The Case For Technical Analysis

In my last post I referred to the amount of money that has come out of equities since the spring.  Apart from those who have left for good, are the remainder doing the right thing?  How will they know when to return?

I am a big believer that we should not invest in anything we don't understand.  Anyone who says they understand this market, other than at a mile-high macro level, is not telling the truth.  Sure, there are people who say it is like the markets during the great depression, or similar to previous major recessions, or like any other recovery - but slower.  The truth is, they are simply speculating.  Some are just outright lying.

Having said what I did about not investing in anything we don't understand, I am going to contradict myself and tell you I have money in this market.  While I don't understand this market, I do know a little about technical analysis.  The beauty of technical analysis, if we can call it that, is we are not required to understand the fundamentals.  Good thing, because fundamental analysis for this current market went out the window a while ago.

I have a methodology I use for valuing companies, but find that information all but useless, currently.  That will not always remain the case, but for now I will rely on technical analysis.  In some ways, it reminds me of the tech wreck almost ten years ago.  I remember finding good companies, yet invariably, only a couple of days later their stock price was lower than ever.  Technical analysis works better on groups than on individual companies.  So, for now, I have switched to Exchange Traded Funds (ETF's).  I have shortened my time horizons since the volatility of this market is high.  Trades tend to be days and weeks, rather than months.  I also risk less by holding smaller positions.

For the people that know little about technical analysis, I think they are doing the right thing by getting out.  The trick becomes knowing when to get back in.  Again, I use technical analysis to provide me with a signal to return.  However, there is another way.  When the stock price of a good company like Research In Motion drops, despite having pretty good fundamentals, I find the best thing to do is to take a "show me" attitude.  I give the stock a couple of quarters for the price to perform consistent with the fundamental valuation.  After the two become more predictable, it could be time to test the waters again.

The "experts" say the problem with leaving the market is knowing when to get back in.  I applaud the people who stop shopping when they can no longer tell a sale price from an exorbitant one.  Why would anybody want to go shopping when all of the price tags are meaningless?  I wish I had a nickel for every time I have heard that you can't time the market.  To my mind, all it really takes is a little common sense.

Crisis Equals Opportunity

Billions and billions of dollars have come out of equities so far this year.  It started around the time of the May "flash crash".  If you have watched the volumes of transactions, you know it is more than people just taking the summer off.  The question is, are they coming back?

If I knew very little about the markets, I would not be tempted to return.  The institutional managers seem to have an unfair advantage in a system we could nicely label as rigged, at worst, corrupt.  The markets seem to have degenerated into a wild west show, where the powerful trump all.

So, while I was watching a David Suzuki rerun recently, I was struck by something his daughter said.  Having heard her father continually rail against the people and corporations that show complete disregard for the environment for so long, she had grown to believe it was too late to turn things around. She felt there was nothing she could do.  After all, they wouldn't listen to someone as well known as her father.

That is, until she became better educated about what her father was saying and learned where the opportunities for improvement lay for her.

Now, I'm no David Suzuki, but I can see how people listening to me, and people like me, could get the wrong idea.  Yes, there are a lot of things wrong with the stock markets and the financial institutions of the day.  However, I do not want to give people the idea that we are all playing a mug's game, that we are at the mercy of their system.  Do I want to give up on a potential income source?  Should I buy real estate instead of REIT's?  Should I hide in bonds and money market accounts?  Should I just stash my cash under the mattress?  Am I going to wait for the government to rescue me?  Should I just rely on my spouse to get us through it?  Hell no! 

I believe the expression is, "You can run, but you can't hide!"  I have already hinted at what I think the solution is.  Learn what works for you.  Get educated.  Start small, start smart.  Make continuous improvements.  Apply that experience to potentially new and better opportunities.  There are no short cuts.  We all have to pay our dues.  Nobody in this world can do a better job looking after your money than you can with a little hustle, and bit of common sense.

The day I walk away from the opportunities the stock markets provide is the day I run out of hope.  Don't give in to learned helplessness.  All too many of those who have given up will never return and will deny themselves of the opportunities ahead.  Instead, when the time comes, be brilliant, not afraid. 

Have you had it?  Are you ready to cash in your chips?

I have been bearish on the TSX for some time.  Even so, I want to share what I would call, a recent sell signal.  Before I do, I want to reiterate that I am not a professional, and as such can not give the reader advice.  But, then, I don't mind sharing what I am doing, either.

I have circled the RSI (relative strength indicator) oscillator (please see http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators ) if you require more information on RSI) at the point where it reached the 70-line.  That is the point I would sell half of any long position I owned.  Beneath the chart, at the bottom, I have included the Stochastics oscillator.  Notice the second peak where the green line touches it.  That is the point in time I would sell the remainder of any long position I owned. Also, notice the divergence between the slope of the green line above the Stochastics indicator, and the slope of the lines under the price candles on the chart, and the RSI at the top.  This divergence often occurs just prior to a trend reversal. 

In my own case, I am using Exchange Traded Funds (ETF's), since I am concerned about the lack of regard for fundamentals in the current market.  A sell signal such as this causes me to sell the ETF's which make money as the market goes higher, and buy the inverse ETF's which make money as the market goes lower.  While there are risks to using leveraged ETF's, I prefer them for short-term trends and use the Horizons' 2 times ETF's.  That means they are designed to return twice the daily amount of the underlying index, or commodity.  In this particular case I am talking about the Horizons BetaPro TSX ETF's, ticker symbols HXU (long), and HXD (inverse).

My current target is the point at which the RSI reaches the 30-line, again.

Only In Canada, Eh?

Previously, I had asked my broker about a particular transaction I had entered. Then, I heard something about the Alpha stock exchange on BNN. That led me to this article in the Globe and Mail. http://www.theglobeandmail.com/globe-investor/banks-face-probe-for-directing-stock-trades/article1694665/ . After doing more research I discovered we should not place a market order before trading begins. Never. Always use a limit order.

Some people will say, "Well, duh!?!" But what I don't think people realize is the opening price on the two exchanges, Alpha and TSX, are not the same. Again, not a huge surprise. In my case they were different by more than what I would have imagined. What I didn't know, is that we are not entitled to the best price between exchanges! For a market order, we get the opening price for whatever exchange our transaction is executed on.

Despite what I have managed to find out, nobody has explained to me how my transaction ends up on Alpha, or the TSX. Apparently, computers are to blame. Anyway, instead of submitting a market order, the advice I have been given is to enter a limit order. So here's the rub. If the price on the exchange which the transaction is being processed is outside the requested limit, nobody has guaranteed me that the order will be filled, even though the other exchange may have a price within the limit (unless of course, the price on the exchange which received the order comes back within the limit). I have no idea, either, how long it might take the two exchange prices to sync up during the day. Perhaps somebody reading this might have the answers.

If you want to get an Alpha quote, you can go to http://www.alphatradingsystems.ca/ and enter the ticker symbol. N.B. they are not real-time quotes.

Good luck!!

The Trend Is Our Friend

I don't often look at monthly charts, so when I saw this one, I was completely taken by the simplicity of what I was seeing. This is a chart of the iShares TSX 60 Index ETF (XIU) from the bottom in 2003 until today. If you look closely at it, (click on it for a better view) you can see the brown line that roughly follows the price bars. It is something close to the 40-week moving average, or 200-day moving average as it is usually referred to.

I wish I had a nickel for every time I have heard how we cannot time the markets. With three buys, and 3 sells over the period of approximately eight years, the average annual return comes to at least 13%, assuming we only participate in the up legs. Today, we have inverse ETF's which would allow us to play the down legs, making the average annual return approximately 17%. Yet, it gets even better than that. If we used the leveraged ETF's when they were introduced by Horizons a couple of years ago, the returns come to a whopping average annual return of 22%.

People will say, "Yes, but that is in hindsight." That is why I drew the trend lines in red. There is no hindsight required. Stick to the trend until it breaks, then either wait for the next uptrend, or follow the ensuing downtrend.

I am intrigued by those who have adopted a passive investing style in order to minimize trading expenses. Doing so will give a return very close to those of the market. I prefer the simple method shown here instead, for one major reason. I believe we are entering a period of higher volatility, with very little overall return in the long run. I think we should be able to make even better returns, relative to the market, than what this basic method demonstrates. Still, it is a powerful example of why I don't believe we should be happy with market returns, let alone less than market returns. I am not saying we should expect these kinds of returns going forward. I just want to outperform the market.

Random Walk - Not!

My assertion was that machines, with the proper programming, could be taught to think for themselves. This was many years ago. Today we refer to it as Artificial Intelligence. Then, the idea did not go over well. At first I didn't understand people's reaction to what seemed like a perfectly logical premise. Later, I realized that people do not like to by categorized, classified, and called predictable.

For decades, many have believed there was no pattern to the way in which prices moved in the stock markets. After all, people aren't that predictable! It is a belief that is still popular today. The financial services industry promotes the idea in order to convince customers to buy into the market and hold for the long term. Of course, if the markets moved in a truly random fashion, it would not make sense that they would have had an upward bias up until this point. Without that bias, buy and hold could not work.

I don't have any difficulty in believing there is a pattern. "To every thing there is a season", so says the Bible (ecclesiastes 3:1). The question is, what does this pattern look like? I tend to favour the Elliott Wave Principle. In my previous post I described some similarities with a couple of other theories. It would seem to have some predictive capability. Some would say it is too vague and imprecise to be of real value. Perhaps the fit is between what we want to find and how the price patterns can be used to portray the theory. After the fact, practically anyone can identify the wave patterns.

Perhaps it is more art than science. I am reminded of stories in "Blink" by Malcolm Gladwell about how we think. There are things we know which we are unable to articulate in words. Until we have a better explanation for how the theory works, it seems, for many, it will remain just a theory.

As for me, it would seem to be the best predictor of market direction. While even the most highly trained and experienced Elliott Wave analysts often seem to get the exact timing wrong (my experience), their ability to predict a market outcome is uncanny to me. What they are currently saying is the markets are headed much lower. That doesn't make me want to completely sit on the sidelines, but it does make me more cautious than usual. If all else is counted as equal - a fifty-fifty chance of the market going up, or down - I am going to give more weight to the Elliott Wave theory. I would rather be wrong and hold onto my life savings, than be wrong having lost them! That is one walk I am not willing to take.

Of Wind & Waves

The underlying premise of the "buy and hold" philosophy has always been the belief that, over time, the market trends upwards. Robert Prechter, of Elliott Wave International, says that may have been the case up until recently, but is no longer. At least not for the next few years.

The Elliott Wave theory is supported by a number of other theories. Just as personality research tends to support the idea there are four basic human personality types, the Elliott Wave is not the only theory where new products, ideas, and services gain acceptance in three phases. Think S-curve in product cycles, or audiences in change management.

Early adopters are first. These people are the least invested in older products or ideas. They are quick to adopt the new behaviour, product, or service. Then comes, what I call, the herd. After a certain critical mass develops, the herd - the largest segment of the three - begins to adopt the new change. This is the period of greatest change. Finally, the third group, the resistors, begin to convert, usually because of obsolescence in the old ways.

This same process can be detected in the way people move in and out of the stock market. The chart (click on it for a larger version) shows a recent example in the S&P 500 index. According to the Elliott Wave theory, the wave with the five segments indicates a downward trend to the market. The three segment ABC wave is counter to the market direction.

Is Mr. Prechter correct? If so, we are in the process of a correction of generational proportions. "It is an ill wind that blows no good", said John Heywood. Perhaps some of the confusion as to market direction we are currently experiencing is caused by a different wind - the wind of change. Need more information? Check out the website at http://www.elliottwave.com/ .