Apprenticed Investor: Tracking Elephants, Part I

The latest "Apprentice Investor" column is up at TheStreet.com. Its called  "Tracking Elephants, Part I." 

Don’t be fooled by the title to this piece: "Tracking the Elephants" could just have easily been named "The non Technicians Guide to Technical Analysis (in two parts)." The idea was to reveal to fundamentalists a few of the more significant ways they can use charts to improve their results.

Podcast:

Here’s the ubiquitous excerpt:

"Here’s an interesting question: If you could look at one and only one source before buying your next stock, which would you choose: a fundamental analyst’s report (with no charts in it), or the chart of your choosing?  While I like having access to both, I cannot ever imagine buying something without first looking at the chart.

And so we wade into the ongoing battle between technical and fundamental analysts. Frankly, it’s one of the sillier debates in investing. But I’ve heard so many bad arguments and misleading theories about technical analysis that I decided to weigh in."

Before we wade too deeply into the controversy, ask yourself: "Why do I need to choose?" Why wouldn’t you use any tool that can be shown to have value? You wouldn’t build a house using only a hammer, but no drills or saws. Why limit yourself away from a tool that can assist you as an investor?

In the column, I used a chart of Ford — but it could have been just about any company , from JDSU to Lucent to World Con or Enron.
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Ford’s Downtrend
click for larger graph

Prior columns can be found here.

To keep the column a modest length, a discussion about Janus Funds
selling of AOL Time Warner was edited out.  For your reading
pleasure, that section is here.

Podcast:

MP3 File

Here’s a DVD extra scene which did not make it into the final cut of the film:

"As we discussed earlier, institutional size positions can take months or even years to unwind. A downtrend is nothing me than the footprints of that distribution in chart form.

A specific example may make the point clearer: When AOL merged with Time Warner, it created a problem for several mutual funds, especially for Janus Funds. At the time, they were one of the largest shareholders in both companies. Many of their mutual funds had significant positions in each. The merger meant that one company would be disproportionately represented in various portfolios. Typically, funds put a cap on positions: They do not want any one company to grow to more than 5% of the portfolio.

click for larger chart

Suppose a fund owned 5% of Time Warner and 5% of AOL. The combined company would become 1/10 of the fund. That single outsized holding could defeat some of the purposes of actively managed funds — diversification, lower volatility and reduced risk.

After the merger, AOL Time Warner had about 4 billion shares outstanding. Some estimates put Janus owning (across many of their various tech funds) nearly 25% of the outstanding shares of the combined companies. You could just imagine the conversations that took place at that time. This concentration simply wouldn’t do. So Janus made the rational decision to reduce their exposure to AOL Time Warner.

Here’s why they call it distribution: AOL trades about between 5 and 10 million shares a day. If the fund’s selling made up half of the daily volume – a huge percentage — it would take 200 trading days (about 40 weeks) to sell a billion shares.

Who wants to step in front of that sort of relentless selling? Unless you knew when the distribution was ending — and you can see why institutions try to keep this secret — you were nearly guaranteed to be upside down almost immediately.

That’s the first and most important lesson of technical analysis: stocks that are trending down are likely to keep going lower as institutions continue to distribute shares.

The same rules apply in the jungles as they do in investing: Do not get trampled by the elephants.