Finance and Stuff

Thoughts on finance and other stuff by Johan Lindén

Page 3 of 5

Cartoon for the Weekend

riots at wall street iphone

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

[youtube_video=http://youtu.be/z4TUgIx60PE&rel=0&w=570 rel="nofollow"]

 

Part 2

[youtube_video=http://youtu.be/U5JX5JjeJT8&rel=0&w=570 rel="nofollow"]

 

Part 3

[youtube_video=http://youtu.be/CUWvuRHb6OA&rel=0&w=570 rel="nofollow"]

 

Part 4

[youtube_video=http://youtu.be/9Glag0EJbNo&rel=0&w=570 rel="nofollow"]

 

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.

[youtube_video=http://youtu.be/aC19fEqR5bA&rel=0&w=570 rel="nofollow"]

 

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.

Free Markets are the Usual Suspects in Economic Turmoil

In dire times people are looking for scape goats. One of the most common scape goats is the free market. So is the free market really the problem? Let us look at what countries do in these troubled times.

  • First, they blame other countries for unrighteously compete with their domestic industries, setting up tariffs for foreign trade, thus engaging in trade wars, instead of letting competition rule.
  • Second, they increase regulations on businesses, blaming trading robots, short-sellers and other participants, and trying to interfere with these tools of the free market.
  • Thirdly, the state out-crowds sound private companies by engaging in their own businesses with the unlimited resources of the public. This is just one of many things the state do to ruin private businesses. Out-crowding is also done by manipulating the interest rate so it either becomes too high or too low, and thus ruining the private businesses’ ways of doing business at market rates.

So there you have some of the reasons why bad gets worse. With all these things happening at once in already fragile economies, there is no wonder that the economy usually hits a depression or crash before things get better.

Also note that all these signs are signs of socialism, taking us further away from the principles of free markets. A free market is a market without rules governed by the state, but instead by rules made by the market’s own participants.

Mortgage Rate Spread

falling house prices mortgage loansThe spread on interest rates between mortgage loans and central banks’ loans to other banks are increasing. While banks pay less for long-term loans, the private households who want a loan to buy a house need to pay a higher premium each day.

This implicitly means that house-buyers have to pay an increased risk premium to their bank and that real-estate investment are getting worse each day, not taking future depreciation of house value into account.

I do not see that this phenomenon is widely recognized and that more pressure on real estate is to come.

Survival of the Weakest

money printing press inflationIt seems that most countries want their currency weaker. At least in bad times such as the present. Both strong countries such as Switzerland, and countries with serious problems such as the USA.

In times of trouble debt is building up. In the US it seems that debt is building up no matter it is the best of times or the worst of times. When debt has reached a level in which it cannot be repaid, then there is one option left, to inflate the amount of that country’s currency and thus devalue the value of its debt.

The downside is that you lose confidence next time you need to borrow. Also note that this trick is worthless if all other countries do the same, which is what we will see happen in the future. Then the value of money just will evaporate all around the globe.

So stay tuned for a nice inflationary cycle to come within the next few years, in times when many countries will try to have the weakest currency. But then again, why not? The intrinsic value of today’s money is nil.

Q-Ratio

q-ratio q-valueThe Q-ratio is one of the methods to estimate the fair value of the stock market. It is defined as the total price of the stock market divided by the replacement cost of all its companies.

To put it more simply, the Q-ratio shows how much do we have to pay to buy the stock market compared to how much it would cost to build it up from scratch.

The Q-ratio is a fairly simple concept, but timely to calculate; fortunately, the US Federal Reserve provides the data on a quarterly basis.

To compare how much the companies cost with how much it would cost to rebuild them seems like a clever and objective way to measure the fair value the stock market. And looking back at “Q:s” history it has been of great value for investors using it.

The basic logic behind the Q-ratio is that if the “Q” is above 1.0, then the market is valuing the present stocks more than it costs to reproduce them; making them overvalued. If it is below 1.0, then it cost less to invest in stocks than it cost to reproduce them, thus making it more profitable to invest in the stock market than creating new companies.

On contrast to the P/E-ratio, the Q-ratio, is independent from the interest yield for comparison analysis. This makes the “Q” an easy and objective way to measure markets.

One of the drawbacks with the Q-ratio is that you have to trust the FED releasing the correct data, unless you wanna calculate the replacement cost of every stock by yourself.

Most people would intuitively think that the value of Q would be around 1 or a bit above in long-run. But its long-term value is close to 0,7. This is probably due to the fact that most firms assets are generally booked too high.

It is a shame that most amateurs in the market does not prefer to use the Q-ratio instead of P/E-ratios or dividend yields, both of which need to be compared to interest rates and other measures to be understood in their context.

Today the Q-ratio is a bit above 1 making the stock market overvalued by 40-50%.

I hope you enjoyed this article! Feel free to leave a comment.

 

Chart below shown for a historical view and is not recently updated

q-ratio historical chart

Chart from: http://mla.homeunix.com/q-ratio/

Fixed or Adjustable Mortgage Rate

Two questions regarding mortgage (home) loans.
Why are most people having adjustable mortgage rates on their home loans?
Is it better to have adjustable or fixed rate?

There are mainly two reasons why people choose adjustable mortgage rate:

  1. Because, an adjustable rate is mainly lower, since you have to pay an insurance premium for knowing your rate beforehand and will not end up with negative (or positive) surprises. You have secured your price of living at a certain rate. Secondly;
  2. since rates have steadily gone down for the last fifteen year or so, the bet to secure at a higher rate have been a losing bet. And since most home buyers memory have only seen interests going down and house prices going up, this is what they will define as a normal state of things.

The typical home buyer do now have the knowledge or understanding that interest rates have been much higher historically and most were not thinking of rates when rates were 15%, just back in the 90’s.

Another misconception is that they will be able to change to a fixed rate later on if rates go up. No such luck. If rates are going up, they will not be able to fix their rate at todays low level. They must then fix it at a higher level or continue speculating that rates will remain low, thus ruining the whole idea about keeping the cost of living low and decrease risk. What all this basically means is that when choosing an adjustable rate you are speculating with your home as security that rates will go down or remain neutral.

When choosing a time-period, do not choose 2 or 3 years, since then you are only insured from spiking interest rates for that period. Choose a period for as long as you need to make payments for the house, thus knowing your cost of living for that period instead of running the risk of ugly surprises. The government will not bail you out. They only do that to the really big and stupid risk-takers that have million-dollar-bonuses every year.

When choosing a fixed mortgage rate today, you get the lowest fixed rates in the history of mankind, and pay the smallest premium ever compared to the adjustable rate. So instead of taking the risk to double the cost of your living, fixing your rate seems like a pretty good deal of you ask me.

Below a chart comparing the long 30-year-old rate (blue) and the short prime rate (orange).

adjustable fixed mortgage rate home loan

Reproduced with the permission of Mortgage-X.com

stock market manipulation

Manipulation Lowering Stock Prices

stock market manipulationI never understood all the fuss about so-called downward manipulation of a company’s stock price. I so often hear or read about people complaining about that their stock is manipulated to be artificially lower than it should be. Even if it was true, that would be a good thing!

As all other things in life, the lower you buy, the better you are off. The advantages of buying a stock lower means, you get more of the company for the same money, a bigger share of future earnings, a higher dividend each year, and a better risk-reward ratio in distance for an up versus down swing.

A low stock price is only bad in one of the two scenarios. If a company needs to issue new stocks. Then they will have to sell out more of the company diluting the current ownership base. And it is obviously bad if current shareholders need to sell stocks at the time of the manipulation.

So please tell me if you know any stocks that are manipulated to be cheaper so I can buy them. I suggest you do the same next time you hear about manipulated stocks.

Click here for a general paper on Stock Market Manipulation.

Page 3 of 5

WordPress & Content by Johan Lindén