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.