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Monday, June 6, 2011

This Week in fortune telling charts

What is the point of looking at stock charts?

There are some charting religions out there including Elliot Wave Theory, Cycle Theory, and I am sure a dozen more. I have come to realize I don't believe in Elliot for fortune telling, and Cycle works, mostly, and nothing works all the time.

What I try to look for is a large running trend, and form a trend line to use as a "signal" that the trend is probably changing. This of course, does not always work, but you need an indicator to keep you focused on what side of the market seems best.

So today I investigated the S & P 500 (SPX) market trend from 1994-2003, 2001-2009, 2009 to t0day. I went back and drew trend lines to see how accurate this fortune telling method is.

In addition, I created two types of charts for each period in time, one is linear, meaning normal charts you always see. Each value is equally positioned to the next value, like graph paper.

The problem with this type of charting is it doesn't indicate PERCENTAGE relativity to each value. For example, 500 to 600 is a 20% gain, but 2000 to 2100 is 5% gain. The lower the value, the more each change is a greater percent of overall value change.

To graph this, you use Logarithmic graphing, where the distance between values on the low end are farther apart, but as the values go up, the distance between lines is closer.
This shows the MAGNITUDE of change relative to value, a much better indicator of percentage change.

The goal of this exercise was two fold for myself.
1) Does large scale trend charting indicate anything worth while?
2) What methodology historically has been best indicator when a trend has changed?

In the charts below, the green line is the overall long term trend line.
The blue line is a secondary trend line that can be drawn in a shorter timeframe, typically as a bubble accelerates before bursting.

Short summary for each group, then at bottom a summary.

1994-2003 - Log then linear
Logarithmic clearly gave better warning than linear for long trend, basically a tie for shorter trend line (blue line).

2001-2009 , log then linear
The logarithmic clearly gave better warnings in the long term trend (green line) and about same as linear for shorter term trend (blue line).

2008 - 6-5-2011 - log then linear
The jury is out of course where the market heads from here. I couldn't find a decent "short trend line", which is disturbing, maybe a bubble acceleration is yet to come?

In the long term trend line perspective, the last 20 years, with the last two major market bubble bursting, the logarithmic chart was a much better warning to sell out of the markets ASAP then linear. Unfortunately, two data points does not prove much. And I don't have the time and energy to go back to the last 8 market declines to get a better trend pattern.

But one thing IS for certain, this past week, using logarithmic charting, we have a warning shot, the trend may be changing. And when a trend changes, it tends to lead to significant declines by recent market standards (1994-today).

One other indicator is the long term trend signal that has been extremely accurate for long term investing for the last 50 years. You can read more about this method here. Although this indicator hasn't tripped yet, it does seem to be starting to curl into that direction. (click here for latest chart)

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