This post has my personal notes on the book Deemer on Technical analysis.
WHY TECHNICAL ANALYSIS?
The costs of living are on the rise. Jobs are decreasing or not paying very much. We need to save more. A real risk-free return is inflation plus about 3 percent. If you want a higher return you need to take some risk. If somebody tells you that you can get higher returns without risk they are lying. At the moment(2012) cash pays a measly return. There are financial assets(stocks and bonds) and physical assets( real estate and gold, art and various commodities). At various times different ones are attractive. Brokers want to make money and not make money for you. Mutual fund managers have a very short-term outlook. Retirees take money out of the market. So we should take responsibility for our investing more. When you invest in an active mutual fund you should remember that smaller sized funds do better, only strong funds survive and often the performance is dependent on the manager. When you are investing for the long-term, say 40 years, then mutual funds are a good choice( the best is a passive index fund). The best way to start making a fortune is to start saving money early. Do not involve in short-term trading. Do long-term trading, however fundamental research can be often inaccurate and a lot of people who are there to con you. Remember that the only purpose of investing is to make money. The statements: This time it’s different. It is whole new paradigm- are costly. They are always false. Technical analysis uses price and uses historical price data to project future data.
There are four common types of analysis: fundamental analysis( studying companies), economic analysis(studying the economy), random walker( efficient market) and technical analysis( price). Technical analysis focuses on the following things:
- Focuses on price alone.
- Concentrates on trends
- Think longer term, rather than shorter term
- Ignore noise, especially the news.
Follow Bob Farrell’s eleven rules.
PRINCIPLES AND USES OF TECHNICAL ANALYSIS
The two basic principles of technical analysis are:
- Supply/Demand: Buyers>Sellers: price goes up. Sellers>Buyers: price goes down.
- Sentiment: Optimism: price goes up.(greed) Pessimism: prices goes down(fear)
Prices may go up irrationally or go down irrationally. But this time is never different. They always revert back. So it may be wise to go against the trend when there is irrationality. When the time comes to buy, you won’t want to. But if you do, you will become rich.
The uses of technical analysis are:
- Timing (when to buy/sell)
- Stock/sector selection ( what to buy or sell)
- History never repeats itself exactly, but human behaviour does.- Bob Farrell
- We time the market when we say something is overvalued or undervalued.
- If we miss the best and the worst days in the market, we will beat buy and hold.
- Don’t try to buy at bottom and sell at the top. That can’t be done, except by liars.
Four phases of market cycles
- Everything goes up, including the averages.
- Most stocks go up, and the averages keep going up.
- Some stocks go up, but the averages turn down.
- Nothing goes up, including the averages
Buy when prices are trending up and sell when they are trending down. Buy when prices have bottomed and sell when they have topped. Look out for when the market stops going down on bad news- and then, in advance of the news starts to rise. Remember, the market leads the news. Sell your stocks, if they fall below a long term moving average: say, of 30 weeks. If there is a bubble, then prices do not go sideways at the top, they burst and rapidly fall. A bull market is when stocks don’t go down on bad news and a bear market is one when the stocks don’t go up on good news. Fear is a stronger emotion than greed-therefore markets are worse at the bottoms.
Buy ETFs and index funds rather than individual stocks. Your risk is less.
Always consider the contrary opinion of the prevailing market sentiment.
CHARTING TECHNIQUES AND PATTERNS
A picture is worth a 100 words. A chart is worth a 100 numbers.
When charting remember two rules:
- KISS: Keep it simple and stupid
- 90/10 rule: You can get 90% of the information in about 10% of the time, but it takes the remaining 90% of the time to get the remaining 10% of the information.
We really need to determine just 4 things from stock charts:
- Is the stock price going up or going down?( whether price is above/below the moving average)
- Is the stock gaining or losing momentum?( is the price moving further and further above/below the moving average)
- Is the stock overbought or oversold?( is the price way above/below the moving average, say over 30%)
- Is the stock’s relative strength line going up or down?( is the price/ broad market index like S&P 500 going up or down)
What we can know from charts is whether risk levels are high or low. If the price is way high, then risk levels are high and if the price is way low, then risk levels are low. But it is hard to know when risk will be perceived as too much or too low. Predicting when it will happen is impossible. But it gives you clues regarding irrational optimism or pessimism.
Some other things to remember are:
- To reflect historical changes accurately, use ratios like P/E or P/gold price or Price/median home price.
- Use log scales rather than arithmetic scales.
- Long term charts show that there are trending markets and side ways markets.
- With regards to P/E ratios: 5 is very low, 25 is very high. Thats all you can know.
- A rising price of gold means either inflation or fall in the value of the currency
- Inflation adjusted numbers are not really precise.
Understanding regression to the mean: The market hardly ever stops at the mean. It oscillates between fear and greed and swings above and below the mean like a pendulum. We should be concerned more with the swings rather than mean. For example if the mean P/E ratio is 15 and the range is 5 to 25. If the market is at a P/E of 15 then it means the market can go down far below. Prices oscillate above and below the least squares trend line.
Relative strength line: You want to own a stock that is doing two things:
- Going up.
- Going up more than the market.(the relative strength line)
- Gaining momentum: going up at a faster rate than before
- Losing momentum: going up at a slower rate than before
Overbought and oversold: gone up too much or down and hence likely to correct
Oscillator: maximum low at the end of a bear market and maximum high at the beginning of the bull market and becomes zero when the price is going sideways. Low oscillator readings mean that one indicator of a bear market being over is met.
Breakway momentum: 10 day total advances on the NYSE/10 day total declines on the NYSE >1.97. The main thing needed to achieve breakaway momentum is lack of declines.
Selling climax: The stock market goes down the fastest at the end of a decline. This is called the selling climax. It then goes through a process of testing the low( 3-4 days later and then 3-4 weeks later). If selling pressure, as measured by volume or new lows does not exceed what happened at the selling climax, then the test is successful. Otherwise, the markets have not reached their bottom.
The S&P 500 index is often not an indicator of the market, as sometimes new issues come into the index at high prices. An equal weighted index is probably better.
CYCLES AND WAVES
Market based cycles:
- The four year cycle: The stock market makes an important low every 4 years or so.( upto 6 years sometime). The peak of the cycle is not regular.
- Kondratieff wave: The stock market makes a generation low every two generations or 50 years or so.
- Presidential cycle: not reliable
- Sell in May and Go Away: not reliable
- Elliot waves: not reliable
Cycles not based on market prices:
- Dividend yield cycle: S&P 500 dividend yield varies between 3% and 6%
- The debt cycle: from high to low. As debt increases, stocks do better and as the debt decreases, stocks do worse.
- The interest rate cycle: from high to low, follows the debt cycle. As the interest rates increase, stocks do worse and as the interest rates decrease, stocks do well.
- Income distribution cycle: peaks at 1928 and in 2012.
Tops and bottoms
- For long term investors look at weekly charts.
- At the top, there is a loss of upside momentum
- At the bottom, there is loss of downside momentum
- Once a stock goes up or down, it consolidates for a while.
Indicators can be confirming or contradictory indicators. They can be trend or contrary indicators. With contrary indicators you are early and with trend indicators you are late. No indicator is infallible.
- News is not an indicator
- Don’t fight the tape. It makes no sense to insist that the market is too high or overbought and therefore has to go down. Watch it but do not sell. The trends you are concerned with last weeks and months and not hours or days.
- Use trend analysis and cycle analysis( starts, accelerates, peak, decelerates, ends at an extreme on the opposite side)
- Broad based advance or narrow advance
- Advance- decline line
- % of sectors above a moving average(100% at the beginning of a bull market)
Speculative activity analysis:
- Compare level of speculative trading with trading in conservative stocks.
- The ratio is: 4 week MA of NASDAQ/NYSE volume/52 week MA of NASDAQ/NYSE volume. >1.18=high. >1.27=clear danger.
Exception analysis:Ignore the indicators if they are within bounds. Pay attention when they exceed bounds.
Sectors: Beginning of a bull market, buy financials. End of a bull market, buy energy stocks. Defensive stocks are consumer staples and utilities.
- Don’t fight the Fed: Three steps and stumble( increasing rates) and Two tumbles and jump( decreasing rates)
- Increasing money supply: good for stocks
Contrarian and sentiment indicators: Buy when there is pessimism and sell when there is optimism
- Buy stocks with high relative strength, especially when the market has decreased.
- Buy stocks that make new all-time highs the quickest.
- Diversify and buy many stocks
- There is no stock equivalent to cash
- Do not buy bulletin board stocks.
- Stocks that lead in a bull market or hold up relatively well in a bear market usually survive. Those that trail significantly coming out of a bear market may have problems that are not apparent. No stock in an uptrend has gone bankrupt.
- If there is a second subpoena, then sell.
- A shake-out, when small investors become disgusted with the market means the bottom is near
- Inflation: Fed wants it to be 2% per year
- Hyperinflation: US printing money
- Deflation: Japan.
- To buy municipal bond, you need fundamental analysis, not technical analysis.
- There is a lot of government debt.
- Europe is not doing well.
- China is double-edged knife.
ADVICE FOR THE PERPLEXED
What to buy when the market is falling
- Cash or cash equivalents
- Rotate into stronger areas of the world economy
- Buy defensives like consumer stocks and utilities: they will still go down
- Real estate: illiquid
- Commodities; tops are volatile, bottoms are rounded.
- Gold: Your view is that the currency is going to devalue and gold is the best alternative to paper currency.
- Art: hard to buy, hard to sell.
Manias, panics and bubbles
- When an IPO in a fad group trades below its offering price on settlement day, the fad has run its course.
- The best time to buy real estate is during a structural bear market.
- When the time comes to buy, you won’t want to. If Wall Street is bullish on it and making boatloads of money on it, it’s either over or about to be over.
- History does not repeat itself exactly, but behaviour does.
Wall Street is not your friend
- The stock market’s real meaning in life is as a post offering venue to give investors who participated in the capital raising stage a place to sell their shares when they want.
- The biggest money on Wall Street is made through underwriting fees.
- More money has been lost reaching for yield than at the point of a gun.
- Investors are better off in mutual funds than with private accounts
- Choose your broker carefully.
- If something on Wall Street sounds too good to be true, it is.
- Take a good look at the guy.
- Investing can actually be speculating or gambling-be careful.
Rules to live by
- Document your important decisions. Once every 6 months prepare a summary report and explain your investment decisions to another human being.
- Learn to think visually.
- Ignore the news
- Ignore the day-day market noise.
- Be an investor, not a trader.
- Be skeptical
- Be cheerful when others are fearful
- Don’t over trade
- Ignore the rumours, don’t buy them
- Cut your losses, let your profits run
- Never confuse wisdom with a bull market.
- Don’t try to catch the exact top or bottom
- Learn from your mistakes
- Read a good book: especially reminiscences of a stock market operator.
- Back up, back up, back up.