Forget War; Focus on Price - TheStreet

While stocks often seem to move in sync with political and social news events, the intersection is typically more coincidental than actual. And we are probably coming up to one of those moments when the two are going to disconnect.

"I don't care about the war," says seasoned researcher and investor Robert Drach, who profitably pays absolutely no attention to the guesswork of when and why. "Emotionally induced behavior has a very poor record." He can get away with his single-minded cynicism because his recommended portfolios have apparently never suffered a losing year (see his picks below).

For stocks today, the most important timing milestones are not future U.N. inspection deadlines or tax-bill votes in Congress but two dates in the recent past: July 24 and Oct. 10. On those otherwise unremarkable days, the broad stock market averages reversed sharply from hard downward spikes, creating isolated reversals, or bottoms, that loom large in the eyes and memories of investment pros.

To understand why, you should know that the ranks of market participants who focus on price action rather than fundamental business quality, called technical traders, have swelled in recent years in proportion to the ebbing of confidence in income reported by corporations. As bulls have lost faith in their ability to buy shares, simply because of estimates of asset value in relation to companies' lasting edge and earning power, they have turned to alternative methods of timing their purchases and sales.

Veteran technical traders such as Terry Bedford, whose views are profiled in detail in my new book,

Swing Trading: Power Strategies to Boost Profits and Cut Risk

, have long made the case that price and volume action tell everything you need to know about the demand and supply of stock anyway, and that fundamentals are interesting but ultimately unimportant.

Time to Kiss Lower Lows Good-Bye?

Bedford and his ilk, formerly out of the mainstream, now find themselves at the forefront of the market. Most spiked bottoms in the market, as well as tops, are given their exclamation points by big funds' massive program trades, which are tuned systematically to buy or sell all the stocks in the major indices at these technical turning points.

At the moment, those trading programs appear to be aimed like 105mm cannons at the lows established by the market on July 24 and Oct. 9. The key levels to watch are 775 for the

S&P 500

, 7489 or 7215 for the

Dow Jones Industrials

and 1192 or 1108 for the

Nasdaq Composite

. That's about a 7% drop from Friday's level for the S&P 500, a 5% to 8% drop for the Dow Jones Industrials and a 9% to 15% drop for the Nasdaq Composite.

Even traders who believe that deteriorating economic fundamentals, diminished fund-buying power and war threats ultimately will push the indices below their October levels are poised at this point for what technicians call a "test" of those lows. This means that if stocks continue to be pressured this week and next, bulls may ultimately concede a 7%-10% decline from this week's prices and only defend their favorite names at those lines in the sand. And it means that if you're just a private investor who's been sitting on cash for the right opportunity to buy beaten-down, high-quality stocks, a return to those lows is the moment you're waiting for.

Without doubt, the October level, since it is lower, is more meaningful than the July level. But here is where it gets tricky, for the market is a capricious beast and loves to pull a fast one.

Very often, successful short-sellers who see the bounce looming will start covering their positions early to avoid getting caught in the rush -- a job that's accomplished by buying stocks that have been pushed down a lot in recent months. And itchy-fingered bulls, seeing the unexpected pop in those badly battered names, often jump the gun and start their own bargain-hunting early. If both of these things happen at once, and something external to the market occurs to give investors a psychological boost, stocks can put in a new bottom that is quite a bit higher than the lows. And ever so enigmatically, folks who are waiting for an elegant "double bottom" are left waiting for an event that never occurs as stocks swoosh higher in a noisy rush.

It's quite possible, though not at all certain, that such a move began on Valentine's Day. If so, it would be a poetic moment to kiss lower prices goodbye and stick a short-seller in the eye. News reporters will declare that the switch from down to up occurred as a result of some geopolitical event, such as the erosion of war fears, while in truth the market was dancing to its own structural rhythm.

The Only Constant Is Change

Drach, of Drach Market Research and co-author of one of my favorite books on the game,

High-Return, Low-Risk Investment

, has also published one of the dullest and most homely weekly newsletters in America since 1977. His proposed positions rarely lose money, and that gives him the freedom of inattention to the niceties of marketing.

Drach likes to point out that investing is not a team sport, and that winners can only be successful at the expense of losers. He proposes that the best way to make money in the long term in the market is to never suffer the effects of negative compounding, so he scales into stocks only when he believes there is a 95% likelihood of a successful result. Those moments have been increasingly rare in recent years, and his followers have spent long periods of time with 20% or less of their funds in stocks. But when his quantitative "time overlay" method (see the book for an explanation) tells him that stocks have declined at a steep enough angle for a long enough period to justify exposure, he slides in over a two- to four-week period to take advantage.

It's always nice to call Drach when the market has cratered for several weeks straight, because you know you're going to hear what passes in his hometown of Tallahassee, Fla., for a happy voice. That was the case back in the third week of July last year, before the July 24 rebound, and it was the case again in the second week of October, before the Oct. 10 rebound. In both cases, his discipline called for buying stocks in a short window around the steepest part of those declines. And it called for unloading those same stocks after the follow-up steep advances. He ended 2002 with a modest 7% gain -- not a huge amount, but much better than the market benchmarks.

As you might have guessed by now, Drach told his readers to move 63% of their money into stocks a week ago. He expects to move to 100% invested if prices decline back toward those lows in coming weeks. "We're buying now when sentiment is negative, and we'll sell 'em back to the masses when they're happy campers again," he said. "It's all about buying inventory at wholesale and selling it at retail. The masses repetitively exhibit a mindset that whatever market condition they have most recently experienced will persist forever, when in fact, with all investment types, the most constant aspect is change."

Drach's Short List of Predictable Winners

His general theory is that most stocks don't have decent earnings predictability, so they don't deserve investment consideration. He focuses on buying only from a master list of 80 large stocks that hasn't changed much over the years.

You'll find companies such as tobacco makers

Altria

(MO) - Get Report

and

UST Inc.

(UST) - Get Report

; financials

Comerica

(GE) - Get Report

and

Bank of Montreal

(BMO) - Get Report

; and consumer stocks such as

ServiceMaster

(SVM) - Get Report

,

Johnson & Johnson

(JNJ) - Get Report

and

Home Depot

(HD) - Get Report

. He requires at least seven years of making earnings projections, notwithstanding a bad quarter from time to time, but he will boot a company if it misses too often.

"Extreme price dislocation in high-quality stocks attracts me to the market -- it's pretty simple stuff," he says. "It's pretty easy to be long here, with almost a third of our stocks registering lows in P/Es. It's times like these that give us a reasonable expectation of success. Irrespective of the prospects of recession, the decline in P/E ratios has been disproportionate."

For the past couple of years, Drach has yo-yoed in and out of stocks, but he thinks that the recent period of high volatility will come to an end soon, allowing him to stay in his new positions. The last time he recalls coming into a year with so much discounting was 1991, when he followed a 2% up year with a 35% up year. If he's worried at all about the prospect of hostilities, he wouldn't admit it. "I don't care about the war -- just the 95% probability of success," he said, scoffing at the question. "Emotionally induced behavior has a very poor record."

Drach is one of a kind. He permanently keeps the conventional wisdom sealed out of his mind with duct tape, and he never varies. His current picks are

MGIC Investment

(MTG) - Get Report

under $41.89,

Freddie Mac

(FRE)

under $55.18, Altria under $38.14, Bank of Montreal under $26.93 and

SunTrust Banks

(STI) - Get Report

under $55.71. If you are interested in some dividend yield, add UST under $28.45, ServiceMaster under $10.15 and

Schering-Plough

(SGP)

under $18.50. These are not to be held any longer than it takes to make a decent profit. I'll keep you posted on his views as the year progresses.

Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund held a long position in DeVry and Freddie Mac, but positions can change at any time.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.