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Guest Post: The 5% Solution
Via the ever insightful Contrary Investor
Art For Art's Sake, Money For God's Sake...No, this is not an homage to the financial archangel Lloyd Blankfein and his flock of chaste and devoted followers on Goldman's prop desk. Okay, lets get to the heart of what we want to look at this month. Be prepared, this is one of those discussions where we are going to let pictures do a lot of the talking. At Contrary Investor, we deal with a lot of fact and fundamentals, but we’ll be the first to acknowledge that technical analysis likewise takes a front row seat in the decision making and risk management process. In our book, the marriage of fundamental and technical analysis is a must. Ignore either and you might as well be flying blind. The discussion this month centers on the technical. Early this year on our subscriber site we looked at the analog of equity movement in the 2003-2004 period relative to 2009-present, pointing out differences in the fundamental backdrop of then versus now, but also the similarities in terms of equity market technical directional rhythm, equity sector performance, etc. We also suggested that just about the last thing the consensus outlook was predicting for early year 2010 was a sideways correction. It just so happens that in 2004 after rising about 4% in the first part of the year, equities went into a sideways correction that really did not best the early January price highs until about the final six weeks of the year. As always, no two periods are ever completely identical, but after a few months of equity market action this year, we believe it’s appropriate to review this analog now, but dig a whole lot deeper and cover a much greater amount of historical experiential territory for clues as to what might lie ahead. Yes, this is about the short term and the overriding principal of risk management. The analog of 2003-2004 relative to the present is captured in the top clip of the chart below.
At least for now, the initial price dip this year is much deeper than was the case at the outset of 2004. Where we move ahead is really anyone’s guess, we just thought it useful to look at the character of the sideways consolidation pattern over the first three quarters of 2004. As documented, the worst of the sideways correction in that year was the third dip registering (7.1%) on the equity market Richter scale. From the greater period measured from the price peak in the early Feb-March period of 2004 to the bottom in August, we are talking about a high to low decline of roughly (8%). Very tolerable in a sideways correction. In fact, forget tolerable, it was healthy. Exactly the base the equity market needed to build so as to work its way higher as the economy and corporate earnings continued to improve as 2004 unfolded. In the current year, the closing high to low correction for the S&P has been 9.2%, not that far off the maximum 2004 draw down, at least so far. So before getting too worked up about the recent dip, we need to see just how the character of the equity market develops from here. If the hurt continues unabated in deeper magnitude and perhaps moves toward a double digit price erasure, then we’ll have an issue.
The 5% Solution?…It just so happens there is another technical demarcation line we mentioned when we had a look back at the 2004 experience and beyond on our subscriber site a few months back that we believe deserves mentioning right now as we contemplate a trading range environment. It was the fact that from 2004 to the equity peak in 2007, the S&P NEVER traded at a level over 5% below its 50 day moving average. Not once, as is clearly documented below. This is the exact chart we showed on our subscriber site a few months ago, now updated through February. Talk about consistency, of course in the absolute clarity of hindsight it was indeed a first rate trading tool as it just doesn’t get much better than this.
And as we’ve marked in this now updated chart it just so happens that at its low closing point this year so far, the level of the S&P below its 50 day MA hit a (4.765)% decline level. Coincidence? Or is history telling us a much bigger story in terms of just how important this 5% line may be? Certainly 2004-2007 experiences is not enough data to draw hard and fast or tradable/risk management conclusions. So before trying to suggest a trading or risk management rule for the current cycle and hopefully directly applicable to what we are now confronted with, we need more data validation. And this is exactly where we are going with the remainder of this discussion.
So conceptually here’s the deal. We went back and looked periods of initial equity market liftoffs in immediate post recession environments. Of course most all of these periods were associated with prior period equity bear markets. Sound familiar? It’s the typical conjoined economic/financial market recovery periods we’ve come to know, love and now need to benchmark against. We’ll roll through these quickly. The first little top clip in the next combo chart tracks the post 1990 recession and equity recovery period. You can see that in the equity recovery of 1991 through 1993, NEVER did the S&P trade 5% below its 50 day MA. Okay, this is getting interesting, no? The case is building. Hmmm.
The bottom clip traces out equity performance in the period many believe was the blast off of the 1980-2000 total equity bull cycle. Yes indeed there was some price volatility coming off of the 1982 recession low, but once again the pattern is wildly consistent. The S&P NEVER traded beyond 5% below its 50 day MA over the four years covering the 1983-1986 cyclical equity bull period. Another check in the plus column for the 5% below the 50 day MA being a very important technical demarcation line.
C’mon, this is the 1980 to present equity bull cycle. It’s a coincidence, right? How could all of these beginning of cycle equity bull movements look so similar in terms of price movement around 50 day moving averages? Let’s turn the pages yet again and venture back to the very mean mid-1970’s equity market decline that was indeed very comparable to what we have already lived through in terms of magnitude of market decline over the 2007 to early 2009 period. It is chronicled in the top clip of the next chart. Wow, the similarities continue. Post the 1974 lows and initially rally, from late 1975 to close to the end of 1978 the S&P NEVER traded at a level exceeding 5% below its 50 day MA. In the late 1970’s (’78 and ’79) inflation was becoming such an overriding issue that volatility in equity prices naturally kicked up. But the 5% below the 50 day demarcation line held for four straight years.
The bottom clip traces out equity performance in the period many believe was the blast off of the 1980-2000 total equity bull cycle. Yes indeed there was some price volatility coming off of the 1982 recession low, but once again the pattern is wildly consistent. The S&P NEVER traded beyond 5% below its 50 day MA over the four years covering the 1983-1986 cyclical equity bull period. Another check in the plus column for the 5% below the 50 day MA being a very important technical demarcation line.
C’mon, this is the 1980 to present equity bull cycle. It’s a coincidence, right? How could all of these beginning of cycle equity bull movements look so similar in terms of price movement around 50 day moving averages? Let’s turn the pages yet again and venture back to the very mean mid-1970’s equity market decline that was indeed very comparable to what we have already lived through in terms of magnitude of market decline over the 2007 to early 2009 period. It is chronicled in the top clip of the next chart. Wow, the similarities continue. Post the 1974 lows and initially rally, from late 1975 to close to the end of 1978 the S&P NEVER traded at a level exceeding 5% below its 50 day MA. In the late 1970’s (’78 and ’79) inflation was becoming such an overriding issue that volatility in equity prices naturally kicked up. But thYes, the bottom clip is a stretch as we look all the way back to the very significant equity bull market of the 1950’s. Yep, if we had not seen it with our own eyes we would not have believed it. 5% to the downside below the 50 day MA was a consistent bottom for virtually the entire period covered. To be honest, when we wrote about the 2004 analog a few months back, we had absolutely no idea how meaningful the trading range around the 50 day MA was to be really looking over the last half century. We suggest the pictures above say it all. By the way, noticeable above is a missing picture of the 1960’s. Trust us, we did not want to clog up the discussion with yet another chart. The 5% negative volatility level was meaningful and tradable.
So, although we would be the absolute first to admit that no two market periods are ever alike, until proven otherwise history is strongly suggesting we use the 5% level below of the 50 day moving average of the S&P as a significant and meaningful risk management line in the sand. If we exceed this level to the downside for any sustainable period ahead, we going to have to assume that something different is beginning to happen and that price risk is accelerating in perhaps an unacceptable manner.
Before concluding this month, have one more quick look at the 50 day MA chart above for the 2003-present period (the second graph in the discussion). Please notice that the S&P cracked below its 50 day MA for the first time after the lows in 2003 during mid-2007 - exactly the peak of the prior equity bull. It was this price move below the 5% demarcation line that was the first foreshock in the last equity bear market earthquake. It was the clue that something was changing, and not for the better. To hopefully add a bit of validity to this potentially very important “warning sign”, have a peek at the chart below that gives us visual representation of what transpired between 2000 and 2003. The first price crack 5% below the 50 day MA occurred in September of that year, exactly when the bear cycle for that period really got underway in a very serious and capital threatening manner. The 5% violation “shocks” only got deeper from there as the bear market wore on. 5% below the 50 day demarcation line held for four straight years.
So, you know the summation comments here. As we continue to move through 2010, we suggest benchmarking against the 5% 50 day MA demarcation line. Again, we wish there were Holy Grails in the wonderful world of investment management and technical analysis specifically, but there are no guarantees. These patterns of cyclical bull market development and maturation have been very consistent historically when looking at this 5% 50 day MA experience. Remember, although there are no guarantees in the financial markets, this pattern has been consistent for over a half century now, through generational credit cycles and otherwise. Over the very short term and amidst the heightened and perhaps unexpected volatility of the moment, we want to make sure we stay in harmony with the message and movement of the market. And this is what we hear when we “listen” to the risk management lessons of the last half century. A half century of human decision making represented graphically. Don’t forget the old Jesse Livermore truism. Human decision making never changes, only the wallets do.
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What's it all mean Mr. Natural?
Well duh, he is the contrary investor after all.
Crap, I feel like the title of this article was a bait and switch. I thought it was about a 5% solution of hemlock for Wall Street executives. :(
when i started in trust investment management in may of 1981, i was told in quick succession: where are the customers' yachts?, then you were a prospect, now you are a customer, when you think you've got the key to the market, it changes the lock, and here, read this. of the here read thises, this post is in the top 10%. thank you zero hedge.
so according to fama, your work has now been incorporated into the pricing mechanism, leaving your theory unusable. good job.
This economy (debt burdens/unfunded liabilties/union controls/globalization) is much worse/different now compared to 2003/2004. Everthing depends on the bi weekly massive Treasury auctions here and in the eurozone. When (not if) the black swan appears (higher rates), the game is over!!
How America picks investments...and other things
http://www.quizyourprofile.com/guessyournumber.swf
http://www.youtube.com/watch?v=_3hZjwWe6Rc&feature=related
http://www.youtube.com/watch?v=AJcxj_Kvu7A&feature=relate
Getting fooled seems to be your answer, which is correct!
idiots...
we'll see how a 5% solution works in a world of 50% haircuts .
All this really demonstrates is the magnitude of market movements is likely limited on a really short-term basis. Having said that, the market can still make significant moves in either direction, while remaining bound by 5% to the 50 day moving average.
Basically sell an iron condor options strategy on the market 5% above/below the 50ma
Unfortunately, it would need to be adjusted, no? The 50 DMA would change over time in the direction of the SPX. Theoretically, the SPX could blow the iron condor (if I understand its construction properly that the payoff is only if SPX stays within the +/- 5% band). SPX could exceed that band - because it changes over time (the band that is). In shifting, it would permit the SPX to trespass beyond the OLD 5% limit, no?
Don't mean shit Flake don't mean shit. What do you mean you don't like boiled cabbage? It'll give you more mileage than a 50 MA. Just remember Frankenfood is only the first salvo. Don't kno about you but I'll be back for another helping there Natch. Just bring on some o'those girls w/the-pretty-legs.
This post, while mildly interesting, is near worthless if you are trying to use it in trading. It makes no allowances for what to do if the 50-day MA is in a kamikaze dive headed straight for the fully loaded flight-deck of the Yorktown. As someone else said, a hell of a lot of damage can be done while still within the 5% confines of the 50 day MA...
uber pwnage
Biff
Yes, you can't make a complete strategy out of this one bit of insight, but you can certainly use it as a component of a broader trading strategy.
So I think it's useful. It's only one ingredient, but a very useful one if you combine it with other ingredients in the right way.
Good info. Interesting.
the problem is these are dependent variables, the 50ma begins to drop in correlation to the percentage of the drop. In other words what would it take to violate 5% of a 50ma on a daily basis? To put this in fractal terms, its just not possible, except in rare occasions.
You think a 50 MA is going to fluctuate that much in normal trading? I could see 10-20MA.
There's no problem here. Dropping 5% below the 50 SMA is a warning; continuing more than 5% below the 50 SMA is a sign of a serious bear market, as happened in 2008 and 1974.
It doesn't tell the whole story by itself, but it does provide useful information about the market's standard boundaries that can help you better round out a trading strategy.
All this does is corroborate what we've all seen: A financial market with a life of its own and far removed from the real economy. U-6 unemployment at 17%, gov't intervention in equity markets at all time highs, FASB accounting rule changes to hide reality, states going bankrupt, people out of work, record foreclosures, record extended benefits claims, on and on and on.....
Jamie Dimon getting a bonus does not mean this economy is sound. So too, just because a 50 dma analysis has some historical relevance amongst a group of greedy gamblers does not convince me, as I submit my extended claims forms, that this is right or that this economy is healthy.
I really appreciate the work you do at ZH. With this piece you have now, more than ever, identified the deep chasm that exists between greedy casino gamblers and the real working economy.
Hmmm... Is it a coincidence that the probability mass between +/-2 standard deviation of a normal distribution is 95%?
I'll leave connecting the dots as a homework exercise for the reader.
Real traders are taught that the Holy Grail to Investing doesn't exist. Real people were taught that all the planet's move about the earth, don't go to far out into the ocean(you'll fall off the earth), on and on..........
When one looks outside the box(inventor), goes against the group(thinks for self), said they found(developed) something that is supposed to be impossible(airplanes), they were once killed. Now these people are called bad names and delegated to be unheard, and ignored group.
The ultimate business solution. The ability to cut the cost of any business expense, or just plain invest.
I developed multiple arbitrages that enable me to trade(not invest) in the finacial markets, without risk(The Holy Grail to Investing), or arbitrage that anyone can do. Over 30% a year.
Athenpro.com is in the building stage.
Thomas Adair
thomasadair@live.com
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