Daily Graphs, eamings are reported

in quarters, with the next quarters projected eamings included. If the correlation holds, then on the bull side, if the rate of change of eamings growth (change in eamings over time) is less than the rate of change of prices (the change in price over time, or the slope of the price trendline), then the stock is a buy. If the rate of change in eamings growth is equal to or greater than the price trend slo pe, then look for a better stock. The reverse holds tme on the bear side.

If you trade a stock on this basis, with other technical reasons included, I want to wam you about something: so many people trade on eamings that estimated quarterly eamings rep orts can kill you, particularly on high PE stocks-they sometimes crash very fast. Find out when the actual eamings figures come out, and if the stock is near its highs, get out before the reports come out. If they come out less than expected, the stock can easily gap down and your accumulated profits will disappear!

The whole idea of looking at yield and PEs is to identify stocks with strong growth potential. Actually, however, rate of change of eamings growth is the primary number to look at for finding growth stocks. Yield, for example, is dividend divided by price. Obviously, a high yield can result from a high dividend being paid by a company with a depressed stock price. But why is the price low? Because eamings are poor!

Both Citicorp and Travelers had declining prices but increasing yields for six months or so as of July 1990. The companies have kept up their dividend payment while the stock price has been falling. Since the stock prices have fallen in greater proportion than eamings, the PEs of b oth stocks have also fallen. What you have in this situation is two stocks with low PEs and high yields. Does that make them a good buy-a bargain?

I dont think so. What if both companies continue to perform badly? PEs and yield can be very misleading, if not viewed in the context of eamings growth. I often think in terms of the phrase, "Wherever a stock price goes, there it is!" It is a good reminder that it is highly unlikely that you will spot an underpriced stock before the rest of the market.

Let me give you an example which illustrates why eamings growth is such an important aspect of picking stocks. Eighty percent of all companies listed on the NYSE pay out 30 to 65% of their eamings in dividends-those that eam money. Assume the stock of a young ompany is selling at $10 per share, is currently eaming $1 per share, is paying a $.50 dividend (50% of eamings and a 5% yield), and has a rate of eamings growth of 25%. Both the PE of 10 and the yield of 5% are mid -range, and say little about the stock as a buy. But the 25% rate of eamings growth tells a lot more!

With a 25% growth rate, the companys eamings will double in 2.9 years. Assuming the same percentage dividend payment, if you buy the stock now, your yield will double in roughly three years, and double again three years after that. If the stock continues in its rate of eamings growth, you will pay out your investment, in dividends alone, in less than eight years, not to mention the equity appreciation

you would most likely enjoy. Pick ing stocks based on yield and PEs alone will tell you nothing about

this kind of potential.

Other Fundamental Considerations

There are a few other fundamental considerations which I use to make a final decision if, on balance, everything else is equal in choosing between two stocks.

First, given two equal bullish charts, I would pick the lower PE stock as a buy. Conversely, if both charts were equally bearish, I would pick the higher PE stock as a short. Graham and Dodd lives as a minor consideration!

Second, in a buy, I would always choose to buy the stock of a company in a less leveraged position over a company in a more leveraged position; the greater the leverage, the greater the susceptibility to a credit cmnch. The converse is tme in a sell. Third, whether buying or selling, I always trade the stock with the most shares on the market to ensure liquidity.

As a final consideration with respect to the fundamental approach, part of being a speculator in the stock market is being able to judge whether or not a new product or service offered by a new or established company will be accepted favorably by the market. In these kinds of cases, the traders in the stock markets are sometimes wrong, and either fail to anticipate consumer demand for a great new

product or overanticipate a new product that bombs.

I dont very often participate in these kinds of speculations, but they are speculations nonetheless. The reason I dont is that there is no way to measure the odds. This is where I think simple common sense comes into play. If a new product is great, tastes good, is unique, is well marketed -if you believe it is going to take off big for common sense reasons then by all means, buy some stock if you can afford to lose your investment.

A Few Extra Words about Technical Methods

Aside from the technical tools in this and the last chapter, there is one more thing I want to add about the technical evaluation of stock charts. Basically, all of the tenets of Dow Theory apply to individual stocks; they just arent quite as valid.

In any statistical study, the more samples you have, the more repeatable the results are likely to be. A single stock has many of the characteristics of a market average index. For example, the sum of all knowledge about that stock is expressed in the movement of the price. Volume relationships are much the same. The psychology of the stock cycle is much the same. Most things are the same. But the first premise of Dow Theory is that it is not infallable. The same is true for individual stocks, nly more so. Also, you have to draw all inferences for individual stocks without the benefit of another index for confirmation. Nevertheless, it is useful to apply Dow Theorys technical observations to individual stocks.

CONCLUSION

At this point, we are equipped with a simple but powerful set of technical tools with which to approach analysis of price movements in the financial markets. We move from the general principles and concepts of Dow Theory, to primary technical considerations, to secondary technical considerations, to some more particularized technical and fundamental considerations for individual stocks. In the next chapters, we will add some powerful, common sense, fundamental economic considerations to our speculating arsenal.

THE JIGSAW PUZZLE

Imagine trying to put together a 10,000 piece jigsaw puzzle that had no picture or pattem for reference. Assume that all the pieces were the same shade of gray, and each was cut in a similar pattem with only slight variations. The process of solving the puzzle would not only be unendurably tedious, but the only result would be a meaningless gray smear in the shape of a rectangle. Do you think you would seriously attempt to solve such a puzzle? I doubt it. Although you may question the motivation of the designer, you would probably shmg it off. leaving it to those eccentric few that could find some obscure purpose in its solution.

Most people view contemporary economics like the hypothetical jigsaw puzzle -tedious and unrewarding-and economists as eccentrics looking for a solution to an unendurably complex puzzle. It is difficult to see the relationship between mnning a business or pursuing a career and economic theory as it exists today. But it can be a financially fatal error to shmg off economics as po intless if you want to make money in the financial markets. It is the designs of theoretical economists and the alleged solutions to economic problems instituted by bureaucrats and congressmen that largely determine the long-term course of business activity and the direction of price movements.

If you already watch the markets, you have seen equities, debt, and futures prices respond dramatically to news of the level of the new budget deficit, to the Federal Reserve Boards policy regarding the availability of money and credit, to reports on the Treasury Departments policy regarding the value of the dollar abroad, or to mmors of new trade legislation. The markets concede that the govemment holds the club that can break the back of American business. A huge part of successful speculation and investment now rests on anticipating the nature and

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effects of govemment fiscal policy, monetary policy, and interventionist legislation on specific markets and on the general business cycle.

Our economy operates according to market principles, but the govemment sets the stage-and its a secret, rotating stage subject to change at any moment. But if you understand the errors in the economic theory that motivate the stage managers, you can anticipate the new s et and position yourself to act profitably. Therefore, understanding economics has everything to do with successful speculation and investment; it provides the foundation for any good system of market forecasting. Let me put that last statement in perspective.

I went to New York City and Queens College to study economics but found it almost completely worthless except in a reverse sense; that is, I gained knowledge of what is wrong with conventional economic thinking rather than what is right.

My formal schooling gave me an understanding of the predominantly Keynesian ideas that our govemment uses in making policy decisions. Studying on my own, however, I discovered that the conventional wisdom taught in most universities was contradicted by th inkers such as Adam Smith, Ludwig von Mises, Frederick Hayek, Henry Hazlitt, Ayn Rand, and others. I leamed that Keynes was little more than a sophisticated mercantilist and a bubble builder. I identified the contradictions inherent in Keynesian economic s and discovered the tight economic principles in the Modem Austrian School of Economics.2 And I began to see the profit potential of riding the govemment bubble in the initial stages of inflation, jumping off early, and being on solid ground when the bu bble bursts, waiting to pick up the pieces.

I dont think you need formal schooling to obtain the economic knowledge needed to succeed in the

The Way The World Really Works: The Basics of Economics