Can Technical Analysis Help? 2 Models Grounded In Fundamentals Which Might Help Right Now

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Includes: JNJ, PH, XOM
by: Jim Sloan

Summary

This is a fundamentalist's view of technical analysis. I sometimes call it "market mysticism," but even the Leading Economic Indicators use market action as a forecasting tool.

The market knows things; technical models function on the assumption that "smart money" grasps events early and leaves footprints in several areas of market action.

The granddaddy of technical models is Dow Theory, a trend-following approach with simple rules and a fundamental value-oriented base.

Analysis of sector rotation uses changes of leadership to identify stages in economic and market cycles.

Leadership by the energy sector normally comes near the end of bull cycles; when consumer staples become its co-leader, the market and economy are likely near a downturn.

Market mysticism is the language I have always applied to the underlying methodology of most technical analysis. By using that term I don't mean to disparage technical analysis. I subscribe to two market newsletters, and one of them is technically oriented. I never do anything specifically because of it, but it is often helpful in reinforcing or raising questions about my own thinking. It also helps with timing long-term entry points and my occasional sells.

What I mean by market mysticism is that most technical systems are based on the concept that the market itself knows things about the future. Coming from the kind of person who would not spend a nanosecond listening to a fortuneteller with a crystal ball, tarot cards, or horoscope, it may seem strange that I subscribe to the idea that market action sometimes provides insight into the future. Let me just remind you that market action is one of the factors included in the Conference Board's Leading Economic Indicators. The notion that stock prices look into the future is very mainstream.

How the market knows things about the future is another question. Many technical approaches presume that smart money of one sort or another flows into the market in a predictable way which is reflected in market chart patterns. Reading the chart patterns correctly may suggest an action before the market or economy fully reflects what the smart money knows. Dumb and speculative money may also leave tracks as it expends the last dollar before the market rolls over.

Does it work? I am open minded. It certainly works a fair amount of the time.

Thirty five years ago, in the pre-CNBC days, I used to watch local market shows for the only available ticker tape. On the day the space shuttle blew up, January 28, 1986, the market had an instantaneous mini crash. Viewed on good old Channel 38 the market seemed to drop several minutes before the actual explosion. It looked like pure market clairvoyance. What had actually happened, I'm fairly sure, was that the reaction on the ticker tape was delivered before the bulletin which got me to switch to a news channel.

The speed of the market reaction was impressive just the same, wrong-headed though it eventually proved to be. The shuttle accident was tragic in every possible way, but it ultimately meant nothing to the value of stocks. The one fairly odd thing was the speed of the gap down in Morton Thiokol - the Thiokol part of which is now a subsidiary of Alliant Techsystems (ATK).

Thiokol made the O-rings that caused the crash. This would not be confirmed until physicist Richard Feynman, the scientist on the investigating committee, dropped one of them into a glass of ice water at the shuttle hearings. He famously embarrassed NASA deniers. Taking the O-ring out of ice water he demonstrated how brittle they would have become under the weather conditions at the time of the launch.

The market had known this instantly. The instantaneous market reaction demonstrated, if nothing else, how quickly people with privileged insight can cause a reaction on the tape.

The market's crystal ball has a decent track record on certain kinds of things, but complicated systems based on it are often murky. There are, however, two technical approaches which draw upon economic fundamentals and follow a simple script. Both are based upon plausible assumptions. Both have a good track record and are often used by investors like myself whose approach is basically long term and fundamental.

Quite a few well-known and successful value investors admit to taking a quick glance at the charts before taking an action. You don't have to be a pro to do that. Both of the models I discuss below are simple enough that an investor of moderate sophistication can apply them without having to subscribe to a newsletter. There's not a lot of mumbo jumbo.

Your Great-Grandfather's Model - The Dow Theory

The Dow Theory is the great-grandfather of all technical analysis. It was proposed by Charles Dow in the final years of the 19th century. Dow was a cofounder of Dow Jones & Company, which publishes both The Wall Street Journal and Barron's. The Dow Jones averages were also his invention. He came up with what is now called the Dow Theory as a systematic way of identifying trends and turns in the market.

Dow Theory is the simplest model for trend following. When I was an undergraduate and taking a course in computer science (then time-sharing with one huge computer), I tried to model the Dow Theory as my final exercise. It basically tracked higher lows followed by higher highs (and the inverse) to give buy, sell, or hold instructions. It wasn't as easy as it looked, at least not in machine language. All I remember about the outcome was being called in and chewed out for using about a third of the time allocation for the entire class.

My personal computer ineptitude aside, Dow Theory is a simple trend-following model which never gets you in at the bottom or out at the top, but usually does well enough. If you have money to put into the market or a need to rebalance or take money out, plus a time window to operate in, you can sometimes make good use of it. To do well, it's never necessary to get out at the absolute top or in at the absolute bottom. The market almost always rallies back up after the first big fall or falls back for a retest of a market low. The Dow Theory principle in which trends are built around higher lows and higher highs (or the inverse) can help you keep your cool and stick to the right side of the trend.

The aspect of Dow Theory most often mentioned today is the old Charles Dow principle that a new high in the industrial average (for which the S&P 500 is often used today) should be confirmed by a new high in the transportation average. The reasoning is that a true rise in production and consumption must be accompanied by an increased volume in goods shipped. It was hard to argue the logic for about 100 years, and despite the shift to a service and internet economy many Dow Theorists still take this rule very seriously.

What is not widely recognized today is that the earliest version of the Dow Theory was grounded in valuation. Valuation at that time meant dividend yield. A historically high dividend put you on notice to look for a buying opportunity while a historically low dividend yield suggested looking for a negative change of trend. This approach worked well until about thirty years ago when dividend yield seemingly uncoupled from market behavior. We'll see in the future if that uncoupling was permanent.

The valuation element of the Dow Theory was based on the notion that, toward the bottom, stocks were bought by the best informed and most experienced investors who were confident that a change for the better was on the way. This was the "accumulation" phase of calm but persistent buying which halted a decline. When the market started to rise, less sophisticated investors noticed and began to join in, often with a rush of panic buying which produced high volume.

This method of identifying exact market bottoms is refined in the approach of William O'Neil, founder of Investors' Business Daily. In O'Neil's model every bull market begins with a turnaround day followed by a "follow-through" day 4 to 7 trading days later. The index must be up at least 1.5% on above-average volume. This system back studies very well for major market bottoms, and I have found it to provide useful information over my investing career. I have to acknowledge at the same time that I have never been able to accomplish much with other elements of the O'Neil system which is more oriented toward speculative growth investors and traders.

The Dow Theory also posits that bull market moves take place in three waves - accumulation, public participation, and distribution - punctuated by lesser corrective reactions. Bear markets are the inverse. There are always areas of dispute as to what constitutes a major wave. The Dow Theory principles involving confirmation and lower/higher lows and highs keep it relatively simple.

Elliott Wave Theory has seemed to me a more complicated version of Dow Theory. It attempts to accomplish more by defining major cycles and super-cycles as well as minute-by-minute moves, but these have never struck me as very useful. There are so many exceptions, uncertainties, and specialized rules that even if I were inclined to be a trader I wouldn't quite know what to do with it. The simplicity of the original Dow Theory seems best for my purposes.

While I don't trade, I find it helpful to have a tentative model on what the market is up to. One habit which originated with Dow Theory, although I don't always apply it strictly, is to sell on a failing rally after the first decline. Strict application of Dow Theory says to wait for the break to a lower low, but when I have formed a general intention to sell I don't do that. Here's an example.

In early 2014 I had pretty much made up my mind to sell my three energy stocks with the intention to never re-buy them. The oil price seemed to me unsustainably high, above 100 at the time. The cure for high prices is high prices, as they say. Oil companies were capital intensive and becoming more so, as oil was increasingly expensive to find. They were also becoming less profitable, in part because of competition with national oil companies. I had also started to give some credibility to the risks of their being undercut by alternatives, which were getting cheaper and suggesting the possibility that assets requiring high-cost extraction might indeed be stranded.

When the market broke there was a serious look to it. I waited, took in the power of the break, let the market attempt a punk-looking rally, and sold near the top of it. One of my three energy stocks, Exxon (XOM) had traded over $103, dropped to $90, and rallied back to the mid-$90s where I sold. A strict Dow Theorist would have waited for it to break $90 on the downside. That would also have worked fine. As of last Friday, more than three years later, Exxon sold at $78 and change.

I have never had a moment of regret. I was happy to pay my long-term capital gains taxes and say goodbye to the energy sector, probably forever. Dow Theory thinking helped. At the present moment, the market has stalled without a new high for an unusually long time after a modest 10% correction. A stall like that puts a Dow Theory practitioner on alert for the next breakout or breakdown.

The Relative Strength Of Market Sectors

Probably nothing in the technical world seems closer to fundamental analysis than studying the rotation of market sectors. It's an area of market behavior that is revealing in a highly detailed way. Its somewhat unlikely author is Sam Stovall, the most fundamental of analysts at the most fundamental of sites, Standard & Poor's, who produced a famous diagram for the 1995 Standard & Poor's Guide To Sector Investing.

Stovall's simple outline of sector leadership over an economic cycle asserts five economic/market phases with sector leaders, in time sequence, for each phase:

  1. Early Expansion: Transportation and Technology
  2. Middle Expansion: Service and Capital Goods
  3. Late Expansion: Basic Materials and Energy
  4. Early Contraction: Consumer Staples and Utilities
  5. Late Contraction: Financials and Consumer Cyclicals

Because it did not seem important at the time, Stovall did not include REITs and telecoms as sectors. They should probably be in the same phase as Consumer Staples and Utilities.

Two points need to be clarified. The market itself leads the economy. So does sector rotation. Cyclical bull markets generally begin when the economy is in the late stage of contraction. Financials and Consumer Cyclicals are generally leaders in the earliest stage of a bull market.

Bull markets are generally in the process of rolling over when the economy is near its peak. Energy and Consumer Staples are often the strongest sectors when bull markets are rolling over. When Energy is strong but beginning to fail and the relative strength of Consumer Staples has perked up and started to rise, the market is usually in trouble. (I owe a shout out for this observation to John Murphy, a master technical analyst, who mentioned it in his book Intermarket Analysis)

The market does not follow the script in detail through every cycle. An expanding economy is often accompanied by slowly rising interest rates, which stocks can resist for a time. A contracting economy is accompanied by falling rates, which are supportive of Consumer Staples and Utilities, then Financials and Consumer Cyclicals, and ultimately of an economic expansion.

The present cycle has been exceptionally long because of suppressed interest rates and also has included a major shift away from the production of tangible goods to services and intangible products. New model technology stocks have been persistently strong throughout the cycle. Because of persistent low rates and the length of the cycle, we have experienced sector rotation of a very gentle sort as the economy slowed (as in 2011 and 2015) and then speeded up again. Now, however, I think we may be getting some more traditional end-of-cycle heating up.

A few notes on observing sectors:

  1. Leadership from Consumer Staples and Utilities isn't healthy for the market. In fact, they may lead despite declining, just declining less than the market. If bought correctly, however, they may be worth holding over full cycles. Currently their valuations are distorted by low interest rates, which is the reason they have underperformed as rates have risen. REITs and telecoms are similar.
  2. Cyclical growth stocks such as industrials are interesting because they provide growth that compares favorably with Consumer Staples. They often provide great opportunities to buy or add during economic downturns.
  3. The behavior of Basic Materials provides important information as to the condition of the market and the economy. For a long term investor, however, they are basically uninvestable because they depend upon cyclical commodity prices; there is no underlying trend in commodities reflecting actual growth.
  4. Energy is also very informative about the market and economy, being the last sector to move in a general advance. There was a time when oil companies combined defensive characteristics with growth. People used their products in good times and bad and they paid good dividends while growing slowly long term. As stated above, I have some fears that their long-term story is unraveling.
  5. Both Basic Materials and Energy look deceptively cheap at the top of the cycle. The swing in price of their inventories - oil reserves, copper reserves, etc. - inflates their earnings. In fact, copper miners always look expensive at the bottom (with no earnings) and dirt cheap at the top with low quality earnings leveraged to the commodity price.
  6. We are about to see this swing in energy earnings produce a meaningful distortion in market PE. Much of the 2018 increase in earnings for the market as a whole, aside from the bump from the lower corporate tax rate, is the result of a large jump in earnings from the energy sector. Don't trust it. This increase is a result of oil price leverage and an increase in inventory valuation. Both are highly dependent on the underlying commodity, thus temporarily inflated and not reliable. Earnings growth that comes from the energy sector can mask the true state of overall corporate earnings.
  7. A good way to track sectors is to chart opposites as a ratio - Consumer Cyclicals against Consumer Staples, for example, or Financials against Utilities.

My personal stock selection does not draw greatly upon sectors aside from avoiding commodity-driven companies. Because I am a long-term investor and hope to hold stocks in my portfolio through full economic cycles, I rarely buy a stock because it is part of a particular sector. I do, however, use knowledge of sector rotation in the attempt to exploit moments when cyclical growth companies become cheap because of a weak economy.

Helped by awareness of sector rotation, I have added to an industrial favorite, Parker-Hannifin (PH), when a whiff of economic weakness made it cheap, and to my only consumer staple, Johnson & Johnson (JNJ) when the opposite condition of a rate scare (2014) made it cheap. Years ago I wrote this piece about the similar long term performance of the two stocks despite their largely uncorrelated ups and downs.

The most important thing about sector leadership, to me, is the information it provides about future performance of the market as a whole. I suggest keeping an eye on Energy and Consumer Staples right now. For the first quarter of 2018, it was all energy, as the price of the underlying commodity rose in typical end-of-cycle fashion. The entire strength of the market came from Energy. When Energy starts to fade, become alert. When Consumer Staples begin to outperform in a serious way, look out below.

Conclusion

Technical analysis is a part of the toolbox even for the fundamental investor. Its underlying assumption is that the market and its segments have a way of looking into the future through identifiable market actions of sophisticated and well informed investors. A major tenet of the Dow Theory is that all generally available public information is already reflected in market prices. Market action nevertheless drops hints for the careful observer.

And Just For Fun

Markets also seem privy to inside information about turning points in global conflict. War is a market specialty. The market is an expert military analyst. A case in point is what the market did at the time of the first Gulf War. Stocks declined and oil spiked to the moon for a couple of weeks before Saddam Hussein invaded Kuwait. During the American buildup, the market continued to decline. When the first bomb fell, the market took off like a rocket and the oil price collapsed.

We were going to win, win big, win quickly, and win at minimal cost. Having some military experience I had said pretty much the same thing at a dinner party of very worried, very rich, and generally well-informed people the weekend before the first air strikes. A large part of the civilian populace is very poorly informed about military matters. The other dinner guests continued to have their doubts. The market knew.

There is a legend - possibly true - that the Rothschild family used a carrier pigeon to get information ahead of the official reports about the outcome of the Battle of Waterloo (1815). They may have used messengers on horseback, a sort of pony express, but they clearly had news ahead of the market. For everybody else, the best approach was to learn what the Rothschild brokers were doing. Barring that, one might have looked for their footprints in the market.

There are a couple of interesting instances from World War II. The American market made a generational low in late April of 1942. That was less than five months after Pearl Harbor but more than a month before the Battle of Midway. American forces had yet to win a battle. Midway was a disaster for Japan. It turned the tide completely. After Midway, the outcome was never in doubt.

The outcome of the battle itself, however, was very much in doubt. You could have run 100 simulations at a war college and Japan's four carriers and high quality and experienced pilots would have won 95 of them. The Midway result depended upon pieces of luck and individual actions that would have been impossible to anticipate or predict. Coincidence? Maybe. A feeling that Japan had reached the limits of conquest? Possibly. The slow realization that Japan never had a chance against American industrial power. Also possible. The market knew.

The German stock market, meanwhile, reached its all-time high in early December of 1941 as German patrols caught sight of the spires of Moscow. Helped by rearmament, the German economy and its financial markets had been the strongest of any industrial power since the mid-1930s. Germany would win battles from time to time through 1942, but its general advance had halted. A few days later Japan attacked Pearl Harbor, America entered the war, and the fate of Germany was sealed. The German stock market would soon be placed under government supervision with no price discovery allowed. The market already knew the outcome.

That's the case for market clairvoyance, the force behind technical analysis.

Disclosure: I am/we are long JNJ, PH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.