At Prophecy, It’s All in the Trading Patterns

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

For most people, Head & Shoulders is what might show up in their locker, alerting them to a personal problem. Not so Jeffrey Spotts, head of Prophecy Capital Management. For Mr. Spotts, it is but one of many trading patterns that may help him forecast stock prices.


Mr. Spotts is a technical analyst. He studies charts and graphs that detail trends such as relative price movements, insider trading, and shifts in share volume to predict what will happen next.


Some market observers may have relegated technical analysis to the same curio dustbin as bell bottoms and shag haircuts. They would be wrong. Though some of the nomenclature has changed from its heyday in the ’60s and ’70s, this type of market watching persists. One of its advocates, for instance, is hedge fund icon Paul Tudor Jones, who has reportedly endowed a chair at the University of Virginia to teach technical analysis.


The process is a whole lot easier with today’s technology. Mr. Spotts, for example, personally reviews the charts of over 3,000 stocks per day. With the aid of a Bloomberg machine and programs developed by Prophecy and others, for example, he can whip through sectors, individual stocks, and indices like nobody’s business.


What does he look for? He looks for a stock that has been in a holding pattern for some time, trading within a narrow range, but then suddenly “breaks out” with rising volume and, better yet, insider buying.


As the stock price climbs, it is also typical to see short interest increase and mutual funds buying in. In fact, as the price moves significantly higher, it is not unusual to see a steady increase in mutual fund ownership – often reaching its zenith long after the stock price has peaked. Oh those foolish mutual funds; the charts are so damning.


Mr. Spotts maintains, as would any technical advocate, that stock prices often start to move in advance of changing fundamentals. And indeed, examples are plentiful.


One example is downright creepy. Months before the 9/11 attacks, the stocks that make bomb detection equipment, body armor, and other security items started to move higher. It was a classic pattern – rising volume and price, along with insider buying. Of course, after the terrible events of 9/11, the sector skyrocketed as demand for all those items went through the roof.


Mr. Spotts has put his techniques to a formal test for a little over three years. Prior to starting up his fund, he was at Merrill Lynch for twelve years. Initially he was in the Private Client Group, where he worked with a team managing more than $500 million in client assets. During that period, he became a technical advocate and used the approach to help manage the equity portion of the portfolios.


His recent performance has been mixed. This year the long/short fund was ahead nearly 10% through October – well ahead of the averages and of many other hedge funds. Assets under management now total more than $30 million.


However, after a strong showing in 2002 Mr. Spotts missed the bull market run last year when most long/short funds enjoyed sizeable gains. Prophecy was up only 5.7% in 2003.


Call it growing pains. During the year, Mr. Spotts had hired a fundamental analyst to provide a more rounded approach to their management style – something he felt was important to the institutional clients to whom they were marketing.


The result was a sort of push-me pull-you struggle to make any decisions, and three consecutive down months. For the rest of the year, Mr. Spotts stayed hedged, fearful of the possibly calamitous effect that another losing month could have on performance and, indeed, the viability of the firm.


The other manager is now gone, and with him any pretense of providing a fundamental second opinion for their trades. Instead, Mr. Spotts is relying on his charts, and on behavioral analysis to provide the insight he needs.


So how does he read the ink spots today?


First, he thinks the market is poised to move higher, but not for long. Specifically, the S&P 500 has moved into a “5th wave thrust, from a 4th wave triangle.” In his view this means that the S&P 500 could top out at 1,275 to 1,300 in the first quarter of next year.


That would, however, be the last hurrah for a while. He points out that bull markets usually come to a close during economic prosperity, with stocks anticipating a slowdown often way ahead of the economists.


In terms of groups, and stocks, he has been bullish on the gold sector for some time, which has paid off handsomely. He was expecting a breakout in bullion prices above $436 per ounce, and now expects a price rise to $499, with the related equity shares reflecting that move.


Mr. Spotts is particularly keen on Asian stocks, especially Korean securities, which he thinks are poised for a major move higher. He cites the action of the MSCIA, an index of Asian securities excluding Japan, which he feels has been building a base for about seven years. Now, the figures begin to look more effervescent.


Closer to home, he likes the nursing home stocks, which have begun to move in a favorable pattern. Also, interestingly, at the end of October he was intrigued by the movement of the retail sector, which had shown some relative strength. Given Wall Street’s generally negative view of the sector, and of the consumer, that could bode well for the stocks.


Mr. Spotts has about 100 stocks in the fund. He has established several internal rules for risk management. First, new positions are initiated at 1.5% of the portfolio. This is a switch from the inception of the fund, at which time the team would buy a 5% position in each new security. That added too much volatility to the fund, meaning that some of the stocks went down instead of up, so now positions are built gradually, and only after the underlying trend has been confirmed.


Also, the firm employs tight internal stops (4%), and never averages down. Leverage is limited to 150% of total assets, and the firm hedges by making a contrary bet on market direction, as opposed to within a group, since most stocks move as a group. Also, Spotts will not put more than 20% of the fund in any one sector, no matter how tantalizing the chart.


Mr. Spott’s approach is beguiling, because much of what he does is based on bucking the herd mentality, which is clearly the right thing to do. He tends to buy with the insiders, who presumably have an information edge, and sell as the rest of the world catches on. He describes the trend in psychological terms -as moving from despair to acceptance, and on to euphoria. You surely don’t want to hang around for euphoria.


Give him a couple more years in which his techniques pan out, and Mr. Spott’s investors may find their own route to euphoria.



Ms. Peek is a former managing director of Wertheim Schroder, now a part of Citigroup.


The New York Sun

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