Unmasking the VooDoo: Overbought and Oversold

Wouldn’t it be great to have indicators that tell you just when the market moved too far in one direction and was about to pull back, if not reverse? The holy grail, you say? Indeed, it would be.

We technicians love to bandy about terms like overbought and oversold, which we think mean just that. An overbought market means too many people bought too many shares/contracts so there is nobody left to buy any more. The market MUST be about to turn lower.

Ditto for oversold. The decline overdone. Too low. Must be a bottom.

That sounds about right. Too bad it is wrong.

Famed technician Alan Shaw used to say, the most bullish thing a market can do is get overbought and stay that way.

Have we all forgotten the very definition of trend? You know, the one from physics that states, somewhat, that a trend in motion tends to stay that way unless acted upon by an outside force. Just so we are clear, that outside force is increased supply or demand, depending on trend direction.

Stochastics reaching 95 is not an outside force. Rallying above the upper Bollinger Band is not an outside force. Neither are VIX spikes nor sentiment survey extremes nor Elon Musk smoking a doobie. Yes, they do tell us about the environment for the market but they are not outside forces that turn the trend.

The only thing that can kill a bull trend is a rise in the amount and aggressiveness of sellers. You know, supply beating demand. Boom! And they said we’d never use what we learned in intro college courses.

How many trends keep going up as short sellers get crushed? Not enough sellers.

How many (dollar) trends kept going up as the balance sheet of the Fed exploded? The dollar was supposed to collapse under the weight of money printing but it did not.

Bad earnings but the stock rallied anyway? Sorry, no sellers.

I think you get the point. Overbought and oversold indicators tell us how far the trend may be stretched but they are not the reasons trends snap back. As I keep preaching, two lines crossing on a chart is not the reason the market moved. The lines crossed because the market moved.

Keep that straight and you will never be ridiculed when you get interviewed or booed when you make a speech.

As with age, overbought/oversold is just a number. It all depends on what else is going on in the market’s, or your, life.

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The Changing Economy

I am an avid follower of Howard Lindzon, founder of StockTwits and an early stage investor on a level I just cannot comprehend. This week was the Stocktoberfest East conference in New York and, despite my usual discomfort and dislike for the city, it was well worth the trip in.

Howard talked about all sorts of trends as they related back to investing - both public and private. Robots, artificial intelligence, social and transactional themes carried over from previous years. What was a bit new, at least to me, was the deepening of the millennial theme. It seems that they like cities and prefer experiences to things. Maybe I knew the latter but the word "density" was used to describe the former. Density means that everything is right there. No waiting. No traveling.

While I knew about decentralization - blockchain and the sharing economy - they used a new term, fractionalization.

I actually have some experience with fractionalization. A company called Motif Investing presented at Stocktoberfest (West) a few years ago and they allow investors to create a portfolio of stocks using fractional shares. If you can't afford even one share of Google at $1051 (stick it Alphabet), then how about 1/15th of a share. And a quarter share of Facebook, for good measure.

It's like a personalized mini-mutual fund. And Motif is not alone. A quick check of the Google shows Stockpile, Acorn, Folio and more.

Stocks themselves are not tangible but this concept spread to the physical world. There was a vendor at the show called Rally Road that bought classic cars and sold shares to the public. It's not a time share where you get to use the car for one week in the year but rather you own a fraction of that car all the time.

You just can't drive it. The car stays in cold storage, nice and safe.

The point is that you can invest in this exotic asset on a retail investor level. If it goes up in price, so does your share.

It's not a brand new idea. I already mentioned time shares and mutual funds. How about limited partnerships on oil rigs, real estate and more?

The difference is that everything is completely transparent. You can even plot the price action to see how you're doing over time. We technical analysts love that. Although the data is monthly, only :-(.

Next, we'll probably see shares of jewels, space ships and maybe even brothels.

Finally, there was a company called StockX that offers bid/ask on high-end sneakers and few other products. Again, I love that you can track the prices but even better you don't have to deal with the other party. As with a stock, you deal with the exchange who guarantees you'll get what you expect, whether the real product or cash. 

At first, I thought this was a ridiculous concept. Maybe that is because I think paying $200, let alone $700 for sneakers, is PT Barnum's dream. But then the CEO explained how it is transparent, safe and efficient in terms of establishing fair value.

Unlike eBay, where you can find your bargain using multiple pages, not knowing for sure if you had a good price. Think about bringing all those prices together on one page. It would force everyone to respect a fair market price.

For now, the business depends on the company fulfilling orders, which does not seem scalable. But then again, Amazon fulfills plenty of orders. If I can buy a car or some other asset that depends on salesmen then they'll have something. There would no longer be a sales person to mistrust. And unreasonable markups would be a thing of the past. What a boon for small manufacturers of any kind!

The times they are a changing, for sure. Some for the worse - like the crypto scam. Some for the better - like remote health monitoring.

See you next year at Stocktoberfest.

The Wisdom of the Talking Head

When I read the comments made to anyone's website articles, I can only conclude that the commenters believe the quoted pundit to be either completely ignorant or really evil. I know from personal experience that I substitute financial Ouija board wisdom for useful analysis.

That's why I stopped reading comments on free mass market websites altogether. If I want to learn about how dumb and out of touch I am I can just ring up my kids. That's too bad, because the 95% of the comments calling me an idiot swamp the 5% of commenters with legitimate questions or constructive disagreements.

Let's break down what a TV (or substitute your favorite media) talking head is really doing. First, I truly believe that most of them are just working stiffs trying to further their careers by donating their analysis for free on a news program. They think that they need to be right in their calls. Well, at least mostly right. If they blow it all the time then they will not be asked back again.

Don't gloss over that word "free."  They are not paid for their appearances and at most get a free limo ride from their office to the studio. The real value is more intangible - exposure. The more times you see a so-called expert the more you come to trust him/her. They hope that translates into book sales, newsletter subscriptions and new clients for their firms.

Let's say Talking Head X says the stock market is going to go up and banks will lead the way. You make a mental note and go about your business.

Within a week, the stock market goes down and the news of the day sends bank stocks reeling. Was the pundit a moron? Or did they want you to buy so they could sell into the bump?

Either way, you wonder how they still get the big bucks, let alone still have a job after such a boneheaded call.

But what was the pundit's responsibility to you? He/she was just interviewed for their opinion. You did not pay for it. And even more important, you were not privy to when he/she put out an alert to clients saying that things changed and they should not buy bank stocks, or at least get out immediately.

You judged Talking Head X on one moment in time that was, admittedly, incorrect, but not necessarily a money loser. Remember, none of us are in this business to be correct. We are here to make money. Similar to baseball, if you get one third of your calls right and use proper money management (cut losers and ride winners) then you get very rich.

Here is my favorite quote in the comments sections - "If this analysis had any value he/she would be trading it and not talking about it." Therefore, this pundit is a huckster.

Do you think the same thing when you see an advertisement for an engineering training course or a set of ratchet wrenches? After all, if you can train people to engineer something then you should already be applying it to build a driverless car that runs on bitcoin.

Just because you learned to swing a hammer does not make you a master carpenter. Therefore, just because you learn to read a chart or a balance sheet does not make you Warren Buffet (and I mean that to emphasize the "oracle" part of his nickname).

You can learn plenty from TV talking heads but don't take what they say as fiduciary trading advice tailored to your unique situation. If you do, it is you, not the pundit, who is the fool.

Unmasking the VooDoo - Michael's Rules

This post is a little different than the others where I usually take a deep dive into one bit of technical analysis or another to expose what's really going on beneath the hood. In this post, I'll simply list my rules for dealing with the analysis in the real world and not in some idealized trading lab.

Sorry AI. This is your daddy, RI (real intelligence). This is what you are trying to be when you grow up.

Follow these rules. You may not make big bucks trading but you will up your win rate. Plus you will definitely avoid misinterpreting the market's message and taking bonehead trades.

I've got some comments below the list, as well.

Michael’s Rules

1. If you cannot see trends and patterns almost instantly when you look at a chart then they are not there. The longer you stare, the more your brain will try to apply order where there is none
2. If you cannot figure out if something is bullish or bearish after three indicators then move on. The more studies you apply to any chart the more likely one of them will say “something.” That something is probably not correct.
3. You can torture a chart to say anything you want. Don’t do it.
4. Be sure you check out one time frame larger than the one in which you are operating (a weekly chart for a swing trader, a monthly chart for a position trader)
5. Look at both bars (or candles) and close-only line charts to see if they agree.
6. Patterns must be in proportion to the trends they are attempting to correct or reverse. I like the trend to be at least three times as long as the pattern.
7. Patterns should have symmetry. A triangle should look like a triangle and not a mile high and an inch wide (or vice versa). A head and shoulders should look like a central peak with two smaller but equal peaks around it.
8. Price rules but it is better when volume, momentum and structure (patterns) agree. Sentiment is a luxury.
9. Always confirm one type of analysis with another type. For example, confirm RSI not with MACD but with on-balance volume or relative performance.
10. Don’t get hung up if all your indicators do not agree. They never will all agree and you will end up missing every opportunity. Therefore, pretend you are a trial lawyer gathering a preponderance of evidence, not guilt beyond a shadow of a doubt.

Comments:

on point 5 - In other words, get different charting points of view. They don't have to be in lock step but they cannot tell you radically different things. If they do, find another thing to trade.
on point 6 - This is a pet peeve. You cannot count the trend as part of the pattern. The pattern must be a separate chart entity.  Also, cup-with-handle patterns are continuations, bottoming reversals. Call the latter something else, please!
on point 9 - RSI and MACD are essentially the same thing. Look at something that covers volume. Look at something that has some sort of sentiment component. Look at something with a time component.

Unmasking the VooDoo: Trends

When discussing technical analysis and trends, the erudite snoots among us, which unfortunately can include me, like to talk about physics. Objects, or trends, in motion will stay in motion unless acted upon by an outside force. That's inertia and yes, markets have it. How else do we explain momentum stocks, let alone bubbles?

As the old Faberge Organics shampoo (with wheat germ oil and honey) commercial used to say, "If you tell two friends, then they'll tell two friends, and so on and so on and so on." The same goes for the markets. It's the ultimate expression of keeping up withe the Joneses. Everyone covets everyone else's profit-making assets

Trends exist because investor B wants in on the action of investor A. But why?

My reasoning is that trends exist because information flows around the market imperfectly. Some people get it sooner and others later. Some people act aggressively and some not at all. Eventually, everyone assimilates the information but guess what, the market is already way up by then. But that's another topic.

If not for this fact, stocks would only trade the bid-ask spread until the next news or earnings report. They would then jump or fall, in one fell swoop, to the next price level where they would trade around the new bid-ask. It is the imperfect flow of information, either lagging or leading when someone figures out the news before it is releases, that allows smooth trending.

Nowhere but in the financial and commodity markets do people want to buy more as the price goes higher. My economics 1a professor, Barney "guns and butter" Schwalberg would not approve. Yet, in the markets, the more people that want it, the higher the demand and higher the price, and (drum roll) the more other people want it.

Talk about FOMO!

With that said, there is still a bit of sanity left here. If prices rise too fast - and that is clearly subjective - then some people wake up and realize they should probably cash some of this windfall in. Supply increases and sure enough price action heads a bit lower.

This could happen a few times and the market establishes a sustainable trend with a velocity that makes sense for that market at that particular time in history.

Right now, Bitcoin merits an insanely steep trend. It's new and, as far as a concept can be, really shiny. Maybe next year, when $30 million simply vanishes as it did just this month in competing crypto-currency ethereum, we'll see the market's invisible hand show itself. 

Here is the headline "A coding error led to $30 million in ethereum being stolen." That is absolutely frightening, but I digress, as I always do.

The real question for most markets most of the time is what do you do with trends. The answer is, "ride them."

The next question is how you tell when they end. The answer is, "the market will tell you."

Huh? So they will ring a bell at the top? or the bottom?

Well, not exactly. It is durn near impossible (yeah, I speak hillbilly) to know when the peak or bottom in any market is happening as it happens. Chances are you will have to give up a bit before the signal becomes somewhat clear. But that's the whole point of stops. They let you ride the trend until it changes.

Now, you may have other constraints such as scaling out of a position after X% and Y% moves. Or maybe you see better opportunities in other markets in trends that are not quite so old. Or your funnymentals change. Whatever your reason, you decide to get out. But that does not mean the trend is over. Only the market knows that.

The old saw, "the trend is your friend" is absolutely, positively true. However, you cannot forget about the second part of that, "until the end."  How may people go broke NOT realizing the trend changed and they continue to BFTD? Can you say Internet bust?

Bonus thought: We usually like to lambast the little guy for being in the wrong place at the wrong time. It is the crux of COT (commitments of traders) analysis saying that when the little speculator gets massively long the bullish trend is about to end.

The thing is that the little guy is right during the meat of the trend. Elliott Wavers cleverly call that "wave 3." They may be slow at the start of the trend and overly enthused at the end but the middle of the trend needs the masses to really get going with size and power.

So, you still have to know a little bit about the trend you are in. Identifying that is more than half the battle when you make your buy, sell or hold decisions. Everything else is gravy.

Unmasking the VooDoo: Chart Patterns

If you are not a charting aficionado you might think that trying to predict future price movements from past price movements is pure folly. And guess what? You would be right.

What? Did I just say that? Well, yes I did but there is more to it than the simple answer. We cannot predict price movements but we can assign porbabilities to what might happen based on what already happened.

"What's the difference?" you ask.

It's a big difference. If you say you can predict what will happen you are gazing into an orbuculum. That's a crystal ball, for you lay folk.

What technical analysts do is gauge future possibilities based on the footprints the elephants leave in the butter. Here is the phrase that pays:

People tend to act in a similar manner when faced with similar situations.

Chart patterns are those similar situations. The "forecast" is the similar manner of action. Nowhere does it say "will" or "must." 

Let me pull a large quote from my favorite author with that phrase embedded.

"Chart patterns are formed by the buying and selling actions of people and people tend to act in a similar manner when faced with similar situations. Some blame this on a self-fulfilling prophecy: if enough investors believe in the significance of a chart pattern ending then they will act, and thus their actions will assure that the assumed result will occur. "

- A Beginner's Guide to Charting Financial Markets: A practical introduction to technical analysis for investors by Michael Kahn.

Wow, that guy makes sense!  Let's continue:

"But investors may not act the same way this time and the charts will tell us when that is the case quickly before losses begin to mount." 

That implies that technical analysis does not expect to be right all the time. If it did, then probabilities would be 100%.  Therefore, trying rate the efficacy of technical calls just by the success rate is a failed methodology.  I challenge you to show me the price/earnings ratio at which a buy signal will always result in profits. Or a percentage of orders or inventory that is 100% right when making a buy or sell call on a stock.

Any single technical analysis-based call can fail. However, string enough of them together with stop losses and re-evaluation at achieved price targets and the Cajun chef will ga-ron-tee a nice positive rate of return.  

What is a pattern, anyway?

Charts are just graphical representations of the tape. They show us how price changes over time and the forms they take actually do tell us a bit about what was going on in the market when they formed. Does the shape of an EKG tell the doctor about what is going on in your heart right now? And can the doctor then "predict" whether you will have heart issues in the future? 

Charts form based on the buying and selling actions of people. And, they really only have three flavors:

1. They can be pauses for rest in an ongoing trend
2. They can be pauses as the market decides it wants to go the other way
3. They can be pauses when the market just has no clue which way it wants to go

Number 1 is called a continuation pattern. Number 2 is a reversal pattern. And number 3 can be a trading range or just a directionless market filled with either uncertainty or apathy.

Patterns have tops and bottoms and they are indeed called resistance and support. Typically, when prices move through one or the other the trend continues in that direction. Something happened to trigger a mood change from the rest or uncertainty of a pattern to the conviction and movement of a trend.

Fortunately, markets have inertia, just as in physics. If they are in motion (trending) they tend to stay in motion. And if they are at rest they tend to stay at rest - both until acted upon by a force.

That force can be truly from the outside, such as news, earnings and legal matters. Or it can be inside the market when sentiment changes or a related stock or index breaks out from a pattern. In either case, pattern becomes trend and it will stay that way until something makes trend turn into pattern.

How do patterns form?

I am not going to get into the nuances of all the things that happen in patterns with volume, momentum and the shapes of various patterns here. Those things give us additional clues as to which way the market can break out but they are not needed to understand just how a pattern forms.

When a pattern first starts to form, the trend hits an insurmountable speed bump. Keeping it simple with a rising trend, it pulls back, finds a new support and rallies again. But it is stopped at the top of the pattern, which now for the first time starts to actually appear. The cycle happens a few more times.

What is happening now is the bulls see a cheap price at the pattern bottom. The bears see an expensive price at the top. Both act accordingly. Nobody has enough nerve to do anything else.

In the case of a triangle or any other pattern with sloping tops of bottoms, the bulls tend to sell out earlier within the pattern. The bears tend to close shorts earlier. Uncertainty builds as neither side is willing to let the market move to their desired prices. They take action earlier and earlier.

Finally, one side finds a reason to push their agenda. For an upside breakout, the bulls no longer sell out at the pattern top. In fact, they buy more. And away we go!

Different pattern shapes are just theme and variation. It is the same dynamic going on in all of them. However, pattern shapes do give us more clues as the eventual resolution.

Conclusion

Chart patterns help us decide what to do based on subjective probabilities that the market will do something somewhat specific once the patterns are broken. The market does not do X just because it broke out. The pattern breaks because the market decided it was time to move. And it lets us know about how far it will go be the way it formed the pattern in the first place.

It is our job to read these signals and do one of the only three things we can do - buy, sell or hold. We do not know exactly where the market will go and how long it will take to get there. However, based on the signs, we will get a very good idea if we should ride that tiger with a lot of money or with a little or forget about it completely.

Nobody cares if you predicted a market target. Only your wallet cares that you made it fat.

Future of Capitalism

In another round of file cleaning on the old computer I found my notes taken when reading The Future of Capitalism by Lester Thurow. The book was written in 1996 and I read it in 1998.

Wikipedia - Lester Carl Thurow (May 7, 1938 – March 25, 2016) was an American political economist, former dean of the MIT Sloan School of Management.

Actually, this is kind of spooky. I made (in 2017) comments in parens places.

Surging inequality (a big political talking point)
China focus will change to India focus (not so much)
Communism had good education (don't know what this meant)
No competitor to capitalism now so it will not implode (true dat)

Economic Surface of the Earth

End of Communism (Plate 1)   (well, Cuba pushed that way a little and North Korea will if they push war)
Offers lots of cheap labor (another political talking point

Migration (plate 4) pushes unskilled workers into 1st world (ditto)

New technologies (plate 2) generates skill shift (in spades)
Need to offset this (by massive skill investment) is resisted by the elderly (plate 3)

Global economy (plate 4) forces wages down (indeed)

Without dominant power (plate 5) there is no economic locomotive. (better watch out)

Progress occurs when technology meets ideology

Inflation is extinct (true dat, too)

Japan will crack (it is number 3)
Europe is biased towards social programs so jobs will flee (Nostradamus)
Global bubbles burst together (looks like that could happen very soon)
Uncertainty breeds religious fundamentalism (its familiar in uncertain times) (O...M...G...)

Capital is human and no longer ownable

Need to spur long-term thinking and R&D - Government's only role  (we wish)

Bill Meehan in the archives

I was looking through old documents buried on my computer and found this raw text excerpts that I believe eventually made it's way into the Market Technician's Association newsletter in 2000 or 2001. It was comments about a recent MTA seminar written by Bill Meehan, whom we lost in the Towers on 9/11.
--------------------


RealMoney.com comments on the Seminar

excerpted with permission from a column written by Bill Meehan.

Voodoo, as I use it here, refers to only one of the colorful descriptors that many on Wall Street use to denigrate those who spend their waking hours devoted to the art of technical analysis. Kooks, I believe, is how academia prefers to label chart readers. However, nothing was quite so satisfying as listening to Dr. Andrew Lo of the MIT Sloan School of Management present mathematical proof at the Market Technicians Association's annual meeting that technical analysis cannot be dismissed, at least when it comes to pattern recognition, as mere voodoo practiced by kooks.

It's good to have one's belief verified by such an acclaimed professor. The work continues, especially as to why the results were so significant when looking at Nasdaq stocks and so inconclusive when looking at those traded on the New York Stock Exchange and the Amex. Perhaps readers might have some ideas after reviewing the data.

Oops! I noticed that I made a big mistake above. Having the chance to meet and spend quite a bit of time with Dick Arms, who so graciously fills in for me, was actually the highlight of the meeting for me, with all due respect for Dr. Lo and his paper. And meeting many other leaders in the field was a real thrill that alone is worth the modest cost of joining the MTA.

Passing on Wisdom

I've been a bit out of touch with the market virtually all of last week, without many of the technical tools that I rely on. Therefore, I'll relay a bit of what another presenter at the MTA meeting had to say about the current technical state of the market. In addition, I'll throw in my two cents about the Federal Reserve and some of the psychological indicators that keep me from becoming more bullish in the short term. As time allows this week, I'll also do my best to respond to readers who sent me email while I was away.

While most of the meeting's presenters were very interesting (although a few were speaking a foreign language to my mathematically challenged brain), Phil Erlanger's observations about short interest struck me as particularly important. The MTA's current president focused on adjusted short interest, a sentiment tool that he developed, which has a very strong track record. The Erlanger short interest ratios for the Dow, S&P 500 and Nasdaq Composite are all at multi-decade lows and at levels far below those generally seen at times of high market risk. The charts were startling and alone should make one pause, although relying on one technical indicator isn't wise, in my opinion.

Bill Meehan is the chief market analyst for Cantor Fitzgerald, a Manhattan-based institutional trading and research firm, and writes daily for the Cantor Morning News. He can be reached at bmeehan@thestreet.com.

Unmasking the VooDoo: Guru Calls

I originally wrote this in August 1998 when I covered technical analysis for BridgeNews to explain what a big stock bull saw in the charts to suddenly turn him bearish. The names have NOT been changed because the call turned out to be pretty darn good.

What did that mean? 

Why a big bull turned into a big bear

This week, mega-stock bull Ralph Acampora, chief technician for Prudential Securities, did something that most people on the Street thought would never happen. He issued a sell signal. Shudders went though the masses. If this guy, who was famous for predicting Dow 7000 when the Dow was 1000s of points away and who clung to his Dow 10,000 forecast for 1998 before last week's fireworks, can turn sour on stocks, what will the itchy trigger fingers of the masses do?

Let's examine what really happened from a charting standpoint. First, Acampora follows trends and patterns in stock market prices. This makes him different from that other mega-stock bull Abby Joseph Cohen, chief market strategist for Goldman Sachs, who leans more heavily on fundamental analysis. We're not going to say here which is better nor who is right. As a column that attempts to debunk the mystery associated with the Acampora side, technical analysis, we'll just focus on what Ralph saw.

There are basically two keys to his new bearish stance -- market breadth and market trends. The former measures how many stocks are going up and how many are going down. It measures how much of each day's volume is attributable to each of these two groups. In other words, is the rising tide carrying most of the boats higher? If it's not, too many of the boats have sprung leaks.

The latter concept, trend, is subject to how the stock market is sliced and diced. There are blue chip stock indices, such as the Dow Jones Industrial average, that show the "market" fairly flat over the past few months. There are indices of big stocks, such as the S&P 100, that have been rising nicely. There are indices of small stocks, such as the Russell 2000, that peaked back in April and are down 30% already. Which one of these really is the market?

The answer is that none of them on their own fit the bill. Perhaps an unweighted index, such as the Value Line Index, which gives its approximately 1800 components an equal voice, is the answer. If it is, we've been in a bear market since April.

Acampora, as well as a whole host of technicians, saw that market breadth had deteriorated badly. More stocks were going down than up. More volume was attributable to declining issues that to rising issues. More stocks were setting new 52-week lows than 52-week highs. More S&P industry groups were lagging the S&P 500 than were leading it. This is curious in that we would expect the number above to equal the number below. The industry groups together are the S&P 500.

Again, Acampora was not alone in noticing that the small stocks were going down while the big stocks were going up. Stocks with Asian exposure, such as the technology sector, were sliding since the Asian stock meltdown last autumn. True, the tech heavy NASDAQ Composite was climbing but when we examine it more closely, we see that only four stocks account for nearly half of the index's movement. That's not the market, for sure.

The 299 point sell-off we had last week was underway well before Ralph said a word. No, comments from somebody famous did not help matters but the bottom line is that the stock market was already on shaky ground.

 

Let's now look into Acampora's new downside target -- 7400. This is 1200 points away from where we are today. First, the jargon. If a correction is defined as a 10% drop, we've already had one. A bear market takes us to a 20% drop so that's where Ralph gets his wording.

Second, how did he get his 7400 number? You can bet he didn't just pull it out of his hat. The Dow 7500 level was the arguable bottom of the July 1997 - January 1998 trading range. It served as the starting point for the rally that broke free from the range and lies at one of the key percentages to which markets often fall back during declines. For those of you so inclined, it is the 38.2% Fibonacci retracement of the rally that began in late 1994.

We cannot know today whether we will see 7400. More conservative technicians will wait to see if shorter-term technical levels are violated before moving into the bearish camp. However, the moral here is that we need to question our indicators, including our definition of the market or what our advisors are saying. Market breadth and small stocks were flashing warnings a long time before the Dow got smacked.

Acampora still looks for the magic Dow 10,000 in a few months. For long-term investors, he does not sound like such as bear after all.

Unmasking the VooDoo: Fibonacci

If you ever want to sound foolish during your next television interview on the markets, tell them that the market is approaching a Fibonacci level and will do X when it gets there.  It is sort of like doing a DIY network interview and saying the house will have four bedrooms because you are using a 32 ounce hammer.

Both the hammer and Fibonacci are tools used in their respective fields. A hammer is used in carpentry to, among other things, frame a house. A Fibonacci - usually a Fibonacci retracement - is used in investment analysis to frame the market's recent move.

Obligatory definitions

Here is the section where we have to define what Fibonacci is and we'll focus on Fibonacci retracements. If you have any interest in who Mr. Fibonacci was, feel free to fire up the Google. It is irrelevant to what we are doing here.

Mr. F's claim to fame was discovering a mathematical sequence that seems to describe a lot of geometry in the real world from how petals spiral on a flower to how stars spiral in a galaxy. And from that sequence we get the "golden ratio" or "divine proportion" which somehow describes pleasing and useful relationships in art, music, architecture and design in general.

The ratio of .618 to 1 comes from a sequence of numbers where any number is the sum of the two that preceded it. Here is it in all its glory:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10946, 17711, 28657, 46368, 75025, 121393, 196418, 317811, ...

As you can see, the numbers start to get huge. Fortunately, we rarely encounter any above 144.

And even more fortunate, the ratio of any two consecutive numbers settles on .618 fairly quickly. As follows:

0, 1, 0.5, 0.666667, 0.6, 0.625, 0.615385, 0.619048, 0.617647, 0.618182, 0.617978, 0.618056, 0.618026, 0.618037, 0.618033

First, this is the ratio calculated out to the number 610 in the sequence.

Second, and more important, you can see how the ratio oscillates higher and lower as it hones in on the .618 value. Any ratio beyond what is shown above is pretty much just rounding error away from that value.

Voila! the golden ratio!

Fun for math nerds
 
The ratio has all sorts of neet-o properties. For example, 1 / .618 = 1.618.

And 1 - .618 = .382.  Guess what the square root of .382 is? That's right, .618.

.382 / .618 =  .618

You have probably seen these two percentages on the charts an they are roughly equal to the simple percentages traders have used for years, namely 1/3 and 2/3 (or .333 and .667).

Guess what is not a Fibonacci number. 50% or .5.  Check out the sequence. It is nowhere to be found. And you cannot concoct it from math-ing 0, 1, and .618, either.

Still, traders do attach meaning to a 50% retracement or pullback and it has wormed its way into analysis using Fibonacci. Don't fight it, exploit it.

Using this stuff

Now is when we get to dispense with the formalities and use the name experience chart watchers use - fibos. Don't confuse this with fibbie, which is the FBI. Or fubar, which was what you may be feeling right now trying to digest all this fibo stuff.

Fire up any charting software package and under the drawing tools section you will see Fibonacci retracements and possibly Fibonacci extensions, time and arcs. They are all just different ways to look at two points on a chart - usually a high and a low - and then draw stuff off of them at specific percentages.

Take a look at this chart of the S&P 500 from 2007 to 2011. Using the basic set of fibo retracements of 38.2%, 50% and 61.8% look how nicely we could project where support and resistance might be.

Here is where you can get into trouble. These levels are likely places to find support and resistance levels but not always. And sometimes you might be tempted to add more fibo lines until you find one that fits.

My advice is to never add more percentages except for one... and it is a bizarre one. We'll get to that later.

Remember, we are only trying to frame the market, not nail all of its turns and accelerations. We'll use other tools to attack that part.

Anyway, we can see that the rally peaked at the 61.8% retracement and the ensuing correction stopped at the 38.2% retracement. Whoopee! It worked once. We can even see the market stumble in the vicinity of the 50% level.

Let's repeat this. Fibos are likely place for turns, not guarantees.  But we can beef them up a bit by measuring fibos from other points and see if they overlap, or cluster. If they do, then we have a better support or resistance target.

Check out how the rally from the 2010 pullback low to the highs of 2011 is 161.8% of the pullback itself. Something usable must be going on here.

Even better, what if moving averages hit those fibos? Or normal horizontal support or resistance? Or trendlines?

Getting the drift? As with any tool, the more things that point to a price level the more likely that price level will be important.

Now for the bizarre.  Some people use a 78.6% retracement level. Note how this is kind of close to 75% but that is not what makes it bizarre. It .786 is the square root of .618.

In my book, if a market can retrace this much of a previous trend, it is rather likely to retrace the whole thing.

The other fibo stuff

We touched on extensions, time and arcs so let's put in the quick definitions. A fibo extension is a number bigger than one and it projects where a market can go. Look for such numbers as 1.382, 1.618, 2.618, 3.618, etc.....

Draw an arc centered on the origin for each ratio (usually the original ones less than 21) to find trend targets.

And instead of measuring price, do it on the time axis. Think about looking for a 61.8% price retracement that took 61.8% of the time of the previous trend to happen. Make a fibo box out of it.

Fibos are also used in Gann and Elliott Wave analyses. For the latter, we like to see Elliott Wave 3 to be 1.618 or 2.618 the length of Wave 1.  That is a whole nother can of worms so we'll end this right here.

Use fibos on your charts but please use other things along with them. They can help you frame the market but like a hammer, you will have to decide where to put the door and windows. Fibos do not dictate where you buy and sell.

Unmasking the VooDoo: Sentiment

Usually, when I discuss the major parts of technical analysis I'll use an analogy of a table. Price is the top of the table and the most important part. The legs are volume, time and sentiment. They support price analysis but do not supplant it.

Everyone gets price from patterns to trends to momentum. Everyone get volume. Most people get the concept of time, too, which includes such things as cycles, analogs and some esoteric stuff such as Gann.

But sentiment is often the red-headed stepchild of the analysis. Sentiment is hard to gauge. It is hard to quantify. And it is usually fairly hard to gather. Just look at your charting software list of studies. You'll see RSI and cumulative volume. You might even see an Elliott Wave "recognizer" but you are not likely to see something called sentiment.

These things do exist but they are not derived from trading as all the other parts of the table. Sentiment is the true oddball of technical analysis because it is the only analysis that seeks to figure out what traders are thinking. It's not like everyone inputs their feelings into an app on their screens and sends it off for tabulation at a vendor.

Yes, I know there are surveys that do just that but for every collector of sentiment there is a different method and interpretation.

And there are many, many different types of surveys and proprietary indices. There are surveys of traders, of investors, of newsletter writers. Then there are surveys of the actions of traders, which are different from surveys of what traders think. There are surveys of money managers and of Wall Street strategist equity allocations.

There are a few oddball things such as the trend of carpenter tool prices and railroad car usage. Most people may have heard of the trend in oil rig counts.

Have you heard of the hemline indicator? They get shorter when people feel feisty and good.

How about the magazine cover indicator? This is a real thing and it is actually pretty good.

The ratio of football revenue to baseball revenue? Football is a darker sport. Baseball seems to do well when people are happy. Just ask George Carlin what he thinks about these two.

How about horror movies vs. romantic comedies? Same logic.

Giving credit where it is due, those last two come from socionomics, which looks at social mood as an indicator of the stock market. It actually works in reverse but they are closely enough correlated for this discussion.

And if that were not enough, there are a few things that are generated from trading including the famous VIX index, which is concocted from options prices. There is the ratio of puts to calls. Of put volume to call volume. Of equity only puts and calls. Of index puts and calls.

I supposed if we go there it is not far to include the number of stocks above their 200-day averages and at new 52-week highs or lows.

Have I convinced you that sentiment is wild and whacky? And hard to quantify? And hard to even obtain the data?

Using Sentiment

Let's assume you have access to some sentiment data or perhaps just have eyes and ears to follow the news.  What do you do with it?

First of all you have to understand that sentiment is a contrary indicator. And most of the time it tells you nothing useful. If the market is going up then sentiment should be happy.

It is similar to the trend is your friend until the end. Most of the time, the crowd is actually right and you follow along. Only at the extremes is it wrong and you need to go against it. You know, buy when there is blood in the streets. Sell when E*Trade runs ads with cab drivers buying islands. Or when the local pizza shop owner brags about how many houses he flipped.

Remember way back to 2008 when the market was going to hell in a hand basket? It was a brutal bear market and the government was panicking to do something - anything - to look like they were able to stem the tide. My father-in-law, rest his soul, called me to sell everything in his portfolio. I sold a little so he would not be mad at me but I kept the rest.

When the public gets so scared that they throw in the towel you know sentiment is at an extreme for bearishness. In fact, the American Association of Individual Investors survey was at a record high for bearishness. Something like 70% vs. its historical 28% (I am just going from memory on those stats).

Take a look at what was on the cover of Time Magazine on March 9, 2009. It said the economy was holding on for dear life. it talked about foreclosures, about nationalizing banks, toxic mortgages and your disappearing savings.

Guess what day saw the absolute lowest close on the Standard & Poor's 500 index? That's right March, 9 2009. It nailed the bottom.

Usually, there is a lag in these things so don't obsess over this perfection.

Why does this work? When editors or general interest media take the pulse of their readers and finally believe that readers want to read this stuff then we know sentiment is very one sided.  You may rag on Barron's covers but Barron's is not general interest. It's covers are driven by professional sentiment, not the general public.

The same thing works at tops. Think tulip bulbs. Bitcoin. And right now, some think Amazon.com. None of these markets, save for Amazon, had any connection with the real world. They were the greater fool, burning match theory in motion. They went up because of FOMO. You didn't think I could schtup in a millennial reference, did you - fear of missing out. Go buy some etherium. YOLO.

When an actual survey goes extreme, you can bet that whatever trend was in place is nearing its end. But remember, sentiment is not a trading trigger. It sets the environment for that trigger to be really meaningful.

If you can find a stock with a reversal pattern or some other technical positive in place and sentiment is awful - like SNAP was in mid-August - it might be ripe for at least a trade if not investment. Likewise, when all the Amazon haters finally acquiesce (i.e. shut up) then we can consider the stock is too high.

Unmasking the VooDoo: Moving Averages

As with all technical indicators, moving averages are just tools chartists use to figure out what they need to do in the markets. Notice I said they are figuring out their own actions, not divining where the market is going. Of course, the two are related but that is not the point.

What is the point is that pundits and journalists like to report when the market breaks one of the more widely followed moving averages. In this edition of Unmasking I am going to take a look at what a move through an average - or a "crossover" - really means.

Let's start with just what a moving average is. If you want the full definition feel free to fire up the google, the bing or even (shudder) the yahoo. And if you know what a moving average is, feel free to skip the next two paragraphs.


A moving average, or average, is just an mean price over a certain period of time. A 50-day average is the sum of all prices - usually the close prices - divided by 50.  Easy peasy.  Since the calculation is redone fresh each period, the value window of data "moves" over time. Get it? Moving average!


Yes, we can change the span, period, input type and even the weighting of the calculation using any number of oddball formulas but again, if you want to learn about that, it's back to the google for you.

So what is the big deal with these things? Do they create trade triggers? Which ones do we use?

To answer the last two questions: maybe and whatever floats your boat. Yeah, not much help but these are answers you need to develop on your own. I'll just tell you what I do with them.

And to the first question, the big deal is that they help us see the forest for the trees. They smooth out jumpy price action to let you see the major and minor trends. You change the parameters depending on what you are trying to do.

You do realize that the government actually uses a moving average on some of its big monthly economic reports, right? Why? They say it smooths things out. Score one for the chartists.

You can use averages in pairs or even triplets, garnering insights as the averages dance around each other and with the price plot. But let's KISS (keep it simple, schmegegge).

Let's talk about the 50-day moving average. Yesterday, August 10, 2017, the S&P 500 and Nasdaq both closed below their 50-day averages for the first time since July (June for the Naz). The financial headlines were quick to point that out and with the news of the day - a potential nuke crisis in North Korea - boy did they make a big deal. Gotta build the click through count.

Chicken Little was ready to sell everything and head for the hills. Now, can we take a peak at the headline from July 6, 2017 when the S&P 500 last closed below this red line in the sand?

July 6 - Nasdaq challenges major support amid geopolitical tensions, S&P 500 nails 50-day average

In the words of  that famous portfolio manager Homer Simpson, "Doh!"

Six days later, the Spoos reached another new all-time high. Talk about a crappy sell signal!

Let's look at the charts. As you can see, price action violated the average on four separate occasions before the current event since the November pre-election low. The 50-day average did not deliver a successful sell signal one time. None. Zilch.

That does not mean that a drop below the average is always meaningless but I'd rather look for something more reliable, such as a support break, to tell me to sell. Rather, I'd use breaks of the average to set up or confirm other signals.

So again, what is the point? The point is that averages help us figure out the trend. Just look at their name - average. Let's expand the chart all the way back to the start of the major rally in early 2016.

I added the trend channel with a little technician's license to make the upper line more meaningful. That means it touches price action more times.

Look at the 50-day average. It more or less runs through the middle of the channel. Price goes above and below it yet it still was a bull market. The average itself spent most of the time rising.

The next question about that time when it was not rising naturally will be, "How do you know it will go back up?" Well, you don't but there are other tools to use, such as the popular 200-day average and any number of indicators.

The point is that in a bull market being above the average is good but being below it is not necessarily bad. In a bear market, being below is good (for the bears) but being above is not necessarily bad (for the bears).

So, slap on your averages, short-, medium- or long-term, simple, exponential or VIDYA, and find out what the current trend is. However, selling just because price dipped below your average is not always a good idea.