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Why Market Type is So Critical
The Market Tends to Repeat Itself by D. R. Barton, Jr.
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Why Market Type is So Critical
Most of you probably know people who thought they had a trading strategy buying technology stocks in the late 1990s. By the time 1999 came around, they considered themselves market geniuses. In 2000, however, they probably continued the strategy even as they watched the market type change. The following chart shows the market type for the QQQ (which is where most people where investing during that time period).
Notice that the market type fell from Strong Bull in late March into Neutral by mid-April. Then, the market stayed either Neutral or Bear for many months and it finished the year in Strong Bear territory.
The market gave another strong sign that the type changed in 2000 — volatility. The next chart shows the volatility of the QQQ during 2000:
Notice that the market was literally nearly off the chart in terms of volatility in the early months of 2000. That’s not a sign of safety, that’s a sign of danger. The market volatility decreased as it became more bearish but it stayed in the very volatile category all year long. This is a great period for day traders who thrive on volatility but it’s not a time for a buy and hold strategy in tech growth stocks. Most of you probably remember than many tech shares dropped 90% or more.
And how long did the Bear phase last? Well, the market type was bearish for most of 2001, with just a short time in neutral territory as shown by the next chart.
In 2002, there was a brief period where it looked like the market type might change, but volatility remained high throughout the year and kept the market in Bear, Strong Bear, or Neutral for nearly the entire twelve months.
As you can see in the next chart, the market type didn’t turn around until 2003 when the market was either neutral or bullish and the last 2/3rd of the year was bullish.
So What’s My Point?
Systems that worked well in bull markets would have been dangerous to trade by the end of 1999 because of the extreme volatility — which usually signals an upcoming bear. And throughout most of the period from 2000 through 2002, bullish trading systems would not have worked at all. Generally, you could have determined that by the market type.
Market type was even clearer at the end of 2007. Our Market SQN® score for the 100 day period changed to a bear market in late 2007 and it remained in bear or strong bear mode for nearly a year and a half. And, as is common in extreme bear markets, volatility was off the charts. After the market bottomed in March, 2009 the Market SQN moved out of bear and into neutral in April 2009 so you had a chance to catch a really nice bull market. You can see this in our Monthly Update on the market by looking at back issues from late 2007 through early 2009.
Rather than acknowledge the importance of market types, I tend to see people look at systems first and try to find one that works. And what they typically mean by ‘work’ is that it works in all markets. To me this is foolhardy. If you understand market type, then you can understand that it is quite easy to develop a fairly good system that will work in any one market type. But the insanity is in expecting a system to work in all market types.
My initial attempt to measure market type was based upon simple logic. Markets go up, down, and sideways. They are either quiet or volatile. That makes for six market types. And my initial definition of market type was to simply look at a six month chart. If it was going up it was bullish. If it was going down, it was bearish. And if I couldn’t really tell, then it was sideways. If the movement was very choppy, then it was volatile and if the movement was fairly smooth then it was quiet.
The next chart shows the S&P 500 ETF SPY from June, 2013 through January, 2014 right before the recent dip. I generally use a six month window to determine market type for US stocks. Based upon my old way of determining market type by looking at the last six months, what is it?
Well, it’s pretty obvious that the market was going up, so it has been a bull market. And at least in the last three months on the chart, there wasn’t a lot of chop so I’d call it a bull quiet market. It’s that easy.
The drawback to my original method was that we couldn’t really objectively classify it and know when it changed. As a result, I decided to look at the daily percent change in the SPY over the last 100 days and then look that the Market SQN score of that data. I made it a little more complicated by having five directions: strong bull, bull, neutral, bear, and strong bear.
In addition, I looked at the ATR % change of the last 20 days and compared it with the historical mean and standard deviation of the last 60 years. I developed four classifications of volatility: very volatile, volatile, normal, and quiet. And most of you know that I give you the market type on the first Wednesday of each month based upon that classification.
You probably don’t need more than the six original market types — but what you do need to know is the conditions in which your strategy works. And when conditions change, you either stop trading or you move to a different strategy that works well in the new conditions. It’s not rocket science, but it is so different from the way most people trade.
Trading is a statistical game. And under different market types you are going to get different conditions. Pollsters know that not all people are alike so they only ask questions of the type of people they are interested in learning about. Traders should know that not all markets are alike and they should only trade systems under the conditions in which those systems are likely to work.
About the Author: Trading coach and author Van K. Tharp, Ph.D. is widely recognized for his best-selling books and outstanding Peak Performance Home Study Program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.vantharp.com. His newest book, Trading Beyond The Matrix, is available now at matrix.vantharp.com.
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The Market Tends to Repeat Itself — Should We Care?
“History does not repeat itself, but it does rhyme.”
—Generally attributed to Mark Twain, though unconfirmed
An interesting chart is still making its way around the markets and financial press. Commonly known as an analog chart, its function is to compare today’s market action to a past period in hopes that history can provide some guidance as to what we might expect going forward from today.
Are such charts useful? Let’s look at the current chart du jour and then we’ll dig a little deeper:
Market Year Analogs — Like Almost All Market Tools- Useful in the Right Context
Let me jump to my conclusion first, and then we’ll dig into some supporting evidence. I have been watching market analogs for decades and have tried really hard to dismiss them. But I can’t. Mostly, however, I have seen them broadly misused as a technical tool (but then again, so are stochastics, VIX lows, etc.).
Because they are not created or used properly most of the time, analogs can be very misleading. There was a time back in 2003 when a very good analyst went down an analog rabbit hole that had him looking for another scorching drop. While he was looking for that drop to happen, he missed the start of a 5 year bull market.
The current popular analog above comparing today’s market to 1929 is an example of a grossly misleading analog, though it does have some merit, as we shall see.
It’s All About the Scale
The biggest problem with market analogs is that you can use any price scale and any starting point to make two curves seem fit each other. Put a couple of clever people in a room for a day, and they can come up with dozens.
What’s the biggest problem with the current analog? The creator used two independent Y axis scales which misleadingly makes it look like we could be facing a 1929-style crash.
If we look at the same data and put all of it on a consistent scale (indexing both time frames to a starting point of 100), we see a very different picture:
The 1929 time period was MUCH more volatile. On an equal basis this analog is much less compelling.
This doesn’t mean, however, that we have to throw the market analog tool out the window. It means we should use it responsibly and with proper context – just as we should use all technical tools.
Is There a Good Use of Market Analogs?
One of the reasons that I can’t throw out market analogs all together is that some really excellent traders have used them and continue to use them.
- In fact the current 1929/2014 chart has been credited back to Tom DeMark, who certainly has plenty of high-powered funds following his work.
- Paul Tudor Jones has widely credited market analog studies as a source of inspiration for his famous 1987 crash call (though he certainly also used other tools).
- A friend of mine and an extraordinary trader, Peter Brandt made a great call at the beginning of 2012 using recent market analog to call the bull market run in the first four months of the year.
If you think about technical analysis in general, it is based on the premise that market patterns repeat themselves. Those patterns arise because buyers and sellers are subject to human emotions and the psychological biases of auction markets. It is easy to verify that some patterns happen again and again. Are market analog charts really so different?
Next week, we’ll look at several market analogs. These ones aren’t in the news, aren't on twitter and aren't in the blogosphere but they will shine some light on where we are in the current bull run.
As always, your thoughts and comments are always welcome - please send them to drbarton “at” vantharp.com
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