The volatility in September and October 2014 brought out the usual ‘the end is near’ crowd calling for a collapse of the bull market. However, our technical analysis of the market shows that the rally that began in early 2009 is on sound footing and stable. In this article, we’ll demonstrate that the rally is in a healthy uptrend as well as a clear, rules-based signal to know then the rally is over.
While IntelligentValue.com is devoted to value investing, it is our opinion that technical analysis (TA) – as an adjunct to value analysis – dramatically improves returns in the context of modern equity markets. We have a substantial amount of empirical evidence, including ten years of market-tromping portfolio performance in IntelligentValue.com with 100%+ annual returns for our two model portfolios that back up that opinion.
Generally speaking, the vast majority of value investors do not give credence to technical analysis. Most well-known value investors follow the mantra of buying a stock when it is significantly undervalued, then holding it until that value is realized, no matter how long it takes. For example, Warren Buffet says his favorite holding time is “forever.”
However, today that attitude towards technical analysis is becoming antiquated. The broad acceptance of the Internet and widespread availability of TA websites for individual investors, as well as a plethora of TA-based algorithmic hedge-funds and TA-oriented computerized trading centers have inherently turbo-charged the accuracy of technical analysis.
As a result of the internet, there is a massive quantum factor of additional individuals utilizing TA in their investing today than there was even a half-dozen years ago. The consequence is that investing decisions based on TA are more accurate than ever.
After all, the ‘market’ is simply the collective decisions of many millions of individuals (and computers). As more follow technical analysis and are using it in their stock purchase and sale decisions, the more those TA techniques become applied to individual stocks and the broad market. If, for example, the majority of savvy investors believe the market will consolidate at a 50-day moving average, then typically it does just that, regardless of value or news considerations.
We mentioned computers a moment ago. There is also an enormous effect on the market from computerized trading algorithms, many of which use TA is a cornerstone. As a result of today’s wide acceptance and use, technical analysis has almost become a ‘self-fulfilling prophesy.’
For this reason, as well as a simple fact that it truly works, IntelligentValue.com uses technical analysis as an adjunct to our fundamental value approach. Please notice that we emphasized the word adjunct, which means that TA is an enhancement to, not a driver-of our returns. Fundamental value investing the driver of our returns, but TA goes a long way toward optimizing entry points and minimizing drawdowns.
USING TECHNICAL ANALYSIS IN LONG-TERM INVESTING
It could reasonably be said that the majority of people using technical analysis are short-term traders. In fact, if you go to a technical-analysis website (Stockcharts.com has a free area), almost all of the default settings on the various indicators apply short-term settings to daily charts. However, those same technical principles that work on trades using daily, hourly, or even shorter settings also work with weekly and monthly charts.
Since we rebalance our portfolios each weekend for IntelligentValue.com, we base our market timing system on weekly charts. We publish the results of that rebalance, with analysis of the stocks in our portfolios each Saturday/Sunday. We have found that an intermediate-term investing approach is, by far, the optimum for maximum performance. We are not buy-and-hold value investors, because we cannot achieve the incredible returns we do by holding for extensive periods of time.
We utilize technical indicators to minimize market-related drawdowns, but we are not short-term trading the market. We modify the standard settings of technical indicators to make our entry/exit system investment-oriented instead of trading-oriented. For example, for one technical indicator we use that normally has a standard setting of 20 days, we use a setting of 500 days.
With a weekly rebalance and modified technical indicators, since 2004 we have an average of 1.4 market-risk-related closed positions per year. We hold our stocks an average of 3.6 months and both our portfolios generate long-term annual returns greater than 100%.
We find that technical analysis, when used as an adjunct to a fundamental value investing approach, substantially turbo-charges our performance. Returns increase by a factor of 300-500% over a system with no consideration of technical entry and exit points and no market timing.
For example, a well-designed value approach without TA may yield 20-40% per annum, but with carefully-crafted TA-based entry and exit points added to take advantage of long-term market volatility, annual returns can reach 150% or more (our DEEP VALUE Portfolio has a long-term annual return of 185%).
WE’RE NOT EVEN CLOSE TO A MARKET COLLAPSE
Many of the pundits who appear in the media continue to forecast a collapse of the U.S. stock market. The most recent calls for calamity came in the late-September/early-October downturn. While these self-appointed ‘experts’ have been predicting it for years, it just isn’t happening.
The fear that still grips experts and mainstream investors alike following the 2008 crash has caused many to lose money by staying out of the market or even shorting it. This fear has affected both individual and professional investors and is the motivation behind the speculative disaster prophesies. It does not take much at all for the market boo-birds to come out calling for another crash.
A LOGICAL APPROACH FOR DETERMINING WHEN TO EXIT THE MARKET
In the section below, we have charted the small-capitalization Russell 2000 index and the large-cap S&P 500 since the September 2008/March 2009 lows. (NOTE: We use the Russell 2000 small-cap index, with substantial minimum volume requirements for liquidity, as the stock universe for our DEEP VALUE Portfolio. We use the Russell 1000 mid/large-cap index as the stock universe for our RELATIVE VALUE Portfolio).
As you can see from the charts of these indices below, prices are well within an upward-sloping Trend Channel that we have plotted for the last six years. The channel for each chart has a Primary Trend Line (blue dotted line in the center) with a multitude of touch points (highlighted in yellow) beginning with the 2008/2009 lows and continuing through last week.
There is a parallel Support Line (green dotted line) below the blue Primary Trend Line that runs from the 2008/2009 lows to the present. For the small-cap Russell 2000, this Support Line is touched at the early October 2014 low. For the S&P 500, the last time this index touched the green Support Line was in late 2013. It has stayed above the blue Primary Trend Line for the last year. For this reason, we believe that this index may be overdue for a correction down to the green Support Line.
We have also plotted a parallel Resistance Line (red dotted line) that runs above the blue Primary Trend Line in both charts. This line designates the upper resistance to price gains. The last time the small-cap Russell 2000 touched this line was March 2014. It has been working its way lower to the green Support Line throughout 2014 and finally reached that level in October 2014. For this reason, we believe that small-cap stocks may be due for outsized performance gains compared to large-cap stocks.
We show two charts below, one of small-cap stocks (Russell 2000 in Chart 1) and one of large-cap stocks (S&P 500 in Chart 2). Both categories of stocks are well within these precise six-year Trend Channels, and neither index is threatening to break out of those channels to the downside.
CHART 1: RUSSELL 2000 (SMALL-CAP) SIX-YEAR TREND CHANNEL
CHART 2: S&P 500 (LARGE-CAP) SIX-YEAR TREND CHANNEL
Using the trend lines shown in the charts above, we can see a very precise channel from the September 2008/March 2009 lows to present with a multitude of touch points over the course of six years. You have to admit; the accuracy of these trend lines is compelling.
In a trend channel, the upper and lower Resistance and Support Lines as well as the Primary Trend Line must all be parallel to one another. The market does not necessarily have to stay within the channel 100% of the time. In fact, the Trend Lines are more of a general area around which prices coalesce. Sometimes prices will stay just above a Trend Line and sometimes just below.
However, a Trend Channel should provide a clear demarcation of Support and Resistance levels over long periods of time. The channels in the two charts above accomplish that objective and provide us with a clear basis for stating that the bull market rally that began in 2009 is alive and well!
Investors would be wise to rely on these channels to determine when to exit stocks, rather than rely on speculation of coming developments or valuation measures that historically have low correlation to future stock prices.
WHAT WILL THE MARKET DO FROM HERE?
After bouncing off the green Support Line in mid-October 2014, the Russell 2000 Index rose recently to just above its Primary Trend Line (blue line in the middle of the channel). For the S&P 500, prices are dropping from the upper Resistance Line (red line at the top of the channel), but this index has not seen prices drop to the lower Support Line (green) since late 2012. As long as prices stay above the green Support Line, the uptrend will remain intact, so there is plenty of room to maneuver while staying within this range.
It is possible for us to estimate a range of prices for the market within the trend lines. We measure upper Resistance Line (dotted red line) being 12% above the Primary Trend Line while the lower Support line (dotted-green line) is 9% below the center Primary Trend Line. In prices, that calculates out to be a current upper range around 1316 and the current lower range down to 1070 on the Russell 2000.
For the S&P 500, the current upper range in its trend channel tops out around 2040, where it peaked recently. The lower Support Line of the channel is all the way down at about 1800. Is it possible that large-cap stocks, which have done extremely well over the last two years, are now due for a selloff? It appears that’s exactly ehat’s happening. Will small-cap Russell 2000 stocks now take the lead in a ‘great rotation’ of market cap stocks?
No predictions here. Our policy is to observe and react, not speculate.
However, both the small-cap Russell 2000 and the large-cap S&P 500 (and all other indices) are clearly moving within these very steady Trend Channels. Until we see a change in that dynamic, we don’t expect a major disruption of the market. Volatility within the Trend Channel, yes. But a crash? We’re not even close.
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