August 20, 2011

PortfolioMatters: Don’t Rely on a Single Indicator (Guest Post)

By Charles Rotblut

Today was another rough day for the markets. My crystal ball is not good enough to predict where a bottom will be but, so far, the fear about what could happen (e.g., a double-dip recession) has been worse than what is happening. Fear brings opportunities, so I would use the current weakness to consider rebalancing and look for bargains. At the very least, you should create a shopping list of stocks and ETFs you would buy if they got cheap enough.

I always encourage investors to look at a variety of indicators. By itself, any single indicator can lead you astray. More importantly, many indicators sound like they would be predictive, but are actually not very profitable.

An example is the “death cross,” which appeared on S&P 500 charts this week. The ominous-sounding event occurs when the 50-day moving average crosses below the 200-day moving average. For those of you who are not chartists, a moving average calculates the average price over a specified number of days, such as 50 days. The next day, a new average price is calculated based on the new set of 50 days, which now starts one day later than the last set. (Hence, the average moves one day forward.) This forms a series of dots, one for each day, which is tracked with a line on charts.

A death cross means the average price for the last 50 days is less than the average price for the last 200 days, a sign that the short-term trend in stock prices is negative. (EconMatters Note - View SPX death cross technical chart by Yahoo Finance here.)

This may sound somewhat scientific, but the event is not really as bad as the name sounds. A short-term downward drop in stock prices can be painful, but it does not tell you if stock prices will keep falling. Back in July 2010, Mark Hulbert looked at the historical performance of the death cross and found that it has not been reliable over the past two decades. “Overall, in fact, there has been no statistically significant difference since 1990 between the average performance following death crosses and all other market sessions,” Hulbert concluded.

Plus, I would add that today’s weakness was attributable to anxiety about global economic growth, not to any particular chart pattern.

It’s not just the death cross. There are various indicators that people tout as reliable or at least indicative of where stock prices are headed. For example, on the fundamental side, there is Robert Shiller’s CAPE ratio. This number calculates the S&P 500’s valuation based on the index’s inflation-adjusted price and average 10-year earnings. As an article in next month’s AAII Journal will point out, this indicator has its flaws.

I should also mention that even when a stock, or any asset, appears to be excessively cheap or expensive, it can stay that way for a while. As many traders can attest, the market can remain irrational far longer than you can remain solvent.

This is why, when trying to predict a trend or go against an existing trend, you want to have as many indicators in your favor as possible. You want outside confirmation that your opinion is correct because there is always someone on the other side of the trade with a different opinion than yours. The need for confirmation applies to both calls on the market and decisions on whether a specific security is a bargain or not. You can still end up being wrong, but if you stack the deck in your favor, the odds of being wrong will be smaller than if you based your decision on a single indicator.

Using Technical Analysis

Though I personally do not pay much attention to the death cross, I do look at charts. My reasoning is simple: price volatility can often be a tip that something impacting the company’s financials occurred or is expected to occur. I’m willing to go against the trend displayed on the chart if I strongly believe my analysis is correct, but I use charts to increase the odds that I didn’t miss something in my fundamental analysis.

The Week Ahead

Only six S&P 500 companies are currently scheduled to report earnings next week. They are H.J. Heinz (HNZ) and Medtronic (MDT) on Tuesday, Applied Materials (AMAT) on Wednesday, Hormel Food (HRL) and Patterson Companies (PDCO) on Thursday, and Tiffany (TIF) on Friday.

July new home sales data will be released on Tuesday. Wednesday will feature July durable goods orders. The final August University of Michigan consumer confidence survey and the first revision to second-quarter GDP will be published on Friday.

Federal Reserve Chairman Ben Bernanke will speak at the Kansas City Federal Reserve Bank conference in Jackson Hole, Wyoming, on Friday. This is the same venue where he announced the last round of monetary stimulus. Given current dissent among Federal Open Market Committee members, it is unclear whether a new quantitative easing program will be announced.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

The level of pessimism continues to pull back from the 2011 high recorded two weeks ago. Even with the improvement in optimism, there is still a higher percentage of individual investors expecting stock prices to fall over the next six months than expecting prices to rise. The recent volatility in the markets has created additional uncertainty. This is in addition to the problematic headline risk caused by the slow pace of economic growth and sovereign debt issues (both in the U.S. and in Europe).

About The Author - Charles Rotblut, CFA is  the VP for American Association of Individual Investors & AAII Journal Editor.  Charles is also the author of Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio (W&A Publishing/Trader's Press).  (Author archive at EconMatters here.)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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