Market Timing based upon Technical Indicators

In chapter 7, we examined a number of chart patterns and technical indicators used by analysts to differentiate between under and over valued stocks. Many of these indicators are also used by analysts to determine whether and by how much the entire market is under or over valued. In this section, we consider some of these indicators.

Past Prices

In chapter 7, we looked at evidence of negative long term correlation in stock prices - stocks that have gone up the most in recent periods are more likely to go down in future periods. Studies do not seem to find similar evidence when it comes to the overall market. If markets have gone up significantly in the most recent years, there is no evidence that market returns in future years will be negative. If we consolidate stock returns from 1871 to 2001, into five-year periods, we find a positive correlation of .2085 between five-year period returns - in other words, positive returns over the last five years are more likely to be followed by positive returns than negative returns in the next 5 years. In table 12.1, we report on the probabilities of an up-year and a down-year following a series of scenarios, ranging from 2 down years in a row to 2 up years in a row, based upon actual stock price data from 1871 to 2001.

Table 12.1:Market Performance

Priors

Number of occurrences

% of positive returns

Average return

After two down years

19

57.90%

2.95%

After one down year

30

60.00%

7.76%

After one up year

30

83.33%

10.92%

After two up years

51

50.98%

2.79%

It is true that markets are more likely to go down after two years of positive performance than under any other scenario, but there is also evidence of price momentum, with the odds of an up year increasing if the previous year was an up year. Does this mean that we should sell all our stocks after two good years? We don't think so, for two reasons. First, the probabilities of up and down years do change but note that the likelihood of another good year remains more than 50% even after 2 consecutive good years in the market. Thus, the cost of being out of the market is substantial with this market timing strategy. Second, the fact that the market is overpriced does not mean that all stocks are over priced. As a stock picker, you may be able to find under valued stocks even in an over priced market.

Another price-based indicator that receives attention at least from the media at the beginning of each calendar year is the January indicator. The indicator posits that as January goes, so goes the year - if stocks are up, the market will be up for the year, but a bad beginning usually precedes a poor year.5 According to the venerable Stock Trader's Almanac that is compiled every year by Yale Hirsch, this indicator has worked 88% of the time. Note, though that if you exclude January from the year's returns and compute the returns over the remaining 11 months of the year, the signal becomes much weaker and returns are negative only 50% of the time after a bad start in January. Thus, selling your stocks after stocks have gone down in January may not protect you from poor returns.

5 Note that there are narrower versions of the January indicator, using just the first 5 or 10 days of January.

Trading Volume

There are some analysts who believe that trading volume can be a much better indicator of future market returns than past prices. Volume indicators are widely used to forecast future market movements. In fact, price increases that occur without much trading volume are viewed as less likely to carry over into the next trading period than those that are accompanied by heavy volume. At the same time, very heavy volume can also indicate turning points in markets. For instance, a drop in the index with very heavy trading volume is called a selling climax and may be viewed as a sign that the market has hit bottom. This supposedly removes most of the bearish investors from the mix, opening the market up presumably to more optimistic investors. On the other hand, an increase in the index accompanied by heavy trading volume may be viewed as a sign that market has topped out. Another widely used indicator looks at the trading volume on puts as a ratio of the trading volume on calls. This ratio, which is called the put-call ratio is often used as a contrarian indicator. When investors become more bearish, they sell more puts and this (as the contrarian argument goes) is a good sign for the future of the market.

Technical analysts also use money flow, which is the difference between uptick volume and downtick volume, as predictor of market movements. An increase in the money flow is viewed as a positive signal for future market movements whereas a decrease is viewed as a bearish signal. Using daily money flows from July 1997 to June 1998, Bennett and Sias find that money flow is highly correlated with returns in the same period, which is not surprising. While they find no predictive ability with short period returns - five day returns are not correlated with money flow in the previous five days - they do find some predictive ability for longer periods. With 40-day returns and money flow over the prior 40 days, for instance, there is a link between high money flow and positive stock returns.

Chan, Hameed and Tong extend this analysis to global equity markets. They find that equity markets show momentum - markets that have done well in the recent past are more likely to continue doing well,, whereas markets that have done badly remain poor performers. However, they find that the momentum effect is stronger for equity markets that have high trading volume and weaker in markets with low trading volume.

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