The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

08 November 2009

Of trends and traditions

Support and Resistance
Think of share price fluctuations as a skirmish between buyers (bulls) and sellers (bears). The price at which bears and bulls reach a consensus and a trade takes place is the clearing price. There is a level at which bulls think the price will move up and which bears are not willing to sell. From that point, below which bears won’t sell and bulls are willing to buy, the purchases are the kinetic energy that generates higher prices, and trend. And, of course, vice-versa.

Thus, support levels indicate the price where the majority of investors believe that prices will move higher, and resistance levels indicate the price at which a majority of investors feel prices will move lower. Resistance is the opposite of support. It’s the point at which sellers take control of prices and prevent them from rising higher.

But, over time, investor expectations change, often abruptly. When a share price rises above the correctly identified resistance level, they tend to do so decisively, resolutely, and with alacrity. A significant increase in volume accompanies the breakout (above resistance), and convinced that the share price would remain above its breakout, more investors are willing to buy at higher levels, thereby creating the new trend; i.e., both price and volume rise. Similarly, sellers who previously sold when prices approached resistance also begin to expect prices to move higher and are no longer willing to sell, and instead began to purchase shares. More buyers, fewer sellers, and fewer shares for sale sum as a powerful new trend!

Supply and demand
There is nothing baffling about support and resistance; it is supply and demand. Supply manifests the quantity — i.e., the number of shares — sellers are willing to supply at a given price. When prices increase, the quantity of sellers also increases, as more investors are willing to sell at these higher prices. Demand shows the number of shares that buyers are willing to buy at a given price. When prices increase, the quantity of buyers decreases, as fewer investors are willing to buy at higher prices. And, theoretically, as prices decline, the quantity of buyers should increase… but fails to; likely because human nature takes hold, and subverts the symmetry of this notion.

As investor expectations change, so do the prices buyers and sellers believe are acceptable to satisfy their objectives. A breakout above a resistance level is evidence of an upward shift in demand as more buyers become willing to buy, and at higher and rising prices. Perhaps the best method to track changing expectations following a breakout is with volume. If prices break through the support/resistance level with a large increase in volume relative to its recent average volume for the examined periodicity, it implies that the new expectations will reign. Low to moderate volume — again, relative to that  periodicity’s average volume — on the breakout implies that very few investor expectations have changed, and a return to the original expectations — and original, if not lower, prices — is likely.

Resistance becomes support
When a resistance level is successfully breached, that level becomes support. Similarly, when a support level is successfully penetrated, that level becomes a resistance level.

Knowledge and portfolio management
To generate consistently successful investment results the investor must consider the following...

: the macrocosmic, or geopolitical, social,and economic perspective. This type of analysis is more than mere mind candy; the investor gives thought to those factors that are larger than his specific portfolio needs but have a direct bearing on his investment’s corporate results. In the present market environment, arguably the most critical geopolitical factor is the next major direction for the US$.

: the microcosmic, or market perspective. The investor who studies and understands market cycles and history has an advantage. Attention paid to greater epochs —periodicities measured in decades — can offer substantial reward. This means the belief that the market’s rising trend continues forever is folly. That  moment was the appropriate time for the shrewd investor to re-think his or her strategy, and to follow through with new, more correct portfolio tactics. And there is the truth of it: when I enjoined, "Prepare to have your assumptions shattered, or have the market shatter them for you…” I referred to the general predisposition for a bullish mindset, which continues today.

: the implementation of strategy, or day-to-day perspective. Portfolio management follows the investor’s market strategy. Either the investor patiently awaits the next major market trend, or he proactively determines a portfolio strategy and a market strategy. If the market perception is bullish, the investor will purchase each dip or breakout. If the market perception is for one that trends sideways, the investor would purchase dips and sell rallies.

A key requirement for successful portfolio management is the ability to make decisions, and finally to abide by those decisions without self-recriminations. Investing in all market conditions, but especially in fast markets, entails split second judgments based upon rapid recognition of the problem at hand and how best to deal with it -- without second guessing the decision. To adapt and embrace changing market conditions, to embrace change itself.

Critical thinkers and successful investors are honest with themselves, can resist manipulation, overcome confusion, ask questions, look for connections between subjects, make judgments based on evidence, and are intellectually independent.

Barriers to effective decision-making
Indecision: To avoid making decisions in the hope of sidestepping risk, fear, and anxiety;
Stall: Obsessive gathering of endless facts; refusal to face the issue;
Overreact: Let a situation spin out of control; allow emotions to assert control;
Vacillate: Reverse decisions; half-heartedly commit to a course of action;
Half measures: Muddle through.

Errors of omission vs. errors of commission
Unfortunately, it seems that most market participants either lack deep market understanding, do not deploy a sense of perspective (market history), ignore the market’s perdurable oscillations, do not explicate their investing strategies, or suffer a failure of imagination. Investing is not done in a vacuum — awareness of geopolitical, social, and economic factors is critical, as well as apprehending where the market is within its current cycle, the age of its current trend.

So is the awareness of the possible unreliability of his portfolio investments; bad or wrong decisions — corporate risk, market risk, event risk, etc — do occur, and must be corrected. After having discerned his objectives and goals, understood the market’s mechanisms, discovered those companies whose shares will help achieve specific investment goals, it is insufficient to hesitate and not act decisively and resolutely, instead praying that a (or any) market trend will remedy errors. Having made the initial investment decision (purchase or sale), the responsibility, the decision, is the investor’s to make. To make one decision ("I am an investor") is wholly insufficient to the task at hand. Decisions must be made always; i.e., whether or not to take profits, stop losses, buy this, sell that, even that a specific investment is proceeding nicely but a new one seems to offer greater potential profit. To shrug off the importance of these necessitous and omnipresent decisions is tantamount to poor money management — itself a term that denotes the process rather than the event.

If breaking up the one decision (to take action) to a sequence of smaller decisions is helpful, then do so. The decision process is now more emotionally digestible because it is more holistic, no longer monolithic. No longer fraught with having to make the one right decision but a series of smaller ones better enables the investor to forge ahead to his true goal — to make money, not be right.

Minor periodicities
Though there exist distinct minor trends within greater periodicities, no market leader will break out and trend to new all time highs without the market emerging from its high level consolidation. Of course, the market will not emerge from its base without the new market leaders commencing their new trends. Critical to this notion is the understanding that the new leaders must emerge as a group (drugs, grocers, telecom, et al), sector, or theme. Isolated instances of new highs during a lengthy high-level consolidation or bear market are common — as is the inverse — and are not a true signal. How do the other companies in that group or sector fare? The example of one company’s shares (in a sector of ten) emerging to new highs is insufficient to generate a true signal.

Because all true patterns are replicable in all periodicities, the investor should time purchases at optimal moments of low risk and high reward. Recognize, though, that the half-life of any trend is directly proportional to the studied periodicity. To accumulate shares with full recognition of the market’s trading range. It is not always necessary that markets decline in  devastating bear market fashion. It is probable that the current instance of a now 12-years lengthy high-level consolidation evident in the Dow 30 Industrial Average and S & P 500 will continue, at least until corporate earnings can catch up to current valuations to again create an undervalued and perhaps under-appreciated market. The prerequisite for success is not to know precisely where prices will be in the future — but to improve the odds. So the shrewd investor not only seeks market leaders, but simultaneously pays heed to the market’s message; if the market is discerned to be trading in a high level consolidation and at the top of the correctly identified range, not only is risk present, it is heightened.

Determinism vs. deterministic behavior
"Psychology is both the reason for the consistently superior performance of the methods the financial academics cannot explain, as well as the consistently poorer results of those approaches that fail.” -- David Dreman

Our world is neither static nor absolute. Everything is relative. Change is the only given, nothing remains the same, and all standards are relative. We are born, we mature, we grow old, and we die. Only the fact of change itself is unchanging, the sole reality. So it is with our investments. Buy low, sell high; buy cheap, sell dear. The investments we consider do not come into being the moment we first notice them. In some form they have always existed. Recognition of this continuum allows the investor to place appropriate emphasis on what is important and critical, not merely urgent.

Charting and technical analysis offer neither science nor black art of predictive ability, tiresome claims of the naysayer notwithstanding. These analyses are the science and art of observation. Of discipline, patience, and diligence. Samuel Johnson said, "What we hope ever to do with ease, we must learn first to do with diligence.” This moment — here, now — is equally good for the tactical and strategic investor to learn how the market works, to set into place that recognition as foundational portfolio behavior, and to profit from the increased percipience that recognition brings.

When a market or company shares breakout from a High Level Consolidation, that sudden volatility has the potential and possibility to transmute as a new trend — either up or down, but no longer sideways. And then age accordingly.

Markets are not living proof of determinism. However, trends do have a discernible life that age in a time-tested manner. The ability to discern trends — how they birth, live, age, and die — helps alert the investor to heightened risk or increased opportunity. As a result, it is not the ad absurdum claims of determinism in the markets but the investor’s deterministic behavior that ushers in portfolio success. Investing is about odds, chance, actualizing possibilities. None of this is possible without choices selected, decisions

Where now, blue DOW?
As bull markets crescendo, the investor must change his time frame and focus on the signals generated by the lesser periodicities. Conversely, at bear market or trading range lows the investor seeks guidance from the greater (longer term) periodicities. These tell-tales offer alerts far in advance of market pundits whose prognostications are too-often awry. Though market and share volatility can help with minor, short-term errors, do not allow these errors to magnify beyond proportion. Think before investing. Develop a contingency plan. “If (the market does) this, then (I do) that.”

For the past ~12 years, it is the high-level consolidation that best exemplifies the current placement of the Dow Industrial Average and S&P 500, assuming correctly identified trend lines. For however long this condition persists, this trading range manifests as opportunity for the patient investor. Low risk/high reward opportunities prevail at Major Trend Lines. Particularly tempting are those company shares found either near their own Major Trend Line, or now experience an important and actionable breakout. The investor who recognizes this pattern will be better placed to apprehend the shift in reality before it occurs; that is, the understanding that the major channel lines are inflection lines but the maximal and optimal inflection points occur on breakouts through these correctly identified lines. All else is noise, in any periodicity.

Don’t pursue opportunity; allow opportunity to come to you
To gaze at a chart of financial assets can be, for most, an experiential moment of consternation, even heterodoxy. “What do I see? What am I supposed to see…?” might best sum the tyro investor’s first glance at a stock chart. Too many investors erroneously identify volatility for a trend; they are not synonymous. When the understanding that specific patterns recur across the spectrum of investment assets but especially publicly traded shares, then the cardinality of the relationship between volatility and trend becomes clear: within any studied periodicity, all volatility is circumscribed by the extant trend but it is only volatility that can end that trend. Because most investors require certainty, they jump aboard the trend late. How many data points are required to delimit a trend? Hence, watching for increased volatility as a harbinger of a trend’s end is critical to improve the investor’s odds for success.

What is the value of correlating news to current prices when the data is already old, only now collated, and the market has already factored this news into current prices? The markets are a discounting mechanism — the investor buys today to sell tomorrow for a profit because the invested company is perceived to make more profits in the future than today. The investor that considers insufficient data or studies an insufficient periodicity exposes his portfolio to added risk. To chase after a rising share price (bid up) to purchase what is, in all likelihood, mere volatility can be hazardous. More helpful is to discern where the shares lie within its trend, and the age of that trend.  So the patient, disciplined investor allows the price of his considered investment to come to him, to gravitate lower to his eager, strong hands. Again, know thyself. What are your goals and needs?

PS: For specific investment opportunities, price and timing included, please visit Investment Poetry.
-- David M Gordon / The Deipnosophist

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