Finance and Stuff

Thoughts on finance and other stuff by Johan Lindén

Category: Trading (Page 1 of 3)

Key Reversal

Last night we had a Key Reversal in the both the S&P 500 and the NASDAQ. If one is to believe in classical technical analysis and its followers that is a sign of exhaustion and means that we should go further down. But be aware! According to quantifiable analysis of similar patterns we have NEVER seen a major top forming this way. Statistical analysis shows that we are going to have new highs and that will be the way we will primarily bet until new evidence emerge.

S&P 500 Makes a New Multi-Year High

Some people cannot believe it — The S&P 500 and the NASDAQ 100 has made a new four-year high under what seems the be a financial Armageddon if one was to listen to the financial press. Readers here should not be surprised though. Let’s see what the last follow-up said and what to expect next.

From the last follow-up in the 23rd of April:

What can we expect next?

Most statistical signals are indicating that the market will be higher in the coming months. The risk-averse person should be out of the market while the speculative person should be buying on short-term oversold conditions and selling on overbought conditions.

What we should look for before expecting a longer change of the trend is that sentiment gets increasingly bullish while hitting new highs or that it gets stubbornly bullish while making the next correction down.

The market had a fair share of zig-zag movement and to buy the oversold conditions and sell on the overbought conditions would have been highly lucrative. So let’s make a new probability forecast:

What can we expect next?

We still have a few long and intermediate term indications of a higher market. We also just received some indications of some warning signs. According to the Hulbert Financial Digest, newsletters that are focused on the NASDAQ Composite index are now recommending a 60% net long position. It may not sound that extremely bullish but that’s in the top 11% of readings since 2000, and is up from a recommended net long of 18% just two weeks ago. Fundamentals can be regarded as either bearish (Q-ratio, P/E10) or bullish (P/E in a none recession environment) and that is why we don’t look at them to take decisions. At the moment we only go long on oversold conditions and sell on overbought conditions until a longer term scenario is set out by the market’s price action.

Good luck and please feel free to post questions or comments in the comment field of this post.

Stock Market Analysis Follow-up

In my previous stock market analysis I thought the market would make a down turn before reaching multi-year highs and then make a false break up before a big downward trend.

What happened was, as you can see in the chart below, that the S&P500 index only made a minor move down (A), before it broke up (B) and giving a false buy signal so that people would buy, then continue down (C) tricking people it was a false buy signal so that they would sell. After shaking of some weak hands of their positions the years strongest rally started (D), which was followed by the years biggest correction (E) which again landed below the previous multi-year high.

The S&P 500 was trading at 1357 at the previous analysis, while todays futures indicate and opening at 1361 (+0,29% change) in over two months time. So although a lot has happened in volatility, nothing much has shifted when it comes to valuation.

So what can be learned from this? Well, we still see that the market trying to make the most amount of people to become losers. We also see that contrarian sentiment has been reliable. It showed us the bottoms at (C) and (E), when people quickly panicked and started talking about a bigger correction down. It also showed us that the tops at (B) and (D) were not likely to give stronger long-term trend changes since people had become skeptic about the market trend.

That is obviously the reason why the market did not continue down but instead made new multi-year highs.

S&P500 technical analysis stock market

What can we expect next?

Most statistical signals are indicating that the market will be higher in the coming months. The risk-averse person should be out of the market while the speculative person should be buying on short-term oversold conditions and selling on overbought conditions.

What we should look for before expecting a longer change of the trend is that sentiment gets increasingly bullish while hitting new highs or that it gets stubbornly bullish while making the next correction down.

My Ideal Scenario

It is said be many, and I agree, that the stock market is rigged so that as many people as possible will be wrong as often as possible. This contrarian thinking is also backed by many studies which show that strategies that work are counter-intuitive.

So far it worked well for me trying to figure out the route of the market since I got active analyzing the market again last fall.

Let us take a look at my favorite scenario that I think will fool most people getting in the stock market at the worst time.

The facts are as follows:

  • Since last fall we have had many difficulties all over the world
  •  The stock market has risen a lot
  • Most people have been afraid of getting in the market
  • Most ways of measuring the trend is pointing up, which is what many people like to see before entering the market
  • The last movement up has been almost without any big draw-downs.

So most people now are noticing that the trend is up, they also read all the positive things happening in the economy (the bad things aren’t shown so much in media when the stock market is going up). So now people are looking at a time to enter the market. Every big draw-down now will likely attract a lot of money.

When the market finally enters a multi year high, just 2% up from where we are now, then they will throw their last dollars in desperation not trying to miss the rally. They do not even realize that they just missed a 25% move from the bottom. When that happens I think we reached a new multi-year high, maybe for many years to come.

This is just an ideal scenario that I would like to see. Of course there could be other similar scenarios or I could be totally wrong, but this would fit my expectation of the psychology and knowledge of the market.

Also note that I will short the market at a time when most of the traditional type of technical analysis would scream buy.

bear bull trap stock market top

Sentiment Getting Too Bullish

At this time I would recommend everyone to get out of all high risk assets such as stocks as we are reaching a multi-month high.

There are too many factors to mention but I will add two charts from the blog of SentimenTrader below.

What I would preferably see is that we get a new multi-year high which means above last summers high. We are very close to that now, only a few percent below. Then most people will reason that a new bull era has begun. That will be the mistake of the century. But at this time, at least get out of every high-risk asset and, and start taking small negative positions.

The market is now driven by enormous amounts of liquidity provided by central banks all over the world, and that is a strong force, but valuations driven by politicians rather than by value will be very vulnerable when reality takes its course.

sentiment chart rydex fundsrydex sentiment chart bearCharts from SentimenTrader.com/blog. If you are interested in contrarian analysis and market sentiment I highly recommend the subscriber service at SentimenTrader.com.

Gold Weekly Buy Signal

Gold finished last week bullish and gave a buy signal in the weekly chart.

I call this signal “Buy The Dip” and it gives us a good buying point. But no buying signal is ever good without a proper exit strategy. But if you are being long-term bullish on gold like I am, you should widen that stop loss. So please remember to always define your exit signal before you take on a trade or investment.

A wider stop loss means you also need to take a smaller position on your trade. But I hope most readers already have gold in their long-term portfolio as insurance as I have written about before.

The last local low point was $1,535 so that will be my stop loss unless sentiment changes.

[Edit: Added the following paragraph on Nov 1st]

Mark Hulbert who is tracking sentiment in his Financial Digest wrote on the 25th of October that “[…] gold market exposure among the short-term gold market timers […] dropped to its lowest level in two and one-half years — minus 13%.” This will really help to give the positive signal above a kick-start.

gold buy signal chart buy the dip

A Quick Look at the Stock Market

A quick look at a chart of the stock market movement since the October bottom. Annotations provided in the chart. Feel free to leave a comment!

stock market  contrarian rally

The Truth Behind Technical Analysis

Let us take a look at technical analysis, which is used by many to make a profit by predicting the stock market.

Technical analysis is a set of tools used to analyze the movement or behavior of a stock or index instead of the facts surrounding the company or the economy, which is usually used when trying to predict where stocks are heading.

trend channel technical analysis

Trend Channels

Some use trend lines or channels to figure out the trend, some use resistance and support lines to see where there will be a lot of buyers or sellers.

One of the problems with this approach is that in any given chart, even randomly produced, you will in hindsight easy spot a trend. Of course if a chart is randomly produced you will not be able to forecast the next move. So how come you can do that in the stock market?

People in the field of statistical analysis are often dogmatically blindfolded. They might claim that since so many people are using it, it cannot be wrong. Or they know successful people who are using it, or even use it successfully themselves.

technical analysis support resistanceHowever, this type of reasoning suffers from strong statistical bias, such as survival bias, where only the winners tell the story about how good it works. While the losers go back to their jobs and usually do not speak so much about their failure. It could also be that since some only use a long strategy only, in a rising market. In other words they would have done well be just buying and holding.

Scientific research

Now let us look at the scientific research in this field. Oh yes, there is quit a bit of research, but strangely enough it never reaches the believers.

In the research paper “On the Analogy Between Scientific Study of Technical Analysis and Ethnopharmacology” via CXO Advisory they write:

There are four areas of similarity between folk medicine and technical analysis:

  • Both have foundations in folk science, with most claims proving false when subjected to rigorous scientific testing;
  • Both have strong potentials for statistical bias, the placebo effect for folk medicine and data snooping for technical analysis;
  • Both boast commercial popularities that support large markets for products/services; and,
  • Both are possible sources of scientific knowledge (for pharmacology and financial economics, respectively).

The essential lessons from folk medicine for testing of technical analysis are:

  • The study of technical analysis should mirror the rigor of drug evaluation methodology (e.g., randomized, double-blind, placebo-controlled trials involving homogeneous populations);
  • The study of technical analysis should include greater emphasis on explaining the behavioral mechanisms underlying hypothesized market inefficiencies; and,
  • There should be a independent peer-reviewed journal devoted to the rigorous testing of technical analysis.

In another scientific peer-reviewed paper, “Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals” via CXO Advisory it says:

David Aronson opens with two contentions: (1) “much of the wisdom comprising the popular version of TA does not qualify as legitimate knowledge;” and, (2) “TA must evolve into a rigorous observational science if it is to deliver on its claims and remain relevant.”

None of the 6,402 rules tested on the S&P 500 index, after adjusting for data mining bias, generate statistically significant outperformance. More complex/nuanced rules, or other financial data sets, might indicate abnormal returns.

From the paper “Identifying Noise Traders: The Head-And-Shoulders Pattern in U.S. Equities”, where a commonly used technical pattern called “Head and Shoulder” the following is summed up by CXO Advisory:

The author determines that head-and-shoulders pattern trading exists but is on average unprofitable, mistakenly interpreting randomness as information.

Is technical analysis worthless?

Yes and no. It is if you do not have a quantifiable edge. That means that you must have a statistical edge before you trade or invest. A rigorous back-test of your hypothesis must be done. What most people seem to do is that they are guessing or using some false authorities providing them false information about what is supposed to give them an edge.

Not even if you are back-testing your strategies to gain a statistical edge you are guaranteed future winnings. In fact there will be long periods, minutes, hours, days, or a lifetime where a historically proven winning strategy will become a losing one. To avoid this, look over your strategies often and see if they are obsolete in the current environment, and use many different strategies to diminish the risk.

The human brain is not particularly well wired for finance and trading. That is the reason why not even central bankers or countries know how to run their economies.

Most of the argument on technical analysis above can also be applied to fundamental analysis such as P/E-ratios, the FED-model, dividends-yield, et cetera, but that is for another article.

I would say that probably more than 90% of the “knowledge” out there on trading and investing is bogus, so watch out. Maybe even this article is, so always use your most critical judgment, and if you cannot, staying out of the markets will win you do most in the long-run.

Good luck! (or rather stay out of the luck part and in to the field of competence instead)

Market Wizards Lecture

Jack Schwager, the author av the trading bible Market Wizards, now has a lecture that can be watched on Youtube or here below.

Since most of his advice is very good, you can really understand that he is a smart man who interviewed and learned from some of the best traders of all times.

The whole lecture is divided in four pieces.

Part 1

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Part 2

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Part 3

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Part 4

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Related Article:
Quotes from Market Wizards

The Truth Behind the Trader on BBC

If you have not seen it yet, see the clip from BBC about the trader who spoke frankly about what he thought about the market. Some of the things he says is:

  • The smart money, do not buy the European rescue plan. The stock market is finished. The Euro is finished.
  • That he and most traders do not care about how the economy goes. He says that he goes to bed every night dreaming of a recession since they equal opportunities.
  • A trader or any person can make money if he is prepared.
  • This economic crises is like a cancer. It will just grow if not taken care of. Get prepared.
  • Governments don’t rule the world, Goldman Sachs does, and Goldman Sachs does not care about the European rescue package.
  • In less than 12 months the savings of million of people will vanish, and that is just the start.
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I mostly agree with him, and think he has some good observations. But there are two main issues here that I want to point out. Firstly, from a contrarian view it is very bullish when mainstream television like BBC air such an ultra negative outlook like this.

Secondly, what is really interesting is that many newspapers today write about this interview. But instead of focusing on what the trader said, they focus on him as a person trying to discredit him. When people trying to hide their heads in the sand by discrediting sources instead of statements, then that should be seen as very negative from a contrarian view.

Market sentiment remains very negative at the moment, making it hard to bet on a downward market (S&P500 1163), more upside risk than downside risk at the moment. However, the long-term outlook is still very bearish as long as most people are denying the risk of a disaster.

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