Martin Zweig Winning on Wall Street

Copyright

Copyright © 1986, 1990, 1994, 1997 by Martin E. Zweig

All rights reserved.

Warner Books

Hachette Book Group

237 Park Avenue

New York, NY 10017

Visit our website at www.HachetteBookGroup.com.

ISBN: 978-0-446-56168-6

First eBook Edition: June 2009

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Acknowledgments

I'd like to thank those whose contributions made this book possible: Joan Graff and Lisa Liss, who typed and retyped the drafts; Joe Di-Menna, Carol Whitehead, Tim Clark, Michael Schauss, Andrew Salamy, Catherine Nolan, and Tony Berkman of Zweig Securities, Ned Davis of Ned Davis Research and Ken Tower of Delafield, Harvey, Tabell for their research help; Debbie Drake (and Ned once again) of Ned Davis Research for their generous aid in doing the graphics; Jim Frost, Larry Kirshbaum, and everyone else at Warner Books; Nat Soble, my agent; Lou Rukeyser of Wall $treet Week and Alan Abelson of Barren's, who each, many years ago, gave me the opportunity to be heard or read when my career was embryonic; Jonathan Weiss, who taught me to trust my own stock market judgment; my mom and late father for obvious reasons; my late Uncle Mort, who first encouraged me to learn about the stock market; and most of all my friend and collaborator Morrie Gold-fischer, who first urged me to write this book and then diligently edited the manuscript and gave it cohesive direction, all the while abiding my idiosyncrasies and time constraints.

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CHAPTER 1

How This Book Is Different from All Other Books on the Stock Market and What It Can Do for You

If you are looking for a simple, reliable, and workable system for playing—and beating—the stock market, this book was written for you. I will show you how to avoid the most common investment errors, preserve your capital, and make a good deal of money as well. All you need is a willingness to spend half an hour or so a week keeping up with the market indicators that I will describe, and a commitment to maintain a discipline.

Let's face it. No one is smarter than the market all the time. If market forecasting were easy, everyone would be rich. Even Bernard Baruch, the legendary Wall Street financier, went broke early in his career. I don't have a crystal ball—and wouldn't want one. I've found that investors who rely on crystal balls frequently wind up with crushed glass. I'm satisfied if I can predict a market trend, get in tune with it, and stay with that trend as long as it lasts.

Since becoming an investment advisor, I have read most of the books on the stock market—not that I buy them; publishers send them to me hoping I'll promote them in my market letter. Sad to say, most of them are not very helpful.

Some books dangle the get-rich-quick bait. How I made $1,000,000 overnight without trying. These are just plain hype. What they're selling is the end of the rainbow. Greed is a very powerful emotion, and a lot of people buy these books hoping that, by following an offbeat formula, they will immediately find that elusive pot of gold. Of course that's impossible. The world just doesn't work that way.

Other books may not make extravagant promises but offer systems—simple or complicated—for playing the market or picking stocks. A system is not necessarily a bad tool, but many of these are ineffective or worse. It is said that no girl was ever ruined by a book, but I suspect some would-be market plungers would come pretty close to ruining themselves if they tried to implement these schemes.

Then there are the virtual encyclopedias on investments, books that span the spectrum from options to precious metals, from Ginnie Maes to Freddie Macs, from commodities to collectibles. They describe every vehicle comprehensively, but I don't think such overwhelming detail equips you very well for the nitty-gritty of investment decisions.

I should also mention books like those by Adam Smith and Andrew Tobias. They entertain with great anecdotes, humor, and bits of wisdom. And that's fine; they serve a purpose and the general reader will get useful advice from these books. But they don't offer a system for making money in the market.

However, don't despair. There is valid academic work that proves conclusively that a few methods do exist for "beating the market." I have incorporated these tools into my stock selection techniques and have junked those methods that are popular but, unfortunately, futile. With this book, you can find the proverbial "edge" in playing the market.

I am proud of my winning Wall Street track record. Since the mid-1980s when the independent Hulbert Financial Digest began rating advisory services, through 1995, my Zweig Forecast showed a total return of 898.9% which, on a compounded basis, equalled a 16% annual gain for the period. I was the number-one stock picker for two years straight and Hulbert ranked The Zweig Forecast number-one for risk-adjusted performance for the fifteen years through 1995.

The job of selecting stocks should never be taken lightly. It's tough to be a consistent winner. Although Wall Street spends millions each year analyzing stocks, the best available research indicates (1) that analysts cannot consistently predict earnings—which makes such strategies as buying growth stocks at any price multiple rather risky (as many institutions have found in recent years); (2) that mutual funds and other institutions as a group have failed to beat the broad market averages over the years regardless of their methods; (3) that such technical tools as charting and relative strength don't predict any better than pure chance; and (4) that expensive and lengthy research reports from brokerage houses generally fail to pinpoint stocks that outperform the broad market.

My proven methods for market forecasting and stock selection, painstakingly developed through trial and error over the years, are suitable for both conservative investors and those who wish to trade more actively. My principles have been extensively tested and are all verifiable and thoroughly documented in this book. They work!

I can't possibly include all the variables I track on market activity because it would get hopelessly complicated. So I have simplified my approach to make it understandable and workable for the nonprofessional reader. In this regard, I have tried to follow Albert Einstein's dictum: "Don't make things simple. Make them simpler."

THE FUNDAMENTAL INDICATORS

First I would like to tell you about my basic approach to investment decisions. Most people think of me as a technician, but actually, I use anything that works. If they worked, I'd track the planets or sunspots, or even use a Ouija board. Instead, I rely heavily on a group of fundamental indicators.

The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movement of interest rates. To monitor these and other vital trends, I have devised several simple indicators, described fully later in the book, that I have found very reliable.

My guidelines include purely technical indicators. I refer to this factor as the tape action, or momentum, in the market. Here I combine various price and volume indicators to measure the actual behavior of an individual stock or the overall market. To appreciate the role of momentum, think about a rocket ship being launched to the moon. If it takes off with a lot of thrust, it has a chance of making it out of the earth's atmosphere. If it doesn't, it will turn around and flop back. Broadly speaking, the market behaves in a similar fashion. To me, the "tape " is the final arbiter of any investment decision. I have a cardinal rule: "Never fight the tape."

If you buy aggressively into a bear market or into individual stocks that are performing badly, it is akin to trying to catch a falling safe. Investors are sometimes so eager for its valuable contents that they will ignore the laws of physics and attempt to snatch the safe from the air as if it were a pop fly. You can get hurt doing this: witness the records of the bottom pickers on the Street. Not only is this game dangerous, it is pointless as well. It is easier, safer, and, in almost all cases, just as rewarding to wait for the safe to hit the pavement and take a little bounce before grabbing the contents.

I also follow closely the degree of optimism and pessimism in the marketplace and will share with you my key sentiment indicators, which provide an early-warning system to detect market trends. I believe you'll be surprised at how wrong so-called expert opinion can be.

Last but not least, I monitor what I call the fundamentals—the actual value of a particular stock. That includes analyzing earnings, dividends, and balance sheets. Fundamental analysis doesn't do much for forecasting the broad market direction but is very important for individual stocks. I use fundamentals for probably 90 percent of my input on stock selection but for not more than 10 percent of the weight in predicting the market as a whole.

Big money is made in the stock market by being on the right side of the major moves. I don't believe in swimming against the tide. It's rare for me to recommend stock purchases when my market-timing models are bearish, or a short sale when the reverse is true. I would like to be fully invested when the market goes up and fully in cash when it goes down. But the market couldn't care less about what I like. The idea is to get in harmony with the market. It's suicidal to fight trends. They have a higher probability of continuing than not.

Actually, about two-thirds of the time markets are either neutral, or rising or declining moderately. Under these conditions, the trend of the market isn't so crucial and you might trade profitably by selecting the right individual stocks, although the returns would not be nearly as great as those in a strong bull market.

PICKING WINNING STOCKS

In addition to describing my various indicators and how you can use them, I will discuss my criteria for choosing individual stocks. Here I look at two main areas. One covers the earnings and the relationship of the price to the earnings (the P/E ratio), the earnings trend, and a few balance sheet items. I don't get that much involved in the product being produced. If a company can show nice consistent earnings for four or five years, I don't care if it makes broomsticks or computer parts.

The second factor I examine is the action of the stock itself, to see whether it is performing well. If the stock is going to climb, I'd rather let somebody else buy it at the bottom. I want to see if the stock acts well relative to the market before I buy it. I find that buying on strength gives you an edge. You must pay a premium, but you increase the probability of being right.

People somehow think you must buy at the bottom and sell at the top to be successful in the market. That's nonsense. The idea is to buy when the probability is greatest that the market is going to advance. If a bear market were to bottom at 4000 on the Dow, and eventually go to 6000, you don't have to buy at 4000. You can buy at 4300 if the probability were, say, 90 percent that it would go higher.

And you don't have to sell at the peak. You might sell after the top or maybe a little before. Let's say you get out at 5700 when the probability is very good that the market will decline. There's nothing wrong with buying at 4300 and selling at 5700 and giving the other guy the last few hundred or so points either side. What you are concerned with is the probability of success or, alternatively, the probability of losing money. You want to avoid loss. So it's fine to buy above the bottom and to sell below the top.

According to my rulebook, the only consistent way to make money in the market is to cut losses and run with profits. You can be right on individual stocks as little as 30 percent of the time and still do well if you can get out when the getting is good.

Regrettably, many investors haven't learned this lesson. Ego prevents them from admitting a mistake. Perhaps there's something macho about it. A slap in the face, as represented by a 15 percent price decline, is greeted with stubborn persistence to hang around for a severe pummeling. I'm a trend follower, not a trend fighter. I'm smart enough to realize that a slap is easier to recover from than a beating that, in this case, leaves you unable to pursue future gains.

I have found that, in this business, you usually have to make mistakes in order to come up with something that really works. In fact, the whole idea of using momentum as a stock market indicator (which you'll read about in chapter 5) came to me as a result of mistakes that made me miss a major market move. Several years ago a client of mine gave me an abstract painting incorporating this quotation from Benjamin Franklin: "The things which hurt, instruct." I keep that painting and its message in a prominent place in my office.

As a risk-control strategy, I use a system of stops (sell orders at predetermined levels) that I will describe in depth later in the book. This gives me the discipline to avoid fighting crippling battles. Basically what I do is place a stop, generally 10 to 20 percent below the current price, whenever I buy a stock. The exact level depends on my own analysis of the stock's trading pattern. If a stock violates this stop, I'm out with no second-guessing and no regrets. I admit my mistake, but also view it as an opportunity to find something better. If the stock goes up, I'll tell you how to raise the stop to lock in profits. That way you can let your profits ride … but with the protection of the trailing stop.

To illustrate this market strategy, I will give real-life examples of the stocks I have recommended in the past, both winners and losers. I'll relate when stops took me out of stocks that eventually became disasters and, unfortunately, when I was stopped out at the low point and wistfully watched the stock climb higher. If it's a volatile stock, a random downward move might take you out. That's happened before. But so what? There's always another stock. In the long run, the probabilities favor using stops.

A FLEXIBLE INVESTMENT PHILOSOPHY

And now a word about my investment philosophy. I consider myself both conservative and aggressive. By nature I'm conservative. I'm very risk averse. I want to protect myself and the people who follow my advice. But there are times when you have to be aggressive. The problem with most people who play the market is that they are not flexible.

The conservative person tends to stick with such instruments as utility stocks and Treasury bills. He never makes a lot of money, but he doesn't get hurt. The aggressive investor buys wild stocks or drills for oil or speculates with high leverage in real estate. During boom times he makes fortunes, only to lose it all in the bad times.

I don't think either approach is sound by itself. If you're an aggressive trader, that's okay, but there's still a time to be conservative. If you're conservative, that's fine, too, but there's a time to be aggressive. That moment may not come very often, but when it does, pounce on it and take advantage of it. The rest of the time you can cut back and be your conservative self.

People sometimes ask me what traits an investor should have if he wants to succeed in the market. I tell them discipline is the most important—the discipline to follow your method or system and not give in to all the temptations that might weaken your resolve. The broker calls you with a hot tip. Forget it. Someone else says, "Why don't you buy some call options on Interplanetary Bionics? You'll make a fortune." Forget it. Stay with your discipline.

The second trait necessary for beating the market is flexibility. Let me give you an example. I remember back in February 1980, when I thought the market was going to get the stuffing beat out of it. Sure enough, it started to unravel and came down very hard. That was around the time the Hunt brothers cornered the silver market and everything began to collapse around them. Some brokerage houses were on the verge of going under because of bad loans to the Hunts, and we were close to a financial panic. I was very bearish.

Then, one day in March, without advance warning, the Federal Reserve came to the rescue with the bailout provision for Bache & Co., one of the brokerage firms involved, and stemmed the tide. What they did was send a message to Wall Street that no brokerage firm was going to sink because of the debacle. The market, which was off 27 points at 3:30 P.M., spurted and closed down only two points on the day. That was one hell of a rally in the last half hour. The next day the market went through the roof.

I was sitting there looking at conditions and being as bearish as I could be—but the market had reversed. Things began to change as the Fed reduced interest rates and eased credit controls. Even though I had preconceived ideas that we were heading toward some type of calamity, I responded to changing conditions. Each day I got less bearish and more bullish. By May I was a screaming bull and 100 percent invested in the market. A pretty decent bull market ensued for the next year or so.

Summing up, to succeed in the market you must have discipline, flexibility—and patience. You have to wait for the tape to give its message before you buy or sell. That means you must forget about trying to catch the exact tops or bottoms, which no one can consistently do anyhow. But success in the market doesn't require catching those tops and bottoms. Success means making profits and avoiding losses. By using the indicators in this book and waiting for a trend to develop, you can make money, stay in tune with the tape and interest rates, and, best of all, sleep better at night.

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CHAPTER 2

How and Why I Got into Market Analysis and Stock Selection

The fall of 1948 was a special time in my life. I had just started first grade in East Cleveland, Ohio, and I thought school was great. The whole town was nuts over the baseball team. The Cleveland Indians were about to win their first world series in twenty-eight years (they haven't won one since), and their march toward the championship became our special project in room 10. I was the kid who knew most about the team, thanks to my dad, who used to take me to games even if it meant playing hookey some afternoons.

I knew every player's uniform number and even had a vague idea about what batting averages meant. So I was in my element when we cut out little paper Indians, drew numbers on their backs, and hung them in the classroom. I had begun to love numbers. Perhaps this was a tip-off that I would later gravitate to the stock market and apply my numbers approach to it.

Later that fall came the presidential election in which Thomas Dewey was supposed to trounce Harry Truman. A church next door to my house was used as a polling place. Its parking lot, which I had always regarded as my private playground, was decorated with American flags. Cars and people were everywhere, making it necessary to call off my daily game between the Indians and the Boston Red Sox in which I played for both teams. Somehow, the Indians invariably won, although some of the games were exceedingly close.

I was disappointed the day after the election when I found an empty parking lot, no American flags, and no fun. There was also little joy in my house that evening. Usually my father would look up from the Cleveland Press sports page to tell me the latest news about the Indians from the hot stove league. This time his face was buried in the stock market pages. His expression was as sour as it had been the day I broke the living room window with a baseball.

My father mumbled something about Truman and what a disaster he was for the stock market. I had no inkling what he meant. To me the stock market was a fuzzy thousand numbers in the newspaper, none of which I understood at six years of age. In fact, I thought it had something to do with socks or stockings. But I surely knew my dad was unhappy.

I eventually learned why my father was so distraught that day, aside from the fact that he had voted for Dewey. Wall Street thought Dewey, the Republican, was a sure winner and was shocked when Truman, the Democrat, scored an upset. The market reaction was devastating. The Dow Industrials plunged 3.8 percent the day after the election, roughly the equivalent of a two hundred and fifteen-point drop in mid-1996. On the New York Stock Exchange, thirty-six stocks had declined for every one that advanced. In all the years since then, the daily advance/decline ratio had never been worse until October 19, 1987, the day of the crash.

My father died when I was nine years old. A year later my mother remarried and we moved from Cleveland, where I was born, to Miami, Florida. My interest in the stock market began in earnest when I was thirteen. For my birthday, my uncle Mort, my father's brother, gave me a gift of six shares of General Motors stock. I thought that was terrific. Each day I would search the stock listings to see how General Motors had fared. I didn't know why prices fluctuated, but I enjoyed tracking my own stock. I also looked forward to receiving the small dividend payments every three months. The checks whetted my interest even further, and I began to follow a few other stocks of the day.

Later on, in a high school American history class, we learned about the famous industrialists (some called them robber barons). By chance I chose to write a report on a book about J. P. Morgan. I was fascinated by his life story, and I believe it was at that point I decided that I wanted to become a millionaire—and that I would do it via the stock market. Nothing in J. P. Morgan's life proved to be any guide to me, then or now—he's not one of my heroes. It was just a case of an enterprising man making it big in the market, which served to inspire me.

I began to pay more attention to the performance of various stocks. I remember an occasion during my junior year in high school when, in a discussion about the market, the teacher asked, "Does anyone know the name of the stock that sells at the highest price?" Well, no one else in the class knew beans about the stock market, but I raised my hand and said, "I believe it's Christiana Securities." I was right—and the teacher almost fainted. (I think the stock was around $1500 at the time.) I even managed to say I thought Superior Oil might be the next-highest stock. Again I was correct and the teacher was incredulous. So far my stock market knowledge was only secondhand.

I graduated from Coral Gables Senior High School in 1960 and was accepted at my first and only college choice—the University of Pennsylvania's Wharton School of Finance. I had selected Wharton because I wanted to study business and, of course, the stock market. Also, it was the best undergraduate business school in the country. It still is, although I might have an axe to grind since I now sit on its board. (To be fair, Harvard and Chicago don't have undergraduate business schools.)

In the fall of 1960 I began my four years at the Wharton School, still eager to learn about the stock market. But our first-term class schedule, which was set automatically, didn't include any stock market study. That was for upperclassmen. The course closest to my interest was economics, taught by Professor Murray Brown, and I vividly remember his opening remarks. He said most of us had probably come to Wharton to learn how to make money and his course would not be much help in that regard. Well, he was only partly right. If you master the lessons of economics and the laws of supply and demand, it's bound to be beneficial in business or the stock market.

My first few weeks with Professor Brown were touch-and-go, from his side as well as mine. Things came to a head when we were discussing the coming presidential election between Richard Nixon and John Kennedy. Professor Brown went around the class asking each of us, "Are you a Nixon supporter or a Kennedy supporter?" I resented this inquiry, believing that my political convictions were my own private business. When he came to me with the same question, I replied, "Neither. I'm an athletic supporter."

The class cracked up and Professor Brown was appalled. He responded with a snappy comeback: "You mean you're a jock?" Well, I had been a jock of sorts in high school. I was on the basketball team and had played just about every other sport as well. But I really didn't mean to be a wise guy. I was just trying to puncture what I thought was a hot-air balloon. Unfortunately, he had a terrible impression of me from the incident.

I may have been irreverent, but I was serious about learning all I could about economics and business. I just wasn't comfortable with the Ivy League atmosphere. Perhaps I was still in a state of cultural shock coming from Miami to Philadelphia, although nowadays I go into culture shock going to Miami. But that's another story.