Martin Zweig Winning on Wall Street

by Martin Zweig

  MY FIRST INVESTMENT

  Late that summer I finally decided to test my knowledge by putting some money where my heart was. I had a couple of thousand dollars in savings and was ready for the big plunge. My first purchase, not surprisingly, was General Motors. I bought fourteen shares to round out my position to an even twenty. The stock was selling in the low forties at the time, and I would eventually double my money in it, excluding the dividends, which were fairly hefty. Years later I discovered this was a typical first-time investment. The novice feels more secure buying the blue chips, and there were few stocks higher on the blue chip scale than GM in those days. Besides, I was comfortable with it, having followed the stock for a long time. Turned out to be a darn good investment, too.

  Of course I wanted a diversified portfolio, so I busied myself trying to select more stocks. My second choice turned out to be an immediate disaster and taught me a lesson. A broker recommended American Cyanamid, a large chemical company. I had analyzed the earnings and done the statistical work, and the investment seemed to make sense. I purchased twenty shares. And, wham, my first day in it the stock dropped four points, a 10 percent plunge. I couldn’t believe it because the market had been very quiet that summer and price movements of even half a point were a lot. What the heck had happened?

  It turned out, as I recall, that the company was hit by some kind of government antitrust suit. What mattered, though, is that there was unexpected bad news in the stock and suddenly I was down 10 percent before I had barely gotten my feet wet. I did hang on to the stock, and I wound up making money on it. But it was a pretty lousy way to start out. Over the next couple of weeks I also bought some odd-lots of Gulf Oil and Dan River Mills. Thus I began my portfolio.

  Although I had been buying odd-lots in the summer of 1961, I really didn’t want to see the market take off at the time. In a few years, when I turned twenty-one, I was going to inherit several thousand dollars from my father’s estate, and I was hoping I could invest that money when stocks were cheaper. As it turned out, I didn’t have to worry about it. From the spring of 1961 on, the market began to churn on extremely light volume. If you think the tape is slow today when three hundred million shares are traded, imagine how lethargic it was on those summer days when trading failed to reach even two million shares.

  The market had had a huge run-up from the fall of 1960 into the spring of 1961, when the momentum waned. Prices then stayed in a very narrow range for the rest of the year and into the first quarter of 1962. In the early spring of 1962, the market began to cave in.

  I was then in my sophomore year at Penn. Just about when school finished for the spring, the market collapsed in what became known as the 1962 crash. The debacle was blamed on President Kennedy’s strong words against the steel industry, but that was just the catalyst, triggering a break in a very weak market. Actually, I found the dramatic slump in the market exciting to watch, especially since I had very little invested and very little to lose. But I noticed the pain around me.

  In the summer of 1962 I spent a few weeks in New York visiting school friends. I vividly recall a night in early June at a friend’s home. His father was there with his accountant, and they were furiously going through stock transactions and other records. There was anguish on his father’s face, and I knew something was seriously wrong.

  My friend filled me in on a few of the details. Apparently his father had been heavily margined in the stock market and had been hurt during the break, especially in his big Polaroid holdings, one of the day’s chief glamour stocks. Now he was scrambling to raise money from his other assets to meet the margin calls. Polaroid had climbed smartly for years, but the 1962 break hacked the price considerably. At least that story ended happily. My friend’s father survived the crisis and the market rebounded, with Polaroid one of the leading stocks in the ensuing bull market.

  The point of the story, however, has nothing to due with Polaroid. Indelibly etched in my mind was the agonized image of my friend’s father that spring night of 1962. Watching the wound inflicted by stock market reverses gave me concern. It increased my respect for the impact of any future stock market break. I had had something of a hang-up about 1929 anyhow and couldn’t help worrying about what would happen if I were in the market and another 1929 occurred. I had just witnessed a miniature version of it. That incident lit a red light in my mind to alert me never to get caught in a stock market collapse. At that time I still knew absolutely nothing about the warning signs of such a break, but I was determined to find out.

  I finished my four years at Wharton, majoring in finance my last two years and specifically concentrating on investments and the stock market. I took every stock market course offered, but I knew my education was far from complete. About the only thing they really taught us was how to evaluate individual stocks, using as a text Security Analysis by Benjamin Graham, David L. Dodd, and Sidney Cottle, a bible of fundamental analysis. The whole idea with Graham, Dodd, and Cottle is to buy stocks with good value that are selling at reasonable multiples and paying satisfactory dividends, and to make allowances for risks. That’s okay as far as it goes, but, to my mind, it left a lot of important things unsaid.

  Nothing was taught about movements of the market as a whole, about technical factors such as the market’s own price action, crowd psychology, or the impact of the Federal Reserve and monetary and economic variables. In other words, when I left Wharton I had at best just one tool to work with, and that clearly wasn’t enough.

  I started in the M.B.A. program at New York University in the fall of 1964. I selected that school because it was located next door to the American Stock Exchange and because they had numerous stock market courses listed in their catalog. Unfortunately, during that first term I had to repeat the same fundamental courses I had just completed at Wharton. That rankled me because I felt I wasn’t learning anything new. I had also just gotten engaged to my future wife, Mollie, and she was in Miami going to college. Tired of being away from home, I decided to return to Miami.

  Resuming my education, I enrolled at the University of Miami, taking courses at night. I opted to work during the day because I needed the money. Unlike my previous job-hunting experience, I was immediately offered jobs by three brokerage houses. I mean I was offered the jobs—I didn’t ask for them. I had already gotten a modest reputation as a trader in the market, not necessarily a good one, just an active one. Active enough to earn the nickname Trader Horn from my friends.

  I had carried an account for a couple of years with Bache & Co. in Surfside, Florida. The branch manager there, Edwin Crooks, offered me a job as a broker. I accepted it against competing offers from two other firms because I liked and respected Crooks. I stayed there only about seven months, just long enough to get my license and then relinquish it, because I wanted to return to school. But my time at Bache was not wasted, thanks to Crooks.

  Crooks was an old-timer who, early in his career, was the youngest member of the New York Stock Exchange at the time of the 1929 crash. He loved to talk about the old days, and I was his best listener. Of the many stock market stories Crooks told me, I found most fascinating his descriptions of what it was like working for Jesse Livermore, one of the most fabulous traders of all time. Later I read a great deal about Livermore, and if there is anyone who is even close to being my hero in market lore, it is Livermore. His emphasis on letting your profits run and cutting your losses has always stood me in good stead.

  Leaving Bache at the time Mollie and I were married in 1965, I went to the University of Miami as a full-time graduate student. I picked up my master’s degree in one year, again taking every stock market course available. All these courses were taught by Professor Wade Young, who was heavily oriented to the technical side of the market. Technical analysis, as we’ll see later in the book, in its purest form is a study of only those variables that you can see on the ticker tape, namely price and volume.

  At first I did not agree with Professor Young’s methods, eve
n though I had studied technical analysis on my own. But years later I recalled some of his advice such as “Buy on strength and sell on weakness,” and I began to appreciate the value of that approach more and more. But in those days, like most novices, I thought the trick was to buy on weakness and sell on strength. That’s exactly how most people get themselves into trouble in the market.

  While finishing my M.B.A. work during the summer of 1966. I taught a course in corporate finance at Miami and enjoyed the experience tremendously. For several years I had dreamed of getting up in front of a class and lecturing on finance or stocks, and finally I had my chance. I knew I didn’t want to spend my life as a cloistered college professor but found the work most rewarding. However, the more I taught, the more I realized how much I had to learn.

  The next step was my decision to go for a Ph.D. in Finance. Miami did not have such a program, so in the fall of 1966 I took off for East Lansing, Michigan, where I enrolled in the doctoral program at Michigan State University. Determined more than ever to improve my formal education in the whys and wherefores of the stock market, I naturally majored in finance and specialized in the stock market. I spent three years at MSU, finishing in 1969.

  At Michigan State I learned a lot about economics and more about the fundamental analysis of common stocks. I was also exposed to the academic theories of the market, which boiled down to the idea that the market moves in a so-called random walk in which past pricing patterns do not necessarily predict what will happen in the future. Moreover, the academic community generally favored the concept of an efficient market, one in which no amount of economic, fundamental, or technical data could hope to forecast stock prices any better than you or I could by buying a large, diversified portfolio, putting it away, and forgetting about it.

  I rebelled at these ideas. In fact, one of my professors, Alden Olsen, didn’t agree either. Professor Olsen apparently had been rather successful in managing money for himself and others and generally proceeded on the basis of value and contrary opinion. That is, he bought stocks that were out of favor and that were undervalued.

  But most of what I learned in my three years at Michigan State I picked up on my own, particularly as a result of research for my Ph.D. dissertation on the puts-and-calls option market, my main interest at the time. (Basically, when you buy a put, you acquire the right to sell a hundred shares of a company’s stock at a stated price within a specified period of time. Conversely, a call is an option to buy a hundred shares of a company’s stock over a stated time period.)

  These were the days long before there was a Chicago Board Options Exchange or any other listed exchange on which to trade options. Back then, puts and calls were traded by dealers who specialized in them. The market was small and not very liquid. I was hoping to find a way to make big money in options but, after studying the results of fifty-four different trading strategies, I concluded in my dissertation that the returns on a risk-adjusted basis didn’t warrant playing the options market, largely because of the huge transaction costs. Those findings do not necessarily apply to today’s options market because transaction costs are lower and liquidity has improved. Nevertheless, I’m still not enthusiastic about trading options.

  I was disappointed that all my work on options had failed to uncover a way to beat the market. But I did discover something that proved to be more valuable in the long run. In accumulating data for my dissertation, I unearthed some figures from the Securities and Exchange Commission going back to World War II and found that when options investors got too optimistic—buying lots of calls and shunning puts—the stock market was generally heading for trouble. The reverse was also true. When the options players were very bearish on the market—favoring puts and selling or avoiding calls—the market usually was near a bottom.

  It also became apparent to me that when options players were extremely active, it was a negative sign, and when they shunned the market and options volume dropped off, it was frequently a good time to buy stock. In other words, it was the old game of contrary opinion—don’t follow the “crowd.” My studies also indicated that most speculators were not very successful. Because they invariably lost money on balance, it followed that they weren’t right very often, regardless of whether, as a group, they were bullish or bearish.

  It was shortly after finishing my dissertation that I invented the puts/calls ratio, which is now a widely used technical benchmark, especially because there are so many new options markets against which to apply this ratio. This discovery was important to me not so much because of that particular indicator, but because I began to integrate various numbers that measure market sentiment and to use the result as a forecasting guide. I did the same for monetary and technical indicators. This helped build a bag of useful tools that I’ve been using in my advisory letter and in my money management business for years.

  I finished my Ph.D. work in the summer of 1969 and, eager to be in New York near Wall Street, accepted a position as assistant professor at the City University of New York. In the back of my mind was the hope that somehow I could become involved in the Street on a consulting basis. In my first year of teaching I got that chance. I was engaged as a consultant by the Chicago Board Options Exchange, which didn’t even have that name at the time. They were trying to get SEC clearance to set up their exchange, and it took them four more years before they got going. I also parlayed my options knowledge into a brief stint teaching the options business to beginning brokers at E. F. Hutton.

  Although my work was varied and interesting, I wanted something more stimulating and rewarding. My old college friend Ron Rothstein opened a new door for me. He had become a partner in a brokerage firm and invited me to join them as a consultant. I grasped this opportunity even though the company was small and relatively unknown. After working on several projects, we decided that I would write a stock market letter geared to institutional investors.

  THE ZWEIG FORECAST IS LAUNCHED

  The launching pad for the market letter and my subsequent career was built on a few articles I had written for Barron’s over the prior year. The first was in spring 1970, as the market had just suffered its most violent crash since the 1930s. It was virtually at the bottom in May when The Wall Street Journal carried a report from a second-rate brokerage firm recommending the sale of American Telephone & Telegraph stock. It was rare that Wall Street firms put out sell recommendations and it was virtually unheard of for the bluest of all blue chips.

  I read the so-called reasoning behind the sell recommendation and immediately concluded that (1) it would scare the hell out of all the widows and orphans who were in the stock, (2) it was based on faulty logic, and (3) it was so much gobbledygook. Although I had no particular interest in AT&T, the report made my blood boil and I decided to do something about it. I sat down and wrote a rebuttal, but it was much too long for The Wall Street Journal. So I sent it to Barron’s, which, like the Journal, is published by Dow Jones.

  Luckily for me, Alan Abelson, then managing editor of Barron’s, liked what I wrote and had his secretary, Shirley Lazo, call me immediately to tell me they would run it. Only much later did I realize my good fortune, because Barron’s receives hundreds of submissions and only a few are published.

  In June of 1970 my first article, called “Tea and Sympathy,” ran in Barron’s, refuting the brokerage firm’s bearish recommendation on Telephone. I proved to be right. Both the stock market and Telephone were virtually at their bottoms. Moreover, the brokerage firm responsible for the misguided recommendation went out of business a few months later.

  Naturally, I felt very good about being published in Barron’s, especially since I had been correct. But writing about Telephone wasn’t my specialty; I really wanted to write about stock market indicators. Having had one article published gave me an opening to write additional pieces.

  A couple of months later I sent Alan Abelson another article, this one dealing with options activity, utilizing the data I had uncovered for my Ph.D. d
issertation. I invented an indicator called the option activity ratio, which gave bullish signals for the market when volume in options was low and bearish signals when volume was high. The article, published in late November of 1970, predicted a very bullish outlook. What timing! The day Barron’s hit the newsstand, the market exploded, and it continued to rally sharply for the next several months.

  It was gratifying to be right again, and it made me even more eager to write another article. The next one was on the puts/calls ratio, to which I referred previously. This came out in the spring of 1971, when that indicator had just turned bearish. For the next seven months the market went down, and again I had hit the nail on the head. The two articles on technical indicators brought mail to me from investors who wondered if I was writing, or planned to write, a stock market letter. I saw this as an ideal opening because I was ready and eager to get started in this direction.

  Soon after, I began to write a market letter for the brokerage house, gearing it to institutions. I favored the institutional approach because I thought it would permit me to provide more sophisticated information, which is what I really wanted to do. In the fall of 1971 I wrote the first issue. As I was writing the second, the brokerage Firm went under. One of the partners allegedly had embezzled a couple of million dollars, and the firm collapsed.

  So there I was with my new stock market letter and no brokerage firm. What to do? I had received about 120 pieces of mail from Barron’s readers who were interested in my work. On the chance that they might want to buy a letter from me, I wrote to each individual. Over the next few months I managed to pick up about 40 subscribers to my new letter, which I decided to call The Zweig Forecast. And that’s how I started, almost through the back door.