How Not to Get All
Shook Up by Volatility

By Lynn Carpenter

So far, in our hunt for volatility we’ve gone where few true-blue investors dare tread. We’ve looked at volatility and exposed its threat to trailing stops. We’ve looked at how you can preview how much a stock is likely to go the wrong way before you should be worried by using ATR —average true range.  Now we’re going to talk percentages.

Instead of asking, “does this stock swing by a dollar a day?”—which is a big move on a $5 stock and nothing on an $80 stock, we want to know whether it normally jumps up and down by 10% or 30% and how often.

As we did last week, we are going to rob the traders’ tool chest to get the answer. And I promise you, this one is so easy, you’re going to fall over, gob-smacked with joy at how simple it is.

There’s a little gadget you can find at stockcharts.com and similar sites that I long ignored. I use technical tools a lot for The Optionist, to find options trades, so I’m apt to borrow what works for investing help, too. All’s fair in love, war and trying to beat the market, right?  And though the overlay called “Zigzag” looked neat, it didn’t help me unearth a stock about to go ballistic. It’s mostly used by people who do Elliot Wave predictions, which I most certainly do not.

In fact, all the “Zigzag” thing seemed to do was trace and simplify what a stock had already done. It showed how many times a stock reversed up or down by a selected amount. … Then the light dawned.

How often a stock reverses by a certain amount is a pretty big thing to know if you are considering one for investment.  It might even make you change your mind about buying it. And you would definitely want to manage a stock that has a habit of dropping 30% a couple of times a year differently than you would a stock that hardly ever falls by 20%.

Let’s say you are feeling really risk averse. You want something calm but good for a special trust fund. You would rather have a stock that climbs slow and steady, as long as it doesn’t give you sleepless nights by going down more than 12% very often. You have two stocks that seem to have the qualities you’re looking for. Which one is better for your purposes?

Look at these two charts. To make the Zigzag easy for you to see, I have reduced the price to “dots.” The line you are looking at is the Zigzag tool if it is set at 12%...

First a tech stock you might expect to be volatile, Taiwan Semiconductor:

Then a stock you might expect to be fairly stable, Nike:

What a surprise. Taiwan Semiconductor doesn’t drop 12% any more often than good old Nike does. But, as you can also see quite easily, when it does fall it tends to make bigger moves. Since I set the Zigzag chart for 12%, each time the line changes direction, it means that the stock moved at least 12% the other way. Or more.

This is the one catch with Zigzag.  The lines just keep going as long as the price stays on its trend. But this little problem is easily solved.

Just change your Zigzag setting.

Let’s say you are still trying to decide between Nike and Taiwan Semi. They both go up and down 12% or more about as often. Do either of them have a habit of dropping 25%? Easy to find out. In Stockcharts, you just go to the overlays for Zigzag and change it to 25%:

And instantly, you will have your answer. Could there be anything easier than this?

Nike is a champ at staying calm. It took this year’s bad bear market to finally move the stock down by 25% for the first time since 2002. (I used a monthly chart this time because Nike has so little volatility to show.)  

Taiwan Semi, in contrast, is working on its fourth 25% or greater drop in four years:

You can see that anyone with a 25% stop loss has been taken out of Taiwan Semi several times.

About this time, if I were anyone else, I would be quoting you that excellent bit of boilerplate: “past performance does not guarantee future results” and so on and so forth.

You already know that. Sure, it’s true, but it’s not an issue for our purposes in today’s example, which was choosing a calm stock for a trust fund. Or simply getting a feel for how often a stock moves and how big its moves the wrong way tend to be.

The truth is that even longtime blue-chip steadies can get themselves into trouble. For example, Citigroup and its credit fallout. Technical tools cannot predict news or foretell stupidity, unless it’s a recurring feature, that is. Just look at steady-Citi take a dive:

In most cases though, when you are dealing with well-established companies and stocks, their past performance is very much the face of their future. Taiwan Semi is probably going to continue to reverse and make bigger moves than Nike for years to come, given its cyclic business. But it is also so well established that its bad years in the near future are probably going to be a lot like recent bad years, too.

Strictly speaking, Zigzag doesn’t predict where a stock is going or when it will turn around—next week’s volatility tool is the one that does that. But Zigzag is a nice, quick way to look at how often a stock tends to drop 10%, 25% or whatever number you’d like to know. Change the parameter setting and you can check for any level you want.

What We Take from This

• Established stocks with steady management tend to behave predictably; that’s why Zigzag is useful in showing likely behavior.
• Zigzag will give you a fast scan to show how often a stock reverses direction by a set amount or more.
• The tool is preset at 9.77%, but you can change it to any number you like.
• Use a weekly or monthly chart to get a longer picture.

People who do Elliot Wave analysis (which I do not) use the tool for reading 3-5-3 cycles and such. To the rest of us, it has no real predictive usefulness for pinpointing when a stock is about to turn. But that’s OK. Because there’s another volatility tool for next week that also runs on percent and does give some hints when reversals seem to be brewing.

Respectfully,

Lynn Carpenter

P.S.  To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.

Market Watch

This is a Strange Recession

By Lynn Carpenter

Falling confidence, weak dollar, wasting employment, backtracking GDP… many things point to a recession, but it’s certainly an odd one.

Productivity is rising, for instance, and is up 3.2% this year. That’s not the kind of thing you see in China, but it’s a good strong number for the U.S., and in a recession, any gains are unusual. 

Even more puzzling, capacity utilization is also high at 80.1%, though that is down a half percent from last month. In short words, factories and businesses are running briskly, using 80% of available space and resources. We never hit 100%. An 85% level would be the equivalent of all hands on deck.

As you can see from the chart above, a number like 80.1% typically occurs when the economy is healthy. In the past two recessions, the gray bars on the chart, capacity utilization (hereafter dubbed “caput”) dropped to the 70s.

What could this mean? We know that factory orders for durable goods are down somewhat, which is odd if everyone is producing at close to the normal pace. It should mean more finished goods are ending up on the shelves than in customer’s hands. But so far, there’s no sign that inventories are fattening.

Either this recession has not really begun and the utilization number is on its way down to the 70s, or the economy’s problems are more localized than everyone thinks. Almost all economists believe the credit crisis from mortgages and their derivatives has spread to the entire economy. Even if that had not soaked through the whole wadding, the rocketing price of fuel should be spreading its harm across all areas.

These puzzle pieces don’t fit. But, as I mentioned in March though, the caput number smoothes over some weakness. This is why inventory is not stacking up, because the reported number is for the total caput. The production of finished products is only at 76.9% capacity, and that’s in “slowdown” range, though not as low as the 2001-2002 recession. Manufacturing in general comes in at 79.2%, just slightly below normal. There’s more weakness in utilities, though. That area now measure 85.2% of capacity compared with an average level of 86.8%.

It’s the strength in the third component that is masking these slowdowns. Mining is now operating at 89.2% of capacity, which is notably higher than this group’s 87.5% average and far above the 83% and 84% levels it showed during the past two recessions.

This also helps explain why production figures are holding up as well as they are. We are producing very well—in mining.

Still, the whole picture is looking much better than I expected so soon. Let’s hope next quarter sees more improvement. Then we can put another one behind us.

As soon as we get the cost of gas and groceries under control, that is.

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