Tuesday, April 9, 2013

Technical Tuesdays: The Mega Trend

The Mega Trend is the title I gave several years ago to a price pattern that identifies the momentum of an index. It works by taking an index's price and its moving averages* and seeing how they act in a mutually supportive manner that helps predict its future price action.

To work, all three conditions of the following conditions must be met:

* Price above or below its two key moving averages - 50 day and 200 day
* The shorter term (50 day) above or below the longer term (200 day) moving average
* Both moving averages pointed in the direction of the existing move (upwardly sloped for a bullish environment, downwardly sloped for the bear case)

Now, let's look at where we are today.

As the above chart illustrates (click chart to enlarge), price is above its moving averages, the 50 day is above the 200 day, and both are upwardly sloped. The justification for why this works is rather simple (as are most core concepts): the momentum of a market move tends to be a self reinforcing process in which the large sums of money available for equities are applied as the performance needs of this institutionally dominated market drive professional investors to not lose too much alpha (relative performance). I referred to this in my book, "Sectors and Styles", as "keeping my house in Greenwich" (that wealthy enclave in Connecticut where many a well heeled fund manager resides), which is to say that a consistent loss of alpha can be hazardous to one's financial well-being (let alone access to the country club and other accoutrements).

Re using the Mega Trend, a few points need to be noted:

1 - Once a trend is established, it tends to remain in force for a considerable period of time (as the above chart makes amply clear).
2 - Identifying the major turning points (trend reversals from the established trend - bull to bear, and vice versa) works best during market tops than bottoms.
3 - The indicator works best for broad markets, economic sectors, and industries. It is not so useful for individual stocks or other markets (e.g. Gold, Bonds, Currencies)

Re the second point - trend reversals: due to the nature of how market tops are formed (confidence and rationalizations) versus market bottoms (panicky affairs), the rolling action of market tops enable one using the Mega Trend with a sufficient amount of time to note the trend change and to act accordingly. In other words, stock declines are merely corrections supported by the rationalization that the forever, overly optimistic bottom up equity analysts and the forever, overly clueless economists actually know what they are doing.

Whereas, market bottoms are more of panicky phase (losing real money versus incurring an opportunity cost tends to change behaviors) and, therefore, are far less useful is spotting the trend change (as in many months later and at a significantly higher price).

Why Does This Work?

Technical analysis does not receive its just due among many traditionally oriented investors and those firmly ensconced in their tenured academia dominions mainly due to the fact that it is observationally based versus theoretically based research. Or as Dr. Andrew Lo once stated in a podcast interview he did with me several years, when it comes to pipe smoking ivory tower crowd, "It takes a theory to beat a theory". So, academia will forever be dismissive of observationally based research since it is not rooted in some theory first. Of course, what should be but isn't debated is whether a social science (e.g. financial markets and the economy) which involve people who are sentient beings that are both interactive and highly dynamic should even be held to the same standard that physical sciences are (which are not sentient). Medieval thinking at its best!

However, from a more 21st century perspective, consider the following:

In many ways, the Mega Trend is the personification of behavioral finance as it is observational research that identifies the momentum of the market and the nature of its participants (those pesky and often irrational human beings). For what is behavioral finance but the study of how people do what they do? And isn't one manifestation of that the ability to track how people do what they do with their money and how such behavior can be used to predict future such behaviors? Or am I just blowing smoke out my backside?

Is it 100% accurate? Of course not. What is?

No, it is not a 100% perfect indicator but its history of accuracy is undeniable. And the bonus is the fact that those who do not subscribe to using such observationally based market analysis tools due to the reasons noted above (and for other reasons, as well) is all the more better in serving as a highly predictive tool of future market action. (For when everyone follows the same methodology it tends to distort that approach. Hedge fund clones, anyone?)

One Final Item

No one tool should be used to determine the future direction of such a highly volatile investment as stocks. The Mega Trend is an important one and very useful. So is the Divergences Principle (see last week's Tuesday posting). However, used in conjunction with these and others tools (including valuation models and thematic analyses) tends to increase the odds of doing what all active investors seek to do: outperform the market.

Investment Strategy Implications

It's a bull until it ain't. The Mega Trend for the US says that's the case here. This, however, is becoming worrisome elsewhere in the world, most notably in that high growth segment known as emerging markets. This will be subject of next Tuesday's posting.

*I have found that the exponential moving average (in which the most recent price receives a higher weighting than the more distant) works better than the simple moving average.

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