Different Strokes

S&P 500 Index – Weekly

Once upon a time, the most widely-used investment textbook was Graham and Dodd’s Security Analysis. Still relied upon, it was actually that book that my finance professor used for my MBA course in investments. Fundamental, value-oriented investing was the order of the day, and this was the tool. The mantra of investment professionals was buy-low when stocks are relatively cheap; sell when they are expensive. Many wise investors simply bought and held dividend-paying stocks when those stocks were selling at prices lower than the fair value calculated using those fundamental tools.

In the early ’80s, in an effort to find continuing education that I thought to be both interesting and helpful, I attended a short course in technical analysis. I was immediately impressed with the idea that useful information could be gleaned solely from charts of stock prices and volume data alone. Contrary to all that I had been taught in school, there was absolutely no focus here on fundamentals. I immediately subscribed to monthly updates of point-and-figure (PnF) charts. Those are some of the strangest looking charts you can imagine: a column of X’s while prices are rising, reversing to O’s when prices are falling, all without regard to time. Of course, it is the reversal from one to the other that garners a trader’s attention. Buy when the trend shifts from O’s to X’s, and sell when the X’s reverse to O’s, and you can generally make money. Back in those days, technology to continuously monitor such charts on an ongoing basis was only available to a few large firms, if at all. Technical analysis was embraced by very few investors, and was often referred to as heretical by many professionals.

A few short years later, Professor Markowitz, modern portfolio theory, and the efficient markets hypothesis became the order of the day, and the mantra of investment professionals became buy-hold-and-rebalance. Simply put, one only had to determine the level of volatility that can be tolerated (how risk got defined), perform an optimization of risk and expected return, select the asset allocation for that optimal point on the efficient frontier, and then rebalance it periodically.

One of the early proponents of Asset Allocation was Roger Gibson, who wrote the book of that title, now in its fifth edition. I was in the audience when Gibson spoke in the early ’90s. This theory was just getting off the ground, and I asked him how long it would take to disprove it. He said that it would likely take about 400 years of data. After much debate about this concept, more recent research by Mordecai Kurz at Stanford concludes that it is not wrong, but incomplete.

In fact, the Greater Recession of 2008 exposed many of the practical limitations of Modern Portfolio Theory. When it became clear that simply buying and rebalancing to a static asset allocation would not work to protect capital in the perfect storm, we shifted our focus back to a combination of fundamental and technical analysis. With the advent of the internet and fast personal computers, TA has evolved significantly over the 25 years since I bought my first monthly chart books. It is now taught in leading schools of finance, and we embrace it.

One of the leading lights in technical analysis is Alexander Elder, MD (www.elder.com). He is a psychiatrist as well as a professional trader, and a teacher of traders. The accompanying chart of the S&P 500 is his construction, and provides a good illustration of what he calls The Impulse System.

In short, this chart combines inertia, measured by the slope of the fast exponential moving average; and power, measured by the slope of a histogram of another indicator, the moving average convergence divergence indicator, MACD. Stockcharts.com has made Elder’s chart style available in its paid subscription.

Elder originally thought it could become an automated trading system; buy when green, short when red, and cash checks when blue. Rapid changes from red to green or vice-versa precluded that possibility. Instead, in a flash of insight, he concluded that it was not an automatic trading system at all, but a censorship system. It tells what NOT to do. No buying while red and no selling short when green. Either is okay when blue, but only with caution. Our firm’s trading plans are developed around a number of criteria, but we have found Elder’s chart to be quite useful, and we monitor it daily. We become very interested in buying when a red bar becomes blue, and take some interest in selling at the top of the range. The mantra of buy-low and sell-high still fits.

Scott Neal is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm, with offices in Lexington and Louisville. Send your questions via email to scott@dsneal.com or call him at 1.800.344.9098.