I attended a great local meeting of the American Association of Individuals Investors [AAII] that included a discussion on relative strength and position management from Clay Allen, CFA, a prominent point & figure technical analyst for institutional customers. I was less familiar with the second speaker, Michael Edesess, who holds a doctorate in Mathematics and has consulted for Wall Street firms on risk assessment using different modeling techniques. Dr. Edesess has a fundamental focus and the thrust of his discussion was the importance for investors to use strategies that employ very low fee, diversified funds given the inability of Wall Street to predict market movements.
The reason the meeting was great is that a very important distinction between market prediction and assessment arose, and it forced me to identify the value of technical analysis for both investors and traders. This dovetails nicely into the market outlook theme for the month and merits discussion here. As mentioned in this column previously, traders in particular are faced with the extremely difficult task of assessing the markets in an analytical manner while being prepared to immediately turn away from the assessment if conditions changeâor it's simply incorrect. Don't underestimate this challenge in your trading.
Prediction versus assessment may seem like a "to-may-to" / "to-ma-to" distinction, but it underscores an important skill that must be mastered. That skill is having an opinion regarding what may happen in the future while only responding to what actually does happen. One could say a trader is predicting future movement, but the reality is that individual is merely assessing the probabilities that different movement will occur in the future in order to establish a position.
Both speakers stand firm in the "markets cannot be predicted" camp. I agree â¦ for the most part. It's my understanding that a couple of years back some researches in Santa Fe were able to accurately predict movement in the futures market a few seconds out in time and similar work was being performed by Massachusetts Institute of Technology doctoral students in Andrew Lo's Behavioral Finance Department. Since this level of analysis is not available to most traders and not really useful to long term investors, it seems okay to ignore these results.
One of the more contentious comments was made by Dr. Edesess regarding trends. He stated that there was no study providing statistically significant proof that trends were predictive. Unfortunately, this was heard as "trends don't exist", but that's not what was said. While we note that longer term trends have greater strength as do those that have touched a trendline more frequently, the fact remains that the existence of a trend does not guarantee the trend will remain intact. All trend traders can do is manage their risk.
Building on last week's chart and outlook, here's more on a current assessment of US equities markets.
Market Benchmark: The S&P 500, Dow and NASDAQ 100
The next six charts provide monthly and weekly views of the S&P 500 cash contract (SPX), the Dow Jones Industrial Average (INDU) and the NASDAQ 100 Index (NDX), all on logarithmic scales. The index data is accompanied by:
Figure 1: Monthly SPX Chart with Fast MACD and Stochastic
The SPX continues upward, closing today at 1456.81. This level remains within the 4 year linear regression channel that appears skewed by the logarithmic chart setting. The Oct 06 MACD breakout preceded the recent index surge and remains bullish. However, the rate of ascent is slowing, as are the Stochastics readings. MACD and Stochastics will be monitored for continued insight as the index continues towards the upper regression line. Strengthening in either may suggest a push above this upper line.
Since it's expected that price will remain in this channel, moderate indicator divergence is also expected. For now, the long-term outlook is bullish. Ultimately the market will decide how it will proceed in terms of both direction and strength.
Figure 2: Monthly INDU Chart with Fast MACD and Stochastic
INDU closed at 12,765.01, another new high. Not surprisingly, INDU is above the center regression line, but further from the upper channel line. This is reasonable given the length of the regression channel; it is not suggestive of weakness in the index.
Two vertical lines are included in the chart, which coincide with a MACD breakout and subsequent Stochastics breakout in late 2006. This Stochastics breakout coincides with index movement above the middle regression line when the chart is set to a normal scale. Keep in mind you'll want to switch to a standard scale when completing regression channel analysis.
Both MACD and Stochastics appear more bullish for INDU than SPX; this may be difficult to see in the image since more data is included in the SPX chart it's a little more difficult to see. The longer-term outlook for INDU is bullish with expectations for the index to continue towards the upper channel line. Weakness in the indicators will be monitored, as will any return of the index to the middle regression line.
Figure 3: Monthly NDX Chart with OEX Overlay, Fast MACD and Stochastic
The NDX closed today at 1823.41. The incorporation of an OEX overlay chart seem to bear out strength in large cap particularly during the later part of the year (2006 information is displayed in the box highlight). The Stochastics breakout for this index occurred later; again suggesting s delayed follow through by this index. The index is above the middle regression channel approaching the upper line and is expected to continue in that direction.
MACD strength is more difficult to observe given the extreme values the indicator achieved in the 1999-2001 period. When this occurs, enlarge the chart view so you can gain a better sense of what's happening when these extreme values are removed. Stochastics and MACD strength confirm a continued long-term bullish view for the index.
Do these long-term assessments mean it's a straight shot for the upper regression channel? Absolutely not; these charts minimize shorter noise so an analyst can more clearly see the big, longer-term view. Shorter-term moves are better viewed using shorter-term charts such as the weekly charts that follow.
Figure 4: Weekly SPX Chart with Fast MACD and Stochastic
The weekly SPX charts similarly display a bullish intermediate view for the index. However, the MACD in particularly is showing signs of a potential slow down in upward movement. The index is nearing the upper regression channel line, but may or may not reach it. A pullback would not impact the bullish intermediate or long-term view for the index.
In the very short-term a pullback is expected for the SPX. This could be all the way to the middle regression channel. Renewed strength in MACD and Stochastics would counter this assumption and possibly provide the strength needed for the index to breakout above the channel.
More severe indicator divergence and movement below the middle regression line would provide warnings about the health of the intermediate term trend, as well as possibly the longer-term trend. At that point, the monthly chart would be re-visited.
Figure 5: Weekly INDU Chart with Fast MACD and Stochastic
The weekly chart displays a slightly stronger MACD and Stochastics picture for INDU on an intermediate basis. MACD has leveled out, while Stochastics has turned upward. The index remains above the middle regression line heading towards the upper channel line.
The shorter term view for INDU suggests continued upward movement toward the upper line. Since the regression periods are different, this isn't counter to the SPX view. However, since changes in the two index levels are highly correlated over a long period of time (0.92 using daily changes over 19 years), each will be monitored with respects to the other for alerts to a pending change.
The inability for INDU to continue upward and a return to the middle regression line will be monitored. Indicator divergence and movement below the middle regression line would provide warnings about the health of the intermediate term trend, as well as possibly the longer-term trend. At that point, the monthly chart would be re-visited.
Figure 6: Weekly NDX Chart with OEX Overlay, Fast MACD and Stochastic
Although the NDX remains in an upward intermediate trend, MACD and Stochastics divergence suggest some short-term weakness ahead. Using a normal scale, price is currently expected to return to the middle regression line. At that point, a turn of Stochastics above the bullish level at approximately 40 supports continued intermediate bullishness. It's simply too soon to tell.
The ADX indicator is currently being analyzed to address two items noted last week when the settings were changed. These include: 1) Is the 14-period default setting standard too delayed for downward moves which often move more quickly and 2) How does the calculation maintain the same timing for two of the three instances of an ADX trough while only impacting the depth of the trough?
In addition, it was noted that when the +DI and âDI lines are displayed, the lower line appear smoother than the upper line regardless of which directional line is lower. This is likely due to the manner in which the indicator is constructedâthere is a re-set to 0 process for the measure that is small during each period.
So what is a trader left to do? Assess the markets so you can establish trades with a higher likelihood of successâthat is with the trend, in relatively strong markets. Contrarian trades supported by strong divergences are certainly reasonable; however, avoid predicting a turn before its time. Manage all trades and be prepared to exit them when conditions change. Above all, manage your risk by establishing a reasonable position size with a maximum loss that is determined prior to trade entry.
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Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site