The Analyst and the Oracle

Published on 5th May 2009

In a volatile market environment, it can be quite difficult to know when to put your money back into various asset classes and when to remove it. If you play too defensive, you risk the danger of underperforming your benchmark but if you attempt to be a stubborn bull, you might just end up on the dinner platter. The biggest danger for an analyst in finance is to become an oracle. Often, clients will complain when the predictions of analysts do not turn out to be true but the key to being a good forecaster is not to make any.  

Econometrically based forecasts are difficult to implement with non linear data. Technical analysis in an inefficient market, a necessity for such an analysis to work, allows the analyst to stay away from becoming the oracle. 

In my previous article, I talked about how market timing can be an almost impossible task to master and that before one buys, he should look at the technicals of the market rather than harp about price to earnings ratios. I also talked about how it was not only possible to create synthetic puts in the market but also gradually participate on the upside while maintaining a high floor. The Constant Proportion Portfolio Insurance (CPPI) strategy for example allows the manager to gradually enter the market when it trends so that he may gradually participate on the upside while protecting his downside risk. The CPPI strategy with a very high floor was in fact the best way to enter the market in March of this year and the most successful alpha seekers in the market were able to make full use of its convex payoff structure. 

In the last article, I also talked about how one needs to consider the lagging nature of the Mauritian stock market, the outlook on the Mauritian Rupee and what investors need to look at before entering a market. For example, I talked about how the Yen needed to depreciate versus the US dollar and that various credit and market spread measures needed to tighten before one could enter into stocks in an aggressive manner. 

The bear is still around  

As governments around the world pledged to pump billions worth of liquidity into financial markets, risk appetite suddenly appeared at very depressed stock levels. The logic became contrarian in nature. There were so many bears in the market that the downward trend broke down. Stock prices evolve exponentially in various systems. While I donot wish to bore the readers by talking about modern trading algorithms (that are too complex these days) and the notion of fractality, you should only understand that eventually all systems break down as they accelerate and peak out. 

As physical systems accelerate, oscillations become more frequent while its magnitude falls. Eventually prices break out of the exponential trend and a new system is born as another dies. This does not mean that stock prices will go in the opposite direction however, it just means that a new system is created and that only within such physical systems does technical analysis work well. While basic technical analysis cannot always work well compared to more complex trading algorithms that resemble physics rather than finance, it can still prove useful to the average trader and institutional fund manager. 

Before we get down to it, suffice to say however that the best investment in an uncertain global environment remains cash but holding onto a lot of cash does not mean that you do not come into the market when it goes up or stay put as it goes down. The key is to identify the trend and apply various portfolio management strategies such as the CPPI and follow that trend until it breaks down.  

Parameters need to however be statistically calibrated to yield optimal results and can spell trouble for the novice. The first thing to look at in the global market was the continued appreciation of the Yen over the past eight months. As risk appetite fell across the world, the unwinding of the carry trade forced large investors to keep more money in Treasury Bills and Yen denominated assets which have the perception of being safe. As the Yen began to depreciate versus the USD in late February, it was a clear signal to traders and fund managers that shorting the market was about to become unprofitable. 

As can be seen in the first graph, the Dow Jones index was still falling in an accelerated fashion during the month of February and early March as the Yen began to depreciate versus the USD. This was the first sign that the system was about to break. The Moving Average Convergence Divergence (MACD) also crossed its short term Exponential Moving Average (EMA) and shot upwards by the early part of the second week of March as the Relative Strength Index (RSI) fell close to 25.  

Fig. 1                                                        Photo:Courtesy
The RSI also began to diverge slightly from following the price trend indicating to traders that the downward trend was tiring. It was clear then that regardless of your abilities as an astrologer, that once the RSI diverged, once the MACD crossed its EMA on the upside and once the Yen began to depreciate versus the USD, that it was time to come back into

stocks. The MACD also indicated that a new bullish run was forming and to an alpha seeking fund manager, this would have meant that it was time to reenter the market in a controlled manner by following a CPPI style strategy with a high floor for downside protection or more cheaply by taking long positions in futures or calls while covering the downside with out of the money put options.  

So what does basic technical analysis of the Dow Jones tell us to do now then? It tells us that the MACD is approaching its EMA and is hence falling. The RSI remains in sink with the price chart and tells us that the new bull trend is not yet over but that things are about to slow down. 

If one considers the fact that earnings season is about to dump quite a lot of data on the analyst next week, it is clear that it is now too risky to “risk” a lot in the market. Should the earnings season be worse than expected, the charts tell us that things could again get

nasty rather quickly. Should the season be better than expected, then we could see some more rallies in this still bear market. In sum, the charts tell us that while the bull may be back albeit temporarily, he remains a weak bull and that bad news could easily turn him into a bear. The bear is still around and can still call the shots. The investment decision is hence stuck in mono at the moment because we have seen these bull runs before only to be disappointed with even larger bear routs. The good news is that various spreads such as the  LIBOR to Fed Funds rate spread have come down in recent weeks indicating to us that  things appear to be getting better. 

However, regardless of where the markets goes over the next few weeks, and believe me, nobody really knows, it is  mportant for alpha seekers to learn how to understand when trends form and break down so that they can ride the wave as much as possible. It was clear that once global markets began to rally, the lagging nature of the Mauritian stock market would allow for interesting trading opportunities. It was also clear that as risk appetite increased again in march, selling pressure by foreigners in the domestic market would ease somewhat. This would have an obvious impact on the Rupee. It was also clear that as more and more people became bearish on both the Rupee and Mauritian stocks that the downward system would eventually break down.

By Sameer Sharma

A Canada based Financial Analyst


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