Commentary: Break out the Bollinger Bands, MACD and other trading tools
MIAMI, Fla. (MarketWatch) — Is it possible to predict what the stock market will do next?
After months of research and interviews with dozens of traders and investors, here are a few lessons worth sharing:
Study sentiment surveys
Two useful contrarian indicators, the American Association of Individual Investors (AAII), and The Investors Intelligence Sentiment Survey (II), measure the mood of investors. When these two surveys get frothy (over 60% bullish or bearish), it’s a signal the markets are becoming extreme. That’s when many traders consider doing the opposite of the crowd.
Although these sentiment surveys can’t precisely time the market, both have had uncannily reliable records of forecasting tops and bottoms. For example, in March 2009, these surveys were signaling extreme pessimism — which happened to coincide with the lows on the Standard & Poor’s 500-stock index and the Dow Jones Industrial Average. As you may recall, people back then were running for the exits, frantically selling stocks for the safety of cash or bonds.
The reason sentiment surveys work is that humans almost always overreact when the market hits extremes. Therefore, if you only rely on your emotions to trade or invest, more than likely, you’ll get it wrong. Suggestion: look for long-term trends in the sentiment surveys, not just one week’s results.
Use market indicators
In addition to using sentiment surveys, most traders use one or more indicators plotted on a chart to help determine market direction. They primarily use them to increase the probabilities that a specific trade will be successful. It also helps with entries and exits. Even investors and professional money managers routinely refer to indicators for an unbiased second opinion.
Based on the research I did for my recent book, All About Market Indicators (McGraw-Hill, 2010), here are a few trader favorites:
Moving Averages: Helps to determine if a trend has ended or begun.
MACD: Trend-following momentum indicator.
New High/New Low: Tracks stocks that are making new highs or new lows.
Bollinger Bands: Helps traders identify overbought or oversold conditions
RSI or Stochastics: Helps traders determine if a stock or market is overbought or oversold.
Arms Index (TRIN): Helps traders identify overbought or oversold conditions.
Advance-Decline Line: Helps traders measure how many stocks are participating in a rising or falling market.
CBOE Put/Call ratio and ISEE Call/Put ratio: Contrarian indicators that track the buying and selling of options.
VIX: Measures fear in the stock market by tracking implied volatility of call and put options.
Can these indicators predict what the market will do next? The answer depends on the time period: the shorter the period, the easier it is to have correct predictions. While no indicator can tell you with 100 % certainty what will happen in the future, they can give important clues.
What indicators can’t do
Even though indicators are useful for anticipating short-term direction, no one can consistently predict the market’s highs and lows and attach a date to it. The market’s Holy Grail is still elusive, but many are still looking. Even if you’re armed with a handful of reliable indicators, it’s nearly impossible to predict the unexpected, for example, when the price of oil or interest rates will rise, or when the next war may erupt.
For traders with short-term mindsets, indicators are invaluable. Long-term investors, however, may find many technical indicators less than helpful.
A few years ago, I spoke to Peter Lynch, bestselling author and legendary mutual fund manager. I asked him if it’s possible to predict the market and he replied: “I’ve been trying to get next year’s Wall Street Journal for 40 years. I’d pay an extra dollar for it.
“I’d love to know what will happen in the future,” he said. “I have no idea what the market will do over the next one or two years. What I do know is that if interest rates go up, inflation will go up and the stock market will go down. I also know that historically about once every two years the market has a decline of between 10% and 20%. These are called corrections. Perhaps one out of three of these corrections will turn into a decline of 20% or greater. These are called bear markets.
“If you understand what you own, you’re in good shape,” Lynch said “If you don’t know what you own, and don’t understand what a company does and it falls in half, what do you do? Call the psychic hotline? If you understand clearly what the company does and you understand who the competitors are, and the market goes down and the stock goes down, you don’t panic.”
Observe human behavior
Finally, if you study booms and busts throughout history, you’ll recognize that although many stocks come and go, human behavior never seems to change. At market bottoms, people ignore or fear the stock market. At the very top, they can’t get enough of it.
While you’re waiting for the eventual top or bottom, you might consider the advice of renowned trader Jesse Livermore.
Livermore said that after years of making and losing money, he discovered one of the secrets to being a successful trader: Be bullish in a bull market and bearish in a bear market.
This is excellent advice except for one problem — are we in a bull or bear market? Perhaps some readers will have an answer.
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