Sunday, May 9, 2010

Trendline Analysis - The proof is in the pudding

Does past performance tell us anything about future performance? An astute investor pointed out the fact that every prospectus ever printed discloses that past performance is no guarantee of future performance.

Does what happened last month, last week, or yesterday in the market really have any bearing on what may happen in the near future? After all, what happened in the past is old news and the future cannot be known.

Trendline Analysis is based on the past and the present. Is it really of any value? If you are not familiar with Trendline Analysis read the May 2010 issue of The Gerritz Letter; a link is provided below.

When you were a child you might have placed your hand on a hot stove, ouch! If you did, it would be my guess that you never did again, at least not on purpose. Life teaches us a lot of lessons. We either learn from our experiences or we repeat mistakes.

Market movement is comprised  of three important trends superimposed on each other.

Primary Trend

The main or primary trend, is often referred to as a bull or bear market. Bulls go up and bears go down. They typically last about nine months to two years with bear market troughs separated by just under four years. These trends revolve around the business cycle and tend to repeat whether the weak phase of the cycle is an actual recession, or if there is no recession and just slow growth.

Primary trends are not straight-line affairs, but are a series of rallies and reactions. These series of rallies and reactions are known as intermediate or medium term trends.

The intermediate or medium term trend can vary in length from as little as six weeks to as much as nine months, or the length of a very short primary trend.

Intermediate trends typically develop as a result of changing perceptions concerning economic, financial, or political events. It is important to have some understanding of the direction of the main or primary trend because rallies in bull markets are strong and reactions are weak. On the other hand, reactions in bear markets are strong and rallies are short, sharp, and generally, unpredictable.

If you have a fix on the underlying primary trend, you will be better prepared for the nature of the intermediate rallies and the reactions that will unfold.

In turn, intermediate trends can be broken down into short-term trends, which last from as little as two weeks to as much as five or six weeks.

The market after all does have a history of trending both up and down as well as going sideways from time to time. Past market price trends are therefore relevant to the present condition of the market.

Trend lines can help us determine current market direction. Additionally, trend lines can help us filter out normal short-term market fluctuations. If a trend line is broken it warrants our attention. If a new counter trend develops it needs to be confirmed and assessed.

If we use this information and decide to sell out of an equity position, we have protected our account from a potential drawdown. If we are wrong and the market resumes it's climb higher; we just buy in again. Most people cry harder over big  losses than missing a couple points of gain.

As you may known our portfolio model went to zero equity exposure on the 4th of May, two days before the extreme volatility on the 6th. Without the benefit of Trendline Analysis we could not have made this, what now seems to be, critical decision. We protected client accounts from a large drawdown in what is now clearly an intermediate change of market direction.

The proof is in the pudding.

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