TSX TrendWatch Weekly

It had to happen eventually.  Investors can only wait on the sidelines with their cash so long while desperately looking for signs of a bottom.  When any good news comes along that really looks like it’ll help the markets, a buying frenzy often ensues.

Sadly, although such knee-jerk reactions don’t usually last very long, last Friday’s was impressive.  848 points to the upside for the S&P/TSX Composite Index on Friday alone… around +7%.  The previous record was a 9% gain a couple days after the 1987 crash, after a major cut in US interest rates assured some investors at least that the worst was over.
A cut in interest rates is one thing, but last week what we saw was the US government throwing cash at a financial crisis.  Perhaps it hasn’t sunk in to the average American that they will be paying substantially more taxes to fund the banks that hold their mortgages.  That will make it easier for the banks to continue their foreclosures.  Americans will be paying for the privilege of having their homes taken away.  How much of an investment incentive is that?

All the same I’m willing to suspend disbelief for now, and hope for some follow through from Friday’s rally as we move into the coming week.  As you know, the theme here is to let the trend and consistency data speak for themselves.  We don’t need to know the fundamental causes of good (or bad) news. We just go with the flow.

The end-point in this week’s chart is at 35%.. up from 28% the previous Friday. That’s still far short of the comfort zone for us.  Short-sellers can possibly still capitalize on that, but it would be wise to see how the markets react once this US government bail-out gets pushed through for approval.  There are very few details about how this $700 billion rescue attempt will get divided up among the financial institutions that are hurting (aside from what has already been earmarked for Fannie Fae, Freddie Mac and AIG).

The net-out for the week was a 1.1% improvement in the S&P/TSX Composite Index. FINANCIAL SERVICES, CONSUMER STAPLES, and CONSUMER DISCRETIONARY groups are in positive trend territory. The price of gold bullion leaped ahead 14% over the week, causing some improvement to the MATERIALS group. INFORMATION TECHNOLOGY stocks (as measured by the index) took the biggest hit for the week… down 9%.

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RTA Strategy Tip: Combining Trend and Consistency ValuesThis is the first in what we expect to be a series of “strategy tips” associated with our relative trend analysis™ (RTA) framework.The general idea is to build RTA into a more complete trading system, as opposed to simply a screening tool.

In our Visitor Guide we clearly lay out the basics of how we compute trends and their consistency, and the importance of looking at them separately. The general idea is to screen for a trend level that you’d find acceptable, while being wary of the very high values that are almost always the consequence of a take-over bid or some other unique one-time event.  Such events typically set at least a temporary cap on the share price, so you can hardly expect any follow-through, no matter how atractive the trend value may appear.  Don’t forget to read the news before acting on any seemingly attractive trend/consistency combos that you may find here.

Similarly, you’ll want to find stocks that are rising with a comfortable level of consistency. As we like to say, “a consistent trend is less likely to bend”.  From time to time we’ve referred to our “1/70″ threshold.  It’s totally arbitrary, but a 1/70 stock is one whose share price is rising at 1% per week (or about 50% if annualized) with 70% consistency.  Generally, there aren’t a lot of those, so one might consider relaxing that threshold a bit.

We think you can get the most out of RTA by establishing comfort levels with trend and consistency as separate thresholds, but we often get asked about combining the two into a single measure, and sorting opportunities accordingly. While this isn’t our preferred way of doing things, you certainly can do that. We would simply multiply the two of them together.

Let’s consider what that means using a stock that’s right on our “1/70″ threshold. So, we have a stock whose share price, if the trend continued, could accumulate to around a 50% gain over the next year.  But our consistency number is telling us that 70% of the price movement is in the same direction as the trend. Taking 70% of the 1% per week trend value gives us 0.7% per week or roughly 35% annualized… still a very attractive return.

So, by combining trend and consistency by multiplying them together and annualizing the results, you’d have a projected annual return estimate. You could sort as many stocks as you like with this combined measure.

We’ve already talked about the loss of information by using a combined metric, but there’s also a potential psychological disadvantage… you might actually start believing that you will earn the kinds of returns that your numbers are implying.  You might or you might not.

Investors live in a very dynamic world. We can factor out a lot of noise by looking at trends and their consistency, but this week’s trend and consistency numbers will almost always be different to some extent a week later.  That will also be true of the combined Trend X Consistency.

The bottom line is that if you can use sound judgement while working with a single projected return estimate like the one we’ve described, go right ahead and do so. It might also get you thinking about some trading rules to go along with it. For example, your personal level of risk tolerance might suggest whether you go after a sock with an estimated 50% return or one at a more modest level. And, if you did buy some shares of that stock with the 50% projected return, you might set a rule for selling that investment if, say, the projected return value falls to 10-15%%. Alternatively, you may even consider buying more if the weekly data show an increase in projected return.

As usual, you’re comments and questions are welcome!