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Spotting Stock Market Moves Before They Happen
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What makes stocks go up and down in price in the time we own them? How can we figure out which stock is going to go up before it goes up? How do we figure out which stocks are going to go up the fastest so we can capture those bursts? Aren't these more important questions than whether we like the "fundamentals" of a Computer Associates or the management of a Microsoft? Aren't these the real goals we're after, not just the reshuffling of the S&P 500 deck?

I asked all of those questions during the interviews when I was trying to get a job at Goldman Sachs out of law school. People would talk to me amorphously about how high-quality stocks went higher and low-quality stocks went lower. They would relate the management of the company and the prospects of the company to the stock price and hold up examples of how the decline or advance in fundamentals always seeped into the price of the stock, either immediately or eventually. I took it all in but still was confused about how a stock pushed from 10 to 11, or fell back from 11 to 10. The so-called obvious case of the fundamentals guiding the stock's movement just didn't seem selfevident to me, and it may not seem self-evident to you. The moves, at least short-term, seem almost random, not based on the fundamentals.

Then one day, I annoyed a senior executive of the firm with my incessant questions about what causes a stock to go up a point. I just couldn't figure out how it all happened. He then called me over to his Quotron—that's what they were using then—and said, Okay, watch Stride Rite. He then hit up SRR and it showed the bid price (where the stock could be sold) and the offer price (where the stock could be bought), both of which were clustered around 7. He said to me, "You want to see a one-point gain; you want the anatomy of a one-point gain? Okay." He punched in a light on his keyboard and said, "Buy me fifty thousand Stride Rite at the market." Next thing I know the stock is tearing toward $8, careering toward it like a moth to a two- hundred-watt bulb on a hot summer evening. It was only after the exec said, "Okay, that's enough," after about 30,000 shares had been swept and the stock stopped at $7.50, that I recognized how easy it could be to move some stocks, It was the essence of supply and demand. The exec had created demand that could not be met by the sell­ers "on the books," so the specialist was letting the stock climb until it reached a level where sellers appeared.

pf course, most stocks aren't as illiquid, meaning there are many more sellers and buyers at all different levels, than Stride Rite had that day. But you get the idea. Demand and supply determine the minute-to-minute pricing of stocks, and if you blitz a stock with demand, unless it is one of the larger companies, unless it has more than $100 million in market capitalization, the level I think where you first get some real-time liquidity, you are going to produce your own anatomy of a one-point gain.

In the real world, the day-to-day world of stocks, there are many forces that can affect the pricing of an equity. The first and most basic is the sheer act of buying and selling a stock that doesn't have much volume. That's where we move stocks with our own buying. That won't happen very often to you as a smaller investor.

Even at the height of my firm, Cramer Berkowitz, I managed only about $450 million for a bunch of wealthy families, a pittance compared to the major mutual funds and some large hedge funds that control the marginal dollar that determines stock prices at the end of the day. I mention this to drill into your head the importance of considering supply and demand of the stock at all times. That's because way too many people get confused; they think we are trading the actual companies themselves, that the pieces of paper we are trading, investing, owning, are some sort of redemptive right, a coupon that will give you certain cents off, or an ownership right that will allow you to have a chunk of the brick and mortar if not the cash in the treasury of the joint. Untrue. These are, in the end, simply pieces of paper, to be bought, sold, or manipulated up and down by those with more capital than others. All other investment books stress the linkage between the stock and the company. Me? I stress the abject lack of short-term linkage and the opportunities that such an unconnectedness presents. While it is true that over the very, very long term—say your lifetime— stocks should indeed reflect the fundamentals, over the short term, the twelve- to eighteen-month time frame that is most applicable to most owners these days—like it or not that's how long most stocks are held—the fundamentals of the company play only a part in what moves a stock up or down. In fact, I believe the reason that so many professional managers and amateurs fail to beat the market or make big money is that they are way too hung up on the largely artificial linkage, short-term, between a company's health and the health of the stock. I think that deep down they like the linkage because it makes them feel that they aren't gambling with their money (or their clients' money). They think that if they stay focused on the fundamentals they have turned gambling into investing. I wish I could be so glib. I wish I could focus only on the company and not the stock, because it would be much easier. But it would also be much less lucrative.

Remember my litmus test: I am trying to get you to buy stocks that go up quickly, in a time frame that matters to you now, and get you to avoid stocks that go down rapidly, that could wipe you out. If I can do that I can help you become wealthy. But if I choose to ignore that short-term direction of stock, I am leaving endless amounts of easy cash on the table for others to pick up, and that's just not going to allow me to outperform others and grow wealth in time for it to be used. If we lived for hundreds of years and didn't need the money for eighty to one hundred of those years and if we were incredibly rich to start, we could overlook these short-term bull markets quite easily. Yet, to me, it is just plain unrealistic and far too paternalistic to think and act otherwise, even though the vast majority of the practitioners out there ply this pristine but impractical advice.

More important, finding out when a stock is about to have what I call a Game Breaker move requires only some knowledge of the company and much knowledge about the way stocks work as they go about the process of growing. There will be lots of stocks that we will see move up by a billion dollars or more in capitalization—a totally catchable move—without any real, discernible change in or development at the underlying company. I have seen stocks tack on $500 mil­lion in market cap simply by saying that they are now nanotechnology stocks, not just technology stocks. I have seen fortunes made by adding a ".corn" to a company and fortunes made by taking a ".corn" off the name of the company. In each case these were fathomable moves. Remember the diet analogy: I don't care how we catch the moves, whether it is with carrots and melon and broccoli, or whether it is with steak and bacon. I just want us to catch the darned moves. Again, I know this is heresy. No investing text advocates trying to catch these moves. No market professional wants to be affiliated with these moves because they can be short-term in nature and they resemble gambling more than "investing." But so what? If we can catch Taser or Netflix or eBay or Yahoo! while not wholeheartedly believing in them long-term, if we clearly mark them as the speculative entry in our diversified portfolio, why should we not take the dozens of points that can be offered by these situations? Why can't we snare them? Why must we be bound by, for example, a bear market in most equities if there is a bull market in some speculative enterprises that we can capture with buy-and-sell disciplines?

To me, the landscape looks like this. First, there are undiscovered companies with undervalued stocks—that's where most of the Game Breakers come from. Then there are discovered companies with undervalued stocks—that's the small-cap-to-mid-cap phenomenon, where some great gains can still be had regularly. Then there are discovered companies with fully valued stocks—that's where the vast majority of money managers play. We can make money in that cohort, but it's very difficult to make big money. I think of the gains from this segment as singles and doubles rather than home runs. Finally, there are undiscovered companies with fully valued stocks, the most dangerous sector of all for most undisciplined investors. That's where most of the speculation occurs and why most people lose money speculating. The typical uninformed speculators are buying stocks already exploited by the process of discovery. Once a stock is discovered, it is difficult for it to stay undervalued. And once a stock is fully valued, a whole new set of rules applies if you are going to make money investing.

All of these situations require disciplines: a buy discipline, which allows us to figure which quadrant we are in—for if we are in the discoveredlfully valued quadrant we must be quite disciplined—and a sell discipline, which requires rigorous departures from stocks that we desire to keep.

How different are the quadrants? You need a market dislocation to buy in the discoveredlfully valued segment, but you can act at will in what you will regard as a venture capitalist style in the undiscovered1 undervalued segment. Each cohort is different, but none is more dangerous or risky than the other, provided you sell right in the early stages and buy right in the later.

We know that hoped-for future growth in earnings propels stocks. So, it is natural that we begin to believe that the catalyst for a big move requires a recognition that there is more growth to come than anyone knows.

For some, these metrics might seem strange. Most stock pickers think of groups as small, medium, and large capitalization. But capi­talizations can lie. Some stocks are large cap that shouldn't be. Some stocks are small cap, but not for long. If we want to make big money— the purpose of this book—the cohort that makes the most sense to look at is the undiscoveredlundervalued, even as the graybeards would no doubt thumb their noses at these stocks, despite the likelihood of finding the next Starbucks or Home Depot or Comcast—all incredibly speculative at one time—among them.

Indeed, let's not kid ourselves. When you are buying the discovered stocks of discovered companies, you are simply doing handicapping and risk-reward work as we performed on Walgreens versus Rite Aid. But when you are trying to find the next Game Breaker move, you are strictly embracing speculation because, by nature, you are on un- proven and subjective grounds. The earlier you move, the more your actions resemble gambling. However, as is so often the case, the earlier you pounce, the greater gain you can have. Once again, the investing that looks the least like gambling produces the most humbling returns, while the investing that seems much more like wagering produces the heftiest of returns. That's why this book not only doesn't frown on speculation, it insists that a part of your discretionary portfolio be dedicated to it.

The types of gains that can be had using this method are similar to those of another form of investing: venture capital. You place a series of bets on a bunch of long shots—that's what VCs do—and you recognize that many, sometimes even most, will not work, but that the winners will more than make up for the losers. Amazingly, because of the asymmetric nature of losses—stocks stop at zero when they go bust—the losers can't possibly wipe out more than what the winners, with their infinite potential, can make. Further, when my trading rules for speculation are adhered to rigorously, you end up with a truly bountiful combination where your winners are allowed to run and your losers are stopped out before they get to zero. That's because the stocks that go from unknown and undervalued to unknown and overvalued exhibit similar characteristics that we can flag in order to exit before they flame out.

Let's take the different techniques and rules I use for each cohort and discuss how you can spot the big moves in each size of stock before it happens.

I am going to give you the traditional large cap analysis first, to walk you through the way that most managers do their thinking. Given that the vast majority of conventional stock picking involves choosing among higher quality blue-chip stocks that either pay dividends or can pay dividends, I want you to be grounded in the traditional methods and type of moves that can occur.

The reasons behind traditional moves of large cap stocks can be grouped into two .logica1 catalysts:

•  Rotational catalysts: Decisions by portfolio managers to shift
from group to group depending upon the macro backdrop: weak-to-
strong economy or strong-to-weak economy, as dictated by the in­
credibly important actions of the Federal Reserve. These catalysts
involve switching between secular growth stories and cyclical (smoke­
stack) blastoffs that must be captured if you are to make money in all
kinds of markets.

•  Estimate revision catalysts: Given the need all managers have to
try to figure out where the biggest future earnings gains are going to

Once you have mastered these traditional stock-picking method­ologies, I will show you how to spot undervalued stocks and undiscovered companies before others do so. That's where the biggest gains can be had. The disciplines involved in the undervalued and unknown stocks are completely different from those involving large capitaliza­tion entities. That's because most of the small caps never get to be big caps or even transition through to mid cap, yet they are still fertile places to look and explore and exploit.

Only after that discussion will I identify the rules you will need to trade and invest in all of these stocks correctly, as well as show you the mistakes that I have made in trying to exploit this methodology so you can learn from them.

The Secrets of Successful Large Cap Investing

As a successful hedge fund manager, running hundreds of millions of dollars of capital, I had to be sure that I could get in and out of stocks and be able to change my mind and direction without clipping huge percentages off my performance. The only stocks that allow that kind of flexibility are large capitalization stocks. As an individual, you are not so restricted. By the nature of the smaller size of your individual portfolio, you need not dwell in the house of the large cap. Nevertheless, that is where most people feel most comfortable selecting stocks, so we need to master the ways of making as much money as possible in this cohort.

Most discovered stocks do nothing but mimic the market. They trade largely on the underlying specific businesses and on the progress of their sectors in the overall domestic and worldwide economies. In fact, for discovered stocks, I find that sector analysis and specific stock analysis each explain about 50 percent of the moves. In other words, knowing a business cold may not be as important as knowing how the sector is doing and how it performs in a given economic cycle. Whirlpool and Maytag are never going to trade like biotech companies no matter how great they are at washer and dryer making because the appliance sector only grows at about the same pace as the gross domestic product. There are a limited number of product modifications that Maytag or Whirlpool can add to spur growth before the sector over­takes and then stunts that growth. You don't have such an inhibiting course in biotech, where the drugs themselves define the limit. In other words, catching a Game Breaker move in Maytag or Whirlpool or most cyclical stories is difficult unless the world economy is growing at a huge pace, a cyclical theme such as a housing boom has ignited, or the company gets a takeover bid. But other industries, tech and biotech classically, are uniquely prone to these Game Breaker moves. I like to have a mixture of all of these kinds of situations with at least one entity, the speculative entity, where a Game Breaker move is more likely.

Sector thinking is so ingrained among the "big boys" at the mutual funds that they tend to determine the marginal prices not of businesses themselves—they don't take over anything, just the stocks—so that if you try to buy a good company in an out-of-favor sector you are most likely going to lose money until that sector comes back in favor, which will have little to do with the company's intrinsic fortunes. We call this the "best house in a bad neighborhood" thesis: No company, no matter how good, can truly transcend its sector.

I am not as concerned about sectors and companies right here, though. I am concerned about finding stocks that have catalysts, that are about to move, to put on huge point gains. All my life I've been fascinated by the ability to catch "the big move" in a stock, that spurt that makes you all the money there is to be made in a stock. Capturing that spurt was my specialty. (Remember that example of getting Gulf Oil before the takeover clearance? That is the outsized move we are trying to catch.) It is not enough to know Maytag versus Whirlpool on an earnings basis. You have to know what makes Maytag or Whirlpool break out of the range that either will most likely be trading in most of the time. You need to figure out when Maytag is going to make that move, that multi-billion-dollar market capitalization move, that makes the stock worth so much more than it is now. Figuring out that inflection point, that catalyst, knowing when a stock goes from dormancy to action, from caterpillar to butterfly, is what you've got to be able to do if your stock picking is going to yield extraordinary results, results not bound by the S&P 500 or the Dow Jones or the NASDAQ 100. If you aren't soundly beating those indices, you might as well hand off your money to the mutual funds.

Remember E X M = P? That simple equation is what drives the vast majority of stocks. The E is the earnings, or more accurately, the earnings estimates of a company. The M is the multiple, what multiple of those earnings estimates people will pay for a stock. P is the price of the stock. In other words, if you know what a company could earn and you know how much people value those earnings, you will be able to figure what price the stock is selling at. I know multiplication seems pretty easy. Solving for M is as simple as dividing the price by the earnings per share. Think back to the work we did on Maytag. If Maytag is going to earn $2 a share and it sells for $30 a share, the multiple the market will pay right now is 15. So, let's take that a step further. There are only two ways a stock should be able to obtain a higher price in the market: The earnings can go up or someone will pay a higher multiple for those earnings. So if Maytag is going to earn $3 per share instead of $2 and the multiple stays the same, the stock should trade to $45. If you knew or could build a thesis that Maytag might be earning $3 instead of $2 and the stock was at $30, you would know you are going to make money buying that stock because it will eventually go higher when the new earnings are reported.

Unfortunately, figuring out how Maytag is going to make $3 instead of $2 is not something that can be easily done by reading the documents and looking at the business model. Think about all of the things that go into making those earnings per share. If you are going to predict that Maytag's estimates are a dollar too low, you have to know that Maytag's products are going to sell at a much better than expected level or that Maytag is going to make its products more cheaply than anyone thinks and sell them for more money than anyone thinks, or that Maytag's got some newfangled product that no one knows about that is going to make it a fortune. New product introduction, better sales, better margins—this is the stuff of higher earnings estimates, and if you can predict them, you are going to land a big win.

But what if instead of the earnings estimates changing radically, the M changes? What happens if you can figure out that the multiple is going to get bigger? Remember, if "E X M" equals the price of the stock, then we should be trying to predict when the M is going to get bigger even if the E is going to stay the same or go up just slightly. Let's say you know that Maytag's going to earn $2, etched in stone, but you believe that people should pay more for that $2 than the 15 times that they currently pay. Maybe you think Maytag should fetch 20 times earnings. That means you think the multiple is too low and should expand to a much higher level. If you are right, you could have a gigantic hit, as the stock would proceed to $40.

At Cramer Berkowitz, whe~ I compounded at 24 percent year after year with no down years, I specialized in trying to determine whether the multiple was going to expand or contract on the same earnings. I spent most of my time trying to develop models and methods that would predict that the M would go up, often in conjunction with work that showed that the E was about to increase beyond what people expected.

I did this because it was obvious to me that if I could figure out which companies were going to beat expectations, I could get in front of large moves before they happened.

Fortunately, understanding why a multiple will expand or grow is something that anyone with common sense and a keen eye for what matters can learn to do. Unfortunately, the vast majority of people, including professionals, have no idea about why a multiple will expand and don't even think it is possible to figure this out. These people are wrong. Given that I have repeatedly managed to predict multiple ex­pansion, I know it is not only possible, but, given the directives I am about to describe, it is actually easy.

The first reason a multiple expands and contracts is the macro concerns that have nothing specifically to do with Maytag, Alcoa, International Paper, or any discovered company with a fully valued stock. Some in the business call this "top down" thinkmg, meaning that if you have a view of the nation's economy—and you always have to have a view if you are going to pick stocks with any consistency before they move—you can predict the direction of the multiple.

Let's stick with Maytag for a moment, because it is, in many ways, a perfect proxy for the macro elevation of the multiple. If the economy is heating up, or, more importantly, if you believe that the economy may heat up because the Federal Reserve is going to cut interest rates—something that always stimulates the economy—you should be betting that Maytag's multiple is going to expand. So, let's say the economy is growing at 2 percent and the Fed is not happy with that growth. And let's also say that Maytag is supposed to earn $2 a share. You can bet that that multiple is going to expand above 15 with an easier Fed. Will it go to 16or 17? Perhaps, if the Fed steps on the gas. If the Fed cuts in small increments, I think you will see people "pay up" for Maytag, or pay a heightened multiple. If you think the economy is going to expand to 5 percent growth, I think you might be looking at a $40 stock, because with that level of growth there will be buyers willing to pay 20 times earnings, because you can see a similar multiple increase in past economic expansions. You can measure that multiple simply by looking at where a stock has traded in the past and what it has earned in the past. Some of that expansion is predictable—people will now pay 20 times because by the time we get to the next year, the stock might be earning $3 in an economic expansion. They pay it now because they know that when we get to $3 the multiple will be 15 again, the average multiple of the stock, except the stock will now be substantially higher because of the E's gains. The way I look at this process is to say that the M anticipates the E, and if you can shift your portfolio toward stocks that should have a greater E when the economy is about to expand, you are going to find yourself riding a wave of multiple expansion to higher levels.

What if you think the economy is downshifting? Maytag's multiple will most likely collapse as it anticipates a decline from the $2 in earnings power that we thought it had. I could see the multiple go down to 10 times earnings or even 9 or 8 as it has in past slowdowns and reces­sions. Of course, when it gets there, when the economy slows, it might turn out that Maytag really earns only $1.25 and it is back at that same 15 times earnings. Maytag would be a "short" in such an instance. (I'll explain shorting techniques in the final chapter.) The M fluctuates in anticipation of the downshift or upshift in the broader economy.

The PIE multiple of all sectors responds to the giant macro picture, which is why it is so important to stay focused on where you think the economy is headed. Remember, I am not saying that you must have a view of the economy to own stocks, I am simply pointing out that if you don't have a view you won't be able to capture the spurts that are caused by multiple expansion or contraction. But I think the gains that can be had by this method are so significant that it is important to try to have the larger picture in the back of your mind when you are selecting stocks.

How important? I had a chart above my desk at my hedge fund at all times that showed what should be bought based on multiple expansion and what should be sold based on multiple contraction. That chart derived from the accelerations and decelerations of the economy. I call this chart, by the way, my mental "playbook" because, as in sports, it tells me which "players" to insert in the lineup, or the portfolio, when the economic circumstances demand changes. On my television show we spend a tremendous amount of time trying to divine the next two to three percentage points of GDP (gross domestic prod­uct) precisely because of the point gains that can be had through multiple expansion or contraction based on that macro performance.

My chart, which looks like a wave, shows the ebb and flow of the economy and what works and what doesn't depending upon where the waves are going. Let me walk you through this. You need to know this if only because it explains what is known as "sector rotation," the driving force behind most days of trading in and out of groups of stocks that you see. Such trading drives the shorter-term performance of everything from Avon to Zimmer Holdings.

The chart starts at —2 percent with the economy expanding back toward flat-lining; zero to 7 percent growth. That's a classic recession condition. In a recession, the Federal Reserve can be counted on to cut interest rates on the short end, where it controls them, rather dramatically, as it has done in every recession since World War 11. The longer- term rates, which are not set by the Federal Reserve, also drop as the demand for money declines.

At any given time, the market is churning toward the next possible outcome. When you get to a recession, the stocks that have maximum multiple expansion—the stocks with the highest multiples—are those of companies with recession-proof earnings: the drug companies, the food companies, the soap and toothpaste companies, and the beer and soda companies. At a slowdown's depth, but before the Fed takes any action, these companies' stocks are prized possessions because they still deliver the E in the E X M = P equation. (The cyclical companies are missing their estimates like mad at that point in the economy.) The M expands to what is known as a "peak" multiple right at this point in the recession. So, if Procter & Gamble, the quintessential "recession-proof" company, normally sells at 20 times earnings, it might sell at as much as 25 or even 30 times earnings, depending upon how desperate the market participants are for growth at any cost.

Now, let me tell you what confounds most market players. Just when you think that P&G can't go down, just when you think that the M is going to keep expanding past where it has ever gone, that's precisely when you have to switch horses and get on the most depressed horse, the cyclical horse. No matter how many times I explain this stuff in my columns and on my radio and TV shows, it always comes as a shock to people because it seems so counterintuitive. But when I walk you through it you will see not only why it makes the most sense, but why it is incredibly easy to predict and to catch the gobs of points that come with it.

Right when you think that only P&G can deliver earnings, the Federal Reserve floods the economy with low-priced money to head off a serious downturn. Remember, the Fed can control both the printing presses of dollars—through the reserve levels it allows banks to carry—and the price of those dollars, by setting low rates for how much it costs borrowers to take down that money.

For individuals, who live and die by mortgage rates that don't fluctuate that much or by credit cards that never fluctuate, the lower rates may mean nothing. But for companies that are constantly making decisions about deploying capital, the sudden decline in rates acts as a spur to investment and demand. I have found that stocks anticipate that money spigot by about six months. In other words, when you think the Fed is about to become accommodative, to start slashing interest rates, that's when you have to leave P&G and focus on the "smokestack" companies that are cyclical in nature, companies that actually make things that are discretionary, as opposed to the necessities from P&G. Again, it always helps to think of this process in terms of stocks. So, let's take P&G versus Maytag. As the economy slows down or shrinks, the market anticipates the Fed's actions. It anticipates that what currently may look bad for Maytag and look good for P&G is going to switch. So, in my wave chart, I would have "sell PGIbuy MYG" because I was anticipating that while the E for PG is going to stay steady, the M would shrink, while the E for MYG is about to get better, and the M would therefore begin to grow. That's the opportunity to make the most money in Maytag; it's also the moment when you should anticipate losing money in P&G.

Remember, I always try to distinguish Wall Street from Main Street. In real life, business at P&G remains constant. The company doesn't do any better or worse depending upon the Fed; we just "pay up" or expand the M because we trust the E so much versus all of those cyclically dependent companies.

At Maytag, however, the lowering of rates is a big event. The stock acts accordingly and anticipates that things are going to get better.

The reason why most people don't understand this process is that right at that very moment, the shift of, say, — 2 percent going to 0 percent in the economy, Maytag seems incredibly expensive. Again, the process of the market seems remarkably counterintuitive. At the bottom of the economy, Maytag, which normally might earn $2, could make, say, only $1. As that downshift occurs, Maytag's stock gets crushed. If Maytag might have been at $30 when the economy was booming, I expect it to go down to $20 when the economy rolls over. That's the multiple contraction phase at work. (Why doesn't it pay even less than that? Because in the end, Maytag, the stock, can be bought by another company, one that wants Maytag's earnings for another cycle. The intrinsic worth buoys the stock of the company. That's the AT&T Wireless example in chapter 3. Market players are so fickle and care so much about future earnings that they often forget that these pieces of paper represent real companies and those companies are sought after by other real companies if the stocks of the potential targets trade through intrinsic value.)

Because stocks anticipate the fortunes of their companies, the col­lapse of Maytag the stock occurs ahead of the collapse of Maytag the company. Unfortunately, throughout this process of decline, the analysts who follow Maytag constantly reiterate their buys of the stock saying it seems so cheap based on the past earnings or on the earnings they are predicting. This moment is the most dangerous one for you as an investor. I have seen so many individual investors get burned at this juncture because a stock will seem so tempting as it comes down because it seems "cheap on the earnings." That's because they think both the E and the M are constant and that when multiplied they should equal a higher price. The siren song goes like this: "Maytag, which will make $2, is now trading at only 12.5 times earnings; it should trade at 15 times earnings, so buy it." The analysts don't respect the power of the cycles enough.

Me, I step aside, or at my old hedge fund, I would be shorting— or betting against Maytag—furiously as I would recognize that the E would soon fall apart, making a mockery of those who are looking at the past. During this freefall period, the analysts are slashing their estimates, and with each estimate slash the stock goes still lower. The estimate slashing collectively drives even more money to the PGs and out of the MYGs as the market seeks safety of earnings and flees earn­ings at risk.

That keeps happening. PG keeps getting pumped up and MYG keeps getting punished until the estimates for Maytag finally reflect the reality of the company's true fortunes. Of course, that's when the analysts who have been recommending Maytag all the way down because it appears to be so u cheap" on the $2 they are expecting at last cut their estimates down to $1. Because the process of analysis as practiced on Wall Street is so flawed, the analysts downgrade the stocks. That's right, all the way down they kept reiterating their buys, saying how cheap the stock is, trapping you in Maytag for the horrible slide. But at the bottom, they cut their numbers and then they say the stock is no longer cheap—the E is cut in half, making the M look really big and expensive—and the analysts take the stock to a hold or a sell. If they don't do this, their investment policy committees will make them downgrade the stock because Maytag is now too expensive on next year's earnings versus other stocks the firm is recommending.

That's precisely the moment when I cover my short or begin to buy Maytag. At that price and after that decline, I can predict that the Fed will take action to stimulate the economy. I can also predict that the intrinsic worth of a Maytag will buoy it. I would also expect that the dividend of Maytag, which might have been not meaningful at $30, could support the stock at $20. It is true that in a really tough recession Maytag might have to cut the dividend, but it can't cut its own intrinsic worth to another company that might want to own Maytag's business.

The reason why all of this processing seems so difficult is that with cyclical stocks, stocks hostage to the economic cycle, you must purchase them at precisely the moment when the M is highest. That's the opposite of what you do for noncyclical stocks. Noncyclical stocks must be sold when their M is highest.

Here's how the process plays out. As the economy downshifts, the stock of P&G goes up as market participants seek safety and pay more for P&G's earnings power. They sell Maytag because they recognize that Maytag's earnings power is too iffy. But once the economy shows significant deceleration, you have to have faith that the Fed will cut rates and start the expansion again, so you pay a super-high multiple for Maytag just when you must sell P&G at its super-high multiple. The process then works in reverse. As the economy improves, the analysts who deserted Maytag at the bottom and slashed estimates now have to take up their earnings estimates for MYG. Maytag begins to look cheaper and cheaper to them as the E is coming back in the E X M = P equation.

For me, as someone who anticipated the economy expanding, I now ride Maytag up, perhaps back to where it was, as the earnings estimates expand. During this period, one by one, the analysts come back to the stock and begin to recommend it. How do I know when to get off Maytag? I could, again, anticipate the slowdown that eventually occurs in all cyclical economies, but I have a much easier way. I sell it when all of the analysts love it again and start talking about how Maytag deserves an even higher multiple than 15 on that $2.I have captured the big move; I let others have the rest. In fact, that's when I tend to start embracing Procter & Gamble because at the top of the cycle nobody needs the safety of a PG, and its M shrinks.

So, you can see, as the wave progresses, from —2 percent to 0 percent to, say, 2 percent growth, I am riding MYG and shunning PG. As we get to where I expect the economy to peak out, 3-5 percent, I am selling MYG and starting to shift to PG. When we get to that 5 percent, I expect the Fed to put the brakes on, slowing the economy, and the process of the crushing of Maytag and the expanding of PG begins anew as PG will make its estimates despite the Fed's forced slowdown.

I don't mean to limit the discussion to Maytag and Procter. Some stocks, known as secular growth stocks, can transcend almost all cycles because they grow so fast. Yahoo!, eBay, and Amazon, for example, face few of the pressures of the Maytags or the P&Gs because they have organic growth that isn't dependent on interest rates. These kinds of stocks—which are few and far between—don't get caught in the cyclical pull. I consider them "unsinkable" against any tide, even if their growth can't last forever.

But the vast majority of stocks at these various stages in economic growth are just like men on a chess board: They advance or decline in predictable patterns that can be gamed. When I anticipate that the economy is about to reverse waves because of the Fed and go from soft to strong, I buy Dow Chemical and DuPont and I sell Coke and Pepsi. When I see the economy acting too strong I begin to anticipate the process of M compression and I lighten up on my Phelps Dodges and my Alcoas as the Fed starts tightening. Again, it will seem counterintuitive to most outsiders because at the top of the economic cycle these big cyclical companies are making money hand over fist, but you must anticipate that such profits can't last and you must jump ship when the M is the smallest, just when, all those analysts are telling you how cheap things are getting.

This sector rotation is perhaps the single most difficult part of the investing process because the notion of selling cheap and buying dear is totally antithetical to the beliefs of most investors. Yet it is a total article of faith with me to the point where it will seem that I am recklessly buying the most overvalued cyclical stocks and mindlessly selling the cheapest cyclical stocks.

I love sector rotations and have gamed them for years and years. Near the top of every economic cycle I reach into what I call my fridge and medicine chest stocks, all of which have been thrown away because no one wants dowdy old Procter or General Mills or Colgate when things are booming. And just when things look most terrible I banish all that stuff that you buy at the supermarket and the drugstore and I load up on the big uglies the market gives away. That's how you let the market work for you to catch the biggest sector rotation gains.

If this method strikes you as something you could do at home, you need not be limited to individual stocks to exercise it. While I have a predilection toward individual stocks, both the sector exchange traded funds and the Fidelity sector funds can be used to move in and out ahead of sector rotations.

Let's go through the typical scenarios of the wave of the economy so you too can anticipate the ebb and flow correctly when you are picking stocks. These scenarios are preciously important for those who are trading discretionary money for big profits, but less impor­tant for those playing the twenty-year investment cycle with retirement money. The classic texts all repeatedly deemphasize these cycles, but I have talked to thousands upon thousands of investors and they all have one thing in common: They don't like to lose money even if it means that they can make it back on the next cycle.

If the economic waves are coming in, meaning the economy is getting stronger, we have to monitor the Fed as soon as the GDP growth gets above 4 percent. That kind pf growth rings bells at the Fed that it is time to cool things off, that it has to tighten—even if the Fed says otherwise. Am I calling the Federal Reserve governors or the chairman liars? Not really. But the Fed's job is not to figure out this stuff for you, it is to keep prices stabilized, and the governors send out multiple false signals. Just pay attention to the growth rate and don't listen to what they say, because you know what they will do. We can forecast what they will do based on what they have done in the past. When the economy heats up you will begin to see all things financial—real estate investment trusts, savings and loans, banks, insurers, brokers, mortgage companies, and homebuilders—trade down. It is ritualistic and can't be ignored by anyone trying to make bigger money than the market it-

self. That's because the big mutual fund elephants want out of these stocks before their earnings are impacted negatively—or the estimates get cut—because of rising interest rates. I know for many that's a big leap of faith. You might own companies that claim that they aren't rate sensitive. But if you are in the business of money you are by your very nature rate sensitive, regardless of what you say and tell investors. More important, remember that this book focuses on the stocks, not the companies, and whether the execs at the companies like it or not, financial stocks go down in this environment even if the businesses perform at better than expected levels.

At the same time, the techs and the cyclicals will react well during this period. The price of money, while important, isn't as important to them, and they are usually starting to fill up their order books nicely courtesy of the growth in the GDP. They "correlate" properly; this is why they are called cyclicals!

When the economy steamrolls even higher, to 5 percent, you have to start selling the stocks of the retailers and the autos because the higher interest rates that are coming are going to impact consumer spending. That drag will cause the earnings estimates to get cut and the M is going to shrink in advance of the E! You can still add to the positions of the deeper cyclical companies and tech companies, though, as their earnings momentum is slower to be broken by Fed tightening.

By this point, at 6 percent, the Fed should have hiked once, maybe even twice or three or four times. If we are at 6 percent and the tide is coming in and the Fed is still tightening, we have to anticipate that the tide is about to go out—dramatically, as it did in 2000 and 2001 when the Fed sent us into recession by moving interest rates all the way up to 6.5 percent. We have to begin to sell the cyclical stocks and the techies that we accumulated when the economy was just accelerating and we have to anticipate that even as rates go higher, the Fed will soon be­come too vigilant. The moment after the third tightening is the most perilous moment in all investing. It is the time when I like to stay on the sidelines, build up maximum cash for all but the longest-dated of my portfolios (my 401 [k] and my IRA), and wait. Cash, not even bonds, is king at these junctures. In fact, because the Fed is raising rates regularly at this point, the price you get for your cash, for your money that is being kept in the bank, is beginning to look attractive, especially against the dividends that won't keep up with the Fed rate hikes. Cash is king. I like to presume that after the fifth or sixth tightening, the Fed's actions will have the desired effect. That's because, with short rates so elevated, it becomes prohibitive to build up inventory of just about everything, from stocks with margin loans to copper, plastic, wood, or any other kind of inventory. The business cycle shuts down at high rates because businesses can't afford to borrow to take down merchandise to sell. They also can't afford to bet that if they order a lot of stuff to sell they will do well, because the price of that stuff increases due to inflation. It is the inventory cycle that gets busted by high rates. It always happens. It happened in 1994 and in 2000, the first time with what was known as a "soft landing," meaning that the economy braked nicely, and the second time in a hard landing, where businesses quit taking down any inventory and sales just stopped.

It's at that moment when the economy still appears to be roaring that I switch to buying the most boring consumer staple stocks, the ones that do best without econsmic strength, the Procters and Kim- berly~ and Colgates. Then, when these stocks are all at their fifty-two- week highs for several months—it does last that long—when the m's are steepest on them, you sell them, sell them hard, and buy the home- builders, the real estate investment trusts, the brokers and insurers and the mortgage companies and even those retailers that you threw out when things got too hot. Their time on the wave is now at hand as the tidal process begins again.

For the most part, the mental playbook that I have now put on paper for you rules. The playbook is so powerful that if the big market participants even think there could be rate hikes ahead, if they even smell rate hikes, they are going to sell whole groups because they anticipate the decline in the economy. It is incredibly important to have a sense of where you are in the economic cycle if you are going to pick stocks even for the long term. Otherwise I predict you will get dis­couraged when you buy Coke and expect it to ramp up only to see Alcoa and International Paper taking off every day while Coke and other growth names languish.

These patterns are burnished into the thinking of all big-time portfolio managers; when these elephants move, they move stocks with them. To ignore their activities—especially when they are so easily predicted and anticipated—is a tremendous waste of money for all investors, short- or long-term. Given that you can set your clock to these patterns, why not take advantage of the big GDP cycles and make some good money at the expense of the elephants who simply can't help themselves. Except for takeovers, their movements are by and large the most important catalysts for large-scale moves in stocks.

The second and by far the most difficult way to predict a big move is to try to figure out possible changes in the E portion of the E X M = P equation for an individual stock away from the broader economic cycle. This is the method that the vast majority of people on Wall Street—sell side, buy side, hedge funds, mutual funds, strategists—try to live by and, predictably, it is the hardest and least rewarding. Put simply, every brilliant mind on the Street is playing in this field. It is, I am afraid, an almost Sisyphean task and not just because of the bruising competition.

For the longest time, I was able to chat with the chief financial officers of companies to see how their businesses were doing versus their competitors. With this information I was able to build models that showed me what companies might really earn versus what Wall Street thought they would earn. Sometimes I would divine that companies were going to report upside surprises, other times I could figure out when there would be shortfalls. It was never perfect because no CFO was allowed to talk to you during "quiet period" when they were within five weeks of the end of a quarter.

Still, when the companies reported their real earnings, Wall Street was surprised to the upside or the downside and I would sell my stock into the upside surprises I predicted or cover my short into the downside. There were tremendous and quick profits to be had using this method.

But several years ago the SEC decided that these private conversations should no longer be allowed between private citizens and the CFOs or the CEOs. The SEC passed a rule that said there had to be fair disclosure of data to everyone simultaneously or that no one could get it. That meant that nobody could do homework working with the company to build a better model than anyone else, and the possibility of predicting surprises with help from the company ended for all, including the sell-side analysts who used to cozy up to and have special relationships with management.

That was a bummer for me as a professional, but it has proven a boon to me as an individual investor. Now I know that no one has an edge over anyone else at least as far as what the company might tell them legally. That doesn't mean, though, you can't predict the surprises. It is just either more cerebral or more time-consuming and requires a lot more research.

For example, when I was just starting at Goldman Sachs I was able to catch a big earnings upside in Reebok simply by noticing that Reeboks didn't stay on the shelves during the aerobics boom in the 1980s. Sure, I had to go to a dozen stores and chat up salesfolk to ask, but that's still legal. You can still build a model from the ground up. It just takes a tremendous amount of time and energy to do so, too much time and energy for anyone not doing the research full-time.

Similarly, I had the greatest short of my career by staking out a couple of Gantos, a now-defunct retailer, on several key Saturdays and noticing that no one was buying. My dad and I stationed ourselves right next to the register weekend after weekend for a month at selected Gantos and tallied how much-—or in this case how little—was really being purchased. I was able to predict an astounding decline in earnings as the analysts took as gospel from management that the company was doing well. Those big store registers never lie. That's still fair game, too.

But that kind of difficult and time-consuming research is beyond the abilities of most, but not all, everyday investors. The more realistic approach to gaming the E is to try to anticipate spending cycles, particularly capital expenditure cycles, and ride the stocks from undervalued to overvalued as it dawns on other market participants that a big earnings cycle is at hand.

For example, the airline business is notoriously cyclical, with a seven fat year, seven lean year cycle almost etched in stone. Boeing, one of America 's best companies, has been fairly good at predicting cycles through its own order book. When I detect that Boeing sees a cyclical upturn, I load up on the stocks of all of the companies that make parts for Boeing, all of which tend to be through the floor at the bottom of the cycle. I buy the stocks of companies that make fasteners or screws (Fairchild) or seats (BEA Aerospace) or cockpit instruments (Honeywell) and I wait until they see the orders and then the earnings that those orders provide and then, when everyone starts touting the stocks—usually at least a year into the run—I begin to scale back the holdings and sell into strength. It's tougher than it sounds; I start to sell when all of the analysts are furiously raising estimates and the stocks are expanding by leaps and bounds. But you must sell that strength gingerly, scaling out into the strength so as not to get caught at the top. The keys are to have lean enough inventory of the merchandise when the big Wall Street store is giving it away and have enough inventory so that you have enough to sell when your wares become ultrafashionable again.

There are many big economic cycles like the one in aerospace. Semiconductor equipment cycles, for example, are long and easily playable. When the semiconductor companies begin to do well, they raise money in the public markets to buy equipment. These companies can't resist doing so. You then have to buy the stocks of Applied Material and KLA-Tencor and Kulicke & Soffa and Novellus. However, once Wall Street starts raising too much money for these equip­ment companies, it is time to leave the table.

My favorite cycle to play is the telco equipment cycle. Here you have an extremely competitive industry that has lean and fat years. When these big telephone companies are flush they always begin to buy equipment, and you can predict that the earnings estimates for the Nortels and the Lucents and the JDS Uniphases will soar. But when the companies start to get too competitive and the returns aren't there, or when they merge, they will cut back dramatically on equipment spending and the stocks get crushed. You can't judge these vendor companies by the managements; they almost never see it coming and have been known to blow analysts and investors out of the water regularly. You have to watch the customers themselves, the SBC Communications and the Bellsouths and the Verizons and the Voda- phones and Nippon Telegraph & Telephones. When they are doing well, that's when you buy the telecom stocks. When they are doing poorly, regardless of what the vendors say, you must sell.

There are many cycles out there that are worth playing. Pharmaceutical companies are constantly introducing new drugs, some of which sell exceedingly well, boosting profits dramatically. And of course, the takeover cycle that I anticipated in the oil patch with Gulf Oil can make you a fortune if you are in a group that's about to consolidate because there are too many players. As I write in 2005 the oil cycle is very much "on," particularly for the under $1 billion equity names. You could have thrown darts at the participants in that cycle in 2004 and crush the S&P 500's return.

In these methods of predicting big moves, the multiple expansion- contraction process and the predictable sector spending cycle technique, it is the anticipation that matters. Once everyone realizes what you anticipated, it is time to take profits.

That makes investing, by the way, a much more lonely and difficult process than most people think. You have to love stocks when people hate them, you have to leave stocks when people love them. That's the most puzzling thing in the world to do because you will always feel alone and isolated. It is amazing, but those are the feelings I always have in my gut before I make the most money. Because I am so public with myActionAlertsPLUS.com account, I am constantly selling what's hot and buying what's not, feeling the heat of the investing public telling me how wrong I am. I will know, though, that that's when the biggest gains are about to occur. The day I don't hear the catcalls is the day I know that I have already missed the big chance for big money.

For many of you, this whole notion of catching cycles of any kind might just not be worth the effort. You simply want to own high- quality stocks all the time and you don't have the time or the inclination to make the switches or play the cycles. It is too labor intensive for you. Or you find it too difficult to fathom the changes and make the calls. That's okay, you can still do fine, maybe even as well as the mar­ket, but you will never beat the market and you will never catch the big moves that can make you rich in a shorter time than the long-term stock cycles will allow.

So let me tell you a story that might change your mind and get you to think more about these cycles. When I started my hedge fund in 1987,I was determined to buy the most consistent growth companies I could find. I was determined to avoid the rotations, to buy and hold good-quality companies and make money over time. 1 figured that those growth companies would continue to increase in value over time because the market loves growth so much. Isn't that what great investing was supposed to be abo~? Don't heed the short term, think long-term!

After two months of running my hedge fund I found myself down 9.9 percent. Unbelievable. I was being taken apart, just annihilated by my growth stocks, like Heinz and Merck and General Mills and Coke. My partnership had a "down 10 percent" clause—I go down below 10 percent and I have to give the money back. It's pretty frightening when you are about to lose your livelihood because of your poor performance; it concentrates the mind about the cycles like nothing else.

What was worlung? Why, Phelps Dodge and Dow Chemical and Alcoa. These stocks were killing my stocks. I thought it was incredibly unfair given that these big metal and chemical companies didn't have real growth over the long term, certainly not any growth in excess of the rate at which the gross domestic product of the United States was growing. Their rallies seemed absurd. Didn't any of the buyers under­stand how they would eventually be led astray by PD and AA? Didn't people just want to buy and hold the great growth companies? Isn't that the best way to get rich?

At the time my girlfriend, Karen Backfisch, was on the trading desk of Steinhardt Partners, where every day she was taking down 500,000- share blocks of Alcoa and Phelps Dodge and Georgia Pacific and International Paper. She read me the riot act when I told her that I was sticking with my consistent growers. She explained to me that the market only likes "consistent" growth during an economic downturn or when the economy is doing nothing. Its first love affair is with "inconsistent growth" during one of its periodic explosions. She traced out a chart for me that I have been using ever since and that you can find on page 115. Put simply, when the economy is growing between 1 and 3 percent, you should own all of the Coke or Pepsi you can get. You should load up on the Pfizers and Mercks and Heinzes. When the economy is growing at a 3-6 percent clip, though, you have to own the cyclical stocks because they will have the best year-over-year comparisons. My future wife convinced me that most people who determine prices in the stock market have no real knowledge of history. They simply look at the number that is reported, and when they see PD .86 versus .38 (as in Phelps Dodge earned 866 this quarter versus last year when it earned 386), the market will go crazy for Phelps Dodge regardless of whether it will slip back to 384 or not by this time next year. While she was, of course, being a tad glib, to ignore these moves, to act as if you can sit out these moves, is the equivalent of saying,"You know what, I don't care if the elephants are about to trample me, I don't care if there is a stampede going on, I am just going to lie here and tough it out in these growth stocks and ignore the pain." How terrific it would be if I could tell you to do the same and you would do it.

Every single investment text I have ever read says you should ignore the thunder and just stay put in growth if not buy more. Every single one! But remember, I don't put much faith in investment conventions. I know better. I know human behavior. I know what happens in real life when you ignore the playbook, when you stick with the so-called secular growth stocks while the elephants are dancing to the cyclical tune. What happens is that you panic. You sell at the worst time, the bottom. You bail. You say, I can't take the pain. I have seen this so many times that it bugs the heck out of me to hear the arid, bloodless graybeards say, "Oh, just ride it out : ' knowing full well that they aren't! Riding it out is for masochists, and I don't know a lot of masochists when it comes to money. I know that back in 1987, I switched then and there to the stocks that were working and I saved my company. I never again listened to those who advocated riding out the storm in so-called high-quality stocks. Oh, and for the record, my faves never came back; many are still priced at roughly where I sold them almost twenty years ago.

Let me give you another real-life example. A caller rang me up last year during one of my radio sessions where I play "Am I Diversified?" He owned a ton of bank stocks ahead of an imminent series of tight- ening~. He said he had heard me preach that he should step aside, avoid the pain, that the pain doesn't always produce gain. But he couldn't because he needed the yield that the financials offered, many of which were in excess of 3.5 percent at the time. I laughed. I said, The market works in strange and positive ways. For every major bank stock yielding 3.5 percent, I know an oil stock that yields 3.5 percent. The difference is that the banks are soon going to be yielding 4 percent because those stocks are going down (remember, the dividend stays constant, but you divide it into the stock price to get the yield, and the yield goes up when the denominator—the stock price—goes down) while the oils are going to be yielding 2 percent because they are going higher! My point was that the idea of staying in the financials for the dividends is pointless given the capital depreciation ahead, but if you insisted on yield I know I could find you a like group with a like yield that will go up, not down, ahead of rates.

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