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5 Different Technical Tools For Traders In One Chart

Last fall I wrote a post titled, “This Is Now The Worst Possible Environment For Stock Market Investors.” My point then was that stocks were very expensive, sentiment was exuberant and the trend had shifted to the downside. In other words, all three of the major components of my investing strategy were bearish.

None of this his has changed (though stocks may bounce after the persistent selling we have seen recently). But, in that post, I shared a version of the chart above which became fairly popular so I thought I’d explain what’s going on it and the individual components noted in it.

First, the horizontal blue lines show a Fibonacci target for the S&P 500 at 2138 (2015’s high was 2134.72 on May 18). This target is calculated simply by projecting a 61.8% (the Fibonacci Ratio) extension of the bull market gains from 2009 to 2013, the point at which we finally broke above the old 2007 high. (Apple reached a similar target about a year ago which was a decent sell signal, as well.)

The vertical blue lines simply measure the time between major peaks. The span from the March 2000 peak to the October 2007 peak was seven years and seven months. Seven years and seven months from October 2007 was May 2015, the exact month the S&P 500 peaked last year.

I’ve also highlighted the momentum divergences on the chart. While prices made higher highs in March of 2000 and October of 2007, RSI was making lower highs, suggesting momentum was waning. The MACD crosses at the bottom of the chart were also decent sell signals on those occasions. Both occurred again last year in very similar fashion to those prior occurrences.

The “9” and “13” on the chart are DeMark Sequential signals. The 9 signifies a completed sell setup and the 13 is the completed sell signal. These are essentially the inverse of the buy signals I highlighted in March of 2009. (I also used these as part of my sell signal in Apple.)

Finally, I have included a 10-month moving average on the chart, roughly equivalent to the 200-day moving average. This may be the easiest signal for individual investors to monitor. It’s also Paul Tudor Jones single most important indicator. When prices close above this average, stocks are in an uptrend. Below and stocks are in a downtrend.

Do these things work on their own merit or do they work because so many traders watch and use them? That’s the age-old question posed regarding technical analysis. However, it’s fairly plain to see that simply paying attention to the overall trend can make a massive difference in your investing success by keeping you on the right side of the market. If it’s good enough for Paul Tudor Jones, it’s good enough for me.

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Greatest Hits 2015

Here are a few of the most popular TFR blog posts from the past year:

This Is Now The Worst Possible Environment For Stock Market Investors

How To Trade Like Stan Druckenmiller, George Soros And Jim Rogers

The Single Greatest Mistake Investors Make

How The Baby Boomers Blew Up The Stock Market

The Most Crowded Trade On Wall Street: Denial

Thanks for reading. I wish you a very happy and prosperous 2016!

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Ignore The Primary Trend At Your Peril

Quantitative study of the markets has become incredibly popular over the past few years. Looking at specific, technical stock market events and then backtesting to see how the market performed after similar events in the past has become the pastime of many a market watcher. And it’s valuable stuff. But the real value is in how you use it.

I have argued in the past that some analysts using data in this way can become far too reliant on it alone. The process becomes too mechanical as it eliminates any real thinking or true analysis. And no matter how far technology takes us, critical thinking will always be an integral part of successful investing.

One area I see investors possibly making this mistake today, is in putting too much faith in bullish studies while stocks remain in a downtrend. As Paul Tudor Jones suggests, whether an asset is trading in an uptrend or a downtrend is of primary importance. Everything you study should be looked at in that context.

For example, a “Zweig Breadth Thrust” was recently triggered in the stock market. This has bulls seeing dollar signs. However, as Tom McClellan recently noted, this indicator works great when stocks are in an uptrend but when they’re not it’s track record is pretty poor. In fact, if used alone, this indicator would have had you getting bullish at some of the worst times over the past century.

This can be said for almost any quantitative study like this one. The primary trend matters. Ignore it at your peril.

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Why This Correction Will Likely Lead To Another Painful Bear Market

Back in May I wrote a post arguing that the record-high levels of margin debt should make investors more cautious. Basically, there is compelling evidence to suggest that margin debt is a very good indicator of long-term fear and greed in the stock market.

When margin debt is relatively high it signals that greed is predominantly driving stock prices. Conversely, when margin debt is relatively low it indicates that fear is the predominant factor. If an investor believes it’s wise to ‘be fearful when others are greedy and greedy when others are fearful,’ as Warren Buffett suggests, then it’s probably going to be hard to find a better indicator for long-term investors looking to do so.

This also makes perfect sense from an economic viewpoint. Relatively high levels of margin debt suggest there is little potential demand left for equities and plenty of potential supply to pressure prices lower. Conversely, relatively low levels of margin debt suggest there is little potential supply and plenty of potential demand to pressure prices higher. And, in fact, this is exactly how margin debt has worked its magic on stock prices over the past 20 years.

One of the most valuable ways I have found to view margin debt levels is in relation to overall economic activity. The chart below shows that when margin debt has approached 3% of GDP in the past it’s usually been a good signal that greed has gotten out of hand. Back in April this measure hit a new record. Screen Shot 2015-08-31 at 10.13.45 AMThe reason I find this measure so valuable is that it is highly negatively correlated to 3-year returns in the stock market. When margin debt relative to the economy has gotten very high, 3-year returns have been very poor and vice versa. Right now this measure suggests the coming 3 years in the stock market could be very similar to the last two bear markets we witnessed in 2001-2002 and 2007-2008 after margin debt reached similar levels in relation to the economy.

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What’s more, in the past, when stocks’ 12-month rate-of-change has turned negative it’s usually triggered a significant reduction of margin debt. In other words, once the stock market starts declining over a year’s time record levels of margin debt, which functioned as demand to push prices higher in the past, start to become supply, which pushes prices lower going forward. This is how the last two bear markets began.Screen Shot 2015-08-31 at 10.42.30 AM

Now the stock market only needs to rise by about 3/4 of a percent today in order to maintain a positive 12-month rate-of-change. On the other hand, the longer the current correction in stocks continues the likelier we are to see it evolve into a longer-term bear market, as the massive amount of margin debt stops working in the favor of all of these “greedy” speculators and begins to work against them and they start to become more “fearful.”

And if the past couple of full market cycles are any guide, the potential supply coming to market in this scenario could make the next bear market another very painful one, at least for those who ignore the crystal clear message of margin debt relative to the economy.

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The Warren Buffett Way To Avoiding Major Bear Markets

A year ago, I wrote a post called, “how to time the market like Warren Buffett,” in which I proposed a very simple market timing method inspired by this passage from the Oracle of Omaha’s 1992 letter to shareholders:

The investment shown… to be the cheapest is the one that the investor should purchase.…  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

The idea is very simple and intuitive: When reliable measures forecast that stocks will outperform bonds, buy them. However, when, on rare occasion, they forecast that bonds will outperform stocks then they should be favored. But how to forecast equity returns? Simple. Just use Buffett’s favorite valuation yardstick, market cap-to-GNP. Right now this measure shows stocks to be about as highly valued as they were back in November 1999.

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What makes this measure most valuable, though, is its forecasting accuracy – which may be what makes it Buffett’s favorite. Below is the 10-year forecast implied by this measure (blue line) against the actual 10-year return for the S&P 500. Notice the red line tracks the blue fairly closely but can overshoot in both directions, overestimating returns during the 1973-74 bear market and understating returns during the dotcom bubble.

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The next chart overlays the 10-year treasury bond yield (red line) against the 10-year forecast for stocks (blue line). The majority of the time this comparison suggests stocks are the better investment. There are few occasions, however, when bonds offer the better opportunity. Today is one of those occasions.

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In my original post, I demonstrated just how attractive it would have been to follow this methodology. Since 1962, an investor who simply had bought stocks when they were more attractive and then switched to bonds when they became more attractive outperformed a buy-and-hold approach and dramatically so (mainly by sitting out a significant portion of the last two major bear markets).

What I think is most remarkable about the chart above right now is, at 3.05% (stocks’ forecast return of -1.07% minus a 10-year bond yield of 1.98%), it is signaling one of the largest spreads between forward returns on record. There are only a handful of quarters over the past fifty years that offered investors a better opportunity to switch from stocks to bonds. In fact, the last time the spread was this wide was during the second and third quarters of 2007, just prior to the financial crisis that led to a 50% drop in the stock market.

Now this doesn’t mean you should sell all of your stocks and run for the hills. Everyone has their own personal investment goals and risk tolerance and that should be paramount in their individual process. A practical way to implement this would be to simply underweight stocks and overweight bonds based on today’s reading. Or if you’re making significant new contributions to your account, maybe you just put those in bonds for now until stocks offer a more attractive opportunity. In fact, that’s probably how Buffett would do it. And though I doubt he uses these measures exactly this way, this sort of process has worked well for him for quite a long time.

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