The Hard Right Edge And A Market Timing Strategy Gone Awry

There is such an allure to looking at stock charts. The price jumps up and down, and our tendency to try to make patterns out of chaos makes us believe that we can predict the future based on the past movements of stocks.

When analyzing a chart, it seems so easy to take a chart and look back at all the patterns that the chart formed over time, and say to yourself, “I knew that the stock was going to make a bottom there. I could have made money trading this chart.”

The much tougher part of trading is actually applying the chart analysis principles in the present. One of my favorite trading websites years ago was The Hard Right Edge. It used to be an incredible resource for technical analysis and swing trading strategies. These days, the website is much more stripped down, with many fewer resources. But the concept of the hard right edge of a chart illustrates the challenge and mental anguish that traders experience when trying to predict the future based on the past.

Stocks go up much more slowly than they go down

The long-term trend of the stock market is up. After all, the U.S. economy is growing and its component businesses keep producing larger and larger profits, which they can pass on to their shareholders.

However, the rise in the stock market is hardly smooth. It is much like a rollercoaster, with a slow ascent up, followed by brief, but rapid, falls. When the stock market is rising, it seems like it will go up day after day, making new all-time high after new all-time high.

But when the stock market falls, it falls fast. There are never any stock market crashes on the upside, and stock market falls are rarely orderly.

In the current bull market, many investors, including very successful fund managers, are trying their hand at market timing and predicting a market top. Let’s take a look at one approach to market timing.

Getting out when the music stops

One way you can try to time the market is to ride the wave up and get out before it crashes. It’s a game of musical chairs. Once the music stops, you need to grab your chair (trading profits) before everyone else.

The idea is that we are currently in a bull market, and the eventual decline will not all occur in a single day. Most declines take at least a few months. During the financial crisis, the time from the stock market high (October 2007) and its subsequent low (March 2009) was almost 18 months. Potentially, there was plenty of time after a drop has started to get out and save yourself some losses through this strategy of market timing.

Market timing during the 2009-present bull market

During the S&P 500’s 8-year bull market run from 2009-2017, there have been several market corrections. On each occasion, there have been reasons why the stock market has fallen. In each case, it would be reasonable for a scared investor to predict that this was the end of the bull market and they should pull out their money. Of course, each time, the market recovered, and the stock market is still making new highs.

April-June 2010 (16% drop)

Fresh off the recovery from the financial crisis in 2009, stocks went into panic in the spring of 2010 as Greece teetered on the verge of default, and there was a concern about a double-dip recession.

July-August 2011 (17% drop)

Concerns about the sovereign debt crisis in Europe and the downgrade of United States Treasuries from the top AAA rating caused the stock markets to drop 17% over the course of a month.

March-June 2012 (9% drop)

The sovereign debt crisis reared its ugly head again, causing stocks to drop 9% over the course of two months.

July-September 2015 (10% drop)

A slowing of the Chinese economy and the crash in oil prices sent the stock market tumbling 10% over a two-month period, including the stock market being down over 1000 points intraday on August 24, 2015.

December 2015 – January 2016 (10% drop)

Continuing worry about the slowing Chinese economy and falling oil prices led the stock market to have a second correction in less than a year.

November 8, 2016

In an election shocker, Donald Trump is elected President of the United States. The Dow Jones Industrial Average futures markets were down by as much as 900 points in the evening as the markets processed his victory.

Getting Whipsawed

Imagine selling your shares 5% into each of these mini-panics, thinking that you are getting out early and saving yourself much of the future losses that are to come.

Each time though, the crisis was averted, and the stock market recovered and marched upward.

In each of these scenarios, an escalation of the prevailing market concerns could have spiraled the stock market into a deeper crash. Instead, traders who tried to get out of the market early got whipsawed.

Let’s say you did sell in May 2010, or August 2015, or November 2016. The market moves against you, and you’re sitting on the sidelines as the S&P 500 makes all-time highs. Can you swallow your pride, admit that you were wrong about the market, and buy back at a higher price than you sold? Or will you be stubborn, waiting for the stock market to finally correct itself, so you can be vindicated and buy back your shares at a lower price?

It’s a painful feeling. I know, because it’s happened to me when I traded stocks. It happens to every person who tries to trade the market.

I had forgotten many of these mini-crises. I’m sure most of you forgot about these market shocks. There is no reason why the sovereign debt crisis in Europe couldn’t have been like the mortgage crisis that felled the global economy in 2008. There is no reason why the Chinese economy slowing couldn’t have had effects on the United States and European economies.

Conclusion

It is impossible to predict the future movements of the stock market with any reasonable certainty. It’s fun to hear the talking heads on CNBC make their bold predictions, but most people quickly forget these predictions soon after they are made. That is, unless the predictions come true. In that case, they’ll toot their horn and get publicity for their next prediction.

It’s easy to explain why stocks moved the way we did in the past. Hindsight is 20/20. But to look at the hard right edge of a graph and make money on your predictions? That is much, much harder.

What do you think? Have you ever tried to use charts to trade stocks? Did you get whipsawed when you tried to get out early with any of the pullbacks in the recent bull market?

[All charts courtesy of Stockcharts.com]