Uncategorized | Portfolio Yoga

In Defense of Technical Analysis

One of the ways to beat down a strategy is to apply it wrongly and claim since the results does not match expectations, the strategy has to be wrong. Technical Analysis has its faults and there is no denying that. But claiming that those who use technical analysis as the tool of choice tend to have their performances drag down is doing it a bit too far.

That thought is based on a survey which has been done by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University (Link). The key reasons they come up for the under-performance are:

Investors using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective.

Investors tend to hold more concentrated portfolios which they turn over at a higher rate

Investors are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of non-systematic risk to total risk

Investors engage in more options trading, and earn lower returns.

The biggest problem area for me in terms of Technical Analysis is the confusion whether it’s a science or an art. While it’s nice to say that it’s both a science and an art, it’s plainly illogical that something can be both. Think about Modern Art being said to be an Art (which is true) as also a Science. I am not sure if there is any other field where both Art and Science are seen to be acting in tango.

Now, let’s go back to the four points which the researchers say are the key reasons for the underperformance of investors who use Technical Analysis for their decision making.

The time frame of a trader / investor using technical analysis is way too short compared to an investor who uses fundamental analysis as his tool. While a fundamental investor gets 4 data points in any given year (4 Quarterly Results), guy who uses Technical analysis has a lot more data points based on what kind of time frame he operates in. A investors who looks at Daily chart would have around 240 data points to consider in any given year while a Investor who looks at a weekly chart will have 52 data points to consider in a year. No matter what time frame one chooses, the data points generally exceed the data points available to a fundamental investor

Having more data points is both a advantage and a disadvantage. Let’s take a example where more data points would have worked in the favour of the Technical Analyst – Satyam Computers. Long before the shit hit the fan, most guys using Technical Analysis as their tool would have seen that it made no sense to trade the stock with bullish bias. For a Value /Fundamental Investor on the other hand, Satyam was a strong case of a stock available for cheap.

It is interesting that the survey finds that Investors hold concentrated portfolio’s / bets compared to investors using other methods who may be holding diversified portfolios. A lot of water has flown down the bridge as to whether it’s better to hold concentrated bets or diversify as much as possible. Both have their advantages and disadvantages and I doubt that it can be proven that either concentrated or diversified portfolio is the best bet.

Personally I believe in concentrated bets since the more number of stocks one is exposed to, the closer we get to ordinary performance. The same was proved when I did the test of random portfolio strategy as well. But I strongly doubt that a concentrated portfolio is the key to under-performance since I know of many value / fundamental investors too who use the same approach and have been able to beat market averages by a mile.

This point interestingly goes against the point number 1. If investors using technical analysis as their trading tool are trading more, it goes on to prove that they are betting on reversal s to the existing trend at multiple points and in turn can miss the big rally when it comes.

Option trading as such has nothing to do with Technical Analysis but since Option traders are short term traders and are betting on charts to decide on what stock and what strike to buy, it’s easy to get clubbed with Technical Analysis even though one can search the entire technical analysis vocabulary and find not a single instance of a tool devoted to options.

In an earlier blog post, I had written about how people buying cheap options is not the path to riches and instead will result in ruin of capital in the long run. But then again, options are pretty enticing since unlike stocks, they can double / triple in no time at all.

But Technical Analysis as such has no role in how investors / traders risk their capital in the markets. Option trading is similar to buying lottery tickets (though the odds here are much better) and hence not something that is bound by any strategy other than human greed.

To me the biggest negative is the fact that Technical Analysis as a tool is far from refined and adapted to the world where it’s important that it’s scientifically proved beyond doubts. If I were to buy stocks based on PE, that would not make me a Value / Fundamental Investor but if I were to draw a line on a chart, I am seen as a Technical Analyst. End of the day, it’s the perceptions that seem to matter more than reality.

Over period of time, I myself have debunked multiple strategies that are associated with Technical Analysis and showed how they fail the traders / investors who use those tools. But to claim Technical Analysis as a whole is quack is akin to throwing the baby with the bathwater.

Test of Moving Average

A interesting use of Moving Averages is in Mean Reversion. While many trend followers swear by a Moving Average (or Moving Average Crossover), its interesting that the same can also be used for a Mean Reversion strategy (not that I would recommend doing that).

This pic from Wikipedia showcases the same

We can measure a trend in various ways. One way would be to see the number of times it retraces to its moving average before continuing with its previous trend. Based on that though, here are the charts on the number of times Nifty has come back to the moving average.

All data for 2014 is till date (30th May)

10 Day Moving Average

20 Day Moving Average

50 Day Moving Average

100 Day Moving Average

200 Day Moving Average

Based on just a overall view, the data above supports the fact that trend following has been pretty positive this year compared to say 2013. But shall it remain with low volatility and not too may dips remain to be seen

Days since a 3% correction

Once again, this blog is based on a US blog which showed that Dow has had 600 days since seeing a 3% reaction. Since our markets are in itself in the middle of a good bull run, I figured out that it would be interesting to check out as to how many occasions we had seen a 3% reaction in Nifty as well as how many days had been spent from the time we had a 3% correction last time around.

Of the total of 5529 days of data I have, Nifty has seen a fall of 3% or more on 208 occasions. In other words, Nifty on an average has a 3% correction every 26.5 days. But then again, that is the average. Right now, we are 180 days from a 3% correction (last correction >3% was on 3rd September 2013) though this is not the biggest time frame we have had between such corrections. This is not even the 2nd longest but is as on date the 5th longest time between 3% or more correction.

But what interested me was not the days that we spend now but how the reactions were more often seen during the bull run of 2003 – 2008. In fact, the highest days between a 3% or more reaction then was 155 days (in 2006). The trend seems to have changed not in 2009 when markets shot up substantially but in early 2010. Would be interesting if this indeed is a change in terms of markets not seeing a substantial correction for more days than what has been the trend earlier.

CNX Small Cap Index PE – Running Rogue?

Price Earnings Ratio is something I believe is an important number and the PE ratio for Index has a way of showing where we are and based on past data what can be expected (with a reasonable probability of success) in the forthcoming months / year.

Consequently I use Nifty PE (while Sensex PE has a much longer history, its now not available for Free). The other day a friend on twitter asked me whether I was tracking the Small Cap Index. Curiosity sake, I downloaded the same and was stumped on finding it showing moves that even a micro cap will not show.

Do look at the weekly chart of the Small Cap Index

It’s one thing to expect gaps in historical data when you are checking out a stock. But this is worse since the gaps are on both sides and worse, day to day changes are some times so huge so as to make little sense as to what changed.

For example, the Small Cap PE rose from 24.17 to 49.34 one fine day in September 2012. The change in Index on same day (0.8%). On 16th Jan 2013, PE fell by 20% even as the Index fell by 1.5%. Another 20% fall in the PE was noticed on 1st April 2013 whereas the Index that day actually climbed 2.2%

In March and July of 2013, we once again saw 2 bumps up of nearly 20% on the PE Index even as the Index itself remained more or less flat on those days.

And then we had the mother of all rises as the PE index jumped from 50.17 to 162.83 on 28th March 2014. The Index on the same occasion rose by just 2.1%

On 7th April, the Index went up by 15.5%, went down the same percentage on 5th May and made a pole vault as it jumped 48.5% on 12th May. Of course, since after jumping up the pole, the next way is down,, PE dropped by 46.8% on 19th May. 22nd saw the PE Index jump by 20% and yesterday, another 10% rise.

Since the whole thing made little sense to me, I wrote to India Index Services & Products Limited regarding the huge gaps and today they were kind enough to reply to my mail with the following reply

I understand that as stocks are added and deleted, PE does change. But the kind of change one has seen in the small cap Index makes the whole work of tracking valuation pretty worthless. I mean which Index (other than maybe Zimbabwe) has PE valuations of 296 and this is not a single stock Index but a Index comprising 100 stocks.

Unlike say the CNX IT Index where Infy alone contributes to more than 50% of the weight (the top 3 in sum contribute nearly 85% of the weight making the rest of the stocks just showpieces whose movements will have no significant moves in the Index), here the Top 10 in total contribute just 17% which signifies that the spread is good (Link)

As of now, we do not have a ETF tracking small cap’s, but I believe that as the financial markets mature, we should see a lot more ETF’s than those currently in operation and when that happens, this kind of data blows away any analysis that maybe used with good results elsewhere.

Nifty Performance vs. PE Ratio

One of the key numbers I look at regularly is the PE ratio of Nifty to have a idea as to the valuation Nifty currently commands and whether markets are cheap, expensive or neither of the two.

For quite some time now (since mid 2011 to be precise), Nifty PE ratio has been moving around its long term average. Only once did we see a major dip which brought the PE to its 1 Standard Deviation on the lower side.

As on date, the current rise has meant that we are closing in on the 1 Standard Deviation on the upper band though even that is bit far away. But what is interesting is how does the PE compare to the return of Nifty.

Since 2008 low, Nifty has appreciated by 150%, Nifty PE has appreciated by just 85%. But more interesting is the way this has been accomplished. Lets first take a look at the chart;

After the markets bottomed out around October 2008, we witnessed a steady recovery post the bottoming of the Dow in March 2009. But even as the markets were dipping in the first couple of months of 2009, PE was already starting to move higher indicating the impact of bad results which were pushing up the valuation of Nifty even as Nifty itself did nothing.

This can be seen till the early part of 2011. Nifty doubled from the lows, the PE out performed it (in essence markets became pretty expensive in a very short span of time). To get a handle on how expensive Nifty was, do note that the high point was above the 2 standard deviation (which was seen earlier in 2008).

But from that point on wards, things have changed tremendously. Markets started to outperform the valuations (in other words, even as markets went up, quality of earnings meant that valuation wise, markets were still cheap).

I believe that unless we have another major global meltdown, this gap will only increase further. In hind-sight, markets seem to have been a buy on dips since early 2011. Question though is, is that strategy still a valid one? I for one believe so.

Does low volume days say anything

As usual, idea for this particular test has been borrowed from this blog post (Link)

I wanted to check whether there was any such change when the same was applied to Indian Markets. I used CNX Nifty and the Volumes are the total market volumes. While I have used close as entry price since that was the same used in the above test, Next day open is the ideal way to test since one cannot know whether today was a low volume day or not during the market hours.

But then again, such test would have been warranted if the results showed something significant. As the chart below showcases, no strategy can be build around low volume days since there is just no correlation between low correlation days and how markets behave over the next few days.

The Profit / Loss is in terms of Points gained (1 Nifty Unit being the trade size). Profits were not compounded and no transaction charges applied.

The left out feeling

Its been a pretty long time since we saw a move in the markets where dogs, cats and bananas are all rallying together, may with incredible speed that seems to suggest that even the gravitational force of Jupiter may not be enough to reign it in. For guys who have shifted their focus to selective trading / investments, this is a time where holding the nerves calm is a tough ask.

After all, even taking into account the strong showing of BJP in the polls, Nifty if up by just 8% for the month. On the other hand, stocks have done wonders. But how true is that fact?

A few days ago I analyzed the performance of stocks and came up with the following static

While its easy to assume that stocks have rallied across the board, the above data tells us that not everything has gone bonkers. Many stocks have horror of horrors under-performed even as both Mid and Small Cap indices have beaten the large cap indices by a pretty good margin.

What the left out feeling does is make us react in ways we believe we are trained not to react. In other words, while we assume that our thought process is pretty different from the herd, we actually start thinking and behaving like the herd. It takes a lot of effort (mentally speaking) to be able to remain calm and continue to follow the process we have laid out even as the rest of the market seems to suggest that we are barking at the wrong tree.

In 1999, when the tech boom was under-way in US, the one guy who decided to skip investing into any stock was Warren Buffett. As stocks continued to rally, it was seemingly obvious that he may have started to lose touch with the market. But 2000 showed why his famous quote (which he said in Feb 2008) makes so much sense.

But then again, a guy who one can contrast Buffett would be George Soros who has actually delivered a much strong return for his investors. While Buffett chose not to participate in bubbles and instead arguing for value based investing, Soros has once in the past said that while Gold seemed to be in bubble territory, he would be happy to be long as long as the trend was strong. But then again, Soros being Soros was able to get out of Gold well before it started to tank against say John Paulson who made money on the way up only to let go of a lot on the way down.

The reason I brought in Buffett and Soros was to show the diametrically different ways they dwelt with a situation. Both have prospered due to the fact that they both are good at what they do and rarely do go outside their area of competence (think about Soros buying Good Companies or Buffett shorting Euro / Pound).

A interesting adage in the markets goes like this

Bulls Make Money, Bears Make Money, Pigs Get Slaughtered

The retail participant is generally seen as the Pigs / Sheep as the probability of them making money on the long term is pretty low. But that doesn’t dissuade anyone since they believe they are better prepared than the guys who lose the race. Unfortunately, rarely does it turn out to be true (and this despite many of them spending a fortune in attending courses on how to make money in markets, buying tips / newsletters among others).

As Ed Seykota once said

Win or lose, everybody gets what they want out of the market

If you are feeling left out in the current rally, step back for a moment and think about whether you have a plan, a process to ensure that you can make it out if the cows start to come home (and many eventually will). Without a plan, you are a duck out of water – matter of time before you are shot and curried.

Do remember, markets were we were born and shall remain after we are dead, but if we mess us in markets, it can screw up a lot more things in life than just finances.

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