Humility in Trading

Don't be a hero. Don't have an ego. Always question yourself and your ability. Don't ever feel that you are very good. The second you do, you are dead.

Paul Tudor Jones

Technical Analysis Applied to Long Term Investing

Moving averages have captured the imagination (and increasingly the managed money) of advisors these days, and it’s easy to see why, at least through the lens of history. Consider a simple strategy benchmark with an initial weighting of 60% stocks (represented by the S&P 500) and 40% bonds (by the Barclays Aggregate Bond index). Buying and holding this mix earned you an annualized total return of 7.7% for the 20 years through August 2012 while it gave you an annualized volatility (standard deviation) of roughly 10.7. By contrast, your performance would have considerably improved with a market-timing strategy that adjusted the same initially weighted allocation using signals from a simple 10-month moving average (roughly the equivalent of a 200-day average). You would have seen a return of 9.3% a year and volatility of 7.9 (see Figure 1).

Here’s how the moving average strategy in Figure 1 works: When the equity index falls under its 10-month moving average (based on monthly data) at any month’s end, the entire stock allocation is moved to cash (three-month T-bills). There it stays until the equity index closes above its 10-month average, at which point all the cash is shifted back to stocks. The same rule applies to bonds. In short, the equity portion of the portfolio is either in stocks or cash, and the remaining fixed-income allocation is either in bonds or cash. The result is that this moving average strategy would have sidestepped the worst of the corrections and crashes. If that sounds familiar, it’s because similar results have been documented in numerous studies through the years.

Figure 2 shows the differences in one-year returns for the moving-average strategy minus the returns for the buy-and-hold strategy. The dots above the zero mark indicate that the moving-average strategy outperformed for the trailing-12-month period, and vice versa. For much of the past two decades, annual returns between the two strategies shared relatively similar results. But the differences widened dramatically around and during recessions—overwhelmingly in favor of the moving-average strategy.

For this reason, finance professor Paskalis Glabadanidis calls moving average-based strategies the equivalent of an “at-the-money put option combined with a long position in the underlying risky asset” (a quote from his working paper, Market Timing with Moving Averages.) In other words, the main value of moving averages has kicked in when the market has trended lower for an extended stretch—a bear market.

None of this should be surprising, says Adam Grimes, the chief investment officer of Waverly Advisors and author of the recently published book The Art and Science of Technical Analysis. “The major crashes usually come well after warnings signalled by technical weakness.” The steep sell-off in the stock market in late 2008 and early 2009, for example, started about a year after equities set new highs. Soon after the peak, investors saw a series of warnings in the moving-average signals.

That’s not unusual, notes Grimes. He adds, however, that there’s nothing magical about 50- or 200-day moving averages—or any other rules for calculating average prices. Moving averages, in all their variations, are simply tools that quantify some of the “repeatable patterns that illustrate the psychology of the markets.”

The main advantage of looking at prices through the prism of trailing averages is that it takes a lot of the emotion out of analysing market trends, he counsels. “You’d be much better off with this than making emotional decisions,” Grimes says. Is it foolproof? No, of course not. “We don’t deal in certainties—we deal in probabilities.”

Source:  (Re)Discovering Technical Analysis

The GOLDen Consolidation Range

In the previous post discussing Gold in January 2011, it was said that “the next target after the following likely correction is 1600 which may be touched in January – March 2012. Nevertheless, we should be aware that the uptrend may accelerate and become exponential at some point and even higher highs may be registered in a shorter cycle than the regular 34-week cycle.”

After a shorter than expected correction, the uptrend indeed accelerated, tested and exceeded 1600 target in July 2011 overshooting towards 1900 in less than two months before collapsing back to 1600 area. Since September 2011 Gold is moving in a consolidating range between 1550 and 1800.

In the weekly chart above we have the 34 and 21-week cycles centred on the September 2011 important plunging low. The projected cycles point us to end-of-December and beginning-of-January as potential important inflection interval.

In terms of price we notice Gold is in the upper half of the mentioned range which improves the likelihood of a breakout higher in the direction of the long term uptrend thus putting an end to the long consolidation period. Nevertheless, a break below the mid-range around 1675 will most likely keep the price in the same range or even threaten the 1550 support area.

In the daily chart above we have 55-day cycle centred on the latest significant low from May 2012. The projection gives us beginning of January as a potential inflection period.

We notice Gold broke into the upper half of the range in September 2012, travelled to the 1800 resistance area then corrected 61.8% of the latest up-thrust which coincided with the 1675 mid-range. The upturned that ensued was capped so far by the 61.8% (1750) of the latest downtrend but the price is still in the upper half of the range.

1750 and 1800 levels are deemed as key for the next move in Gold. If 1750 is exceeded, Gold can challenge 1800 and stage a breakout in the direction of the long term uptrend.

A break below the mid-range around 1675 will push the price back in the lower half of the range and may even threaten the 1550 support area.

US Homebuilding Stocks Gave Early Signal of Housing Top and Housing Bottom

THIS IS WHY WE FOLLOW CHARTS ... We've been treated to a lot of bullish news on the housing sector over the last month. Builders broke ground on more homes during October. Residential construction rose last month at the highest rate in more than four years. Permits for new construction were 30% higher than a year ago. An index of builder's confidence hit a six-year high earlier this month. It was reported this morning that the Case-Shiller Home Price Index rose 3% for the sixth straight monthly gain in a row. That index is the most widely-followed barometer of the health of the housing industry. It peaked during the middle of 2006 and bottomed during the first quarter of this year. The main reason why we follow price charts is because they are leading indicators of any industry's fundamentals. And, once again, the charts spotted the housing recovery a lot sooner. Chart 1 plots the Dow Jones US Home Construction Index since 2000. The homebuilding index peaked during 2005 (nearly a year before the Case-Shiller index) and broke its multi-year up trendline during 2006 (red circle). That was a clear signal at the time that the housing boom was over. It took the investment community until late 2007 to acknowledge that.

HOUSING INDEX GAVE MAJOR BUY SIGNAL LAST JUNE... Chart 1 shows the home construction index hitting bottom in late 2008/ early 2009. It achieved a successful retest of that low during the second half of 2011 before breaking its major down trendline during that fourth quarter (green circle). More importantly, the housing index cleared its 2010 high during June which completed a major basing pattern and signalled a major new uptrend (solid circle). I've been writing bullish comments on the housing industry since the fourth quarter of last year based on that bullish chart pattern. It took the economic community nearly a year to acknowledge the improvement. Homebuilders have, in fact, been the strongest sector of the market during 2012, and correctly signaled that the housing industry was in recovery. Once again, the charts were early and the economic community late. I can't wait to see all of the buy recommendations being issued by Wall Street in the coming weeks. Meantime, the construction index has more than doubled in price since the fourth quarter of last year. That's why we follow charts. And why we prefer the market messages being given by charts rather than economic messages which are usually way behind the market.

Source: John Murphy's commentary on StockCharts

The Foundation of Technical Analysis

Simply stated, Dorsey, Wright focuses on the “price” of a security, because it is the ultimate determinant of supply and demand in the marketplace. When you cut through all the red tape on Wall Street, what moves stock (and thus ETF) prices is supply and demand. It is nothing more than ECONOMICS 101. We know why tomatoes in the winter don’t taste very good, don’t have a very long shelf life, and are expensive. The same forces that move prices in the supermarket move the stock market. When it’s all said and done, if there are more buyers than sellers willing to sell, the price will move higher. If there are more sellers than buyers willing to buy, the price will move lower. Therefore, recording the price action of a security can yield important information as to who is winning the battle for that security — supply or demand.

Source: Tom Dorsey about Dorsey, Wright & Associates

S&P500 Potential Downtrend Target

The S&P 500 is in a long-term uptrend on this chart and there were two sharp corrections in 2010 and 2011 (17% and 19.7%). A similar correction (18%) would carry the index to the low 1200s. There is, however, a higher support zone around 1300. The spring lows and channel trend line mark support here.

Source: Stockcharts

10-year Treasury Yield to Show the Way

Signs of strength in the economy usually push treasuries lower and yields higher. Signs of weakness usually put a bid into treasury prices and push yields lower.

Chart above shows the 10-year Treasury Yield ($TNX) hitting resistance in the 18.5-19 area and falling back the last two days. The trend since late July is up, but this failure at resistance is not encouraging for stocks. Notice that stocks and treasury yields are positively correlated for the most part. A breakout at 19 (1.9%) would be bullish for yields, bearish for treasury bonds and bullish for stocks. Downside follow through below 16 (1.6%) would be bearish for yields, bullish for treasury bonds and bearish for stocks. 

This week’s economic data may tilt the balance and we could see a decisive move after the election. Directional movement could be limited until we get some clarity on the election.

Source: Stockcharts.com

Nasdaq Tests 200-day Moving Average

Nasdaq Tests 200-day Moving Average:

With a sharp decline the last five weeks, the Nasdaq is poised to test its rising 200-day moving average. The red line is the 200-day and this key average was last tested in early June. Note that the index is underperforming the S&P 500 as the price relative moved below its early August low.

BRD - The Relative Breakdown against BETXT

Weekly chart of BRD against BETXT.

BETFI Index Rally is Taking a Break

BETFI Index marched higher and shattered the previous post discussed target area around 23 000 points (see daily chart above). The index rallied to the next resistance around 25 000 points until mentioned mid February target. Since then a distribution have started with volume-price divergence which may precede a correction back to the 23 000 area. 

The potential correction is supported by the emerging relative BETFI weakness against BETXT indicated in the daily relative chart below.

In the bigger picture, the weekly BETFI Index before Friday close (see weekly chart below) is still trending up but pausing at the potential internal trend line resistance which may bring a correction back to the broken 23 000 points area. 

The up break of the 23 000 area coupled with the break of the 200 weeks SMA and a bullish 20 and 50 weekly EMAs crossover bring the index in a medium term uptrend that may target the 2010 highs around 34 000 points if last year's highs around 27 000 points are cleared. From this perspective, any pullback may be a medium to long term buying opportunity which should be reconsidered if the index falls below 20 000 points.

The weekly emerging relative strength of BETFI against BETXT following the break of a 4 year under performance (see weekly relative chart below) is also pointing to a medium to long term strong BETFI index performance.

BETFI Index Marches to The Next Target

As discussed in the previous post more than two months ago, the Romanian BETFI Index turned bullish and reached the 20 500 - 21 500 mentioned target area by the end of last year. As also hinted in the same post, this target area was the first stop before going higher towards 23 000 later on this year.

 

In the weekly chart above we see the index challenging the weekly EMA50 that proved strong resistance last year. If successful by the close of this week, BETFI next target is the 61.8% Fibonacci retracement of the 2011 downtrend, the falling weekly SMA200 and a previous congestion area, all converging around 23 000.

In the daily chart below we notice the potential a-b-c correction to the 2011 downtrend with the "c" leg symmetrical with the "a" leg (that reached the previous target area around 21 000) pointing to the same discussed zone around 23 000.

The break of the falling daily SMA200 with increasing volumes in the first weeks of 2012 is also supporting the daily and weekly trending index to reach the next target area around 23 000 until mid February when both monthly and quarterly cycles meet. A longer and deeper correction may follow afterwards.

 

As suggested in the previous post, relative to BETXT, the BETFI Index managed to break out of both daily (chart below) and weekly (chart above) underperformance trends and started overperforming the market which also support the march of the index to the next target.