Here is the scenario: You believe we are near a top in the market. I won’t bother to discuss what makes you think that, but if you do, then here is a sampling of things to consider. I was originally going to do this in an enumerated list, but decided my rambling would be better.
I would imagine there are many readers that are fairly new to market analysis and in particular, technical analysis. We have had 10 bear markets in the S&P 500 Index since 12/30/1927 and 15 bear markets in the Dow Jones Industrial Average since 2/17/1885. A bear market is defined as a drop of over 20% from the previous high. Not sure who said or claimed this, but I’m accepting it. Our last bear market lasted from 10/9/2007 until 3/9/2009 (top to bottom). If you have not been an investor or trader during a bear market (last 8+ years), then you have missed one of life’s educational events. Let me introduce a bear market to you using the Japanese Nikkei Average.
I will attempt to show that high sigma is a much more frequent event than modern finance thinks it is. A few examples using the Dow Industrials back to 1885 on a daily basis are shown. Each begins with determining a look-back period to determine the average daily return and the standard deviation, and then a look-forward period is determined to see if the look-back data continues into the look-forward data. Figure A is an attempt to help visualize this process. A look-back period is determined (in-sample data) and a look-forward period is also determined (out-of-sample data). The look-back period is used to determine the average daily return and the standard deviation of returns. From that data, a range of three sigma about the mean is determined. Then in the look-forward data, the number of daily returns outside the +/- three sigma band are tallied with the total being displaying as a plot; any point on the plot represents the data used in the look-back and the look-forward periods.
Periodically I write an article that reviews the past few months of articles. Why on Earth would I do this? Primarily for two reasons. One is that many new readers are involved and often they do not go back and look at the past articles. Two is that my articles are rarely tied to anything that is happening in the markets. Generally, they are about experiences I have had as a technical analyst for almost 45 years; the good, the bad, and the ugly. Click on the article title for a link to it.
After 20 years in the money management business I saw these mistakes all too often. Fortunately, this time, I’m not reciting the mistakes I have made in the past. I certainly made some, but not these. I’ll share those another time.
I am not young anymore, so am going to reveal mistakes I made in the first half of my investing lifetime; about 1972 – 1990. Sadly, I did not learn lessons quickly so repeated some of them. These are not in any particular order. A better title might be True Confessions.
1. Believing that I was right and the market was wrong. I don’t know whether this is ignorance, arrogance, or what. More than likely it is just lack of experience. I would spend hours looking at charts and convincing myself what was going to happen; place a small trade, and usually lose money. I was convinced that I was correct in my analysis, yet it often didn’t work out. So, who was correct? The market or me? Trust me; it is always the market.
The first thing you must realize is that you won’t know it is peaking until the decline is well underway. Market tops are extremely difficult to identify. That might seem hard to believe if you watch the financial media as those 'experts' are calling the top multiple times a day; like they have been doing for years. And yes, they keep getting invited back. With the art of hindsight, I have charted the past two bear market tops. We can refer to them as bear market tops now, but back then you could not. In Chart A, the March 2000 top is shown with data nine months before and after the top. Looks sort of volatile, doesn’t it? Periods of distribution usually are. We call these periods of distribution because stocks are distributed from strong hands to weak hands. A trend follower often starts to question his/her methods during these periods as the whipsaws can mount. I also show the eventual bear market level, accepting the ubiquitous 20% decline as the definition. If you recall, the 2000-2002 bear eventually dropped 50.5%. If you are not a trend follower, I have this question: At what stage did you get out
In the 1970s there were very few books on technical analysis. Now there a many great books available in the field of technical analysis and finance. However, I’m going to keep these lists short and focused. These lists contains many other wonderful books on technical analysis, finance, and behavioral analysis, but if I had to pick a library of only four books, this is it – Getting Started List.
Early in writing these articles I talked a lot about market internals or market breadth. As a refresher, I’ll review the basics and then offer an opinion on why breadth is so important.
Breadth components are readily available from newspapers, online sources, etc. and consist of daily and weekly statistics. They are: Advances, Declines, Unchanged, Total Issues, Up Volume, Down Volume, Total Volume (V), New Highs, and New Lows. From one day to the next, any issue can advance in price, decline in price, or remain unchanged. Also any issue can make a new high or a new low. Here are more specific definitions:
This is the fourth article dealing with cognitive biases that totally screw up your decision making. The first article, Know Thyself, covered anchoring, confirmation bias, herding, hindsight bias, overconfidence, and recency. The second article, Know Thyself II, covered availability, calendar effects, cognitive dissonance, disposition effect, and loss aversion/risk aversion. The third article, Know Thyself III, covered Communal Reinforcement, Endowment Effect, Halo Effect, Overreaction, Prospect Theory, Self-Attribution, and Self-Deception. Most of my education on behavioral investing came from books by James Montier, Hersh Shefrin, and Thomas Gilovich. Two great websites for this stuff are from Tim Richards and Martin Sewell.