Were the Lessons Learned a Few Years Ago the Right Ones?

Musings of a Crackpot

by Martin Goldberg CMT. December 13, 2004

In doing these weekly Observations, my goal is to provide something thought provoking that may not be available somewhere within the mainstream financial media. As a technical analyst, this often takes the form of observing whether "the red line crossed the green line." But as I draft this on a Sunday holiday season afternoon, there will probably not be anything of that sort to report on this week. I would like to explore whether technical analysis (TA), a craft that is seemingly being successfully practiced by everyone, is a sure fire way of avoiding peril in the stock market. My thought is, maybe not, because following the bursting of the 2000 bubble, TA has become essentially a means of getting a lot of people and money to do and think the same thing at the same time. Everyone doing the same thing at the same time has been a characteristic of all markets before major crashes. Dismissing the authors of thoughts such as these as crackpots, especially during a major stock market rally, has also been a pre-crash characteristic (so please read on).

After making a lower low, the green line crossed the red line in mid-August and only checked in to tickle its 50-day moving average for about a minute before celebrating the presidential victory of George W. Bush over John Kerry with a sharp and decisive rally. Aggressive and short-term technical analysts seem to be high-fiving while searching for even more breakouts to 52-week highs. The total market internals are extremely positive. If you were to look at charts of a broad portfolio of sector stocks and international indices you will see chart after chart of bullish patterns and very few bearish ones except for perhaps energy, precious metals, and oil shipping companies. I look at point-and-figure charts because for trending markets, they tend to be easier to view objectively than time/price charts. Using point-and-figure, all you have to do is see if the most recent column that protrudes the most is a column of X's going up (bullish), or O's going down (bearish). If you were to perform this exercise today, you would find that practically every sector is in a bullish pattern (X's protrude), and the current column is a column of X's, indicating that the most recent stock action is bullish. Beyond the simple X/O patterns observed from point-and-figure, there are the volume tendencies. Again, throughout most markets there is a tremendous bullish tendency – up on higher volume, down on lower. If you are in the market with long positions, there is no reason to get out because you are playing with the "house money." If you are short this market, good luck!

It's been only 5-years after what was arguably the biggest stock market bubble of all time and now many averages sit at levels that are decisively higher (in dollar terms) now versus then. Following the technology, telecom, and Internet frauds of the 90's sold to the gullible public, very few people on Wall Street went to jail or paid any fines to speak of. There was no purge, no revulsion, and no stock market bottom. Today after the market rallied back to all time highs in some indices, the gurus on TV are the practically the same personalities that graced the screen 5-plus years ago, and the mood is eerily the same. There are many stocks selling at bubble valuations that were typical of that era. The only major difference between then and now seems to be that some minor degree of profitability is needed for tech companies to be bid to ridiculous valuations, whereas in the first bubble, profit was not required at all for such a reward. Were no lessons learned? Indeed there were lessons learned, unfortunately as suggested here tonight, they were the wrong lessons. Here's an excerpt from an e-mail I received last week:

"I continue to do very well trading miscellaneous 'Investors Business Daily breakouts,' at least 60 percent of the trades are successful."

I think that what is happening in the stock market is typified by examining Investors Business Daily (IBD). Today it is one of the most well thought of publications in the financial "industry" especially by technical analysts, and its following has grown tremendously. While I cannot cite statistics, all you need to know is that the price of a subscription has more than doubled since the top of the tech bubble. And while I'm no literary news critic, I doubt that this price increase is a result of the quality or depth of the editorial content found in IBD. The success and increased following of IBD is based on its technical approach of advising "investors" of the general state of the market and which stocks that tend to do well in a bull market. Of paramount importance is that these stocks be bought at the time when their technical chart patterns have "based" at the exact time when they break into new (52-week) highs. A complete description of this method can be found in William J. O'Neil's How To Make Money In Stocks: A Winning System in Good Times or Bad, a worthwhile read for anyone investing his or her own money in the financial markets. The beauty of that system is its relative simplicity, and its success throughout the last 15 or more years. While many investors enjoyed the ride up in technology stocks in the late 90's, IBD can (and has) boasted that they advised their followers to sell stocks in a manner that had them safely in cash for most of the 2000 crash.

IBD is just an example; what separated those who profited from the first technology bubble from those who lost big is the appropriate use of technical analysis (TA). IBD didn't corner the market on using TA to profit from the rise and get safely in cash for the fall – there were and are many others. The lesson learned from the first technology bubble? If it’s moving up, the stock market can be used as a method to "get rich quick;" however, you must know when to get out or you could get into trouble. Since the 2000 crash, people have learned the importance of the exit point as there were many market "whip saws" that occurred between March of 2000 and October of 2002. Some have even occurred after October 2002. These instances have become just a minor annoyance for those who were following a technical method such as IBD. In general, they were out of their long positions after the fourth "distribution day" and back to buying stocks on the next rally's "follow-through day."

Are these technical methods, that have been so successful in the past, a sure bet to protect traders in the future? Surely it would seem that they are! There is volume upon volume written on technical analysis, and there is even an organization, the Market Technicians Association (MTA) (of which I am a member), dedicated to the science of technical analysis. But is this truly a science, or it there something more to this? Does strict following of the rules of the game assure that investors will reduce risk to a reasonable level? Well, on this question, I must evoke a principle of technical analysis: "Give the trend the benefit of the doubt until proven otherwise." Yet, I have my doubts.

My doubts arise from observing a game, seemingly played by everyone, that is resulting in the masses seemingly getting rich quick (again, but thus far, only on paper) by owning and trading stocks whose valuations are only matched by the biggest technology bubble of all time. They are getting rich by owing and flipping companies that are bid to valuations that are totally unrealistic from any fundamental analysis. And they are going even higher for no other reason than perhaps, the green line just crossed the red line, or perhaps (using IBD), the stock broke into a new 52 week high after basing for 6 weeks. Can this game go on forever? Of course not! At some time, the value of the business will matter. If you want some good historical background and have about 3 hours, read, A Short History of Financial Euphoria, by John Kenneth Galbraith; if you have longer, read, Manias, Panics, and Crashes by Charles P. Kindleberger. There is nothing new under the sun and our current situation is no different than many that occurred through history.

The more important questions are: When the game ends (not if in my view), HOW will it end? Who will call, "game over"? How will it be called? What if we don't get our 4 to 5 distribution days as a warning to liquidate? What if the red line doesn't cross the green line before "game over" is shouted? What if there is no external reason such as a terrorist act to hang the "game over" sign on? What if just one day for no apparent reason, the Nasdaq dropped 130 points and the S&P dropped 60 points between 1 and 4pm on a Friday. What would happen then? Would you hold on? Would your friends?

Still these questions would have been exactly as relevant today as they were in November of 1999 when the Nasdaq broke into new high ground on an IBD follow-through day which then carried it from 3,000 to over 5,000 by the spring of 2000. In retrospect, you would have been wrong to sell at that time based on a (correct) fundamental analysis.

Yet as you can see from the chart above, after the initial drop from over 5,000 the drop was steep except for a quickly failing sucker's rally. Still, although it was steep, there was plenty of time to "get out." Yet many people didn't "get out" quickly enough. I'm sure that many of these people have learned the lesson that it was better to have sold based on the sell signal than hold on for the long haul. (Remember, they had only 1987 as a guide, and the correct lesson learned at that time was "hold on no matter what.") So what lessen was learned in 2000? I think it was when the party appears to be over, you must sell immediately or your portfolio may get devastated.

Still, there were several occasions over the last year where there were sell signals, yet the stock market was somehow resilient enough to come back. I must admit, I felt on each of these occasions, that the market was ready to go right into the tank in both April and August (especially August), yet this didn't happen. If it didn't happen on those occasions, is it a sure bet that it will never happen? More importantly, is it a sure bet that it will happen slow enough for speculators to liquidate their positions at acceptable prices? Each time the market drops to a lower low, it recovers. Each time, speculators feel more comfortable that a subsequent rescue is on the way. The lesson of 2004 has been, "don't panic." Are we being lulled asleep?

Is the lesson of 2004 a lesson worth learning? Ask yourself the question again. What would you do if the Nasdaq dropped 130 points between 1 and 4pm tomorrow? What would you do on Tuesday morning? What would most people do? What would the market do? In short, would the sky fall? Truth be told, I don't "feel" like this could happen. That is to say, I don't "feel it in my bones." Who cares about that? The green line crossed the red line! Follow through day! Get rich quick!

OK traders, if you take issue with these thoughts, feel free to express yourself via your e-mails.

Today's Market

If you owned it, it was probably up today. The market cheered Oracle's purchase of People Soft, and the dividend increase from Honeywell. All three indices were up about 1% on heavy volume, but not the knockout variety of volume that we saw last week. The Nasdaq has yet to produce two straight down days since October 20-something. Sirious satellite radio was up big today. Gold and silver recovered from their hammering last week. Gold is at $439 per ounce and silver is at $6.80. The XAU and the HUI were each up over a percent and a half. Oil rose, bonds were neutral, and the dollar was down. Pfizer increased its dividend by 10% and Merck, seems to be getting its legs under it. These two companies have been absolutely trashed in the media over the last couple of months, yet owners shouldn't pound their chest in a market where everything that moves is going up. Yet, if there is value in this market, I believe it is in big Pharma. Well actually, this was Warren Buffett's opinion about 9-months ago, when these companies were trading at higher valuations.

The Dow transportation index has 100% of its components with bullish charts. The transport index was up another 32 today.

As you can see from the chart below, oil is at a critical crossroad. Having broken its short-term trendline, it is tickling its longer-term trendline. It did that before last summer and it bounced immediately and reached an all time high in August. Will it happen again, or is this drop in oil based on something more fundamental?

General Electric is looking real bullish in the very short run having put up three long gapping white candlesticks. This is probably going to carry some more follow-through for GE in the days ahead, and it probably indicates bullish conditions in the general market as well.

I'll bet this rally has some more life left in it. Why? Alan Greenspan speaks tomorrow, and he will say soothing things to make the stock and bond market happy. The overall goal is to keep consumers confident and spending. I'm thinking that anything to make consumers fearful will be avoided like the plague.He will craft the most nebulous statement about inflation. This will be his toughest task. How do you acknowledge its presence without hurting consumer confidence?

Have a great week.

Martin Goldberg

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