaq has taken was sufficient to crush this speculative sentiment. I think that's a function of time. I think they're going to have to go profitless over rough, washboard-like circumstances for some time before that sentiment is quelled sufficiently for it to be the base for another leg of expansion.

I do think there are fabulous opportunities being created out there. And those people who are savvy enough to know the individual situations, to understand the companies, to understand what their real worth is, etc., will do very well. But there's also so much synergy between these companies that one company's misfortune in the stock market affects many other companies in a way that we really haven't seen before. So many deals and so many partnerships, so many structures are stock-driven, or have stock components now, that I don't really understand how to analyze that part of it, but I think that's probably an ongoing negative.

TSC: Do you think, as we go into this summer period -- if the Nasdaq and other cap-weighted indices don't reach new highs on the leg up -- that that will disappoint people, and maybe flush out some of the speculation?

John Bollinger: Yes, absolutely. I think that's going to be a big part of the puzzle. I think it's highly unlikely that the Nasdaq will make a new high this summer. I think the disappointment associated with that will be part of the -- we use the term "compression" -- "psychological compression," beating down the spirits, [that will] create the launching pad for the next move. "They have other tools besides interest rates that they haven't really used yet."

Who knows how the scenarios are going to work out? Let's suppose -- just for one really paranoid scenario -- that we get a quarter-point move from the Fed, because the Fed believes in some of this weakening thing and thinks, oh, we'll just top it off a quarter and walk away from it. And then suppose you get a couple of strong, whopping economic reports and the Fed comes back with a vengeance later in the summer and the early fall, and really raises rates, and does some of the other things that they haven't done. They have other tools besides interest rates that they haven't really used yet.

That, coupled with the failure of the Nasdaq to make a new high and a few other bits and pieces, make a dramatic fall trench. I don't particularly think that's going to happen, but it's certainly one of the scenarios out there.

From an investment point of view, what you really need to do is create a bunch of scenarios so you understand what the worst case is and what the best case is, and then modify them as the facts come out, and play the most probable path. But if you don't understand what the upside is, what the downside is, it's very hard to understand the central path. What we do, really, in the market, is just muddle through. That's the bottom line. We rarely crash, nor do we launch to the moon. Most of the time, we just kind of muddle through a mix of good factors and bad factors, creating a fair amount of uncertainty.

One of the reasons for volatility is a relatively high level of uncertainty. The collapse in the Far East of a couple of years ago, the birth of the euro, the disturbances in South America, and many other factors contribute to an overall level of global uncertainty on the part of investors.

Soros gets tagged for -- what's the latest number you've seen, 30% of his portfolio? We're talking about the savviest hedge fund operator that's ever been getting clipped 30-plus percent. There's a huge amount of uncertainty out there; that's one of the major factors behind the volatility.

TSC: I can't help but think if someone heard what you just said, they would think you were a fundamental analyst, which I guess gets back to the original question about what technical analysis is.

John Bollinger: Well, think about it this way for a minute: Draw a circle. This circle contains all the fundamental facts that we know. Draw another circle over here. This circle contains all the technical facts that we know. Then push those circles together. There's an area where they overlap; that area is the area I operate in. I call it "rational analysis." It's the juncture of the sets of fundamental and technical analysis. So I'm neither a technician nor am I a fundamentalist. I am solely interested in portfolio returns. And anything that can contribute, I'll use.

It's interesting that technicals often are the best tools for understanding the fundamentals, because the price action often happens way in advance of the event. So, in many, many, many situations, you're clued off that there's something wrong, or something unexpected, or something changing by the technical facts, and then you can go out and do your detective work and uncover the fundamental facts that are creating this change. This is the ultimate expression of capitalism in my view. The price formation mechanism is at the very center of this equation.

The technicians, to the extent that they focus on that price-formation process, have a handle up on a lot of other people. The price-formation mechanism is the central issue ultimately, however flawed it is.

TSC: Do you think when you have a mania like that it represents a bring-down in the price-formation mechanism?

John Bollinger: No, not at all, I think that's just one extreme. It's like statistics: We're taught that there's a normal distribution and that there are tails. Well, the tails go on a long way. So we need to expect the manias; they're part of the process, they're part of the structure, they're part of the markets and the air pockets in stocks and the vertical ramp-ups. They're out on the tails, but they're to be expected."If we all went from point A to point B we'd just be crowds of lemmings, but this more dramatic path is both creative and destructive, and is a very important part of who we are."

There's much more extreme behavior in security prices than there would be, say, in manufacturing light bulbs, or some other process that you could model through statistics. If you examine security prices, the tails are dramatically fatter. Those fatter tails mean that you need to expect more outlying events, more dramatic events that are anormal. I think manias are not only a part of the process, but I think they're necessary. They inform society in a meaningful way; they have a structural function in terms of the psychological lessons that they teach the people who are involved in them.

And that volatility is a very, very helpful, formative influence. If we all went from point A to point B we'd just be crowds of lemmings, but this more dramatic path is both creative and destructive, and is a very important part of who we are -- the joy and the creative capabilities of who we are.

TSC: So what is the most important psychological lesson that individual investors should have taken from this most recent mania or continuing mania?

John Bollinger: It's a basic lesson about life. It's a kind of, don't let greed blind you -- that's one aspect of it. It's OK to be involved, it's important be involved, but don't let greed blind you. Don't ever become too credulous. Always question. Always think. Always be alert.

I think the real bottom line is, bring your critical thinking facilities to work with you every day and use them. Don't become a passive member of the crowd. Think. It's hard, it's not comfortable, it's much easier to go along with the corporate culture, the social culture, but I think the lesson of all manias, not particularly this one, is that independent thinking, critical thinking, is of the highest importance.

TSC: Thanks very much.

John Bollinger: My pleasure entirely.