Why I Don't Use Stock Filters

Part of the reason why I enjoy networking with smart friends from around the world is that they get me thinking, and usually they don't even do it on purpose. A recent example was a conversation about how I don't use filters to find trading opportunities. This topic came up several times over drinks and/or dinner this past week at Stocktoberfest down in beautiful Coronado, CA. My response to questions like, "What filters do you normally use?" was, "I don't use filters". The expressions on people's faces were priceless, especially from those who have followed my work for years and are aware of the diversity of asset classes that I incorporate into my analysis.

There is a perfectly good reason, I promise. After I explained it to them, on the several occasions where this topic came up, I decided that this was probably an interesting point and one that I should write about on the blog. There's a reason why I have a blog and so many others do too. We're here to share ideas and brainstorm with each other. This is a great community that we're a part of and sharing ideas, whether we agree with each other or not, is what we're here to do. So here's how I look at it.

Long time readers and followers on the Stocktwits and Twitters of the world know that for me it's all just letters and numbers. I don't care whether we're shorting S&Ps or buying Indonesia or Soybeans or Apple. I'm not a long-only guy, thank the holy lord. I'm not an U.S. equities-only guy, thank the holy lord again (and don't even get me started on how lucky I feel every day when I wake up and I'm not an economist). I'm extremely fortunate that in 2005 I decided to get into technical analysis and have approached the marketplace as just that: a marketplace of buyers and sellers. Through my work, I have discovered, both the easy way and the hard way, that every market environment is different.  Where a particular pattern (price pattern, intermarket pattern, correlation pattern, etc) once worked in one environment, won't work the same way a few years later in a completely different type of environment. It's not that it's different this time......it's different EVERY time.

The biggest reason why I don't use filtering systems is because in order to understand the current market environment, I think you have to do the work and go through them all. You can easily punch in a bunch of data points into a filtering system and get what you want and keep adding filters until it only spits out a hand full of names. You can go and back-test any sets of filters you want to match whatever successful strategy in any environment in history. We can all do it. I sat through an "Intro to the Stock Market" talk a few weeks back and they were teaching people how to use filters about 20 minutes after teaching them what the Dow Jones Industrial Average was. It's not hard.

We're all different and approach the market from different perspectives and with different goals. For me, I want to get a good understanding of how the world looks. I want to know how the different sectors in the U.S. are behaving relative to one another. I want to know what the energy commodities are doing and how the agricultural commodities look. How are precious metals behaving like Gold and Silver, and how does the US Dollar affect them and how are the individual components of the U.S. Dollar Index like Euro or Yen going to affect it. What does that do to individual sectors here in the U.S. or other countries around the world like Peru or Chile or other Emerging Markets that are tied to their currency being affected by commodity prices. These are just a few examples of the intermarket weight-of-the-evidence work that I do, but there are an infinite amount of examples that I can point out.

I sit there constantly and review every single stock market around the world on multiple timeframes. I want to look at longer-term charts of each country to gain some historical perspective on where we are and then work my way down to a daily timeframe from the past year or two to get some short-term context for tactical opportunities. There is a huge advantage in using multiple timeframes. I then use this same multi-timeframe approach on every single sector and sub-sector here in the United States. I'll look at Energy as a group, S&P500 Energy Sector and then break it down by category: Oil Services, Refiners, E&Ps, etc. Then I'll go to Financials: S&P500 Financial Sector and then break it down to Regional Banks, Broker Dealers, etc. Same for the rest of the sectors like Healthcare/Biotech or Technology/Internet or Materials/Miners which then break down to precious metals miners, base metals miners, coal, etc. If I decide that buying Financials is the move, then which type - Banks or BDs? Is an ETF the best risk/reward or does an individual component present the best bang for your buck? Do I own $KRE as a group or is one of the individual banks better, or perhaps a couple of them? Do I not like the S&P500 and prefer to own banks as a pair and buy $KRE and short an equivalent amount of the S&P500 to take advantage of relative strength? It all depends on the environment and not all of them are the same.

Once I've gone through all of the stock markets around the world and come here to the U.S. I want to make sure that not only do I have a good understanding of the sectors themselves, but on the differences between the major averages. The NYSE composite for example is heavily weighed in ADRs. In fact almost a quarter of the holdings are international names and more than half of the biggest 100 names (it's a cap-weighted index) are from outside of the U.S. This index gives us a more global outlook. Then I look at the large-caps S&P500 and Dow Jones Industrial Average. Although one is cap-weighted and the other is price-weighted, the correlations are through the roof, don't let anyone tell you otherwise. Then I move on to the Tech-heavy Nasdaq100 Large-cap index. Then I look at the Dow Jones Transportation Average which consists of completely different names that are in the other averages. Once I get a good idea of what the large-caps look like and their differences, I work my way down to Mid-caps, small-caps and micro-caps. Even the Dow Jones Utilities Index and Dow Jones Composite Index (all 3 together) have a place in my analysis. All of these, again, are on multiple timeframes - to get both long-term and short-term perspective.

An often over-looked piece of the puzzle is how valuable it is to go through all 30 components of the Dow Jones Industrial Average. I would argue that this is one of the most important activities in my regular process. There are only 30 stocks. So you want to know where the U.S. Stock Market is going? I promise you that if there are more bad ones than good ones, it's probably not going up. The opposite is also true. Going through all 30 names one by one on multiple timeframes really gives you great perspective on things. Where is the strength? Where is the weakness? Are there more good ones or bad ones or is it evenly split? Nike and Home Depot don't look anything like Exxon or IBM this year do they?

Finally I want to see how interest rates, currencies and commodities fit in to the over all picture. This, to me, really brings it all together. When you see the oil stocks getting smoked, in the Dow review (XOM & CVX) while the Energy Sectors are getting killed (XLE, OIH, XOP, etc), and then you see how Oil is getting slammed along with some of the other energy futures like Heating Oil or Unleaded Gasoline, it all makes sense. It's a big puzzle we're putting together. I want to look at all of the commodities futures (there are less than 20 that I look at ) and all of the major currency crosses (I look at about 15). Not that it's necessarily always relevant, but how do interest rates look, both local and abroad, short end and long end of the curve?

Correlations are another part of the process that I value. This is something that is constantly changing so it's important to always keep up. There have been times when the U.S. Dollar and U.S. Interest Rates move together, and there are times where they move in completely opposite directions. This sort of thing drives the theoreticians, like academics and economists, crazy. Every environment is different and contrary to popular belief, U.S. Rates and the U.S. Dollar do NOT always have to move together. In fact, there have been a lot of times where they move in completely different directions. So I suggest being careful in what you assume and do the work for yourself to figure it out. Theoreticians see price do something in reality and then come up with reasons why it can't happen in theory. I never understood that. The great Yogi Berra, may he rest in piece, once said, "In theory there is no difference between theory and practice. In practice there is."

Finally I want to do my ratio analysis. I have about 40 different ratios that I review constantly to see how money is flowing. Although you can get a pretty good idea of what the deal is after all of the multi-timeframe analysis we've already mentioned, the ratio analysis can either confirm a given thesis or perhaps point out something that you may have overlooked. Some of these ratios include Consumer Staples vs Consumer Discretionaries, US Treasury Bonds vs US Corporate or Junk Bonds, Stock Markets of Developed Nations vs Emerging Markets, U.S. vs Europe, Latin America vs Emerging Markets, Gold to Crude Oil, Gold to Silver, etc. All of these ratios tell a story and all of them are relevant, in some cases more than others depending on......? You guessed it: the current environment.

This now brings us full circle. Sometimes certain things are more important than others. This makes it impossible to create a filtration system that will always work. Some people don't have the time to do all of this work, but this is what I do for a living. Even if I didn't do it professionally I would still do the work because I love it. To me it's a hobby that I happen to get paid to do every day. I feel like a pro baseball player that gets to do what he loves every day, play ball. My grandmother asks me, "I don't understand, what is it that you do?". I tell her, "I build puzzles and answer emails". The answering of emails is not anything I can help, or a lot of us for that matter, but the puzzle building is something that I cherish. This is a constantly changing and evolving puzzle that I'm always trying to solve.

By using a filter to bring names to me I would be skipping all of these steps mentioned above which makes it impossible to get the same feel for the current environment as I would otherwise. We can sit here all day going back and forth about this, but I promise, by going chart by chart, market by market, you begin to recognize certain trends or patterns. The flow of money is a story that the market is telling us. But you have to read the story in order to figure it out. By reading the front cover and skipping to the back of the book to find out the ending leaves you with a lot of questions that a filtering system simply will not provide for you.

With each asset class I use a 200 day simple moving average (daily & weekly) mostly for trend recognition and historical context. By going chart by chart all over the world, you can see where each market is relative to longer-term and short-term smoothing mechanisms. This helps me discover where the relative strength lies and where the areas of weakness are. I use a 14-period Relative Strength Index, otherwise know as RSI (daily & weekly) mostly to look for reversals in trend. When you start to see bullish momentum divergences within declines again and again and again market after market.....guess what? A reversal is likely coming. 3 weeks ago was a good example and I was very vocal about it on Stocktwits. There were simply far too many bullish divergences for me to ignore. Had I skipped that step and tried to use a filter to generate ideas, I would have missed that move, I promise.

So what filters do I use? Truthfully I do use filters when it comes to Sentiment. Unfortunately this is data that 95% of the time is completely worthless. Market sentiment tends to live somewhere in between bullish and bearish. For me, I want to know when sentiment, regardless of the asset class, is at an extreme. For me, sentiment is only valuable during or just before the unwinds from these extremes. The U.S. Dollar this March was a great example. I've never seen so many bulls in the Dollar in my life. That was insane. We've gone straight down ever since.

So that's my take on filters. I'm open to hearing your thoughts, but I wanted to share with you guys some of the conversations I had repeatedly over the past week and one that has come up plenty of times in the past. I think it's important to put thoughts on paper, both selfishly as an exercise, but also for others to read and benefit from. I promise I've learned so much by simply reading things written by those who came before me and had to learn things the hard way. Some of this top/down process came by learning from others, but the majority of this process has come through trial and error and by navigating many different market environments over the years. It's the only way to learn.

I hope this adds some value and you can include some of this into your arsenal. But this is how I see it. It works for me and this process really gives me a good handle on where money is flowing in and out from and where to look for the best risk vs reward opportunities. It's a top/down approach that I am happy and proud to call my own.

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