Over My Head...

The article titled, The Use of Hurst and Effective Return in Investing by Andrew Clark, contains much that is over my head. But, that shouldn't dissuade me or you from diving in and learning what we can. Heck, any article that contains the following statement is definitely worth my time...

Ideally, a good performance measure should show high performance when the return on capital is high, when the equity/return curve increases linearly over time, and when loss periods (if any) are not clustered.

In the sentence above, Andrew Clark describes just exactly what all of us are looking for in designing, testing, and evaluating our trading systems.

Sorry for the lack of updates on the Melba Toast System. I've been very busy with other projects. But, haven't stopped dreaming up ways to capture the congestion. Here are just a few ideas that I will test as soon as I get the time:

• What if you count the number of weeks a stock closes above its mean and number of weeks closed below its mean? If the ratio of above to below is close to 1 then does that suggest a congestion range-bound area in the time series?



• Should we look for these congestion areas within a certain percentage from their all-time high? Or all-time low? Or both? Or maybe all-time high is too limited and we just need to look for a certain percentage from their 5-year high and low.



• Could using a stock's beta help identify congestion areas? Does the congestion area exhibit less beta than the market? Speaking of beta...has anyone ever attempted to create an indicator out of beta? Basically, the number of stocks with a beta above 1? If so, please share.

Well, that's it from here...where I'm looking forward to seeing Ricky Bobby on the big screen! Ha ha!

Later Trades,

MT

Quote of the Week

"I'm not smart, but I like to observe. Millions saw the apple fall, but Newton was the one who asked why." -- Bernard M. Baruch

Observation is important but the true key is the ability to open your mind to new possibilities. Without an open mind...you cannot see all that's possible.

Have a great week!

MT

Melba Toast Examples

This page will showcase all stocks that I find exhibiting the Essence of Melba Toast. The more examples I can find of Melba Toast...the better chance I have of identifying the logical conditions present in the pattern. So, this page will evolve as new charts are added.







MT

Quote of the Week

"No question is so difficult to answer as that to which the answer is obvious." -- George Bernard Shaw

Have a great week!

MT

Tom Basso Interview

I haven't fallen off the face of the earth. But, have been extremely busy at my day job. I'm also busy testing various ways to capture the sideways congestion in Melba Toast. The initial rules work to some extent...but after further tests...still don't capture the exact model I'm looking for.

So, I've decided I've got to go old school and start collecting charts of all the sideways congestion examples I'm looking for. I'm going to create a page on the blog and store the charts there. That way I can spend more time checking out the specifics of the moves. And hopefully find a way to logically explain the pattern I'm looking for. I'll post a link to this page in the next few days.

Until then, check out this great little interview of Tom Basso. Read the pdf here. Basso is one of my favorite fund managers in the Market Wizards book series. And in this interview Basso shares some gems.

Back-testing can be useful, but I recommend you go one more step. Print out the gory details.

I look for an indication that a trend either exists or doesn't. I like to look for those markets that aren't currently trending, the ones nobody cares about. Those are the markets that are likely to make a move one way or another.

If you mismatch what you're trying to do to who you are and what skills and resources you have, you're always going to be fighting it and never be in sync with it. If, on the other hand, you match your trading system to yourself, then trading can become as easy as breathing.

And don't miss Basso's famous money management test on a random selection of trades. Profits to losses were setup as a two-to-one ratio and the buys and sells were fed back randomly. The tests showed professionals focused on risk while amateurs focused on gain. Something to think about.

MT

Quote of the Week - Cowboy Up!

"If you're ridin' ahead of the herd, take a look back every now and then to make sure it's still there with ya."

We are so busy blazing our own path through the markets. We often forget what really matters...equity performance. Our job is to wrastle that equity to higher ground. All the talk, debate, yip-yap, and how often you're right isn't worth the bucket it sits on...if your equity isn't still there with ya!

Later Trades,

MT

Melba Toast - First Test

If you've read my first post on the system idea of Melba Toast...then you're probably wondering just how that simple little idea performed in market history. Now, remember...all we did was apply a few simple filters. We haven't gotten our hands dirty yet. That happens when we start focusing on patterns. And thanks to Damian for his pattern idea submission...which we'll be sure to use when we get to that point.

Now, when I get a rough set of filters built...I'll usually start looking for stocks that I want to pick up in the system. I do in this in two ways. The first is by using stocks that I've experienced the idea I'm trying to develop with. And I shared those with you in the first post. The second thing I do is run a quick backtest on a small subsection of the market to see what other stocks it's selecting. And to get a rough idea as to how on the mark the filters I'm using work.

Typically, I'll use the Nasdaq 100 to test with in the very beginning. Yes, I know...the Nasdaq 100 is a current snapshot of the Nasdaq 100. And it is the cream of the crop of stocks in the Nasdaq Exchange. So, if I'm looking for big gainers in the past...well the current Nasdaq 100 has them (and only them). In other words...the dice are loaded. But, regardless of these loaded dice I'm rolling with...using these stocks help initially in the test...let's me know just what the filters are picking up. And helps me find more examples to use in my development.

So, here are the results of the first test on the Nasdaq 100:

Win Ratio: 69.23%

Avg Profit: 180.34%
Max Consecutive Winners: 8

Avg Loss: -30.68%
Max Consecutive Losers: 2
Max Drawdown: -8.12%

Profit Factor: 12.54

Actually, not bad considering it's a first run. The profit factor of 12.54 is really nice considering I typically receive profit factors on first runs in the 5 to 8 range...if the idea has merit. Maybe we're on to something? :)

Here's some example trades from the backtest:







As you can see...some potential...but for the most part we're catching the stock a little too early in the process. I'm also worried that we might be filtering down too much. So, for the next test we might open the filters, especially the average price - the max closing low piece. Maybe less than 1 ATR is a bit too tight. We'll see. Until then...

Later Trades,

MT

Developing Melba Toast

I usually keep system ideas and designs to myself. I let my readers in on the mechanics of system trading such as money management, position sizing, etc. But, the actual generation and creation of a system has always been personal. And to be honest...never wanted to give away an edge.

I guess, times are a changing. I've decided to develop and test a system idea in real-time here on the blog. My point isn't to build a system for you, the reader. The point is to share my process...how I capture an idea logically. And more importantly how to continually develop and test until a) the idea's acceptance into the trading library or b) the idea's admittance into Heavenly Hills System Cemetery.

So, what's the idea?

Ever sell a stock out of boredom? When you bought the stock...it looked great. But, after months of underperformance...no better yet...after months of the stock doing nada...you sell. The good news is you didn't really lose money on the investment. But, didn't make any either.

A few weeks or months after closing out your position...the stock breaks to a higher level. Not by a whole lot...still higher than you've ever seen while holding the melba toast. Since the price isn't that much higher than your selling price...you ignore it.

Weeks...months...maybe years go by. Then, like the curiosities of an old flame, the mind wonders...what ever happened to that stock I held back in the day? Pulling up the quote in Yahoo Finance hits you like a Mac truck. That melba toast gained more than 10 times the price you sold it for. Oh, if only I had held it. If only I could stand a little fiber in my diet.

How many of these stocks have you encountered in your trading life? I've experienced plenty. Here are some examples.









About 90% of my equity is allocated to my systems. Around 10% is left as fun money. I can buy stocks for any reason and hold for as long or short as I like with this fun money. The examples above are trades made with this fun money. As you can tell...the trades were horrible. But, this fun money does two very important things for me.

1. Allows me to release the self-destructive side of my trading where I can participate a bit with the market masses without destroying my bottom-line.



2. By participating in the euphoric buying and panic selling sprees I feel all the things the masses feel. I know what it's like to put 100% of my fun money into one position and get hit like The Equities Research Center's FCL trade. To experience those feelings enable me to observe the patterns and more importantly generate system trading ideas.

And with that we get to the main point. How do we logically capture the stocks that go from nothing to something? The Melba Toasts of the world?

My initial thoughts are to identify areas in the time series where buyers are not rewarded. Basically, no new highs are made within a certain time period...let's say one year or 50 weeks.

What about the downside? I think it's okay for the market to make new lows...but not too much on the downside. So, maybe we can check the max closing low for the past year and compare against the average. How many ATR's is the lowest closing price from the 50 week average? Less than 1 ATR sounds about right.

What else? Hmmm...trend. Yes, we need to check the trend of the stock. We basically need a stock that is not trending upwards. So, trending downwards to a degree...or better yet...no trend at all will provide the maximum frustration for holders of the stock while still keeping them in it.

Let's also add a minimum volume filter of at least a 50 week average daily volume greater than 20,000 shares.

So, what do we have?

• No new highs within the past 50 weeks;


• (50 week average close - 50 week lowest closing price) less than 50 week Average True Range (ATR);


• No uptrend in place;


• At least 20,000 shares traded daily for the past 50 weeks.


• We'll slap a 2 * ATR disaster stop and a 3 * ATR trailing stop from the closing price.

Results? Here's what we've captured on the LGF chart with these rules in place:




Looks good, huh? Well, believe it or not...we've got one heck of a long way to go. LGF is just one stock. Now, the real work begins. And I'll have to leave that for another night. Until then...

Later Trades,

MT

Quote of the Week - Winners

"Winners compare their achievements with their goals, while losers compare their achievements with those of other people." -- Nido Qubein

Gotta admit, I'm guilty of this losing trait...comparing against others. And it's one I'm determined to work on for 2006. But, first...gotta make some goals. :)

Later Trades,

MT

Quote of the Week

"All progress is precarious, and the solution of one problem brings us face to face with another problem." -- Martin Luther King Jr.

Great quote isn't it? And very true.

Sidenote:
Looking for more information on money management/position sizing? There's a nice little thread from EliteTrader discussing the topic. Read here.

Finally, investors tend to believe sentiment is too optimistic if a top magazine's cover is bullish. Do we give equal attention to bearish magazine covers and their potential implications? It looks like we have a new test case: the current cover of The Economist. And it seems most people are missing the contrarian indications.

Have a great week everyone!

MT

Ed Seykota Student Interviews

Insightful post from Michael Covel on Ed Seykota's Class of 2002 here. Interesting bytes:

"To me trend following is more than an investment philosophy it is a way of life. Once I became familiar with how to stick with what is working and get rid of what is not, my personal life as well as my trading saw vast improvements. Unhealthy relationships and losing trades are cut and all I am left with are winning trades and rewarding, supportive relationships." -- Jason Dekker

"Trend following at its core is "simple", but the key lies in the consistent execution of a positive expectation system over time." -- Michael Covel.

Yes, simple is the trend following system. The complex is the consistent execution. It is amazingly hard to stick to a trend-following system year after year. Harder than this old country boy would like to admit.

Have a great weekend!

MT

Update on Innovating Exits...Graphs

I've updated the Innovating Exits post with graphs from one of the system's past trades. I've also described a bit of the system in the comments section of the post. Check it out.

I shared some quick research on Trader Mike's beloved T2108 indicator in a recent post of Mike's. You can read my comments here. Trader Mike uses the T2108 as an overbought/oversold indicator on a daily timeframe. I find it useful as a trend strength indicator on a weekly timeframe. Just goes to show...more than one way to skin a cat.

You know, there are just times when you need to jump on bike and get out of dodge. What better bike than this new one from Triumph...The Scrambler.


Source: Forty Years on Two Wheels.

Later Trades,

MT

Innovating Exits

I haven't written much on system trading lately. Mostly, because I've been wandering out in the deep jungle of quantitative finance and to be honest...got lost. I got so engrossed in theory that I forgot just what I was after.

Luckily, I found an old creek that led me back to my entry point. A little weary but a little wiser and more appreciative of the systems I currently trade. What's really amazing is after 5+ years of developing systems and trading them...the very first one is the most successful. And the second one is the second most successful. And the third is the third...and so on...and so on.

This reminds me of a programming conundrum that I run across all the time. When tackling a problem of how to program a certain piece of logic...my very first solution to the problem is always the best. And I don't know why. Because the solution I come up with isn't an "Aha!" moment. It's basically a thought that you "could" do it this way...but I'm sure there's a better way. And notoriously, there isn't. It's always that first split-second solution that is the most adept at cutting straight to the heart of the problem and getting the job done. Crazy, ain't it? Especially, if you're a logical type of person who believes the more thought applied to a problem, the better the solution will be. Wanna know what's crazier?

There are programmers out there who do not have this type of split-second solution ability. Or...they do and don't honor it. Allowing themselves to stew on the problem too long. Thus, the corresponding logic and code is horrible. These "gifted" programmers have a name...The Innovators. And know what? Nobody wants to support or work on an Innovators code. Funny.

Anyways, back to the post. One of my original systems (2nd one) has always had impressive entry logic. But, I never focused on the exit piece just because the entry worked out so well. The exit to the system is a cut-and-paste job from my first system's exit logic. Your basic run-of-the-mill ATR trailing stop. Take a stock's current price and subtract it's ATR multiplier. For example:

XYZ stock closed at $30.00.
Average True Range (ATR) for 5 days: $4.00
ATR Multiplier: 3
ATR Trailing Stop := Close - (ATR * Multiplier) := $30.00 - ($4.00 * 3) := $18.00.

This ATR Trailing Stop would scale up...never down...as the price of the stock closed higher and higher or as the stock grows less volatile. And then, if the price were to close below the ATR trail...you'd exit your position.

Get the picture? Now on to my system. The problem I've noticed after trading this system for a number of years is that investments (stocks) would exhibit very small ATR's for the majority of time but every so often experience a huge expansion of range for just one day taking the price many points higher. As a result, I'd get kicked out early in the long-term move because volatility would sink back down, price would sink back down, while those price spikes scaled me up on the trailing stop to a level that didn't fit with the overall move in the stock. Cause as I said before...we always scale our stops up...not down.



What to do, what to do? The easy solution was to change our ATR Trailing Stop formula to use the Average price instead of the Closing price to determine our trail. The new formula would look like this:

XYZ stock closed at $30.00.
The average closing price of past 20 days: $27.00
Average True Range (ATR) for 5 days: $4.00
ATR Multiplier: 3
ATR Trailing Stop := AverageClose - (ATR * Multiplier) := $27.00 - ($4.00 * 3) := $15.00.

As you can see, we decreased our trail 17% from the original trail. This might not be the right thing to do in most trading systems. Since most systems are trying to capture range expansion in some shape or form. But, if you're one of the few long-term traders out there who try to capture long-term moves...expansion is not your friend. It will shake you out prematurely. Changing the calculations in your systems to moving averages instead of just one or two price points...may help keep you with the trend longer.



Note: Please check out the comments for further detail on the type of system being used in the ATR Trail example.

Later Trades,

MT

Quote of the Week

"Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions, and prejudices so you can separate them from what you see." -- Bernard Baruch

The brain can be a wonderful tool or a horrific set of tinted glasses that bias everything you see. And these tinted glasses can be an extremely expensive accessory to wear in the market.

On to other things. My daughter and I are planning a Spring vegetable garden. Should be lots of fun. I figure there's no better way to teach her the following:

"Don't judge each day by the harvest you reap, but by the seeds you plant." -- Robert Louis Stevenson

And I hope the teacher learns as much as the student. :)

Later Trades,

MT

Quote of The Week

"In these times, when so much is written about the "money supply" and when some observers assert that an abundance of money will forestall a slump, it is interesting to note this comment by Senator Burton: "...paradoxical as it may seem, the starting point for crises and depressions may be found in abundance rather than in scarcity, whether of money or capital." -- Humphrey B. Neill in his book, The Art of Contrary Thinking, which was first printed in 1954.

True words of wisdom by the great Vermont Ruminator. In seeing all the wasted words spent on the yield curve conundrum this past week...I figured I'd waste a few more...

"The reason the contrarian needs to be aware of history, in this regard, is because changes in trend occur before the masses are consciously observant of the fact. Also, because when socio-political conditions seem to revolve and repeat, the average person (of brief memory) is unaware of the "cycle" and is likely to think that a "new" condition has developed." -- Humphrey B. Neil

So, what's that leave us with? Well, possibly we need to analyze the current trend in the markets. For a few years, the markets seems to have priced in a good sound economy. Do you believe the next year will see more of the same? Or will markets need to price in a little risk with that cup of joe?

Happy New Year everyone! I hope all have enjoyed their holidays. And gained focus on the tasks at hand for the new year. This year will be filled with many new events for yours truly. Found out last week that we're having a boy! Yeah! We are excited but our daughter is a little bummed. She was hoping for a little sister. But, once we told her that a little brother wouldn't play with her girl toys...she quickly warmed up to the idea of having a brother. Kids are funny that way. If only we as adults could be so adaptable.

P.S. This weekend I watched one of my favorite movies...Open Range with Robert Duvall, Kevin Costner, and Annette Bening. If you haven't seen it...you're missing out...Bucketmouth! :)

Later Trades,

MT

More Food for Thought

Thought these two posts were linkworthy...

Bill Cara shares his Rules for Successful Trading. Read here. My favorite rule? Rule #9: Take risks, not chances.

My wife and I were talking about the difference between Donald Trump and Warren Buffett last night. And it was just funny that I then find this post by the Daily Dose of Optimism on Trump's Rise to Wealth. Read here.

Just what were my wife and I discussing in regard to Trump and Buffett? Well, we were just making the case that Trump has a tougher row to hoe in staying rich because his wealth depends upon his lavish lifestyle. He has to project an image of a rich billionaire in order to keep his billionaire status. Buffett known for his value-conscious investments and lifestyle has a wider margin in his billionaire status. In other words, he can be cheap and still retain his status.

Gotta go...time to make cookies for Santa and Rudolph.

MT

Food for Thought

"Things should be made as simple as possible, but not any simpler." -- Albert Einstein

Diversification is Balderdash? Here.

This time it's different? First the New Economy and now the Inverted Yield Curve?. Here.

Baby Sitters, Protectionism, Starbucks, Export Bans, and the Bubble? Now that's my kind of economist. Read here.

Two great articles posted recently by Dan over at the The Art of Streetplay. Read Model Building Thoughts here. And Indexing the Answer here. He mentions a quote that "Stock picking is a very complicated process." I agree with that quote but with an addition..."Stock picking is a very complicated process because it is so simple."

Reminds me of programming projects I've worked on. Wanna know what the hardest projects were? Not the ones that seemed so complicated to understand at first that there was no way it could be done. Those ended up being fairly easy to design and implement. The simple little buggers are the ones that ended up causing the most problems. Time clock-in/clock-out systems for instance are very simple...yet very complex. I have spent more hours on time systems than I've ever spent on designing and implementing the merge of a sysplex into a 24-hour window. Y2K...very simple...yet very complex. Payroll...cut a person a check...how hard is that? Simple...yet complex.

Are simple things turned into complex things because of people? Or are simple things complex because the multitude of variables effect on the simplest of things? And people just happen to be one of those variables? Too deep for me.

I just know the more I study the market the less I end up knowing. A very humbling experience. So, I find myself over the years sticking more and more to the simple stuff which takes me into very complex directions. The vicious cycle of simple to complex to simple...never ends.

Happy Holidays!

MT

Quote of the Week

"Listen to what the market is saying about others; not what others are saying about the market." -- Richard Wyckoff

Nice quote. Don't listen to all the yick yack from others. Listen to the market. If the world is falling apart...is gold rallying? If we're going to have a rough 2006...how are the tech stocks doing? If gold and techs are both on the rise; what's Mr. Market trying to tell us? Hmmm...

While you're chewing on that...check out the two articles below.

The CEO of Raytheon, William Swanson, shares his management lessons...here. My favorite rules? Rule 30: Short them to the ground.

Bloomberg asks "What is Your Total Return?"...here. I have to admit...I asked myself one of the same questions mentioned in the article just a month or so ago. "Are you doing what makes you feel most alive? Does what you do add or subtract from your overall goals and happiness?" Careful about asking yourself this...life changes can occur.

Later Trades,

MT

Millionaire Next Door?

"Seeds are a lot like dollars. You can eat the seeds or sow them. But when you would see what seeds turned into...ten-foot-high corn...you don't want to waste them. Consume them or plant them. I always get a kick out of watching things grow." -- quote from Millionaire Next Door

Every so often I pull a book down from my library and skim through the pages just seeing what catches my eye. This morning I pulled down The Millionaire Next Door by Thomas J. Stanley and William D. Danko. This book uncovers some interesting statistics regarding millionaires in America. Here's just a few...

Self-employed people make up less than 20% of the workers in America but account for two-thirds of the millionaires.

About half of the millionaire's wives do not work outside the home. The number-one occupation for those wives who do work is teacher.

About 80% of millionaires are first-generation affluent.

Have more than 6 1/2 times the level of wealth of their nonmillionaire neighbors, but, these nonmillionaire neighbors outnumber us better than 3 to 1.

How to determine if you're wealthy? Multiply your age times your gross annual income and divide that figure by 10. This figure is what your net worth should be. For example, if your gross annual income is $70,000 and age is 34...then you're net worth should be $238,000. If your well under that figure...you're an UAW (under accumulator of wealth). If well over that figure...a PAW (prodigious accumulator of wealth).

The reason why I enjoyed this book so much when I bought it 3 or 4 years ago is because of its contrarian tale. Millionaires aren't the figures you have conjured up in your mind that live lavishly, spend furiously, and never worry about money. They're the people you overlook in a crowded room. The tightwads...driving used non-descript cars, working in dull industries, and loving every minute of it.

In fact, one of the few I do know is a welder in the backwoods of East Texas. Had him weld a car part for me a few times. Owned a pet raccoon, several dogs, and cats. Lives in an 80 year-old home with no central air/heat. Wife is a stay-at-home mom. He's around 40 years of age. How do you imagine a welder in a very small town struck it rich? He has sucked every last drop of opportunity from his land and welding business. Created a parking lot for overnight truckers where he receives money for parking as well as working on their rigs. Sells ad space on his high-traffic (for East Texas) road signs. The list goes on. And let's face it...he lives extremely frugal. The words tightwad have been mentioned several times when his name is brought up.

Another millionaire I know started out as a commercial fisherman on the lake. Ran trot-lines for catfish. Did fairly well in a barely break-even business. Then began an auto-repair business. Something thousands of mechanics have done. But, this one through extremely frugal living has turned it into one heck of a profitable business. And unbeknownst to many, has turned the land behind his shop into a very lucrative Pecan farm. Again, sucking the blood out of every last drop in his assets and being frugal with the returns have turned this local genius into a millionaire.

I'll leave you with one of my favorite stories of all time in regard to millionaires. It's one I have told over and over to many of my friends and coworkers. And best of all...it's from the Millionaire Next Door Book...

The first time we interviewed a group of people worth at least $10 million (decamillionaires), the session turned out differently than we had planned. To make sure our decamillionaire respondents felt comfortable during the interview, we rented a posh penthouse on Manhattan's fashionable East Side. We also hired two gourmet food designers. They put together a menu of four pates and three kinds of caviar. To accompany this, the designers suggested a case of high-quality 1970 Bordeaux plus a case of a "wonderful" 1973 cabernet sauvignon.

Armed with what we thought would be the ideal menu, we enthusiastically awaited the arrival of our decamillionaire respondents. The first to arrive was someone we nick-named Mr. Bud. Sixty-nine and a first-generation millionaire, Mr. Bud owned several valuable pieces of commercial real estate in New York metropolitan area. He also owned two businesses. You would never have figured out from his appearance that he was worth well over $10 million. His dress was what you might call dull-normal...a well-worn suit and overcoat.

Nevertheless, we wanted to make Mr. Bud feel that we fully understood the food and drink expectations of America's decamillionaires. So after we introduced ourselves, one of us asked, "Mr. Bud, may I pour you a glass of 1970 Bordeaux?"

Mr. Bud looked at us with a puzzled expression on his face and then said: "I drink scotch and two kinds of beer -- free and BUDWEISER!"

We hid our shock as the true meaning of our decamillionaire's message dawned upon us. During the subsequent two-hour interview, the nine decamillionaire respondents shifted constantly in their chairs. Occasionally they glanced at the buffet. But not one touched the pate or drank our vintage wines. We knew they were hungry, but all they ate were gourmet crackers.

When we interview millionaires these days, we offer a spread that is more congruent with their way of life. We provide them with coffee, soft drinks, beer, scotch, and club sandwiches. Of course, we also pay them between $100 and $250 apiece.

What are the three words that profile the affluent? FRUGAL FRUGAL FRUGAL.

Check out the book and more importantly, check out yourself and chosen lifestyle. Are you frugal enough?

Later Trades,

MT

[Edit: Corrected the calculation of "how wealthy you are." I miscalculated ($70,000.00 * 34) / 10. Does not = $280,000.00 but $238,000.00. Sorry for the mistake. ]

S&P 500 Index, Consistency, and Hot Stove Lids?

TraderMike posted a link to an article by Jon Markman titled, "The S&P 500 is a mutual fund - and a bad one." Before I begin my rant...first read the article. Really read it. Such things as:

"One myth that appears to be imploding along with the market is the notion that investors should “passively” buy the market via the S&P 500 Index ($INX) rather than buying individual stocks."

"This is not just a question of one company picking better stocks than the other. It’s a question of a flawed design that rewards sector momentum over common sense. Unlike most index publishers, such as the Nasdaq and Dow Jones, Standard & Poor’s adds and subtracts stocks from its three broad indexes -- the large-cap 500, the Midcap 400 ($MID.X) and the Smallcap 600 ($SML.X) frequently in accordance with a largely subjective list of criteria that includes market capitalization, liquidity and their representation of industrial sectors."

"It’s the latter criteria that got S&P into trouble in 2000 as it tried to keep pace with the explosive 1999 performance of the tech-heavy Nasdaq 100 ($NDX.X). Every month a number-cruncher at S&P adds up the total capitalization of all 9,000 or so stocks traded on U.S. exchanges, and determines the percentage representation of each broad industrial sector, such as technology, health care and capital goods. After technology stocks roared into favor in the late 1990s, S&P found that the market had given an 18% weighting to tech stocks while its index only had a 14% weighting. So the committee considered itself obligated to raise its weighting in tech stocks in short order."

"In 2002, S&P has continued its tradition of adding fast-rising stocks in the most popular industrial sectors to the S&P 500. In time, we will determine whether they were reflecting economic changes or simply the market momentum of regional banks, real-estate investment trusts, insurance and home improvement products. Top adds so far, in order of inclusion, are Plum Creek Timber (PCL), Ace Limited (ACE), Rational Software (RATL), Marshall and Ilsley (MI), First Tennessee National (FTN), American Standard (ASD), BJ Services (BJS), Apollo Group (APOL) and Simon Property Group (SPG)"

Markman posted this article in June 2002.Yes, 2002. Just 4 months before the bottom of the 2000 decline. Now, take a look at those stocks Markman mentioned being added to the index back in 2002.

Every single one of them are up and up pretty good I might add since their inclusion. Oh, sorry...Rational Software was bought by IBM and First Tennessee National by First Horizon...so they didn't go up as much as the others. But, a 100% hit rate isn't too shabby for a bad mutual fund as Markman calls it.

What does this say about Markman's theory on the S&P 500? His all-knowing implications of we'll just see how badly you fail by adding fast-rising stocks in the most popular industrial sectors? Hmmm...

I think Markman suffers from what most investors including myself suffer from...lack of consistency. That's why you have to admire a guy like Roger Nusbaum over at Random Roger's Big Picture. I've read his blog over a year now and he has stuck to the same investing approach month in and month out. Market does great or market does bad...he's the same. He might suffer from a lack of exciting material to write about at times...but better for that to suffer than his or his client's returns. There's a lot to learn from that approach.

Consistency. How do you become consistent like Roger? How do you get to the point of knowing your investment methodology will work long-term? And then trusting it despite what Mr. Market throws at you?

Maybe this quote will help...

"We should be careful to get out of an experience only the wisdom that is in it — and stop there; lest we be like the cat that sits down on a hot stove lid. She will never sit on a hot stove lid again — and that is well; but also she will never sit down on a cold one anymore." -- Mark Twain

Are we too focused on the hot lids of 1929-1932, 1969-1970, 2000-2002? Does that explain Markman's rant and his ever changing cycles shared with Neiderhoffer?

Have we forsaken consistency for market strategies that avoid those hot stove lids? Buy gold...market looks weak. Inflation rising. Warning, warning, warning Will Robinson. When the lid proves cold...what are we left with?

Or is our focus only on the cold stove lids? Buy the bull...everything looks great. The flowers are blooming and there's not a cloud in the sky. We're in stage 4 of the business cycle and firing on all pistons. Charge! When you burn your tail on the eventual hot lid with too much money on the line...what are you left with?

Maybe we narrow our focus and reduce the duration of our holdings hoping to side-step all lids regardless of hot or cold? Never sitting long enough in one spot even if that means we never sit down at all? Churn.

Perhaps Twain had it right...understand the market is filled with hot and cold lids (stocks). And that's it. Nothing more and nothing less. Focus on the goal at hand...finding a place to sit your money. If the plate is hot...get up and move to the next spot. Never sit long enough on a hot lid (cut your losses) nor put enough weight down on all lids (position sizing) to get burnt badly. Find a place to sit and do what cats do best...sleep (compound).

Goodnight,

MT