Martin Zweig (1942-2013) was a famous American stock market analyst, adviser, and investor. His investing methodology was based on a system that combines macroeconomics, fundamental analysis, and market timing. Apart from his popular newsletter (The Zweig Forecast), he has published two books.

• “Winning on Wall Street” in 1986
• “Winning With New IRAs” in 1987

The following advice is included in his first book.

 

General Advice from Martin Zweig

• The major direction of the market is dominated by monetary considerations, primarily FED policy, and the movement of interest rates
• Once established, the trend typically lasts from one to three years.
• Combining to produce a monetary "climate" are loan demand in the economy, liquidity in the banking system, inflation or deflation, and, of course, policy decisions by the Federal Reserve
• To succeed in the market you must have discipline, flexibility, add patience. You have to wait for the tape to give its message before you buy or sell.

 

Follow the Trend

• To appreciate the role of momentum, think about a rocket ship 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. If it doesn't, it will turn around and flop back.
• I find that buying on strength gives you an edge. You must pay a premium, but you increase the probability of being right.
• After years of testing various market averages, advance/decline ratios, volume figures, and other indicators, I have found that strength does indeed tend to lead to greater strength. Every single bull market that I've seen has started with a tremendous rally. The rally doesn't necessarily come the first day after the bear market ends.
• For a raging bull market, you need falling interest rates, probably an economic recession, lots of cash on the sidelines, low price/earnings ratios-and a great deal of pessimism, because pessimism means there's an abundance of cash.
• At the top, optimism is king, speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated.
• Beware of the crowd when the crowd is too one-sided.

Time Patterns

• The market is a discounting mechanism. The market tends to peak well before the economy does and also bottoms first. In general, the market will bottom six months before the economy does. The best time to buy stocks is during a recession.
• For trading strategies involving months of the year, the best would be to buy stocks at the end of May, hold them throughout June, July, and August, and sell after the Labor Day holiday.
• Art Merrill found that the market tended to be stronger than normal in the last three days of a month and the first six days of the subsequent month, while the rest of the time the market performed below its average.
• There is a theory that presidential elections make a difference to more than just the candidates involved; that they also greatly affect the stock market. This belief is based on the premise that the party in power will attempt to do whatever it can economically to stay in power. The implication is that the incumbents will take positive economic action in the year or two before an election, which normally might translate into better­ than-average results for stocks.

Inflation

• Stocks generally do not do well in periods of extreme inflation ­it's the second worst environment for stocks. The worst, of course, is extreme deflation.
• The worst thing about inflation, as far as the stock market is concerned, is that the cure is more damaging than the disease.
• Investors should consider "real" returns in the stock market rather than nominal returns. If inflation rises 10% during a year and the stock market stays even, you actually lose the equivalent of 10% of your purchasing power.
• Some stocks tend to do well during periods of inflation. These include holdings in extractive industries, such as gold, silver, copper, and oil, as well as timber.
• Most other industries suffer during times of inflation. Utilities, for example, have dramatically increased fuel costs and don't have the latitude to raise prices proportionately.

 

 

Money Management

• When you buy stocks, you must diversify. How much diversification is proper? That depends on the size of your portfolio.
• The only consistent way to make money in the market is to cut losses and run with profits.
• Buy strength, sell weakness, and stay in gear with the tape.
• I'm very risk-averse. I want to protect myself and the people who follow my advice. But there are times when you have to be aggressive. The problem with most people who play the market is that they are not flexible.
• I use stop points on every single recommendation I make. Generally, I set my stops 10% to 20% below my purchase price. I'll always continue to use stops. I can't think of anything more important in managing money.

A Game of Probabilities

• In playing the market, remember you must deal with probabilities, employ sensible strategies to limit risk, and get aggressive only when conditions warrant.
• In the long run, a 60 percent success rate translates into huge gains, a 50 percent rate into solid gains, and even a 40 percent rate can beat the market.
• I would estimate that stocks spend only about 20% of the time in the most active phases of the bull trend and only about 10% in the severe downward periods of major bear markets. Roughly 70% of the time stocks either meander in a neutral trading range or undergo minor rallies or declines within their various bull and bear cycles

 

Defining the Bear Market (3 conditions)

 

I'll define a bear market as a decline of at least 15% in each of three important stock averages. These three conditions all have highly negative implications for the market:

(i) The first is extreme deflation. I measure extreme deflation by looking at the Producer Price Index… and I check for major declines. Such a decline would be a 10% drop in producer prices on a six-month average of annualized month-to-month changes.

(ii) The second very bearish condition for stocks is ultrahigh price-to-earnings ratios (P/Es). For the market as a whole, P/Es in the 10-14 area are roughly normal. Very low P/Es tend to be bullish for the long run, while P/Es in the upper teens and twenties generally reflect excessive speculation.

(iii) The third extremely bearish factor is an inverted yield curve. This is the condition when short-term interest rates rise to levels above longer-term interest rates. To measure the yield curve, I use Moody's Aaa Corporate Bond Yields as the long-term rate, and six-month commercial paper rates as the short-term rate. Sometimes the negative yield curve will last only a month or two and a bear market might not develop. But if the spread between commercial paper rates and bond yields keeps widening in the negative direction, the odds for stocks get worse and worse.

There is no guarantee that a bear market will begin when one of the three extremely bearish market conditions is first present. But the longer such a condition persists, or the more severe it becomes, or when a second or third negative condition joins the first, the odds on a bear market become overwhelming.

 

Key Monetary Indicators

 

These are three key monetary indicators, simple to construct and easy to understand:

 

(A) The Prime Rate Indicator

The prime rate is that interest rate that banks charge their best customers. The beauty of using the prime rate as a stock market indicator is that it does not change every day as do other interest rates. The prime rate has another virtue: it lags behind other interest rates. An interest rate that moves a little behind other interest rates can often mark just that point when stocks finally begin to respond to the changes in rates.

□ Buy Signals:

1. Any initial cut in the prime rate if the prime's peak was less than 8%
2. If the prime's peak is 8% or higher, a buy signal comes on either the second of two cuts or on a full 1% cut in the rate

□ Sell Signals:

1. Any initial hike in the prime rate if the prime's low is 8% or greater
2. If the prime's low is less than 8%, a sell signal comes on the second of two hikes or on a full 1% jump in the rate

 

(B) The FED Indicator

Among the weapons in the Fed's arsenal are the discount rate and reserve requirements. To calculate the Fed Indicator, you must grade the discount rate and the reserve requirements separately. Then their scores are combined.

□ Buy Signals:

Moves by the Fed toward easing have a greater positive impact on stock prices than the negative effect created by tightening moves. So, an initial cut in either of the two tools not only wipes out any negative points that may have accumulated, but it also kicks in two positive points.

□ Sell Signals:

An increase in either the discount rate or reserve requirements is bearish.

 

(C) Installment Debt Indicator

When demand for loans rises excessively, it puts upward pressure on rates. When it drops dramatically, it works to lower interest rates.

Consumer installment debt has maintained one of the best records at calling the shots for the stock market.

□ Buy Signals:

A buy signal is given when the year-to-year change in installment debt has been falling and drops to under 9%.

□ Sell Signals:

A sell signal comes when the year-to-year change has been rising and hits 9% or more.

 

Sentiment Indicators (monitoring crowd behavior)

 

Mr. Zweig maintained a list of approximately thirty sentiment indicators, several of them overlapping to form one indicator out of three or four components. The most important of these indicators were:

• Mutual funds' cash/assets ratio (explained below)
• Advisory sentiment
• Number of bullish ads in Barron's
• Number of secondary distributions
• Puts/calls ratio
• Measures of short-selling activity
• Margin debt trends
• Initial public offerings
• Speculative volume on AMEX/OTC markets

He graded most of these indicators on a scale where + 2 points is extremely bullish, + 1 moderately bullish, 0 is neutral, - 1 is moderately bearish, and - 2 is extremely bearish.

 

Mutual Funds Ratio

The optimism or pessimism among mutual funds can be measured by constructing a simple ratio of cash divided by assets.

□ Mutual Funds Ratio = Cash / Assets

If the funds are very optimistic, they will use up their cash to buy stocks. If the funds are pessimistic, they'll sell stocks, allow their cash holdings to jump, and the cash-to-assets ratio will rise.

 

Stock Picking System

 

My stock-picking procedure involves a search for the following variables:

• Strong growth in company earnings and sales
• Reasonable price-to-earnings ratio
• Buying by corporate insiders (or at least the lack of heavy selling by insiders)
• Relatively strong price action by the stock itself

In other words, I tend to favor buying strength and selling weakness.

 

(A) Obtain the latest quarterly figures on company sales and earnings

• Academic studies have found that stocks that report surprisingly good earnings tend to do better than the market as a whole over the next three to six months.
• Stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the long term.
• There are generally two types of stocks that you'll find with extremely low P/Es, say in the 3, 4, or 5 range… the first is the company in extreme financial difficulty… I generally ignore this type of stock… The other type of stock with a very low P/E ratio is a firm in an industry suffering from general neglect.
• If I come across a stock with excellent growth that has a very low P/E, I immediately get suspicious. I will check further to see if there is a problem on the balance sheet or if the backlog of orders has dropped off, or if there is some other outstanding negative; there often is.
• I also avoid the very-high-P/E stocks. Most of the stocks I select have P/Es near the average for the market or somewhat above it.
• Another factor you occasionally might deal with is the amount of debt that a company has. If a company has a tremendously high level of debt, the earnings or earnings growth rate would be worth less because of the potential risk.

(B) Price action of the stock itself

• I do want to find stocks that are acting better than the market.
• Recognizing the relationship between trends and the industries that might benefit from them can lead to above-normal returns.
• Whether you are right or wrong about the long-term economic trend, it is important to reject picking any stock that violates your perception of the trend.
• In a very strong market, the very best kind of action is a clear uptrend on a chart where you see a series of higher highs and higher lows-sort of a stepladder on the way up.
• The best buying spots are short-term pullbacks of 5% to 10% from a high, provided that the small down move does not violate a recent prior low.
• If the market as a whole is moving sideways for some period, then a worthwhile buy candidate might be one that is just breaking out from a long basing period.

(C) The degree of insider trading

• I define an insider-buy signal as a case when three or more insiders buy stock within the latest three-month period but when none sells.
• I would define an insider-sell signal as a case when three or more insiders sell within the latest three months and none buys. I prefer unanimity for a signal.
• It can get even more interesting when one combines insiders' trading with P/E ratios, particularly when heavy insider selling is coupled with very high P/Es.

 

■ Marty Zweig (Equity Trader)

Forex-Investors.com (c)

 

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