Things I learned from Martin Zweig’s investing book

Martin Zweig

The option activity ratio:
-Be bullish when options activity low
-Be bearish when options activity high

No one can expect to be right all of the time or even most of the time.

You can, however, be right more often than you are wrong.

If you are right 60% of the time, ride your profits, and rein in your losses, you’ll find that when you’re right you’re very right, and when you’re wrong you’re only moderately wrong. In the long run, a 60% success rate translates into huge gains, a 50% rate into solid gains, and even a 40% rate can beat the market.

In playing the market, remember you must deal with probabilities, employ sensible strategies to limit risk, and get aggressive only when conditions warrant.

Dow Jones Industrial Index calculate s average of all shares in the index regardless of size. Total price by the number of shares.

If there is a share split so shareholders get 2 x $20 instead of 1 x $40 per share, it would look like the index has gone down when the shareholders actually have the same value because they have twice as many shows. So use formula to divide up total price of the index, by a greater number than just to total number of companies in the index.

After 30 years the divisor has gone down to 0.346 instead of being. So you could add up the price of all 30 companies, divide by 0.346 and you would have the actual Dow Jones Industrial Average.

In the Dow Jones averages, is the Transportation Average and the Utility Average plus a 65 stock average that combines all three. Occasionally the Utility Average can be an effective indicator for the rest of the stock market, as it tends to be sensitive to interest rates, but it is not an overwhelming tendency.

The S&P 500 index has its stocks weighted by capitalisation, so it is the price of each stock x the number of them. The greater the capitalisation, the greater it’s weight on the S&P Index, so it is dominated by very large companies and smaller firms have less weight.

Dow Jones Industrial Index is weighted for price and only has 30 stocks in, the S&P 500 is weighted for capitalization and has more stocks in. They generally move in the same direction, but gains and declines can differ in magnitude. They can also peek at different times. It rare but does happen where that one declines a bit while the other is climbing.

The New York Stock Exchange Composite Index It’s like the S&P 500, but includes every stock on the NYSE, about 2500 stocks.

He uses an unweighted index, this is where each share counts equally, For this he constructed the Zweig unweighted price index, ZUPI for short. It’s base started at 100 in 1965. If it rises by 1%, It means the average stock grows by 1%.

Another unweighted index is the Value Line Index.

With this index the small company’s share price changes affect it’s total as much as a big ones.

The S&P 500 is better for institutional investors who would have a lot hard time buying large dollar amounts of extremely small companies. Whereas this is no issue for individual investors who can buy enough of any stock.

Page 34 show stock prices adjusted for inflation. Has sale prices in percentages, so 0 to 100 is same vertical space as 500 to 1000.

Better to show this way the nominal prices, because inflation of 10%, or extreme deflation causes a distortion of nominal prices, eg. with compounding it could need twice as much money to buy something with Consumer Price Index than what could buy 5 years earlier. So with inflation you need to adjust stock market averages.

So you could think you’re making money, but you’re not due to inflation.

High inflation can make stocks look like they are going up, but compared to compound inflation they are loosing money.

Page 40, 1966 to 1981 compound inflation of 7.3% meant shares looked like they were going up, but compared to inflation it was a long term bear market.

Compared to inflation, stocks do not do well in periods of extreme inflation, they do even worse in extreme deflation. In high inflation, investors leave the stock market and go into collectibles, gold and real estate.

1960’s to 1983 individual investors were net liquidators of stocks. In 1983 they turned to the buy side.

Prime rate indicator: Rate banks lend to their best customers

Over 8% is high:
-Bearish signal: Any increase of any percent is a bearish signal.
– Buy signal: Second of two cuts of quarter or half a percent, or just one full 1% drop by itself. A full point drop in one go is rarer and more significant.

Below 8% is relatively low:
Bearish signal: Second of two increases, or a full 1% jump.
Buy signal: Even a 1/2% drop is a buy signal.

The trend of rates and level matter, but trend of their direction is more important.

The Fed has 3 overt indicators these create his Fed Indicator:
-The discount rate: rate banks can borrow money from the Fed
-The federal funds rate: Rate banks can use to borrow from each other
-Reserve requirements: The reserve requirements banks have to have

Usually changed 3 times a year so is easy to follow. It’s the direction of change of these 3 tools that matters.

He uses either rate from the Discount Rate or Federal Funds Rate for calculating the Fed Indicator, as each serves the same basic function. For simplicity he only mentions the Discount Rate in his calculation, even though since 1995 this also encompasses the Federal Funds Rate.

So calculate Fed Indicator with discount rate and reserve requirement separately.

Bearish / negative points: An increase in either discount rate or reserve requirements gives a negative point. Also wipes out any positive points if they were there. Another increase puts it down another negative point. Each negative point only remains for 6 months, so if no increases for 6 months it goes back to zero.

The two items do not affect each other, eg. a change in reserve requirement not affect the discount rate and visa versa.

Positive/ bullish points:
Easing effects by the Fed have more of an effect than tightening ones.

So an initial cut on either of the two tools wipes out any negative points that have been accumulated and creates two positive points.

It would also be an initial cut, so two positive points if the rate had not changed for at least 2 years. In this situation there are of course no negative points to wipe out.

So they turn a negative total on the Fed Indicator into a positive total.

An initial cut is the first one following a rise in that component, or if is the first change in that instrument for 2 years. It looses one of the two points after 6 months and the other a year later.

Any further reductions in the discount rate, each add one more point. So another reduction would make it three points.

More discount rate or federal funds rate cuts, each add another positive point that each last 6 months.

A Fed Indicator score of less than -3 doesn’t have a greater effect on stocks than a -3 score.

Also a Fed Indicator score of +3 not have a greater effect than a +3 score.

Fed Indicator recommendations:
Extremely bullish: +2 or more
Neutral: 0 or +1 point
Moderately bearish: -1 or -2 points
Extremely bearish = – 3 or less points

+1 gave low returns

For the 38 years of 1958 to 1996, on the ZUPI the Fed indicator, starting with $10 000 and average yearly percentage gains were on average:

-Extremely bullish: $190 906, +28% per year, 11.9 years, market rose 88% of the time.
-Neutral: $10 472, +0.3% per year, 13.5 years, market Rose 52% of the time
-Moderately bearish: $6756, -3.8% per year, 10.1 years, market Rose 48% of the time
– Extremely bearish: $7357, -8.1% per year, 2.7 years, market rose 30% of the time

You will sometimes lose some upwards movement as this is an average.

It should also protect you from the big crashes.

It basically shows that you ‘shouldn’t fight The Fed’ .

You do need to use more than just the Fed Indicator though.

The Installment Debt Indicator:

Loan demand effects interest rates.
-More demand for loans puts upward pressure on rates.
-If demand drops dramatically, it helps to lower rates.

The US government reports it once per month, about 6 weeks after the month it is for and it’s the trend of it that matters

There is a seasonally adjusted and non seasonally adjusted figure, use the non seasonally adjusted number.

To calculate it:
First: Get total for the month and divide it by the total for the same month a year ago.
Second: Subtract 1.000 to make it into a percentage.

The result is the percentage change since same time last year.

You don’t need to seasonally adjust as are comparing with the same month last year.

An increasing/expanding installment debt tends to be bearish.

When installment debt decreases / plunges it’s bullish.

Bullish / buy indicator: has been falling or drops under 9%.

Bearish/ sell indicator: Has been rising or hits 9% or more

The Monetary Model

Combines the Prime Rate, The Fed and Installment Debt indicators into a model.

Prime Rate Indicator:
Buy signal: 2 points
Sell signal: 0 points

Fed Indicator:

+2 or more points= extremely bullish = 4 model points

0 or +1 points = Neutral = 2 model points

-1 or -2 points = Moderately bearish = 1 Model point

-3 or fewer points = Extremely Bearish = 0 Model points

Installment Debt for the Monetary Model:
Buy signal: 2 points
Neutral: 1 point
Sell signal: 0 points
(His own model has a range, but for the book he keeps it simpler)

Monetary Model maximum score is 8 and minimum is 0

If it rises to 6 it is a buy signal until it drops to 2 where it becomes a sell signal. It is a sell signal until it rises to 6 again where it becomes a buy signal.

So is:
Buy at 6 or above
Sell at 2 or below

When things are neutral for declining, you are best not being in stocks because although you may not lose money, you’re foregoing the money you would make through being in T-bills or certificates of deposits at those times. T-bills and certificates of deposits of course make bigger returns when interest rates are higher.

So the big money comes from the combination of holding stocks at the right time and getting revenue from T-bills and certificates of deposits when stocks will not rise, or will fall.

Dividend yields are also better with the model, as it has you buying shares at market lows when the dividend yields are greater.

The model means you only buy or sell about every 2 years, so transaction costs are low.

You don’t have to just buy or sell everything, you could do ball park partial moves with the Monetary Model such as:
– 0 points: 0 invested
– 1 point: 10% invested
– 2 points: 25% invested
– 3 points: 40% invested
-Neutral at 4 points: 50% invested
-Rises to 5 points: 65% invested
-6 points: 80% invested
-8 points: 100% invested

This means you are partially using the model.

To be even more cautious you could just buy when the model is at 8, anything below you stay in the money markets. You will make less money as you are not getting all of the times the stock market is rising, but you only have to be in the stock market for less of the time.

Do not invest in stocks when monetary conditions are hostile and they are very attractive when the Fed is loosening and interest rates are falling. “Don’t fight the Fed”.

Momentum Indicators

Price is more important than volume

Stock market price rises lead to more rises.

Every bull market starts with a tremendous rally. However it can take weeks or months to come after the end of the bull market, where it goes up a bit first, or goes up and down a bit first. However the rally does come.

For a massive bull rally you need:
-A recession as it helps the Fed to loosen monetary conditions
– Lots of cash on the sidelines
– Good value in the market such as price/earning ratios
– Pessimism as then there is loads of cash

Then the first rally will be strong and the first one will be the best.

It’s like a rocket that needs sufficient thrust to get through the atmosphere into space.

The first big upward movement of the stock market brings more people in. Even a small decline brings in people eager to get in and so it goes up again.

People who miss the first big increase, wait for a decline which never comes. This feeds an even more frenzied influx of people going into the market with the cash they have had on the sidelines. This can go on for 6 months or so.

Advance/ Decline Indicator

Ratio of stocks going up and stocks going down in a particular day. Those that are flat are ignored.

Eg. 1000 go up, 500 go down = 2:1 ratio

During 1953 to February 1991 the author found 11 times where this ratio happened for 10 days in a row, as usually it’s less strong. If it happens a few months after the first signal, it’s just considered a repeat and not counted.

Over the next 3 months after the indicator, stocks on average go up quite a bit, but it’s even more powerful over the next 3 to 6 months.

These were the start of strong bull markets, or the second legs of existing strong bull markets. This is because they tend to start with strong momentum.

You would have had to wait for prices to explode and get to what seemed like high prices, but they go higher as strong momentum tends to persist.

Markets need a lot of momentum to get going and if the momentum isn’t there, it’s not going to ignite.

Up Volume Indicator

Total volume of stocks that rise on a given day and total volume of stocks that decline.

Ignore those that are unchanged.

90% or more going up on a given day, ignoring any unchanged, is a significant positive momentum sign.

A 9 to 1 or more ratio.

Also works for 9 to 1 downwards ratio as well.

Between 1960 and 1992 they were on average about 2 upward days per year and 4 downward.

The upward days are a strong predictor but the downward ones are not very strong.

Between 1960 and 1992 every bull market has started with a 9 to 1 upday.

The biggest ratio he has saw is 42 to 1 up day in 17th August 1982 which led to the strongest bull market in 50 years. 3 days later in August 1982 there wasa 32 to 1 up day as well.

Two 9-1 days within 3 months of each other is even better. Best of all is when have no 9-1 down days between them. Second best is when there is one or more 9-1 down days between the two 9-1 up days and this situation is still a useful bullish indicator.

A 9 to 1 ratio up day on its own does not guarantee a bull market, other indicators are required as well. However it is an encouraging sign.

Almost no returns or negative where not a 9-1 indicator. This indicator can be getting returns running for a year after the indicator to a total of 21.2%.on ZUPI or 17.2% DOW. $10 000 turning into $147 000

In non 9-1 periods lose 8% per year, $10 000 turning into $2012

Buy and hold only 4.7% per year.

The 4% model indicator

It is only right half of the time, but the profits are excellent. Uses the Value Line Composite Index of 1700 unweighted shares.

Look if the closing price on Friday, is more than a 4% drop or rise since the close of last Friday. This is percent, not points.

A buy or sell signal continues for the following weeks, it does not change until there is another drop or rise of more or equal to 4% in a week. Then that new signal runs until there is another buy or sell signal.

So a buy signal will run each week until the next buy or sell signal.

As it is weekly you could be buying or selling after an 8% drop or gain, but you are still going with the market trends and so on the right side of the bulk of it.

You might get caught by a zigzag period of short term moves where the market just goes up and down by more than 4%, putting your buys and sells on the wrong side. However as a whole it is still worth doing this model even with that cost, because of when you will get the major trends.

Should also buy shorts on the sell signals!

The idea of the model is to follow the trend.

He does this model for shorting stocks on the sell signals as well.

Between 1966 and 1995, there were 61 buy signals, only 30 (49%) were profitable.

However the 30 profitable trades produced on average 14.1% profit per trade, the loosing ones only lost 3.5% per trade on average. So the model shows how to cut losses short and let your profits run.

Average profit per trade 4.7%, 80 calendar days per trade. When annualized like you were doing all the year, would be 16.2% per year, compared to 2.7% if bought and held.

These figures ignore dividend payments.

If had sold short the sell signals, would have made money only 28 out of 60 times However each profit 9.6% on average (would have lost 9.6% if bought on them). Each time short selling was wrong it only lost 3.5%.

Nets out average gain per short trade 2.4%, with average holding period each trade of 48 days or 7 weeks

Annualized profit from the shorts was 13.5%, so would have lost this if long on shares at these times. So if had bought shares on the sell signals, would have lost 13.5% per year on those spans.

52% of buy periods lost money, but average loss 3.7%. The 48% that made money were average profit of 11.8%. So average gain over the 122 trades were 4.1%.

The 4 percent model over 30 years gets 13.3% per year vs 2 7% buy and hold.

Only using weekly closing price increases the losses, but it makes it simpler to operate, also not worrying about it all the time and the simplicity makes it easier to keep perspective.

Changing to 5% or 6% means fewer trades and so transaction costs but slightly lower return.

3% or 2.5% higher return but more transaction costs.

So 4% is the mid way balance.

The Value Line or Zweig Unweighted gives greater return as more volatile than S&P 500.

Combining monetary and momentum indicators, called the Super Model

Monetary: Prime interest rate, federal reserve and installment debt. Don’t fight the fed

Momentum: Four Percent Model. Don’t fight the tape.

Monetary Model:
-Buy if 6 points or more (maximum is 8).
-Sell if 2 points or less.

Combined Model:
-4 percent model says buy is 2 points.
-4 percent model says sell is 0 points.

So Super Model maximum is 10 and minimum is 0.

You could use model to be 50% invested, 75% invested, etc.

To be simple he is just showing 0% or 100% invested. If 0% invested then 100% in money market instruments such as Treasury Bills, CDs or Money Market Funds.

So Super Model is:

Buy if model gets to 6 points or more
Sell if model gets to 3 points or less

Summary of Martin Zweig, winning on Wall Street

These are quotes and summaries of what I learned from Martin Zweig’s Book, ‘Winning on Wall Street.’

When fed tightens and interest rates rise, stock markets perform poorly, and visa versa

When fundamentals for a stock deteriorate, sell it and don’t refuse to take a loss as can’t afford to bruise your ego.

Accept your mistakes, deal with them and learn from them.

In baseball a person who hits 2/3rds of the balls is in the Hall of Fame, so don’t expect to get it right all the time.

Look at stock market’s P/E ratio, dividend yield and book value to see if it is over valued, especially during periods of speculative mania.

Only a fool can be totally sure.

Deal in probabilities not certainties, so the aim is strategy and not preaching.

Page xvii, If he thinks that the market will probably crash in a particular month and does a put for it, it will still only put 1% of his assets into it. This is because it’s about probability and the puts will be worthless if it doesn’t happen in that particular month, or go down to enough of a degree to make it worthwhile.

Reality is cutting the risk to the bone when the indicators weaken, hoping that you will make a few bucks when conditions are good, and praying your survive the crashes so that someday you can make money in the bull markets and have money left to do so.

He breaks historical composite readings into 10 deciles, such as top 10% etc.

He is measuring monetary, sentiment and tape (the total stock market price) conditions.

A credit crunch is where the yield curve turns negative.

If the stock market has a grossly overvalued P/E ratio and yields, has been rocketing upward for years without a major correction, which has produced doubles or more in the Dow, things get risky.

A crash is coming if whenever there are minor dips people think the solution is not to fear the dips and just to buy more.

You need constant access to reliable market indicators, and when they tell you to do something, you do it. The mistake is to ignore or distrust your own indicators, like a pilot second guessing their compass.

The key is patience to wait for the fat baseball pitch and not just swing at anything. Only do it when the odds are in your favor as the indicators are in the right direction.

Page 2, from mid 1980s to 1995 the Zweig forecast had a return of 898.9%, on a compounded basis that is a 16% annual return why.

Page 3, book doesn’t track all the variables he tracks on the market activity or it would get hopelessly complicated. So he has simplified his approach to make it understandable and workable for the non-professional reader.

The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movements of interest rates. To monitor these he has several indicators but he has found to be very reliable.

Momentum is like a rocket being launched to the moon, if it takes off with a lot of thrust, it has a chance of making it out of the Earth’s atmosphere. Without this momentum it will flop. This momentum is the final arbiter of any investment decision, he never fights it.

Picking falling shares because you think they have hit the bottom is dangerous. It is easier, safer and in most cases just as rewarding to wait until they have hit the bottom and taken a little bounce upwards before buying them.

He uses sentiment indicators as early warning systems and it’s suprising how often do called expert opinion can be.

He monitors fundamentals, which is the actual value of a particular stock, such as earnings, dividends and balance sheets.This only helps with individual stocks, not the whole market. 90% of input on stock picking is from the fundamentals, then 10% from predicting the market as a whole.

Big money is from being on the right side of major moves, not from swimming against the tide.

Be fully invested when market going up and fully in cash when goes down.

Trends have a higher probability of continuing than not.

2/3rds of the time markets are neutral, or rising and declining moderately. During this time might trade profitably selecting the right individual stocks, but investing in the whole market during a strong bull market gets the best returns.

Pick stocks with P/E ratio, earnings trend and a few balance sheet items. Not care what makes, as long as consistent earnings for 4-5 years.

Not buy stock at the bottom, buy if going to climb and acting well relative to the market. Buying on strength costs a premium, but increases possibility of being right.

It’s not buy at the bottom and sell at the top, it’s buy when the probability is greatest that the market will advance.

If bottom is 4000 and top is 6000, you buy at 4300 if let’s say 90% probability it will go higher. You might sell at 5700 when probability is good that the market will decline.

It’s about probability of loss or decline.

You are cutting losses and running with profits.

You can be right with individual stocks as little as 30% of the time and still do well, if you can get out when the getting is good

Follow and don’t fight the trends.

You want to get out so you are able to pursue future gains.

You have to make mistakes to come up with something that really works. Benjamin Franklin, ‘The things that hurt instruct.’

Uses stop losses (sell orders at predetermined levels) to stop him fighting crippling battles. Whenever buy a stock, he generally sets them 10-20% below current level. Level depends on stock’s trading pattern.

If stock goes up, he raises the stop loss price so still protected.

They might sell a stock that then rises again, but the probabilities are that they save you and there is always another stock

Need to be flexible, so take advantage and be aggressive when during the less common times you should be so, then the rest of the time be conservative.

Most important trait in investing is discipline to follow your method and not be tempted by things that weaken your resolve, such as a ‘hot tip’ someone gives you.

Second most important is flexibility. Eg. bearish when the market is collapsing and people think that brokerage houses are going to go bust, but then bullish if the Fed steps in and a rally starts that looks like it’s going to continue.

Whatever preconceived ideas you have, you respond to changing conditions

You need:
1, Discipline
2, Flexibility
3, Patience

You wait for the tape to give it’s message before you buy or sell

Stay in tune with the tape and interest rates.

As a kid he loved numbers.

Committee made decisions in the stock market tend to be mediocre, he’s never heard of a great investor who operated by committee

You need to be alert to never get caught in a stock market collapse.

The whole idea with Graham, Dodd, and Cottle is to buy stocks with good value that are selling at reasonable multiples and paying satisfactory dividends, and to make allowances for risks.

He wanted to look at the movement of markets as a whole, about technical factors such as the market’s own price action, crowd psychology, or the impact of the Federal Reserve and monetary and economical variables.

Let your profits run and cut your losses, as Jesse Livermore did.

Professor Wade Young ‘Buy on strength, sell on weakness.’. Most novices think it is ‘buy on weakness and sell on strength’, which is how they get themselves into trouble in the market.

Technical analysis in purest form is study only of those variables you can see on the ticker tape, namely price and volume.

He went through data from the securities and exchange commission going back to world war II and found that-

-When options investors got two optimistic – buying lots of calls ( the option to buy 100 shares of a company stock price at a specific price over a stated time period) and shunning puts – the stock market was genuinely heading for trouble.

-Also the reverse, when options players were very bearish on the markets favoring puts (the right to sell 100 shares of a company stock at a stated price within a specified period of time) and selling or avoiding calls, the market was usually near the bottom.

– when option players were extremely active, it was a negative sign.

– when option players shun the markets and option volume dropped off, it was frequently a good time to buy.

Basically the old country opinion, ‘don’t follow the crowd’.

From this he invented the puts/call ratio technical benchmark.

He found that most speculators were not very successful and on balance lost money. They weren’t right very often regardless of whether, as a group, they were bullish or bearish.