Why should a trader not always rely on trading indicators

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Market Snapshot

Anora M. Gaudiano

‘Sentiment is a tricky thing’, says Bespoke’s macrostrategist Pearkes

Investors are no longer happy about stocks, but prices suggest otherwise

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Several measures of Wall Street sentiment peaked this year and rolled over without a corresponding pullback in the stock market, underlining the faultiness of metrics used for timing the market that have so far consistently betrayed Wall Street investors.

The S&P 500 SPX, -1.51% , which closed at 2.582.28 on Friday recorded its first weekly loss in nine weeks. Despite recent modest selling, the benchmark index is still less than half a percentage point below its peak set Wednesday.

As of Nov. 10, the S&P 500 has gone without a 3% pullback for 12 months and the 12-month rolling average implied volatility, as measured by the CBOE Volatility index VIX, -8.07% has been at record lows, closing at 11.29 on Friday, nearly half its historic average at around 20.

In fact, over the past 12 months, the largest decline on the S&P 500 from peak to trough was 2.8%.

Yet, this shouldn’t imply that the stock market will rise indefinitely to records, with the halting of weekly streaks for the main U.S. benchmarks perhaps signaling that some retrenchment may be at hand.

A gradual shift in investor sentiment, however, suggests that despite all-time highs on the S&P 500, investor sentiment is moderating. Sentiment readings are used as a sign of the mood on Wall Street, with swings at either extremes, bearish or bullish, sometimes interpreted as a contraindicator and as a buy or sell signal.

To be sure, those extreme sentiment readings don’t always correspond with moves in the market.

Case in point, last month, CNN’s “Fear and Greed” indicator, one measure of risk appetite on Wall Street, flashed extreme greed, prompting many strategists to call for caution in buying. However, since then, the indicator has retreated to “neutral” levels, while the market mostly clambered to new heights.

Similarly, an indicator run by Nobel laureate and Yale professor of economics Robert Shiller, peaked in March of 2020 at above 90%, marking the highest level for the gauge since 1999. Shiller’s “Investor Confidence” gauge has been around since late 1980 and measures the percentage of investors, both retail and institutional, who think equities will rise over the next 12 months.

George Pearkes, macro strategist at Bespoke Investment Group, publishes a proprietary sentiment index in which he combines Shiller’s confidence and valuation index to gauge “irrational exuberance,” a term coined by former Federal Reserve Chairman Alan Greenspan in the 1996 in reference to the dot-com bubble, which ultimately imploded in the early 2000s.

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And as seen in a chart below, investors were seemingly irrationally exuberant in March of this year when they believed valuations were stretched but also believed markets would rise over the next year.

Stock indexes putting in fresh records, albeit with subdued moves higher, highlight the market’s ability to defy timing indicators that suggests that a market top has been put in.

“Sentiment is a tricky thing. People respond to different market conditions in a different way. And currently, politics is a big factor in how investors feel about the market,” said Pearkes.

Hopes of fiscal stimulus, with an emphasis on individual and corporate tax cuts, have helped to jolt markets into double-digit gains since President Donald Trump was elected last November. The S&P 500 index is up about 21% since Election Day and is up more than 15% so far this year.

Any news that the tax plan will be delayed or derailed has sparked selling of stocks.

“People can be optimistic or pessimistic for the wrong reasons. It would be a mistake to rely on sentiment for an investment strategy,” Pearkes said. He said this doesn’t mean markets can’t see a small pullback in the short term, citing equity valuations considered lofty.

“With a 20% annual gain, stretched valuations and overbought conditions, markets often consolidate. I would not be surprised to see a mild 3% pullback and then record highs by the end of the year,” Pearkes said.

“Often sentiment turns into a self-fulfilling prophecy,” he said “For example, wealthier investors tend to be optimistic when business-friendly Republicans are in the office to the point their optimism raises market prices,” Pearkes said.

That said, there are signs that the market is cooling after its breathless run-up.

“Technical indicators, such as market internals suggests momentum is fading globally, not just in the U.S. Odds are pretty high that stocks will consolidate a little in the short term,” Pearkes said.

In fact, an unscientific Twitter poll conducted by MarketWatch’s Ryan Vlastelica shows more market participants are expecting the S&P 500 to see a 3% pullback before fresh all-time highs.

What’s on deck for the week?
  • Federal Reserve Chairwoman Janet Yellen, European Central Bank President Mario Draghi, Bank of England Gov. Mark Carney and Bank of Japan Gov. Haruhiko Kuroda will meet at the panel hosted by the ECB in Frankfurt
  • Several Fed speakers are scheduled to speak throughout the week
  • Next week’s economic calendar include consumer prices, retail sales and industrial production.
Corporate earnings

More than 90% of large corporations in the S&P 500 index have reported quarterly results, but there are still a few dozen companies that will report financials next week, including foods company Tyson Foods Inc. TSN, -0.60% , a number of well-known retailers including L Brands Inc. LB, +11.72% , Target Corp. TGT, -1.89% , Best Buy & Co. BBY, +1.36% , Gap Inc. GPS, +2.72% and Wal-Mart Stores WMT, +0.70% , as well as tech company Cisco Systems Inc. CSCO, -1.85% .

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Why You Shouldn’t Rely On A Single Indicator

Yesterday 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 (i.e., 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 exchange-traded funds s you would buy if they got cheap enough.

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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.

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 2020, 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.

This Week’s Gratis Tip

A better approach than relying on a timing indicator to tell you when to get into and out of a stock is to stay focused on maintaining an appropriate allocation to stocks and bonds in your portfolio. What Different Conditions Will Affect My Asset Allocation? lists the three major factors affecting how your portfolio should be constructed.

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.

Charles Rotblut, CFA is a vice president with the American Association of Individual Investors and editor of the AAII Journal.

Three Less Known Trading Indicators Every Trader Should Know

Traders can easily get lost among all the technical indicators available for analysis. That’s why I want to show you not only the most popular indicators, but also shed light on the less known indicators which can make a significant difference to your trading analysis. In this article, three less known trading indicators are presented that every trader should know about — The Commodity Channel Index (CCI), the Momentum and the ATR Indicator.

The Commodity Channel Index (CCI), developed by Donald Lambert in the eighties, is an oscillating indicator which measures the deviation of the security’s price against its moving average (MA) and the normal deviation of the moving average. Despite the name, the CCI indicator can successfully be used with various security types like stocks, currencies and indices. As it measures the current price relative to the moving average of the price, CCI increases in value when the price is far above the its average, and decreases in value when the price is far below its average. That’s why CCI can also be used for identifying overbought and oversold conditions.

The chart above shows the CCI indicator plotted below the GBP/USD daily chart. It uses a 20-day period which a common period used with the CCI. This means that each new calculation is based on the 20 most recent days for calculating the average price of the pair. Other common periods used in conjunction with CCI are 30 and 40, which generate a less volatile indicator to price changes. The longer the periods, the less often the value of CCI will move outside -100 and +100.

Notice how the CCI remains for most of the time inside the -100 and +100 range in the chart. Lambert used a constant of 0.015 in the CCI calculation to ensure the indicator falls between this range 75% of the time. Values higher than +100 and lower than -100 are showing extreme strength or weakness in the market. The snap election announcement in the UK moved the CCI to 395, a multi-month high of the indicator for the GBP/USD chart.

  • Tip: The most common CCI strategy is to enter long positions when the CCI moves above +100, indicating a strong move up in the price, and to enter short positions when the indicator moves below -100.

2) Momentum Indicator

The Momentum indicator is a simple technical indicator of the oscillator family, which compares the most recent closing price to a single previous closing price. It shows where the present trading price is in relation to a price in previous sessions.

The previous closing price is determined by the indicator’s setting, for example a 10-period Momentum indicator compares the present closing price with the closing price 10 periods ago.Hence, if the closing price of the most recent period is higher than n-periods ago, the value of the indicator will be positive. If the most recent closing price is lower, the Momentum indicator will be negative.

  • Hint: There are two versions of the indicator: the first one shows the difference of closing prices in absolute terms, and the second shows the difference in percentage terms.

The chart above shows the Momentum indicator on the same GBP/USD pair used for previous examples, so traders can compare the difference in indicator values. The used setting is a 10-period indicator, which in this case means the recent closing price is compared to the closing price 10 days ago.

  • Important: If the recent closing price is higher than the one compared, the Momentum indicator will move above the zero-line (which is plotted at the value of 100). If the recent closing price is lower than the closing price 10 days ago, the indicator will move below 100. The greater the compared difference between the closing prices, the greater the distance will be from the zero-line.
  • Hint: A simple trading strategy based on the Momentum indicator is the zero-line crossover. A cross above the 100-line is considered a buy signal, and a cross below the 100-line is considered a sell signal.

Usually, much of the price move will already happen when the indicator crosses the zero-line. False signals also appear often with the Momentum indicator. To prevent these drawbacks, it is possible to add a moving average of the indicator and to buy when the indicator crosses the MA from below, and sell when it crosses from above.

3) The ATR Indicator

Like the CCI indicator, the Average True Range(Check out the full article on ATR) was originally developed for commodities, but is also widely used for stocks, currencies, ETFs and other securities. The ATR indicator measures the price volatility of previous highs and lows in absolute terms. The recommended ATR setting is 14-periods on a daily time-frame. Generally, the ATR will have higher values for more volatile instruments with broader price movements. Contrary, a lower ATR value means the price is moving mostly sideways. The ATR can also be used as a confirmation for bullish or bearish reversals. A growing ATR value in the beginning of a reversal might be used as a confirmation signal, as it shows rising momentum of long or short positions.

This chart shows the ATR indicator on the GBP/USD pair. As it is a volatility indicator, it doesn’t provide the information where the price is heading. Therefore, its primary use is for assessing the recent volatility change of a security or currency pair. Although ATR does not consider the price direction of the instrument, it can be useful for spotting potential reversals.

  • Tip: Higher ATR readings can be followed by reversals, as underlying momentum is building up. But traders need to use additional signals to confirm the reversal.

Another popular use of the ATR is for assessing the required exit level in terms of underlying volatility. A simple volatility ratio can be calculated by dividing the current ATR reading with the current price. A relative higher volatility ratio would require a wider stop-loss, as the price makes greater up and down moves. A ratio is used because higher priced instruments have a greater impact on the ATR value than lower priced ones, which makes comparing ATRs between different-priced instruments impossible.

Check out my recent article on Top 10 Chart Patterns HERE

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