This is the fourth article dealing with cognitive biases that totally screw up your decision making. The first article, Know Thyself, covered anchoring, confirmation bias, herding, hindsight bias, overconfidence, and recency. The second article, Know Thyself II, covered availability, calendar effects, cognitive dissonance, disposition effect, and loss aversion/risk aversion. The third article, Know Thyself III, covered Communal Reinforcement, Endowment Effect, Halo Effect, Overreaction, Prospect Theory, Self-Attribution, and Self-Deception. Most of my education on behavioral investing came from books by James Montier, Hersh Shefrin, and Thomas Gilovich. Two great websites for this stuff are from Tim Richards and Martin Sewell.
I’m on record in my book, “Investing with the Trend,” and probably in this blog of stating that Financial Academia is nothing more than the marketing department for Wall Street. When I do presentations about technical analysis and / or money management, I always begin with this slide:
First of all, I must apologize for my lack of creativity for these article titles. The previous two “Filtering the Noise” and “Filtering the Noise II” were about moving averages and suggesting a better way to use a relationship between two moving averages, similar to the ubiquitous MACD. In this creatively named article I will attempt to explain my process for finding the shorter-term average using detrending. If you recall from the previous articles, once you have the shorter-term average, you then know the longer term one and the signal value. Instead of rewriting it, I’ll just pull if from an article, I wrote over 30 years ago. See the end of this article for more information on Stocks and Commodities magazine – a must read.
The first article of Filtering the Noise dealt with smoothing the data with moving averages. Here I want to discuss a really popular concept popularized by an indicator called Moving Average Convergence Divergence or MACD. MACD is a concept using two exponential averages developed by Gerald Appel. It was originally developed as the difference between the 12 and 26 day exponential averages; the same as a moving average crossover system with the periods of the two averages being 12 and 26. The resulting difference, called the MACD line, is then smoothed with a nine-day exponential average, which is referred to as the signal line. Gerald Appel originally designed this indicator using different parameters for buy and sell signals, but that seems to have faded away and almost everyone now uses the 12–26–9 combination for both buy and sell.
I have mentioned many times I that I basically only work with daily market data. I do not have the personality to deal with intraday data and weekly data is only good for long term use. I do have a few weekly data indicators that I use as overlays to my trend model, but the bulk of then are daily. One of the concepts I think you must deal with when using daily data is to come up with a method that removes the noise. Noise in this instance is very short term fluctuations in price. One of the most popular is the moving average; and it comes in many flavors. There is a significant difference between the simple and exponential moving average.
This is funny. A few articles ago I commented on the foolishness of the media’s focus on Dow 20,000 and now I’m focusing on my 100th blog article. Is that being a hypocrite or what? I have been racking my feeble brain trying to think of an appropriate topic for this milestone. Maybe I'll start with a little history.
The “Wall of Worry” has been used for many decades to identify the period of time in the latter stages of a bullish run in the stock market, when all the naysayers start talking about a top. I have witnessed this often. As the bull ages, many start to think they can “call the top.” The financial media parades expert after expert showing economic or political situations in which they believe is coincident with a market top. First of all, anyone who has ever looked at a chart knows that the topping process, also called distribution (more on that later), is a really long drawn out affair. The topping process leaves lots of dead bodies alongside the road.
Periodically I write an article that reviews the past few months of articles. Why on Earth would I do this? Primarily for two reasons. One is that many new readers are involved and often they do not go back and look at the past articles. Two is that my articles are rarely tied to anything that is happening in the markets. Generally, they are about experiences I have had as a technical analyst for almost 45 years; the good, the bad, and the ugly.
In 1987 a book was written, entitled “The Great Depression of 1990,” by Dr. Ravi Batra, an SMU professor of economics. Sadly, I bought and read that book back then. Batra was claimed as one of the great theorists in the world and ranked third in a group of 46 superstars selected from all economists in American and Canadian universities by the learned journal Economic Inquiry (October 1978). The foreword was written by world-renowned economist Lester Thurow, who said The Great Depression of 1990 is crucial reading for everyone who hopes to survive and prosper in the coming economic upheaval. The title for Chapter 7 was The Great Depression of 1990 – 96. Not only did he pronounce the beginning of it, he also proclaimed to know the end. The 1990s saw the largest bull market in history, with the Dow Industrials rising from 2700 to over 11,000 during the decade of the 1990s. By the end of the decade we were flooded with books about the never ending bull market such as: Dow 40,000 by Elias, Dow 36,000 by Glassman and Hassett, and Dow 100,000 by Kadlec. From 2000 until early 2003, we witnessed a bear market that removed most of the gains of the previous ten years with the Dow Industrials back down to about 7350.
There are 10 types of people in this world, those who understand binary and those who do not. Yes, the title is binary for 20,000. I knew the title of this article would get your attention. The financial media is possessed with round numbers more than I can remember. Back in the 70s, the Dow Industrials bounced off (resistance) of 1000 many times and it was 1983 (10+ years) before it finally broke through on the upside like a homesick angel. I’m not sure but I think intraday in 1966 it bumped up against 1000 also, but did not close there. In the past few months if you listen to the experts and talking heads, you would think approaching and crossing 20,000 on the Dow Industrials was the only newsworthy thing to talk about. Most, who actually trade, don’t think a thing about it.