Eyes Wide Open

These people, many of them college educated and extremely affluent, play the stock market as you play the lottery: Buy a ticket and hope for the best. The market interests them only up to the point that they actually have to put in some effort. And for such people, "buy and hold" has become "buy and blame." After all...it isn't their fault they lost money. It's the hedge funds', the analysts' or Alan Greenspan's.

As we've written before, trading, or "active investing" as it's now called within politically correct circles, is first and foremost an exercise in observation. In order to see the truth, you must first be willing to open your eyes. Despite the misconception that traders pull the trigger from bell to bell, I spend most of my time watching, not making transactions.

And now more than ever, there's a lot to watch. Because of the overload of information available at a mouse click, the best traders are good at multitasking. Like a chef, traffic cop or the plate-spinning guy from Ed Sullivan, they're able to observe, interpret and act upon a large volume of rapidly changing information. Not Tom Galvin's latest rant or the number of Huggies that Wal-Mart (WMT) sold, mind you, but the signals emitted by the stocks and markets in which they happen to be active at the time. This is the basis for technical analysis: All the information needed to detect what's happening in the market can be found in the market. Not in the heavens, the message boards or the always-hedged analysis of well-paid pundits.

So what do I watch? As much as I can. I watch oats and orange juice. I watch investment clubs and fund flows. Volume and volatility. Gold and gasoline. The widely followed names and the lesser-traded losers. The more markets I watch, the more prices I follow, the more confident I am in my ability to know what's going on.

Of course, keeping tabs on over 10,000 publicly traded companies, thousands of market indexes, hundreds of commodities and dozens of technical indicators might be a little time consuming for those with a life outside the markets. At the very least, then, you need to keep a close eye on your stocks. If that seems like too much of a bother, buy a few mutual funds and put the mental anguish in someone else's hands.

So where should you start? To begin with, watch the stock. As simplistic as it sounds, plenty of people don't know where their holdings are even trading, let alone how they are trading relative to other securities. When the market was going straight up, they couldn't take their eyes off the screen. Now I talk to plenty of "traders" who check their smoke detectors more often than their portfolios. Stocks are like your children. You need to keep tabs on them at all times.

So how does it open? If it's a New York Stock Exchange stock, what time does it open? Where does it trade midday, afternoon and near the closing bell? Watch the volume. Watch how it responds to news, how it closes and trades in the aftermarket. There's a lot to take in. You'll want to make some notes. Next, and perhaps most important, watch other names in the sector. As we've discussed before, the market isn't chaotic. It moves in observable and established trends. And stocks are herd animals. They travel in packs. You've got to analyze the stock on its own merits and as a member of its industry or sector, along with that sector as a component of the overall market. It's a common technique known as intermarket analysis.

So if I'm watching Exxon Mobil (XOM), you can bet I'm also keeping an eye on BP (BP), Chevron (CHV) and Sunoco (SUN) — plus some of the smaller integrated drillers that make up both the Amex Oil Index (XOI) and CBOE Oil Index (OIX). I'm also watching the SPDR Energy fund (XLE), the exchange-traded fund that follows the energy component of the S&P 500. Put together, these indicators give me a better idea of what's happening in the sector better than Maria Bartiromo ever could.

What should you be looking for? As much as it's human nature to want a bargain, the bottom line is that you want to be in strong stocks and strong sectors — nothing but. So when you're evaluating stocks within a group, find the pick of the litter. Don't buy the weak name expecting it to play catch-up. The one you want to own is the leader of the pack.

By watching more than just your pick, however, you'll have a keen sense of the group's overall price tendency. What you're looking for is confirmation. Some stocks will perform better than others, but strength in one name should be confirmed by strength in its peers. The group leader moves first, followed by the other members of its peer group. The respective index or exchange-traded fund, being the most diversified, usually moves last.

You'll also want to isolate a "sister stock," a second-choice favorite within the particular sector. So if you're long Barrick Gold (ABX), watch Newmont Mining (NEM). If you own Citigroup (C), watch Bank of America (BAC), HSBC (HBC) or another large money-center bank. UAL (UAL) and AMR (AMR), Corning (GLW) and JDS Uniphase (JDSU)...you get the idea.

The advantage of watching a stock and its pair is twofold: First, you'll again have a better sense of group dynamics. If Compaq Computer (CPQ) starts perking up, then Dell Computer (DELL) shouldn't be too far behind. The biggest benefit, however, is that you've got a ready-to-go tax swap in your back pocket should the need occur. So if you're shaken out of a position in FedEx (FDX) but want to keep your exposure to the sector, take the loss and swap into United Parcel Service (UPS). Both names move in a similar fashion.

The Web's never-ending stream of market data leaves most traders feeling overwhelmed, not informed. The best way to cut through the clutter is by focusing on what's important — the price action of the stocks and groups you're interested in. By sticking to what matters, and keeping track of a sector's overall action, you'll be more knowledgeable than the pundits, experts and market commentators, most of whose miserable performance speaks for itself.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.