I attended a conference recently where the speaker spoke of a trend based methodology and what appeared to be ‘fool proof’ way to see or at least filter, an uptrend, downtrend or a non trending market using Multiple Moving Averages (MMAs). The ability to ‘validate’ a trend, or ‘invalidate’ it, is crucial to most long term buy and hold strategies that use Technical Analysis (TA). In this post we will examine the importance of a designing your own probability based framework, and in this regard we provide four important principles.
1. The Problem With Moving Averages
The inherent problem with moving averages (MAs) is the catch-22 between slow and lagging MAs, and faster and leading MAs. If the MA lags too much, then it will provide late signals; if it leads too much, then it will provide often false signals which will ‘whip you’ in and out of the market. Historically, the solution then was using two, or three, or multiple moving averages (MMAs) to try to break out of this catch-22, and even using derived tools, such as the MACD.
MMAs can be useful however the chief issue I have with them is that they can take the eye away from price action. You can just rely on the MMAs signals and not look at other key tools such as support/ resistance (SR), trend lines, or volume- the latter being particularly useful for stocks and indices.
The danger then lies in thinking MMAs are the only tool which can accurately validate or invalidate a trend. This is akin to ‘Holy Grail’ thinking, and should be approached with extreme caution.
A preferable approach is to use either one or two common MAs, such as the 50p Simple Moving Average (SMA) or the 200p SMA on longer term charts, such as the weekly chart (W1) and then combine MA signals with other non-correlated tools. The same logic would apply to those who wish to still use MMAs. They key point is to not over-rely on any moving average based tool used alone.
2. Suggested Other TA Tools
Other tools that can combine with MAs for trend validation should be non-correlated as we mentioned earlier. That is, they should be derived from different data sets, or different methods. The ones we find that are useful include:
- Support/ Resistance (SR) lines: particularly on long term charts, such as weekly charts (W1).
- Trend lines: also on preferably on W1 charts; for instance often used when breached to invalidate a trend.
- Dow ABC Pattern: This classic pattern using the pivot peaks and troughs is still one of the most powerful tools to validate or invalidate a trend. It often combines with key MAs very well.
- Candlestick Patterns: These can assist to define the pivots around a Dow ABC pattern or a break-out of SR lines.
- Elliott Wave: The classic 5 wave pattern and the retracing ABC pattern still work well. The key here is to keep the analysis simple and again focus on the longer term charts, such as W1.
- Volume: such as simple volume bars- rising or falling in support of a trend, or spikes around pivot points.
When we combine non-correlated tools with MAs, we maximise the probability of a new trend being defined or an existing trend being exhausted or likely to change. The word ‘validation’ is thus a little strong. All tools in the financial markets work on probability, not prediction. Our framework for analysis therefore should always be seen in this light. The more supporting evidence we have for a conclusion the better. There is no right or wrong- just the weight of evidence, and then a probabilistic conclusion or expectation. This framework stops us trying to forecast from ‘perfect tools’ or a ‘Holy Grail’ system.
Remember the Power of Three and keeping things simple. TA is beset with complexity. Complexity and too many variables creates too many moving parts, and hampers efficient decision-making. With all our analysis it is best to keep things simple, flexible and workable. Here we have found over the years the Power of Three repeat itself time and time again. In our current setting, consider using at most three non-correlated tools to primarily determine a new or ending trend.
3. Combine with Fundamentals
Combining sound TA with sound Fundamental Analysis (FA) can add to the probability of a trend coming to an end or a new trend beginning. It can also support or explain why a market is non-trending or choppy. The current W1 chart of the USD/JPY is a good example.
When we study the history of the markets, we see that FA has been the dominant school of thought for some time, particularly for stocks. Its younger cousin, TA has only really grown in recent decades, and still has many critics. The scales are being balanced a little more in the last few years, but there are only a few of us who combine the schools well. We have found that this provides fertile ground for developing a sustainable edge in the market for either trading or investing strategies.
For example, when we analyse common stocks, we do this at the following levels-
- Macro or Global Macro fundamentals, such as the state of global risk and defensive markets.
- Micro fundamentals, focused on key metrics of the company such as Earnings per Share (EPS) and Earnings per Share Growth Rate (EPSG) calculated over the last 5 or 10 years.
- TA of Global Markets, here we study in detail the longer term charts of the key risk and defensive markets.
- TA of the Stock, here we examine the chart of the stock to determine its nature, for instance if it is in a current uptrend.
When we bring these levels together we have a very powerful framework for decision-making. We can then draw out the probabilities and apply our relevant investing or trading plan. Precisely how this done varies with the instant plan and its underlying methodology.
4. Link to Methodology
Moving Averages or MMAs are usually used for trending markets or trend based methodologies. They will be of little use in a ranging market, or for break-out strategies, for instance. This means we must understand deeply the chosen TA tool including its limitations.
If you hear someone, say a certain tool can do everything perfectly in all market conditions, run! The ‘art and science’ lies in blending tools that can work together and fit your methodology.
For example, if you are investing in stocks long term primarily for growth as a Value Investor you will normally want to at least two things checked in your investing plan:
- FA: the current price of the stock is less than your calculated Intrinsic Value, and the global fundamentals suit a strong uptrend to continue for your time horizon.
- TA: your stock (and relevant indices, at least) are in early uptrends on longer term W1 charts, and you have ‘validated’ this with good probability, and a set of non-correlated tools.
If you cannot at least check these items off, then there is something inherently of concern in your plan or underlying methodology. If you are just relying on one tool, such as a couple of MAs or a MMAs signal and nothing else, then you are still trying to find the Holy Grail.
Lee Spano, Founder & CEO
Creatness International, www.creatness.com
© Copyright Lee Spano. All rights reserved.