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Kaeppel's Corner: Is That a Light at the End of the Tunnel (or do I hear a whistle?)

By Jay Kaeppel, Optionetics.com | Wed October 19, 2011 8:36AM PT

 

History teaches us much - even if most of it we want to forget.  Anonymous

When I first started in this business I read a prodigious number of investment books and advisory newsletters.  I figured who better to learn from than the “experts” right?  Book after book offered up method after method for timing the financial markets with “uncanny accuracy.”  And the newsletters were very enlightening.  So many people with so many different points of view and factors upon which they would focus.  I learned a lot, no question about it.  That of course is the good news.  The bad news is that I eventually noticed a couple of disturbing trends. 

 

The Flight of the “Grasshopper”

As I mentioned earlier, when I started out I read a lot of investment newsletters because I wanted to learn from people who knew a lot about the markets.  I would go to the Library (note to today’s “youth” – that’s a place with a lot of books, but they don’t sell steamed coffee drinks) and read as many market newsletters as I could find.  And as I also said earlier, I learned a lot.  I remember thinking at various times “gosh these guys are smart”.  And in fact, most of them were.  Unfortunately – and to make a long story short – reading investment advisory newsletters ultimately led to:

JAY TRADING MAXIM #72: It’s really hard to predict what’s going to happen in the stock market over the next [your time frame here].  And when I say “really hard” I mean “really, really hard”.

This maxim evolved from a recurring and disturbing pattern of events that basically went something like this:

1) One guy would predict that the market would go up over the next x-months.  And in fact it actually would.

2) Suddenly everyone – myself included – couldn’t wait to hear what this “oracle” had to say next.

3) Maybe he would get another call right, but eventually he would get it almost exactly and completely wrong – either confidently advising everyone to “buy” just before a big market drop, or shouting “SELL” right before – you guessed it – the next big rally.

4) Then everyone would scurry off to follow another advisor who had correctly “predicted” the rally that the last guy had missed.

5) So on and so forth, repeat, ad nauseum, ad infinitum.

 

The Plight of the Programmer

Tired of taking other people’s word for it, I eventually decided that I needed to “crunch a few numbers” on my own.  As a self-taught programmer I spent a lot of time (this was before kids obviously) coding the systems and methods that I had read about in the books that I read.  And when I say “a lot of time”, I mean “a lot of time” (part of the downside of being “self-taught” I guess).  So imagine my dismay when system after system and method after method failed to work in real-time the way they did in the books. 

I specifically remember when I reached the “tipping point” (in this case, the phrase “tipping point” can be roughly defined as “a time of self discovery” or more specifically “discovering just how many swear words I could string together in one sentence”). I won’t mention the author for a variety of reasons (“A lot of my own systems don’t always work great after I publish them”, “Men who live in glass houses”, “I try to avoid litigation whenever possible”, etc., to name a few), but in the book there was a chart showing a buy signal on German Marks (for those relatively new to the market this was a foreign currency that got phased out with the introduction of the Euro – not a rock band comprised of German guys actually named Mark).  The rules laid out in the book had pinpointed this particular bottom to the day!  It was quite impressive.

As an ambitious “youth” – one who was quite anxious - figuratively speaking - to escape his Mother’s basement (unlike much of “today’s youth” who seem perfectly content to remain in their Mother’s basement so long as there is an internet connection down there) I figured this just might be the system to “make me rich.”  So I spent a lot (and again I mean A LOT) of time programming the author’s “pinpoint timing, you can’t lose” rules into computer code.  So imagine my surprise when I found out the following two things:

A) The system did in fact call the bottom highlighted in the book to the day!

B) The four buy signals before and the four buy signals after the one in the book ALL ended up as losses!

Hence the subsequent, ahem, “tipping point” (or “$%&*$%” in layman’s terms).

 

Moving Forward     

If you have followed my work at all then you know that I have developed a lot of systems over the years.  And when I say a lot, I mean, well, by now you get the picture.  There are three basic reasons for this:

1) I am a numbers geek plain and simple (my wife keeps promising me that “we’re going to get you the help that you need” but so far nothing). 

2) I learned early on that if as an investor I tried to “fly by the seat of my pants”, then my pants would eventually burst into flames and I would spend a lot of time standing up, figuratively speaking. 

3) I came to a stark realization early on that led to the establishment of:

JAY’S TRADING MAXIM #124: There is no such thing as one great world-beating system that is guaranteed to generate an endless string of profits regardless of market action (no matter what the advertisement says).

Or, as it clearly states in a more succinct form in:

JAY’S TRADING MAXIM #125: No matter what you do you will lose money sometimes.  So deal with it.  

Hence the reason I have worked to develop multiple systems over the years.  While all have their ups and downs, the hope is that – to put it into “highly technical” terms that I hope you can follow – while some systems “zig” others will “zag.” OK, I will grant you that on the face of it this maybe doesn’t sound like a real solid investment plan but the net effect is that by and large using more than one investment approach tends to dampen the volatility of overall portfolio returns.  This concept is important as it relates to:

JAY'S TRADING MAXIM #4: The volatility of the fluctuations of the equity in your account will have a greater impact on your long-term success or failure than just about any other factor.  

In other words, if the pattern of gains and losses in your account resembles a roller coaster – swooping and soaring on a regular basis – then the odds are great that you will ultimately act out of fear and make a bad decision at exactly the wrong moment (is human nature a pain in the rear or what?).  Conversely, if you sacrifice too much profit potential in order to reduce the volatility of your returns so that you “can sleep at night” then you run the risk of coming out way behind what you might have made had you been a bit more aggressive.  Tricky business, no?

 

Predictions versus Possibilities

So since we are eschewing predictions does that mean that we should just stay fully invested and take what the market gives us?  Not at all.  A few weeks ago I wrote an article that detailed a simple trend-following model that I use (which is still bearish) http://www.optionetics.com/market/articles/24017.  I also look at “possibilities.”  This simply means that if a number of factors start to line up on the bullish side I will, well, start to get more bullish and be ready to buy as early as possible into a new trend. 

At the moment, a number of factors are lining up that make me think that the market could move higher in the months ahead.  That is not a prediction, but more of an “alert” for those fixated on all of the negative headlines, which would more likely make one think that Armageddon is just around the corner. 

So when I say “I think there is a possibility that the market will move higher in the months ahead” I am not “predicting” that it will, only that a strong possibility exists and that I for one plan to jump in if things get going to the upside (that being said, in the interest of full disclosure and in all candor, if the market does in fact rally in the next several months chances are good that somewhere along the way I will drop in a sentence that goes something like “and as I suggested could happen months ago….”.  Sorry, it’s just my nature).

Figure 1 shows that for the first time in a very long time, the stock market is exhibiting strength relative to treasury bonds (ticker TLT).  Very often such reversals highlight important turning points.

Figure 1 – Stocks finally showing some strength relative to Treasury Bonds (as measured using ticker TLT)

Another indicator that I follow divides the daily Nasdaq new highs by the daily Nasdaq new highs daily Nasdaq new lows.  I then take a 10-day moving average.  Readings above 0.41 are a bullish trend-following signal however, an “early bullish warning” occurs when the 10-day average rise from below 0.20 to above 0.20.  As you can see in Figure 2, the recent low reading (seen in the bottom clip) was in the range of readings at the 2002 and 2008-2009 bear market bottoms.   

 

Figure 2 – Nasdaq Composite (top) with HiLo Indicator (bottom) – low HiLo Indicator readings typically coincide with market bottoms

 

Rob Hanna of Hanna Capital recently sent out an interesting piece of analysis.  Rob is a colleague of mine in an organization called AAPTA (American Association of Professional Technical Analysts.  Impressive, huh?  By the way, note to AAPTA administration, I still have not received my decoder ring).  Anyway, in a recent missive Rob noted that there have been only a handful of occasions when the S&P 500 has moved from a 50-day closing low to a 50-day closing high within 10 trading days.  According to Rob’s analysis – shown in Figure 3 - the S&P 500 showed a gain over the subsequent 16 day trading period on each previous occasion.  So while the market appears to be “bumping its head” against resistance and many will conclude that another decline is imminent, this signal suggests the possibility of an upside breakout.

Figure 3 – S&P 500 Performance after a move from a 50-day closing low to a 50-day closing high within 10 trading days (Source: Rob Hanna, Hanna Capital)

 

Summary

So two lessons for the price of one this week. 

1) There is no “one best way”, period.  So give some thought regarding your investments and consider using more than one method/approach/system/etc.  For example one might decide to invest 40% using buy and hold, 40% using a trend-following method like the one in my 10/5/2011 article and 20% to well, whatever.  But also recognize that there will be ups and downs along the way and that anything you can do to minimize the “downs” can be very helpful in keeping you in the game long enough to enjoy more of the “ups”.

2) The easiest thing in the world to do at this moment is to throw one’s hands in the air and assume that the world economy and the stock market are headed for the abyss.  But the stock market rarely does what everyone expects it to.  So if the market can breakout to the upside in the near-term as we head into the typically more favorable seasonal months of November into May, don’t get left with your head in the sand.

I’ve been there.  It’s hard to breathe.

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site 

NOTES:

Interested in covered call writing? Log onto www.MoneySteps.com for a free trial.  Course videos by Tom Gentile and Monday/Wednesday/Thursday Case Study updates by Jay Kaeppel.


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