Stock Investment by the Charts : This Analyst Bases His Decisions on Technical Indicators
Dan Sullivan is considered one of the nation’s more successful stock pickers, but he’s one who doesn’t pay much attention to what’s happening in the outside world.
Sullivan lives and dies by charts and charts alone. He professes not to care about the state of the economy or the management of the companies in which he invests. In many cases, he doesn’t even know where those companies are situated or what they make. And he lives and works in Orange County, far removed from the Wall Street rumor mill.
Instead of relying on the fundamentals, Sullivan bases his investment decisions on sophisticated technical indicators such as relative strength, the advance-decline ratio and the “80/60” rule. His basic strategy is simple: Stick with a few good stocks for the long haul and cut losses before they add up.
That approach appears to have paid off. The Chartist, the biweekly stock investment newsletter Sullivan has been publishing for 19 years, has posted the fourth-best record since 1980 of more than 100 publications monitored by Hulbert Financial Digest, an independent investment newsletter tracking service. According to Hulbert, Sullivan’s recommended stock portfolio more than tripled in value from 1980 through mid-1987, modestly outperforming the market as a whole.
Sullivan, who grew up in Long Beach and now lives above his small office about a block from the ocean in Seal Beach, has drawn attention for having advised subscribers to stop buying stock in the summer of 1987. On Oct. 19, the Dow Jones Industrial Average plunged a record 508 points.
Sullivan admits that his strategy does not always work. He advised clients to unload most of their stock just before the recent market rally that carried the Dow average to a post-crash high of 2131 Wednesday. The blue-chip index ended the week at 2104.
Sullivan, who looks much younger than his 53 years, is an avid jogger who trains for marathons when he is not scanning the charts and writing his newsletter.
Sullivan discussed his investment strategy and his expectations for market movement in the future in a recent interview with Times staff writer Eric Schine. The interview reflects current stock prices as of Friday. Q. So you unequivocally put your faith in charts?
A. Oh, yes. I don’t believe in fundamentals. They can really throw you off. By the time you get information, it’s already old. I’m not saying that insiders act on it, but other people have information before you do. That’s why I say a high relative-strength stock will always have a good story. Pick the stock, then take a look at the fundamentals. Most people do it the other way around.
It’s not that I’m not interested in fundamentals, but you don’t want to get hooked on the story. Because if the stock starts to fall apart, you can rationalize ‘They’ve got great earnings’ and so forth. Then six months later, you’ll hear what went wrong, after the damage has been done to the stock.
Q. So charts can predict what’s going to happen?
A. I believe that they do predict the continuation of trends. It’s been scientifically shown that a trend, once in force, tends to persist. If the market was up yesterday, then the odds are that it will be up today. It does move in trends, and you are trying to capture a portion of the trend.
Q. What is your basic investment technique, and what tools do you use to execute your investment strategy?
A. I use a buy-high, sell-higher approach. I rely heavily on two basic signals: relative strength, which tells me when to buy, and the 80/60 rule, which tells me when to get out.
Q. What is relative strength? And how does it work?
A. The theory behind relative strength is that the stocks that are moving (higher) or that appear overpriced are actually not overpriced because stocks that are moving up have broad public appeal. The idea is to capture a portion of the move and enter the market at a time when there is still enough upside behind it.
Q. How do you know when a stock has relative strength?
A. Stocks that have relative strength resist the trend. For instance, if the Dow breaks to a new low, the particular stocks that I have under observation will be giving up ground very grudgingly. Similarly, when the market rallies, the high relative-strength stocks will break out to new highs ahead of the market.
The best time to use the relative-strength indicator is after there has been a (downward) correction or after a bear market. What distinguishes high relative stocks is that they hold up so well. They really make their presence felt.
Q. What are some examples of high relative stocks?
A. Three really good examples in recent years are Harcourt Brace Jovanovich, MacMillan and Liz Claiborne. I recommended purchase of these stocks in 1985 after there had already been a bull market for months. Harcourt Brace, which I sold in August of last year, returned 307%; MacMillan, which I sold on Oct. 6, 1987, returned 211%. Liz Claiborne, which I also sold on Oct. 6, gained 311%.
Some of the other big ones were Tandy, up 410% from July 1980 through April 1983, and Toys R Us, up 383% from 1980 through December, 1983.
Q. So you recommend stocks when many others would say that they’ve already had their run and couldn’t possibly go up much higher?
A. Yes. At turning points when I am entering the market, my stocks always look overbought, and they always look too high.
Q. Aren’t these moves just functions of a broader bull market?
A. Yes, but relative strength identifies which stocks are going to best participate in a bull market.
Of course, I’m just showing you when it works. When it doesn’t work, you have got to get out fast, because a high relative-strength stock can go down just as fast as it goes up.
Q. How do you know when it doesn’t work? Just a matter of cutting your losses?
A. It’s a matter of judgment. I use mental stop-loss points: If I buy a stock at, say, $19, I might put my mental stop loss at $17.50. A regular stop-loss order is when you call your broker and tell him you want to sell at a certain level. When it goes below that level, you are automatically sold out. A mental stop-loss is one you just keep track of on your own. If a stock closes below my mental stop, I sell. And that’s the discipline I always practice. I don’t rationalize; I admit my mistake, and I sell at the next day’s opening.
Q. Does this take a lot of discipline?
A. Yes, it does. It’s hard to do, but it’s really my cardinal rule, because if you get buried in just one wrong stock in one bad period, you are finished. That’s what happens to a lot of investors. Most investors take small profits and let their losses run. People just don’t want to admit a mistake. It deals a blow to their self-esteem.
Q. What magnitude of losses are you willing to take before deciding to unload a stock?
A. I don’t like to take more than a 15% loss. When it starts getting into that area, I’ll be thinking very hard of selling.
Q. How often do you pick a bad stock?
A. I had a good run from ’82 to just recently. But I would say that I am wrong half the time, at least half the time. But you have to recognize when you are wrong and when you are right. Then you stay with the good stocks for years.
Q. Which specific stocks do you like now?
A. One stock is Lin Broadcasting, an over-the-counter stock. It made new highs in January while the market was still down 500 points. It’s the epitome of a high-relative stock. Another is Windmere, also on the OTC market. And they are both participating very well in the recent rally, which got under way in late May.
Q. How far out does your time frame go? Is it long-term or short-term?
A. It’s long-term. I try to get into the market when a turn is coming. What I try to do is invest half of my money at the outset of what I see as a bull market. And I hold these stocks for two or more cycles, going for long-term gains.
If I do well with the first half, I put the second half in, and at the same time I gradually sell off the first half. When I put the second half in, I move the stop-loss on my initial investment up to at least the purchase price (of the first group of stocks) so that I’m limiting my risk.
Q. How long are these cycles?
A. Two to three years. One cycle began in 1982, and another began in 1985. In 1985, I was selling off the 1982 group as I was accumulating the second group because I found that the high-relative stocks hold up for just so long. So, you want to stay with them for as long as possible, but gradually you move over to another group.
Buying in two increments and gradually selling off the first group just when my second group begins to take hold forces me to take profits. So I buy on strength and sell on strength--or I prefer to sell on strength.
Q. You recently advised your clients to reduce their portfolios from about a dozen stocks to just two stocks. What prompted you to make that move and how has it worked out?
A. It was one of the worst calls I’ve made in years. I couldn’t have made it at a worse time. The market can make you look pretty dumb.
You are only as good as your last call. In this instance, I asked myself some really hard questions. I knew the market was oversold, which means that everyone who is going to sell has sold, and that the market was due for a rally. But, on the other hand, the stocks were just not acting that well, so I sold them. I’m very depressed about that decision now. Not only did we sell out just before the rally, now those same stocks are way up. It’s discouraging, but it’s part of the game.
Q. Which two stocks do you continue to hold?
A. MacMillan and Ball. I’m also recommending that traders hold Windmere, Alberto-Culver, Lin Broadcasting, Premark International and Unifi.
Q. Where are you parking your cash while you are out of the market?
A. In money market funds.
Q. Is the decision to pull out of the market just ahead of this recent rally going to seriously knock down your performance this year?
A. It might, but it’s too early to tell. That depends on what the market does. It looks pretty strong, and if it keeps going it will mess me up because it will have shaken me out of all of the high-relative stocks that I thought back in March had a great deal of potential. I bought them in March and was shaken out in May and then the market rallied.
Q. What do you see as the outlook for the stock market for the remainder of the year?
A. The market is rallying at the present time. It has broken above its 200-day moving average for the first time since October, and it has surpassed its post-crash highs, although it has pulled back somewhat. I’d like to watch it for a few more weeks, but I am really tempted to re-establish positions in some of the same stocks I sold.
Q. What would prompt you to get back into the market?
A. I look at a technical indicator called the advance-decline ratio. It is one of my favorite indicators. Investors normally use it as an overbought/oversold indicator. When it gets above 2.0, which means there are twice as many advancers as decliners on a 10-day moving average, many people would consider the market ridiculously overbought.
Q. Do you?
A. I’ve found over the years that when you have that kind of reading, rather than being in an overbought market, it’s really a measurement of the initial thrust of a rally that should last for at least several months.
Q. Where is the advance-decline ratio now?
A. It’s now at 1.23. It’s moved up since the third week of May, when it was 0.75, but it is still suspect. Back in 1973 and ‘74, the last significant bear market, there were a lot of tremendous rallies, and the advance-decline ratio got pretty close to 2.0, but not once did it hit 2.0. Not until 1975, and that was the beginning of the secular bull market that some people say we are still in.
If the advance-decline ratio goes above 2.0, I’m back in the market for sure. It has a fantastic record. Even if it doesn’t kick in, the market is looking very good, and there is a good chance that I will be back in sometime over the next couple weeks.
Q. Are there other momentum signals that help you determine when to get back in the market?
A. The other one that I like to follow is the 90-plus rule, or the percentage of stocks that are trading above their 10-week moving average. Whenever it moves over 90%, you can be sure that the rally will continue for several weeks and that it’s a safe time to enter the market.
Q. Where does this indicator stand now?
A. It’s lagging right now at 74%. It has a ways to go now. We had two positive readings in 1982 but haven’t had a reading since then. It did get up to 84% a few months ago but has since backed off.
Q. Does this indicator have to stay at or over 90% for any length of time for the signal to be valid?
A. No, it just has to hit it. It tells you that rather than the market being dangerously overbought, that once this kind of momentum kicks in, it’s actually a safe market to enter.
Another positive sign is the number of stocks reaching new highs, which has been expanding from about 10 new 52-week highs a day two weeks ago to 31 as of Thursday. This is not quite a sign of a healthy market, but it’s getting there.
A related indicator is the amount of money on the sidelines just waiting to get in. It’s like the house-buying panic in Southern California today. People tend to jump in when you have a buying frenzy.
Q. Where does this indicator stand now?
A. Currently, institutional money managers are on average keeping 10.8% of their assets in cash. That’s a very high number, more indicative of a bear market bottom than a bull market top. Once this cash kicks in, it could really fuel a rally.
Q. Do you prefer specific sectors of the market over others?
A. No. I take each stock on its individual merits. I will, however, find myself in a particular sector, but not because I’m zeroing in on that sector. In 1985, I ended up in a lot of publishing stock because their charts indicated high relative strength.
Q. You have the reputation of correctly anticipating the October, 1987, stock market crash. What tipped you off?
A. Last summer, the 80/60 rule told me to stop buying. I sold off stock and lightened my position to 40% cash. But more important, I didn’t do any more buying. This was at a time when all the other analysts were buying.
Q. What is the 80/60 rule and how does it work?
A. When a bull market has been in progress for many months, the 80/60 rule tells me there is danger ahead and that it’s time to be careful.
The way it works is that when 80% of the stocks listed on the New York Stock Exchange move above their 30-week moving average, followed by a drop to below 60%, it’s an almost sure sign that the back of the bull market has been broken. The momentum is lost.
Q. So it’s really an advance indicator of a turn in the market?
A. Yes. People still think it’s a bull market, and they are still encouraged, but it’s just a good indication that the momentum is beginning to wane. Last summer, everybody wanted to buy, and I was getting a lot of mail from my subscribers complaining that I was missing the boat. I wasn’t saying that there was going to be a crash, but it indicated to me that it was not a good time to buy stocks.
Q. When was this exactly?
A. May of 1987.
Q. The 80/60 rule is a signal not to buy, which is different from a signal to sell, right?
A. Yes, but it will sure save you a lot of money if you are not buying, because that’s where most of the money is lost. People get sucked into the top of a bull market.
Q. What advice would you give individual investors today?
A. I would tell them to keep their money in money market funds. I would also say wait a few weeks and see what happens to these indicators. And then, if they do go back in, I would suggest that they only invest 50% of their funds in the stock market and that they keep the rest in money market accounts.
