Sunday Musings: Trend Tracking Thoughts

Ulli Uncategorized Contact

One reader emailed an interesting comment regarding trend tracking and the adherence to strict trading rules. Here’s the relevant part of what he had to say:

I have written to you on the subject previously and thanks for the replies. You have devised a proprietary trend line as I understand it. You have a basic rule that is clean and clear to follow. The price drops below the trend line its in sell territory. Above its in buy mode.

Yet today you put a link to explain to avoid whipsaws you wait until the price drops 1% below the trend line. Rules are rules. Made to be followed or broken or interpreted as one sees fit. Statistical back testing can be fitted to achieve the results one wants or random or whatever.

My basic question is as follows: since your trend line is proprietary its only significance is what you have defined it as and established it to be. This most likely came from years of testing and perhaps trial and error after much research on trend following. Why then would you select (an arbitrary) a percentage to wait past the trend line or a “” couple days”” after falling below the trend line?

Are/have these additional rules also been determined through back testing empirical data or “”gut feeling”” from past experience. I understand you want to avoid whipsaws the bane of trend following. That said, it seems to me it breaks the first rule. Why not just adjust your trend line to incorporate this 1% differential into the trend line itself. Surely the rest of the industry is not using your proprietary trend line such as everyone watches the 200 moving average or 50 or 20 period or whatever.

Is this just yielding to your human nature to avoid a whipsaw to have comfort with yourself that you can justify you waited enough to be sure. Most all technicians have rules and preach to follow the rules. Most all of us humans break rules and that is where we get in trouble.

While it is understandable that you would want to systemize an investment approach to a point so that it can be used without questioning any step involved, or even thinking about it, that is simply not realistic. There will always be some subjectivity. Just look at the process itself an investor has to go through to make fund/ETF selections once a buy signal has been issued.

You may not have been a reader long enough to know that we applied the same process of letting the domestic TTI “clearly” cross to the upside during the last buy signal (June 09) to be sure a sudden market pullback would not create a whipsaw situation.

That is the only reason for using what you might call a trading band around the trend line. Remember, that trend line itself represents the dividing line between bullish and bearish territory.

However, after a bullish cycle, such as the last one, it only has a secondary function as an exit point. Our 7% trailing sell stop discipline will have you out of the market and on the sidelines long before the trend line is crossed to the downside. Those readers with a more aggressive risk profile can use the crossing of the trend line as their “last line of defense” before heading to all cash.

Other readers use the straight crossing of the trend line as their sign to move in and out of the market no matter the percentage. As an individual you can do that by using this tool anyway you see fit. When you handle OPM (Other People’s Money), you are dealing with a different set of circumstances. Clients understand that whipsaws are part of the equation, but they expect that efforts are made to avoid them whenever possible.

That does not violate any trading rules; it merely is a smart thing to do. Case in point is the event of last week, when the domestic TTI sank below its long-term trend line by -0.4%. Remember, there are followers of this method who use the downside crossing as a trigger for setting up a short position, which means you want to be as certain as possible that a bear market has in fact started.

By not following last week’s peek into negative territory, we avoided not only a whipsaw signal as the markets subsequently rallied, but also prevented setting up a short position.

Again, looking at the big picture, the reason for following trends in the first place is to step aside prior to a bear market devastating a portfolio. Second, there is no need to get caught up in details that do not detract from this goal.

We have successfully avoided the brunt of the bear markets in 2001 and 2008, and I do not expect those results to change in the future whenever the next bear rears its ugly head.

Is It Time To Take Cover?

Ulli Uncategorized Contact

Hat tip goes to reader Nitin for pointing to this article in the NYT about the latest thoughts from Robert Prechter in “A Market Forecast That Says ‘Take Cover:’”

WITH the stock market lurching again, plenty of investors are nervous, and some are downright bearish. Then there’s Robert Prechter, the market forecaster and social theorist, who is in another league entirely.

Mr. Prechter is convinced that we have entered a market decline of staggering proportions — perhaps the biggest of the last 300 years.

In a series of phone conversations and e-mail exchanges last week, he said that no other forecaster was likely to accept his reasoning, which is based on his version of the Elliott Wave theory — a technical approach to market analysis that he embraces with evangelical fervor.

Originating in the writings of Ralph Nelson Elliott, an obscure accountant who found repetitive patterns, or “fractals,” in the stock market of the 1930s and ’40s, the theory suggests that an epic downswing is under way, Mr. Prechter said. But he argued that even skeptical investors should take his advice seriously.

“I’m saying: ‘Winter is coming. Buy a coat,’ ” he said. “Other people are advising people to stay naked. If I’m wrong, you’re not hurt. If they’re wrong, you’re dead. It’s pretty benign advice to opt for safety for a while.”

His advice: individual investors should move completely out of the market and hold cash and cash equivalents, like Treasury bills, for years to come. (For traders with a fair amount of skill and willingness to embrace risk, he suggests other alternatives, like shorting the market or making bets on volatility.) But ultimately, “the decline will lead to one of the best investment opportunities ever,” he said.

Buy-and-hold stock investors will be devastated in a crash much worse than the declines of 2008 and early 2009 or the worst years of the Great Depression or the Panic of 1873, he predicted.

For a rough parallel, he said, go all the way back to England and the collapse of the South Sea Bubble in 1720, a crash that deterred people “from buying stocks for 100 years,” he said. This time, he said, “If I’m right, it will be such a shock that people will be telling their grandkids many years from now, ‘Don’t touch stocks.’ ”

The Dow, which now stands at 9,686.48, is likely to fall well below 1,000 over perhaps five or six years as a grand market cycle comes to an end, he said. That unraveling, combined with a depression and deflation, will make anyone holding cash “extremely grateful for their prudence.”

Mr. Prechter is hardly the only market hand to advocate prudence now, but nearly everyone else foresees a much rosier future, once current difficulties are past.

For example, Ralph J. Acampora, a market analyst with more than 40 years of experience, said he moved entirely out of stocks and into cash late last month. Now a partner at Alverita, a wealth management firm in New York, he said recent setbacks suggested that the market would drop another 10 or 15 percent, probably until September or October, before resuming another “meaningful rally.”

Over the next several years Mr. Acampora expects an “old normal market,” characterized by relatively short-lived swings that will provide many opportunities for smart investors — one that resembles the markets of the 1960s and 70s. “I’ve lived through it,” he said.

Like Mr. Prechter, he is a past president of the Market Technicians Association, the leading organization of technical market analysts, and he said that his colleague has done “some very good work.” But Mr. Acampora doesn’t agree with Mr. Prechter’s long-term theories, either intellectually or emotionally.

The “mathematics don’t work,” Mr. Acampora said, because such a big decline would imply that individual stocks would need to trade at unrealistically low levels. Furthermore, he said, “I don’t want to agree with him, because if he’s right, we’ve basically got to go to the mountains with a gun and some soup cans, because it’s all over.”
…

In 2002, he (Prechter) published “Conquer the Crash,” which predicted misery ahead. Even so, he said in 2008 that the market would soon rally sharply — then said late last year that stocks were about to fall and that the great decline would resume.

Since 1980, the advice in his investing newsletters, when converted into a portfolio, has slightly underperformed the overall stock market but has been much less risky, losing money in only one calendar year, according to calculations by The Hulbert Financial Digest. Mr. Prechter said he disagreed with the methodology used in these measurements, but offered none of his own.

For his part, Mr. Acampora says that the Elliott Wave has some validity as an indicator but that “it’s only part of the story” of technical market analysis, which also needs to be buttressed by economic and fundamental research.

While I appreciate Prechter’s attempt of forecasting and his good work with the EW Theory, I am not as bearish as he is. Personally, I think that the U.S. markets have a good chance of following the way of Japan (Nikkei) given that nothing was learned from their deflationary circumstances (and attempted solutions to reverse course) during the past 20 years.

While a bear market is pretty much a sure thing, it is also fairly certain that major downswings will be interrupted by sharp market rallies, such as this week’s. I agree with Bob Prechter in that buy-and-holders will absolutely get slaughtered over the next few years, just as they did in 2001 and 2008.

More so, as I have repeatedly said, we’re in unchartered territory in regards to the busted real-estate/credit bubble where potential outcomes have no real historic precedent.

It is therefore important that you are disciplined with your investments, stand aside when trend reversals tell you to do so and live with the occasional whip-saw. Try to look at the big picture and don’t sweat the small stuff.

No Load Fund/ETF Tracker updated through 7/8/2010

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

In a turnaround from last week, the markets rallied higher with the S&P; 500 gaining 5.3%.

Our Trend Tracking Index (TTI) for domestic funds/ETFs moved back up above its trend line (red) by +1.34% (last week -0.40%). For more on how to handle this, please see the above link.

The international index has now broken below its long-term trend line by -0.87% (last week -4.49%). A Sell Signal was triggered effective May 7, 2010. We are no longer holding any positions in that arena.

[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

A Dead Cat Bounce?

Ulli Uncategorized Contact


After a miserable month of June, and a slippery start in July, the markets managed a nice rebound with the Dow reclaiming the psychologically important 10,000 mark, while the S&P; 500 powered through the 1,040 resistance level. It was the market’s first back to back advance since mid-June.

To me, it seems more like a dead cat bounce, as no single catalyst could be identified behind yesterday’s up move. Of course, anytime a market has been beaten up relentlessly, there will be some buyers scooping up what they consider bargains.

I think we simply had become too oversold and negative, which lead to this rebound. Much to the chagrin of the bullish crowd, volume was light indicating prevailing skepticism.

Nevertheless, the rally pushed our domestic Trend Tracking Index (TTI) back above its long term trend line. As I posted during the past week, I like to see a clear piercing of the trend line to the downside before declaring this buy cycle to be over. The clear piercing did not materialize, and now we have moved back above the line by +0.97%.

Yesterday’s sudden rebound is exactly the reason why we give ourselves a little leeway as we approach the long-term trend line either from a level above or from a level below. Doing that clearly avoided a whip-saw signal.

Whenever we come close to breaking a long-term trend line, tremendous bullish vs. bearish forces can be still at play causing this bouncing action around the line while a dominant new trend can’t be identified yet. Sooner or later this bounciness will come to an end, and a new trend will emerge.

We have to be patient and wait for it to become obvious before taking any action. In the meantime, either being out altogether or in hedged positions is the safest cause of action.

Testing Resistance

Ulli Uncategorized Contact


When support levels get broken, they become overhead resistance at the time markets attempt to reverse course and rally again. Such was the case yesterday, when an initial rebound died around the 1,040 resistance number for the S&P; 500.

It was downhill for the rest of the day, but a pop towards during the last 30 minutes of trading moved the major averages back into positive territory. We’re still in that neutral zone between bullish and bearish territory where a break to either side could occur.

Our domestic Trend Tracking Index (TTI) confirms this current uncertainty in terms of trend direction. The TTI retreated and moved closer to its long term trend line but remains below it by a scant -0.04%. That’s certainly not enough for either the bulls or the bears to declare victory.

We have to wait for further market developments to get a better feel as to whether this buy cycle really has come to an end and that the bears have taken charge.

Where’s The Support?

Ulli Uncategorized Contact

With the S&P; 500 support level of 1,040 having been decisively broken, the question some readers had is: Where is new support coming in as we enter bear market territory?

Miynanville tried to shed some light on that question in “Why We Should Be Talking About S&P; 840:”

With the magical 1040 level being tested in the S&P; 500, many technicians and talking heads are looking at this level as the final step before Armageddon. Running through the various newsletters and blogs, a common theme seems to be that if 1040 doesn’t hold, then the 960 level is the last stand before traders get a one-way ticket to test the March 2009 lows of 666. From that point, it’s death and destruction to the American economic system as we know it, or so the naysayers would have you believe.

From my perch, as a money manager and daily commentator in various media outlets, I agree that 1040 holds a lot of psychological weight. If a break of this level holds, it should turn many market participants fully bearish and cause a downward cascade that will be difficult to stop. The proverbial line in the sand has been drawn,and the S&P; is clawing and scraping at this very moment to remain with its head above this low water mark.

Trying to stay two steps ahead of the action, I roll out the weekly charts to anticipate the next areas of support. I’ve marked several areas on the weekly chart below that have been battlegrounds in the past. No, these aren’t Fibonacci retracements but merely areas where the action stalled as traders, investors, and mutual funds jockeyed for position.

The first two months of 2009 would have been the first time traders might have taken note of how much air time 840 was receiving. Prices seemed to be drawn back to this area like sheet metal to a magnet. When selling pressure resumed and the S&P; hit its eventual bottom at 666, 840 was the last area of consolidation. In textbook fashion, 840 once again was an area of consternation and tight play as the S&P; bounced off the lows. From there, there was no turning back as the S&P; raced to 1200.

Now turn your eyes back to the weekly chart for a bigger-picture view. 840 and 960 may never come into play as the markets could catch a second wind and be off like a racehorse. But if 1040 does relinquish control to the bears, then all eyes will be fixated on the next levels of support. It’s my opinion that 840 should be added to the discussion, and that 666 isn’t inevitable as we struggle for footing. 960 to 666 is a long step off the end of the plank, but my bet is on 840 being a safety net. So yes, I’d be a buyer of the S&P;… at 840.

There you have it. From 1,040 to 960 to 840 to 666, these are the numbers to watch for, if the bear has its way. This is not a prediction that we will actual get to the bottom, although the possibility exists, but merely a demonstration of where the support levels are located.

Every level can serve as a springboard to renewed bullish action, but if broken, it will confirm the bearish scenario. With the market having closed at 1,023 last Friday, personally, I will be watching the 1,000 level. Not that it has any technical significance, but it does have a psychological one. I believe once that has been pierced to the downside, we will get to 960 in a hurry.

Of course, positive economic developments, along with a rip-roaring upcoming earnings season, can reverse this current bearish direction, but I doubt it. It may take a lot of zigzagging, but I think the die has been cast, and the major trend will be south.

Whether I am right or wrong does not matter, what matters is that you protect yourself from the increased downside risk via my recommended sell stop discipline.

We may not see a repeat of 2008, but slow and consistently sliding prices will have just as bad of an effect on your portfolio as an outright crash.