Gil Morales Joins TradingMarkets 2008!

We are excited to announce that Gil Morales will be one of the featured presenters at TradingMarkets 2008 during the weekend of November 14-16 at the MGM Grand in Las Vegas, Nevada. At his presentation in November, Gil Morales will show traders the same techniques and rules he used in running his account up 10,904% from 1998-2005, according to an audit by Rothstein, Kass & Company, a large national CPA firm. One of the foremost practitioners of O'Neil's CANSLIM approach to active trading and position trading, Mr. Morales has added a number of his own innovations to O'Neil's famous stock trading methods. Topics he will discuss and share with traders at TradingMarkets 2008 will include buy criteria, sell criteria, the few timeless general market indicators that have accurately put Mr. Morales on the right side of the market for 17 years, and much more.

Gil Morales has been successfully trading the intermediate-term timeframe since 1991. His early success caught the eye of the legendary William O'Neil, founder and chairman of Investor's Business Daily, who personally hired Mr. Morales in 1997 to trade a portion of O'Neil's personal capital, advise over 500 of the firm's institutional clients, and serve as the Chief Market Strategist of William O'Neil + Company. Mr. Morales is CEO of Gil Morales & Company, LLC, (www.gilmorereport.com) based in Los Angeles.

We last spoke with Gil Morales this spring by telephone. What follows is the the complete multi-part interview with one of the most famous and successful traders and investors ever to emerge out of the "academy" that was William O'Neil & Company. If you like what you read here, then be sure to join us and Gil Morales November 14-16 at the MGM Grand Hotel in Las Vegas for TradingMarkets 2008!

David Penn: When we corresponded by e-mail, you mentioned four famous individuals who guided or inspired your approach to trading. Could you talk a little about these four people, who are probably traders all of us should know more about? I'm sure we'll talk a lot about William O'Neil. But what about the others? Nicholas Darvas, for example.

Gil Morales: I think I can summarize it. I could go on forever about these traders, but let's just boil it down to essential concepts. Darvas to me was the first guy
who really figured out bases and figured out that if a stock is moving within a consolidation or a base or a box as he called it, then it was doing what it should be doing.

So learning to interpret stocks within the realm of what is it doing, how should it be acting, was something I picked up from him.

Is it acting correctly? Fine. Hold the stock. And then if it does start to break out of the box or show some deleterious action within that box, maybe some heavy
volume selling that would throw it out of the box, then it's telling you something may be wrong.

Penn: Richard Wyckoff?

Morales: He to me was the first guy who recognized technicals. He said that fundamental analysis alone was insufficient because it lacked the basic element of
timing. And you couldn't make money just trading on fundamentals.

Wyckoff was really the first guy who looked at charts, I believe. He outlined the technical aspects of a stock's lifecycle: all the different labels on it showing how a stock has its big run, how it consolidates, sets up again and then finally gets to a top and a period of decline.

And so a lot of these concepts that Wyckoff outlines, particularly the technical aspects of the lifecycle of a stock, are basically part and parcel of William O'Neil's work on the long and the short side.

I think Wyckoff really contributed also the idea of supply and demand. The idea that price volume action is very important and that it's not necessarily a zero-sum game where every buyer is met by a seller was key. I mean there's also the element that every buyer may be met by one seller but if he wants to buy more stock he may not be able to find more buyers at a certain price point.

So there's the law of supply and demand coming into play that he discussed. I think that's also the essential part of O'Neil's work, that in certain stocks demand builds for them because you have a reason, a cause, which would be the fundamentals.

This is basically the company's position as an innovator with some sort of new product or service that is very compelling – combined with the institutions that have to own these stocks. There's a supply coming in and there just isn't enough of it out there for what they need to accumulate. And so it drives the price higher. In that sense the O'Neil view kind of extends from Wyckoff in that regard.

Penn: And the late great Jesse Livermore?

Morales: Jesse Livermore had this concept that I like which is the pivotal point. Not the pivot point. O'Neil calls it the pivot point. Livermore called it the pivotal
point, or more accurately described it as the line of least resistance.

Livermore had a number of rules regarding this sort of thing and one of the most famous to me is when he's talking about Anaconda Copper—I think it's around 1906 or 1907. Anaconda Copper was a big stock and everybody was playing it.

Livermore had a rule that when a stock went to a century mark, 100, 200, 300 or 400, it should go through that point and trade up 20 or 30 points. Very easily. Very quickly. And if it didn't something was wrong. And so to him those 100, 200, 300 points were lines of least resistance. So when a stock was able to get through there, it had to act a certain way coming through there to confirm to him that the stock was a buy and a hold.

In the book Reminiscences of a Stock Operator he talks on how he identified the market top. Anaconda Copper went to 300 and it could not hold at the 300 price level. And it reversed back down; it violated one of his rules with respect to the line of least resistance. It couldn't hold 300. And whereas it should have gone through and ran up very quickly, it didn't do that. And so it gave him a clue that the market was topping.

The other aspect of Livermore that I thought was very important is that he always felt you should be long in a bull market and short in a bear market. And anything else wasn't worth playing in.

Understanding those is definitely something that O'Neil picked up on and incorporated into his work. I think it's one of the major contributions of Livermore with respect to what I would call "O'Neilian Market Thought."

Penn: You mentioned a minute ago the idea of the big stocks and you referred to your investing style at least in part as following a big stock principle. Could you maybe elaborate on that a little?

Morales: Yeah. They have to weigh at least 200 pounds or, you know …

Penn: Bench 350.

Morales: Exactly. I think you just boil it down to this essential concept: We know there are institutional players. Now back in Livermore's day you had the pools. The investment pools. And they were the basic drivers of stocks. And he would sense their action.

What O'Neil does and what we did at O'Neil's company with respect to what I call the big stock principle was understand which stocks institutions have to own. If you're a growth-oriented manager, performance-oriented mutual fund or pension fund, there are certain stocks that exist in market that you have to own. You have no choice but to own them.

You have to own Apple when it's showing this huge growth because of the iPod and now the iPhone. You have to own Google when it's taking advantage of the Internet in ways that people really didn't think about.

One of the things that led me to Google back in August of '04 right after they came public was the fact that I saw Fidelity had filed a 13D showing they had a 13 percent position. I got to know Fidelity from working at O'Neil. We advised so we knew which organizations were smarter than others. And we know Fidelity, and they still are. They have an outstanding research organization and when you see a Fidelity contra fund come in and take a big position in a name like Google, well, you know they're not buying it to day trade it. They're buying it because they see something there that has a horizon of at least three to five years.

Penn: Right.

Morales: So you know two things: Number one, they're starting to accumulate it so they're maybe the driving force behind sending that stock higher. And number two, if they have a big position they have a stake in protecting that position, and they'll support the stock when it comes off. If you want to buy $2.00 goodies, some Canadian company turning oatmeal into oil and they've got a new financing deal coming through and you hear about this $2.00 thing … well, you're not going to get anywhere because the only other people that are going to drive that up are other fools who think it's a hot idea.

But you buy an Apple, you buy a Google, you buy Research in Motion and you know you have institutions behind you. So understanding which stocks in the market are companies that represent the cutting edge in what is going on in the economy at any given point in time is important.

You know what is their contribution to underlying conditions. We know that Apple's driving the whole movement of handheld devices both with the iPod and the iPhone into things that are much more than a phone.

It's this concept of what is driving the economy right now. Which companies are at the forefront? Which companies are at the cutting edge? Which companies are the big innovators within the economy? And going after these stocks because you know these institutions have to buy them.

Penn: Right.

Morales: In a bull market that's what drives them up. And that's the essence of the big stock principle. And it didn't really occur to me until late '98.

We were buying Schwab and AOL and I didn't think the bases were all that perfect. But it's sort of like an epiphany. I was buying these stocks as well and watching Bill O'Neil operate and the way he bought these stocks, and I realized what he was doing and why he can do it so fearlessly and so relentlessly—buying a million and a half shares of AOL. It was because he knew that the institutions were buying this and he knew these were big stocks.

And I remember him telling me, "AOL, that's a big stock." And when he said that to me it sort of all came to me that this concept of a big stock, this is exactly what it is. Buying that little $18.00 stock, that little tiny bank or whatever it is, you know, some little dinky software company making a medical software product, that's not it. It's the AOLs. It's the Googles. It's the Schwabs back in '98. The Qualcomms in '99/2000.

Those sorts of situations. And that's what the big stock is. I think qualitatively I think people can understand that.

Penn: Sure. You mentioned also a few minutes ago the idea of being in tune. These are stocks that are involved in the economy in a serious way. Apart from that aspect of the stocks, how much does pure economic or fundamental analysis play a role in your day-to-day decisions about whether or not you're buying a given stock?

Morales: We all know from Wyckoff that that's not going to solve your problem alone. But we do know from the O'Neil studies that there are certain fundamental characteristics that are prevalent in these stocks. And the primary one in my view is profitability.

One of the things you see in all these big winners is really a huge return on equity and that in turn drives huge sales growth, huge earnings growth. That's what you're looking for. You're looking for accelerating earnings growth. High double-digit, triple-digit earnings growth. Large five-year annual earnings growth. And, of course, new products.

Understanding what the product is because this all relates back to the big stock principle is important. What is the product? Where does it fit in the economy?
What's driving its sales? How badly do consumers need it?

So basically fundamentals in that regard are very important. A lot of people think O'Neil is just a technical system or a technician system, but it's not at all. It's
combining the two together in what I think is a very intelligently thought-out system.

Penn: Sure, sure.

Morales: And definitely Bill always told me that you have to understand your company in order not just to know the stock's going to have a big move. The more you understand the company and the more you are in tune with the products and where they sit in the economy and the kind of earnings growth they're able to generate, the better.

It also gives you a very important element when you're going to ride a stock for a big move, and that is conviction. So without conviction you're not going to hold something through a correction, a normal correction. But if you have a lot of conviction as a result of knowing where that company's place is within the economy and where their products fit in within the consumer mind or within the general economy, it helps you develop that conviction and helps you hold on for the big gain.

David Penn: When you're talking about these sorts of stocks, these big name stocks, the stocks with these five-year track records of running growth, what's the holding period?

Gil Morales: If it doesn't do what you want it to do, we would generally have a stop loss at 7 percent. My stop losses tend to be a little faster than that simply because I feel that I should be buying them right. At this point I should be good enough at picking stocks that when I am buying them they should be very close to an infliction point. At least a point where they're going to start to move for me.

So if I buy a stock and if after a week, say, it's not doing anything for me, and I have something else that is actually working for me, then I get into what O'Neil calls "force feeding." That's when you pull money out of that stock that isn't doing anything - which is dead money - and you move it into things that are starting to move. So it could be a matter of a few days if something isn't working for me.

In terms of holding for a move, as long as the stock acts properly and it remains healthy, I'll hold a stock. Now from a practical standpoint I probably, in general, hold stocks six to 12 months. Just going by what my practical experience has been.

Now I'll trade around core positions. And I will cut back or even sell a position if I think the market's going into a correction and the stock has run up to a point where I think it's going to have to form another base or another consolidation. Then I'll wait for it to set up within that consolidation and flash to another buy point. And I'll re-enter when I think the general market has sort of righted itself once again.

So an example would be Apple in early 2005. The stock had a great move in '04 and I was holding a million shares. I think it was around $44 back then before all the splits. But it did correct pretty well. Then it turned around and set up and came back in July, I think, and broke out again. And so you could come back to the stock.

But you can see if you were looking at a chart you would notice that it was in a flat base, about a six-week flat base in February through April of '05, and then it failed. And then I noticed it start to fail and I started bailing out right around 42, then 40, 39 and got rid of the whole position, a million shares.

And then it broke down to about 33 and set up again. The stock broke out again right at about 37 or 38 so I re-entered the position right there. I'm not worried about capital gains or anything like that. What I'm more worried about is capital preservation. When you're running a 50 percent position in Apple that's a million shares, you can't afford to really sit there and let it whack you.

Penn: Right.

Morales: So the idea is we're very fluid in terms of being able to re-enter stock. We're never shy about getting rid of them when we think that they may have topped. If you go back and look at Apple in January of '06, it went into a little climactic sort of top in the 86 area and that would have been an area probably to sell because it had a pretty big move.

Now there's one other time when we'll sell stocks and that is if the stock comes out of a consolidation or a base or a box, whatever you want to call it. And it runs up 20 percent in more than three weeks. So maybe it takes five, six, seven, eight weeks to run up 20 percent. We take the profit. And then we'll sit back and we'll see what the stock does because what we notice is that most stocks will run up 20 percent or so and then form a second base.

Now there's this old William O'Neil rule that if a stock runs up 20 percent or more in one, two or three weeks then you have to hold the stock six to eight weeks. However, to be honest, that's not something that really proves out if you look at it statistically. Stocks that go up 20 percent in one, two or three weeks-they can pull right back.

Penn: Getting back to Livermore, you mentioned the idea that when stocks are going up you want to be long. When they're going down you want to be short. What sort of tools do you use to make those determinations of whether or not we're in a bull or a bear? A lot of people said we were in a bull market starting in last fall for example. How do you decide where we are?

Morales: Basically by the action of my stocks. I watch my stocks primarily. The indexes are a primary indicator but also a secondary indicator to some extent, in terms of portfolio management. A good example of this is that I was long a lot in one sector in mid-October and those stocks actually acted very well as the market was correcting going into the end of October. And I should have sat with them based on the action of the stocks alone.

A lot of times stocks will continue to move higher even as the market is starting to correct and top. And you really shouldn't blow these positions out until you start to see them break down as well because a lot of times stocks will hold up very tight and move higher. Look at stocks like Apple running right into their peaks right at the end of the year. We had already supposedly topped in October/November.

So for me, understanding whether the market is in a bull or a bear trend is sort of a function of general market indexes where you see the classic O'Neil distribution. But you're also seeing a breakdown in the leaders. The leaders start to break one right after another.

You may own a couple of them, but we were taught by O'Neil not to sell them until you start to see them break down. For all you know the market's topping - and you have three or four or five days where the index is sold off on heavier volume. Or it's telling you you're getting some distribution on stuff but you don't know if you're going into a 5 percent correction, a 10 percent correction or a 25 percent correction.

So he always told us first and foremost watch your stocks. When your stocks tell you to get out, then you get out. You exit the stocks. But you don't sit there and look at the general market and go: "Oh, my God. The general market's showing four days of distribution but my stock keeps going higher and I'm going to sell it now and miss out on this last 15 percent to the upside."

You watch the stocks and so there's a combination of the two in tandem when you're determining whether you're coming to the top.

Penn: What about the short side?

Morales: Obviously I'm long in a bull market and I'm short in a bear market: Once I can figure out what the longer term trend is. And sometimes even the short-term trend.

I was short coming into January and did pretty well in January but February and March were more difficult because we had such an active Fed which was a little bit unusual. I don't know when you have the market top when you have the Fed coming out every day with a 100 base point interest rate cut or some plan that they're going to do and the market's suddenly jacking up 30 points on the futures before you even get up in the morning.

But one thing I'll look at in a bear market as an indicator are short sale setups. And these are the head-and-shoulders types of patterns and basically they start out where a stock breaks off of its peak very hard. This generally will form the right side of the head. You can actually see that in Apple if you look at it.

So I'm looking for those sorts of breaks and if I see those, you'll see one, two, three and they'll start to pile up. And you may still be in a bull market where some stocks are still acting OK. But those breaks certainly tell you that you're going into a weak market phase.

For example, earlier in '07 the financials all topped. The homebuilding stocks had already been getting crushed. And those are probably early warning signals that we were going to top but you really can't use them as a timing tool until you reach a critical mass of these sorts of setups and that all started to occur in, say, December. Which sort of led you to believe that we were going to top at that time, which we did.

And you're seeing faulty bases. For instance, Apple. Those were faulty bases going into the end of December. I call them late-stage base failure setups. So there are two setups I use - a head-and-shoulders setup and a late-stage base failure. And the late-stage base failure is generally a base that is very short or very odd-shaped or shows a lot of wide, erratic price behavior in it. Maybe heavier volume selling within the little base. And you can see this in Apple on a weekly chart, for example. Are you looking at charts by the way?

Penn: Yes. I am actually.

Morales: If you look at Apple, you see that it came out and then it tried to break out and form this little cup-and-handle type thing on a weekly chart. And then it failed. And you can actually short that pattern right there. And when you start to see that happen, you know you're in trouble. Now you know the market's in trouble.

Now the converse is used in a bear market. During a bear market I'm looking for positive patterns. So I may be short a few things if in fact the market environment is such that I can make money on shorts. It's very difficult to make money on the short side, by the way, and it's not something that I advocate as something you want to throw yourself into if you're new at it.

It's very difficult even for someone like me and I have had periods where I made a lot of money shorting and periods where I've made none or started to make some money and then given it all back as I have this year-so far. But no big deal; that happens.

Penn: Sure.

Morales: It's a function of the active Fed. But when you're in a bear market you start to look for bases setting up in a constructive way. I can remember one example very clearly in early 1995, when the Fed had been raising rates. Were you around back then in '94/'95?

Penn: Yes, as a matter of fact..

Morales: And you remember in February of 1994 the Fed raised rates for the first time and the bond market crashed? And then we went to the stealth bear market of '94 where a lot of stocks got hammered, but the indexes, after breaking down in February, never really went to their lows again.

Penn: Right.

Morales: Then you got into late '94 and you actually had a follow through. I think it was around December 18 1994, and stocks like Cisco started to move up off their bottoms. And by February there was all this fear the Fed was going to raise rates, and they did raise rates 50 basis points , but the market took off and we started a new bull market. And I remember at that time a lot of people were fearful and there was a lot of consternation: "Oh, my God. The Fed's going to raise rates 50 basis points and they're going to kill the market." But what I saw there were a lot of cup-and-handle formations everywhere I looked.

You could go through chart books. Back then I used to but now I go through WONDA, the excellent William O'Neil Direct Access system. And I go to the charts there and I can see what's going on in terms of what sorts of basis are setting up. Whether there are a preponderance of these setups in any given environment. And they'll give you a clue that wait a minute, this market is actually setting up to move higher.

And in late 2002, early 2003, a lot of people were still very bearish and the big mantra was that economic fundamentals don't justify a bull market. Forget that. Economic fundamentals are not a leading indicator. They're a lagging indicator and the stock market's a leading indicator and we were starting to see a lot of bases setting up. And it even included stocks like Amazon and Yahoo which came on and had some pretty decent moves in 2003.

I know Bill was buying eBay up in November of 2002 like mad and if you go back and look at a weekly chart of eBay back then it was forming a very nice tight base and it was a leading stock. And it was telling you, if you were seeing all this just like in '95, that this market is actually more constructive underneath the surface than it appears. Much more than, say, the news would lead you to believe. And even much more than the pundits and the analysts would lead you to believe.

But I'll tell you, I actually think that you're better off being bullish most of the time because you make more money on the bull side. When the market turns if you have too much of a bearish mentality - and I'll suffer from this sometimes - you won't see it right away. It'll take you a little bit of time. And if you're bullish most of the time your orientation is that way. You'll pick things up a lot faster.

Penn: Do you have any sense of what is it, what's the trap that catches traders who get in - I don't mean to impugn someone who successfully short sells or even does that for a living -but for those who become a little bit too wedded to that bearish approach to stock. Do you have any idea what it is that sort of trips in the mind that makes it hard for people to sometimes get out of that bearishness? Is it just fear?

Morales: I think it is fear but I think it's also once people get into a way of thinking it becomes "what is the line of least resistance," and you get yourself into a negative frame of mind. It's easy to go that way. I think it's very typical of the period of 2000 and 2002-things were lousy for two whole years.

And starting now is the longest bear market that many have ever seen-well, it is for me and for you as well if you're under, say, 55, 60. You didn't go through '73/'74-that whole period. It's the longest bear market we've ever seen, and I think it just sort of beats people down so they just no longer can see things in a positive light.

To me, that was Bill O'Neil's great incredible strength. Let's think about this. This guy grew up in the Depression. He started trading, I think, when he got back from the Air Force, which I think was in early '50s or late '40s. And so he's seen everything, bad and good. And yet he's still able to maintain this sort of relentless optimistic force that allows him to see things clearly.

I think that's really the key. You don't allow your mind to get into a rut one way or another. And I think Bill is great at keeping things fresh in his head and also eager to find the next opportunity.