The Limits of Technical Analysis, part 1

from CSS Analytics blog:

My early education was quite typical: I went to business school to get my MBA in Finance and then tackled the CFA designation. I was typically instilled with the “Efficient Markets Hypothesis” and often could be found reading arcane issues of “The Journal of Portfolio Management.” That was also a distant time when I thought CAPM was the single greatest equation in finance. I started my career many years ago in equity research, and then moved on to a stint in wealth management and investment advisory. I had the unique benefit of spending most of early years without looking at technical analysis. I spent years doing both macro-economic and company research, and also invested heavily in research using fundamental scoring systems. My early heroes were Joel Greenblatt, Michael Price, and David Dreman–all pioneers in original fundamental research. While it may be unbelievable to loyal blog readers, I distinctly remember the days when I used to scoff derisively at anyone who begged me to look at a stock chart! Now, after becoming a technical analysis convert so to speak, I have a fair degree of perspective to share on what technical analysis can and cannot accomplish.
First, let me state a unique premise: without other market players believing in fundamental analysis, I believe that technical analysis would not work. Huh? Well the truth is, all major trends including both bull and bear markets are a function of the belief in some theory about fundamentals. Few individuals with serious wealth are willing to risk their own money on the basis of an interpretation of a chart pattern. Imagine telling a client that has given you $25 million to invest that you are going to be investing $5 million in China Telecom because “the chart looks good.” Or how about trying to tell that same person that you are going to increase your exposure to Citigroup in 2008 “because my indicators show that the stock has hit a bottom.” You better have a good reason to explain to this same person why you are risking their hard-earned money on a bunch of chart squiggles. For this reason, most of the money in the mutual fund and pension fund universe is invested using fundamental research and macro-economic theses about a specific stock, sector or commodity. Typical examples include statements such as: “the world is running out of oil”, or that “the internet is going to take over brick and mortar business.”
Not some, but nearly ALL major bubbles or parabolic moves are created by feedback loops that start with a few people believing in a given theory and end with the majority achieving a consensus that a theory is true.
One implication of this process is that the proximity to a long-term top or to a bottom can be better approximated using gauges of sentiment rather than classic technical indicators. Based on the theory postulated above, major moves will start occuring when the majority of people do not believe that a market will reverse course based on fundamental reasons. The smart/more informed money will often be placing their bets ahead of the crowd without moving the market. By extension, this also means that major turning points will be difficult to distinguish since the money flow into a given stock or market will likely be offset by the majority of investors betting in the opposite direction. No technical indicator in my experience is capable of telling you with any accuracy where the top or bottom is. I have never tested or seen anything that can accomplish this significant feat of prediction. Strangely, it seems that most newsletters and market pundits spend most of their time calling tops and bottoms. Perhaps this is why they always seem to underperform buy and hold or a simple 200-day moving average rule despite having arguably excellent knowledge of a wide variety of truly predictive indicators.
The reality is that the fallability of technical indicators is a major limit of technical analysis that cannot be addressed adequately by trying to be more precise. The sad fact is that this never-ending quest for precision is the undoing of many great chartists. Many technical analysts fall prey to “confirmation bias” after analyzing a market because they are desperately looking for some “non-confirming divergence” or other magical signs that they are still correct in their analysis. This same problem also affects quants that trade mechanically: no hidden mathematical transform of price and/or volume (or combination thereof) holds the key to predicting all markets with significant accuracy. At some point no matter how sophisticated you are in your analysis, you will reach a maximum bound of profitability that can be achieved by looking at prices and volume in isolation. This bound can only be surpassed by incorporating variables that are not multi-collinear with price-based indicators. Not only is it easier to improve your precision with other variables, but you also run a much lower chance of having a poor reward to risk ratio.
to be continued………
original story

The "Dumb" Money Gives Bearish Signal

from the Technical Take blog:
Investor sentiment continues on the same path as the two previous weeks as the "Dumb Money" indicator is moving to new bullish extremes. Typically, this is a bearish signal.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

Going back to early March, 2009, the "optimal" time to buy into the market was when the S&P500 closed at 756.55 on March 13, 2009. The "optimal" time to sell was at the close April 17, 2009 with the S&P500 at 869.60. This represents a gain of 15% gain over 5 weeks or 3% per week. This is annualized to a 156% gain, and this is what one would expect at the bottom of the price cycle when the trend changes from down to up. We get an acceleration of prices higher.

From our "optimal" sell signal to this past Friday's close, the S&P500 has gained 9% over 8 weeks or 1.13% per week. This is annualized to a 59% gain, which isn't too shabby but certainly less than the move from the "optimal" buy to the "optimal" sell signal. As an aside, "optimal" doesn't mean best. "Optimal" assumes all occurrences over the length of the observable data. Could the "sell" signal have been better timed? Yes, but over the past years the "optimal" time to get out of the market and protect profits was the "optimal" sell signal. We should note that the "Dumb Money" indicator had yet to move to a bullish extreme, and we were basing our signals on prior bear market experiences.

Then on May 8, 2009, the "Dumb Money" moved into the extreme bullish zone, and this is a bear signal. On May 8, 2009, the S&P500 closed at 929.23. Since that time the S&P500 has gained 1.8% over 5 weeks or 0.36% per week. This is annualized to a 18.72% gain. Once again, this isn't too shabby, but clearly much less than the move off the bottom or from our initial "optimal" sell signal.

Yet, with the "dumb money" now bullish to an extreme, this is the part of the price cycle that appears to be attracting the most attention and most acceptance from investors. Yet, this is the part of the price cycle where the markets haven't gone anywhere. It does seem kind of odd -doesn't it? The time to have been bullish was when investors were fearful.

To embrace higher prices with sentiment so extremely bullish, you must embrace the notion that we are in a new bull market. You must embrace the notion that higher oil and higher interest rates don't matter. You must embrace the notion that second derivative growth will lead to real, sustainable growth. You must embrace the notion that our housing and commercial real estate troubles are all behind us. You must embrace the notion that a PE of 150 on the S&P500 doesn't matter. You must embrace the notion that we can have an economic recovery without any meaningful change in unemployment. And we can go on and on and on....

I have picked my poison. It is a monthly close over the simple 10 month moving average on the S&P500. Once this occurs, I will add equity exposure (that is adjusted for the inherent risk of the asset (equities) and adjusted for the other assets in my portfolio). Personally, I don't like it, and this is at odds with my own analysis that leads me to state that this is not the proper launching pad for a new bull market in equities. But then again, the market cares little what I think or do. Nonetheless, this is how I am choosing to play it. The Faber strategy, which I discussed last week, is a strategy that helps me manage money and manage risk. It is not a "call" on the markets.

For the record, the "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"/ weekly

Confused? Perhaps You Should Be

Real estate magnate Richard LeFrac recently said, "If you're not confused, you're not thinking clearly". At first, I laughed when I heard that. Then, I realized how true his statement really is.

We are constantly bombarded with data, much of which is conflicting in nature. We must analyze and weigh all the data, and eventually, make a decision. Sometimes those decisions prove wrong. Hopefully, there will be more right decisions than wrong ones, or at least the right decisions will be more profitable, while the wrong ones will be small. I have found that this is the more frequent scenario -- small, frequent wrong decisions, and large, less frequent good decisions.

This is a time in which the investment world is experiencing great turmoil. The market can, and often does, turn on a dime. I have also noticed that tops and bottoms -- reversal points -- often occur precisely at the time that we least expect them. Reversals most frequently occur when market sentiment feels like a reversal is the least likely event . It often feels like a continuation of the existing trend is most likely, and yet a reversal at a top or bottom occurs instead. I have also noticed that following parabolic, sharp movements or trends, a sharp reversal is also more likely, as markets become grossly overbought or oversold, like a rubber band that snaps back sharply after being stretched too tight. In Philippe Cahen's book, Technical Analysis and Volatility, this is called the Australia pattern. I have no idea why. On the other hand, if a trend occurs on a more gradual basis, it typically will last longer and is more likely to end with a consolidation rather than a reversal.

I have come to expect market turmoil and uncertainty. Making decisions -- and investments -- in those times of uncertainty are often the best investments I've made. That's why I learned technical analysis. It allows me to make decisions based upon a set of indicators that permit me to remove most -- not all -- emotion from my investments.

Soybean Rebound

Despite an expected further sinking in soybean prices this morning, prices have rebounded instead. In the futures markets, one must always expect the unexpected. That's why I trust my charts. They won't mislead me.

Unfortunately, when I study the fundamentals, they often do. I have found that there is always someone else who has more information, or has that information sooner than I do. However, as soon as traders start to act on the information, I see that activity manifested on my chart within moments. Then, I will take action. It is usually several minutes later than I learn the fundamentals-related reasons for what occurred.

Bouyant Rebound Following Dismal Jobs News

Beyond all predictions of the experts and professionals, stock market indexes have rebounded to positive territory following the abysmal jobs report earlier this morning. What a turnaround!

Trading on the Fundamentals

This is a perfect example of an instance in which market forces have done precisely the opposite of what would have been expected, defying all reason. This is why I don't trade on fundamentals-related news events. I like to be aware of the fundamentals, especially the timing of news events. However, I trade only on technical analysis. The charts don't lie or mislead! I use fundamentals news only to confirm what the charts are telling me.

Bollinger Bands as dynamic support and resistance

I use Bollinger Bands, in part, because they provide dynamic support and resistance. This concept is explained in great detail in Philippe Cahen's book, Analyse Technique et Volatilite (still published only in French). I have noticed that this is particularly true in a consolidation period following a sustained price movement, as shown in the above chart example of this tick chart. (The strong price movement was depicted at the bottom of my last post. The chart above shows only the consolidation phase.) Note how well the Bollinger Bands, shown in purple, provide dynamic (vs. static with many other forms, like Fibonacci numbers) support and resistance. Prices have a tendency to reverse at prices very close to these Bollinger Bands. Since Bollinger Bands are based upon the science of statistical analysis, this holds true for most liquid financial instruments. When prices close outside the Bollinger Bands, this is indicative of rising volatility, and thus, increased momentum in the direction of the prices. Following a consolidation, this is a signal to take a trade in the direction of that Bollinger Band break-out.

When prices (move and) close too far outside the Bollinger Bands, they have a tendency to snap back inside those bands, at least temporarily. In a strong move like what we are seeing in todays grains, prices will show a pattern like the one above (first chart at the top of this posting) on shorter time frames, while they will appear to move back inside the Bollinger Bands for a period, as shown on the second chart depicted here of the 3-minute chart. The consolidation in the chart at the top of this post is also depicted in the section where I have placed the red arrow in the second chart (above right).

Prices and the Exponential Moving Average
Interestingly, as prices approach the Exponential Moving Average in this second chart (shown as a blue line), they are more likely to surge to even higher highs, as we can also see has occurred in this second chart. If prices close below the EMA instead of moving higher, then prices are more likely to consolidate (greatest probability) or even reverse. A reversal is more likely following a consolidation rather than a sudden reversal in an uptrend. In the example shown (above right with red arrow), after prices closed below the EMA (when the blue line changed to red at the second-to-last completed candle, which was red), a consolidation emerged immediately after the screen capture of this chart was made. Another clue of quickly-falling volatility and and end to the price movement is manifested also by the new high price (third from last completed candle -- a slightly imperfect gravestone doji for those trained in Japanese candlesticks) that closes within the Bollinger Bands. This phenomena withe the EMA is also proliferated into the 15-minute chart, as prices later moved upwards again as the EMA in the 15-minute chart provided additional support (not shown, as it occured after these screen captures were made).

Bollinger Bands and the Triptych

This is one reason why I keep multiple time frames on my charts at all times (as shown in the third chart in this post just above this paragraph), because I want to have the perspective of what the Bollinger Bands are doing on higher time frames as well. Cahen calls this a triptych in his book, a perfectly appropriate term. This proliferation of patterns from one time frame to the next occurs with a high degree of reliability on all time frames. Note that the period shown in the first chart above as a consolidation, is also depicted in this second chart as a period of flat trading, following a strong movement outside the purple Bollinger Bands, which resumes once prices approach the Exponential Moving Average. When prices move so rapidly so fast, and thus move farther outside the Bollinger Bands than is statistically reliable, a period of resting prices (consolidation) is needed before prices can resume their upward path. Cahen also explains this concept in considerable detail in his book. I think of it as being somewhat like a rubber band. The more tension that is created on a rubber band, the more likely it is to snap back with some force.

Since Bollinger Bands are based upon statistical analysis, anyone who has been trained in statistics and an understanding of standard deviations from a mean can understand how this force influences prices in the financial markets. Bollinger Bands are based upon standard deviations from a mean, and thus, they can help us to read and understand the financial markets.

Higher Prices and Inflation Ahead?!
This surge in prices is suggestive of continued bullish price strength in the longer-term charts for the grains. We should see still higher prices (new all-time highs in soybeans) very soon. The all-time high price in a front-month contract in soybeans is still $12.90. This price may provide some resistance, but I expect it to be eliminated soon, probably within the next few trading days.

If, in Fed Chairman Bernanke's speech today, he attempts to minimize the inflationary influence of high commodity prices, and/or he signals the markets that lower interest rates and looser monetary policy lie ahead into the foreseeable future, this price surge to higher highs will probably occur sooner rather than later. $12.90 soybean prices may very soon be a very distant memory in the past, despite dissipating momentum and selling volumes on the daily chart (see my previous post earlier today)! This could cause buyers to step into the market once again to force the Klinger volume indicator to begin moving upward again and resume the uptrend in soybeans and other commodity prices.

Can you spell inflation? I knew you could!

Chart Triptych

I use a chart triptych as recommended by one of my teacher/mentors. This one is recommended by Philippe Cahen in his fantastic book on his copyrighted trading methodology called, "Analyse Technique et Volatilite". Yes, it is written in French. I spent 8 weeks translating it into English so I could use it. He wrote an earlier version in English titled, "Dynamic Technical Analysis".

I use 3 time horizons on my screen (this constitute the triptych) at all times to give me context. I also check the daily charts each day, and often I look at other time intervals as well.

One of the reasons that I like this method of trading so much is that it truly is dynamic. Instead of using static settings and fixed lines, this method takes into account the dynamic, constantly-changing nature of the financial markets, including for dynamic support and resistance using Bollinger Bands and EMAs.

Another reason that I prefer this method is that it is entirely visual in nature. I must be very visually-oriented. I have modified and added other indicators to Cahen's method, but I have kept the triptych, which I consider to be a necessity.