Introducing the ‘Fusion Method’

Stock Market Analyze
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Yesterday I explained why I thought you shouldn’t get too bearish on this market. Overnight, US stocks soared for the first time in a week on the back of Warren Buffett’s massive purchase of aerospace manufacturer Precision Castparts.

Even commodities lifted themselves up off the floor. Gold traded nearly as high as US$1,110 and finally looks like putting in a weak bounce after the big sell-off of recent weeks.

After a good rally yesterday, the Aussie market looks set for another strong session today.

Does this mean I’m right? Is the correction over? Kris Sayce and I ponder this very question in the second instalment of our Facebook mini video series. Simply click on the screenshot below (and remember to ‘like’ it!).

Of course, I’ve got no idea what’s going to happen tomorrow or the next day. But that’s not a bad thing. In fact, knowing that you don’t know is a major advantage. It’s when you think you know how things will play out that you get into trouble.

That’s why I’ve developed a new type of analysis that fuses both fundamental and technical skills. I’ve been testing and using it since November last year and so far, the results are very impressive.

You’ll hear more about how it works later this week. I’ve just finished putting a report together on it and plan to send it to you on the weekend, so keep an eye out.

The big idea though is to not be too wedded to any one view. While it’s important to have a view, being too rigid can cause losses or missed opportunities. I wrote about this to my subscribers recently. It a really important topic to tackle if you want to develop as an investor so I’ll reproduce some of it here…

Being a slave to your prejudices or biases is the greatest mistake you can make as an investor. I’ll tell you a story in a moment that confirms this and recounts my biggest investing mistake.

Yet the finance industry and the financial media make little attempt to genuinely educate investors against falling into this trap. Rather, they take advantage of your emotions!

Perhaps that’s because investors walk into the trap with such ease time and time again. And they put their bad decision making down to just about everything but their own failures.

But let me tell you: you don’t lose money in the markets because you’re unlucky. And you don’t lose money because someone did or said so-and-so. You lose because you’re trapped in a narrative of your own making. This trap is built out of inherent prejudices and moral judgments about the way things ‘should be’.

This is not meant to be a sermon. I’m saying this because I’m guilty of the same mistakes. Guilty of thinking the world is a mess, and that the problems that led to the 2008 crisis have only grown worse in the years since. Guilty of thinking that because of this, an even bigger stock market collapse lies ahead.

More than that though, I’m guilty of thinking the future will, or should, play out according to my view of the world. What hubris to think I can tell the future!

We’re told good investors have strongly held views — that they have conviction and make bold calls. And that is true. But good investors also know that they don’t know. And they are ready to change their views if things don’t pan out the way they expected.

They are not locked into a narrative. Nor do they put their money where their morals are.

Of course it’s not easy to put your biases aside and invest truly objectively. But it IS doable…and it’s easier than you think.

Last year, after thinking long and hard on this, I developed a system of analysis that fuses two traditionally separate investing methodologies to test my opinion against the market’s view. Yesterday, I said I’d show you how you can use this ‘fusion method’ to buy and sell individual stocks.

Let me show you how it works. A good example is in the energy sector. Fundamentally, many large Aussie energy stocks look vulnerable. That’s because they’ve spent billions investing in massive liquefied natural gas (LNG) projects over the past few years. More to the point, they invested in the expectation of high oil prices.

Now, just as those projects kick off, the price for LNG (which is linked to oil prices) is so low that the returns on the capital invested will be very low indeed. More than likely, the returns will be below the cost of capital. Such an outcome doesn’t bode well for share price performance.

But because these are such large and long life projects, companies will continue to produce despite lower prices. It’s not as if they can just sit down and wait for prices to recover.

So the fundamental story is negative. But do the charts back this view up? Indeed they do. Let’s have a look at one of the more vulnerable Aussie energy stocks, Santos [ASX:STO].

It has a large exposure to new LNG production. This should lead to a big jump in profits. But it’s unlikely to happen. The market is telling you to be very cautious. Have a look at the chart below:

The first warning sign that something was wrong with STO occurred on October 2014. I mentioned ‘moving averages’ yesterday. They remove the noise that comes from daily price volatility. They are a good indicator of the underlying trend. As you can see in the chart, the moving averages crossed over in October last year, signifying that the stock price was in a downtrend. This was a signal to get out.

Then the stock collapsed in November and December before the bottom pickers came in.

But here’s the problem. The buyers were swimming against the tide. They were fighting the trend, which is always a low probability outcome. Despite a series of bounces in the share price since December 2014, the trend continued to point down.

And just recently, the stock made a new low. This confirms STO’s downward trend. Trying to pick the bottom is a dangerous game. I know, because I’ve played it before. Sometimes you win, sometimes you lose.

In this situation, the ‘fusion method’ of analysis tells you to stay away from the sector. Poor fundamentals combined with a negative technical outlook is a red flag.

And it’s not just Santos. Woodside [ASX:WPL], Oil Search [ASX:OSH] and Origin Energy [ASX:ORG] are all in downtrends. WPL and OSH are close to making new lows while ORG recently broke down to new lows.

The message here is that this is not a stock specific issue. The whole LNG sector is under pressure. Avoid these stocks for now. They may be good buys now, but you’re taking a big punt. Wait for the trend to turn first.

I’ll explain the best way to spot a change in trend later this week. For tomorrow though, I want to focus on something I discovered quite recently — the fatal flaw in value investing.

Regards,

Greg Canavan+,
For The Daily Reckoning, Australia

Join The Daily Reckoning on Google+

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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