Make sure your investment techniques serve the investor you really are, and NOT the investor who is newly inspired to take more risk because the markets seem so strong.
In pre-computer times, stock market technicians used to plot their charts by hand, believing that their zigzags had predictive value. When I first entered the investment business in 1975, I was intrigued by a ‘point-and-figure man’ who carried a huge bundle of hand-drawn charts under his arm. He presented his hand drawn charts to us rookies along with his colour commentary. The intriguing part was that his painstaking system actually worked!
This experience inspired me to read a book published in 1948: Technical Analysis of Stock Trends by Robert D. Edwards and John Magee, the so-called bible of technical analysis. The authors explained a variety of stock chart patterns that occurred at tops, bottoms and during a stock’s price trend. One pattern was described as the most dangerous of all topping patterns: the broadening formation, also called ‘the five-point reversal’. What happens is this:
Point 1: the stock stops going up and abruptly reverses;
Point 2: after a short sharp decline, the stock reverses again and goes up to a new high;
Point 3: after rising to a new high, the stock reverses again, and declines to a new low;
Point 4: after this second sharp decline, the stock reverses again and rises to yet another new high;
Point 5: this is the ultimate high. Following this, the stock enters a prolonged zigzagged down trend.
Wild price swings are logical
The psychology behind these price swings is perfectly logical. The first up-to-down reversal occurred because excess speculation set the stage for a sharp correction. The subsequent upswing showed the excessive speculation returning. The next, even deeper decline reflected and ‘corrected’ that excessive speculation. Then followed another onset of speculation to yet another new high. By now, speculators had become over confident, believing that whenever the stock went down, it would always go back up. Those sharp ‘corrections’ became reasons to buy more.
By July 1, 2019, several major stock market indices completed this pattern. Let’s review the financial markets, keeping an eye out for the ominous five-point reversal pattern.
US stock market: S&P500 has completed a five-point reversal.
Point 1: Jan 26, 2018, followed by a 251 point decline;
Point 2: Feb 12, 2018, followed by a 319 point rally;
Point 3: Sept 21, 2018, followed by a 543 point drop;
Point 4: Dec 27, 2018, followed by a 580 point rally, which may not be over yet;
Point 5: Jul 1 2019, so far.
A new high or low?
Technically the pattern is complete, but it is still possible for a higher level should the current market rally continue.
The NASDAQ Composite index has also completed this same pattern, starting Jan. 26, 2018, and ending July 1, 2019. There is also a chance that a new short-term high could be made in this index.
The famous Dow Jones Industrial Average has not completed this pattern: it needs to rise about 50 points more. However, the DJII does show this same pattern on a smaller scale.
Point 1: Feb 26, 2019, followed by a 947 point drop;
Point 2: Mar 12, 2019, followed by a 1473 point rise;
Point 3: Apr 24, 2019, followed by a 1718 point drop;
Point 4: June 3, 2019, followed by a 1944 point rise;
Point 5: June 21, 2019, followed by a tiny decline and tiny rally so far.
These patterns show us the first part of Edwards’ and Magee’s broadening formation observation: a series of bigger and bigger speculative swings. The second requirement to complete their “most dangerous topping formation” is a large downward zigzag during the next six to twelve months. If that occurs, the best time to have sold your US mutual funds would have been July 1, 2019.
Canadian Stock Market
The TSX Composite has also traced out the same topping pattern.
Point 1: Jan 4, 2018, followed by a 1635 point drop;
Point 2: Feb 9, 2018, followed by an 1801 point rally;
Point 3: July 13, 2018, followed by a 2810 point drop;
Point 4: Dec 24, 2018, followed by a 2896 point rally;
Point 5: April 23, 2019, followed by a small decline so far.
The zigs and zags of the five-point reversal pattern reflect the ever-changing attitudes of major-league investment managers toward stock market risk. Edwards and Magee studied the same thing decades ago; but in those days, the markets were not so dominated by institutional investors. Those increasing swings in the stock market represent swings between greed and fear; increasing swings in emotion.
US long term bonds and interest rates. Bond prices rose sharply between April 22, 2019 and now. Long-term interest rates have dropped dramatically. Because of this sharp rise in bond prices, we are changing our view of the trend of long-term interest rates from UP to NEUTRAL.
Canadian long-term bonds have also risen in price from November 2018 until now, and are currently at the same level as November 2014, November 2015 and December 2016. The long-term trend of Canadian bonds and interest rates has changed from UP to NEUTRAL.
The US Dollar vs the basket of non-US currencies has been drifting sideways since 2015. The trend is NEUTRAL.
The Canadian Dollar vs US is in a NEUTRAL sideways pattern.
The price of gold (in US Dollars) rose sharply in June, recording its highest level since May 2013. This long-term breakout signals the resumption of the up trend that began in December 2015. The long-term trend is now UP.
Oil prices have been in a volatile up trend since February 2015. The long term trend is UP.
June 2019 has been a pivotal month. Both Canadian and US long-term interest rates went from an UP trend to NEUTRAL. Gold went from NEUTRAL to UP. And both Canadian and US stock markets have shown us early warning five point reversal patterns. These trend changes are the seismic activity that precedes a financial earthquake.
Could the stock market drop by half?
Please re-examine your financial plan from the viewpoint of risk control. In 2000 to 2002-3, the stock market dropped in half. It happened again in 2007 to 2009. It could happen again, now. Big declines are opportunities to dramatically increase your long-term returns by avoiding loss. It’s not about making money—it’s about not losing. In a few months, we will know whether or not the July 1, 2019 high in the S&P500 was the ultimate US stock market high.
Looking back at the year 2000, we wonder how investors missed the warning signs that the high-tech bubble was about to burst. We wonder why the investors of 2007 didn’t heed warnings about bad mortgage paper and the US real estate bubble. In ten or twenty years, will market analysts wonder why today’s investors didn’t see the trade wars, the Canadian real estate bubble, the spread of nuclear arms or modern mass migrations of refugees as signs of instability.
The reason today’s investors don’t see what future observers will see is that they are not looking for problems. With the S&P500 hitting a new all time high on July 1, today’s investors are looking for opportunity.
Only after the market falls will they look for reasons why it fell.
What kind of investor are you?
This is the cycle contrarians try to break. We look for reasons why the market could fall before it falls. When it starts to fall, we sell our stocks. We look for investment opportunities after the stock market has fallen. And when it starts to rise, we buy.
Investment opportunities are found in up trends. Right now, oil and gold are in up trends. Does this mean we should buy energy stocks or gold mining stocks? No. If you buy Barrack Gold stock, the up trend in gold will help the stock, but the down trend in stocks in general will hurt it. The same is true for energy stocks. It’s a ‘push-pull’ situation. Skillful traders know how to play this game. Long-term investors do not.
Are you a trader or a long-term investor? Please revisit what kind of investor you are. Then, make sure your investment techniques serve the investor you really are, and NOT the investor who is newly inspired to take more risk because the markets seem so strong. At times like this, risk averse investors sometimes forget they are risk averse. Investors manage risk by owning investments that are in up trends and not owning investments in down trends. As financial trends change, our investments should be changed too.
Ken Norquay, CMT, is the author of the book Beyond the Bull: Taking Stock Market Wisdom to the Next Level, which discusses the impact of your personality on your long-term investments: behavioural finance. He can be reached at firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the July 2019/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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