Five Questions Regarding the Australian Share Market for Australian Based Investors.

Five Questions Regarding the Australian Share Market for Australian Based Investors.

(This does not examine comparative investments in other markets, commodities or currencies)

1. Is there a possible buying opportunity?
2. Should I buy some now?
3. Can I lose by buying now?
4. Is my reliance on these indicators appropriate for the market we are in?
5. Is the 12 month macro environment/outlook positive or negative?

Is there a possible buying opportunity?

Yes!

Should I buy some shares now?

Yes! The 10 day simple moving average has turned up after a fall of 20% (using the intraday low).

Can I lose by buying now?

Yes! The 10 day SMA is volatile and gets whipsawn, but no market recovery starts without the 10 day SMA turning up. Based on the price pattern after the 1987 crash, you can expect to make a loss from whipsawing until there is a significant major uptrend. That major uptrend might start now in which case you will have no drawdown or there may be say 10 false signals, many involving a loss on the round trip trades, until a major uptrend starts. But, you will not be caught in a future major downtrend if you follow a moving average strategy. You may, however, not do as well as if you just bought in 100% now and held as long as possible.

Is my reliance on these indicators appropriate for the market we are in?

This depends on your age/recovery time, other assets, income outlook but if you are highly concerned about major losses (the Japanese scenario where their market is now down 78% from its all time high in 1990) but also want to participate in any upside, a moving average strategy will protect you from a Japanese scenario but at the likely cost of reduced returns in a sideways or uptrending market (This statement based on analysis by Doug Short: www.dshort.com).

Is the 12 month macro environment/outlook positive or negative?

My opinion is that it is negative. This is based on the unresolved PIIGS debt problems, the introduction of fiscal austerity in US, UK and Australia as well as in the PIIGS and the current trailing earnings in the US being at a never sustained multiple of the 10 year average real earnings. The abandonment of mark-to-market also causes concern. However, central banks are taking extraordinary measures to ensure financial stability and to destroy incentives to hold cash and short and even long term securities. The US 10 year rate is about 2.2% and the S&P 500 earnings yield is about 5%, a ratio rarely sustained for long since 1960, so stocks are quite attractive if earnings merely hold up at current levels. I follow the hypothesis of Richard Koo that this is a balance sheet recession and that to avoid GDP falls the government must take the savings of the private sector and spend them.

Detailed explanation.

I analyse the relative performance of the Australian All Ordinaries Index since 1984 including:
1. returns over 2 mnths and 1, 2, 3, 4 and 5 years
2. whether it is overbought/sold against its 200 day SMA
3. its position against its all time and most recent tops
4. the length and size of its most recent rise or fall against all rises and falls of more than 8% since 1984. (8% is a not quite arbitrary number to eliminate the noise of minor, short term fluctuations).
5. its volatility (persistent high volatility is correlated with major bear markets)
6. the comparative percentage recovery over time from major bottoms
7. the rises and falls between major tops and bottoms and between tops and bottom 3 years apart. (to smooth numbers and avoid comparison only to some extraordinary crash or bubble)
8. What gains/losses have been for 1,2,3,4 and 5 years since the previous tops and bottoms to assist in identifying whether based on past growth rates for those periods at prior tops and bottoms we are likely near a top or bottom (but this analysis will not assist in a long term secular downtrend like Japan as each cyclical top is often lower than the previous cyclical top).

Buy indicators
Present indicators of now being a likely buying opportunity include (based on prices since 1984):
1. The Australian market has only been below its highest point previously by the current 37% for 8% of the trading days since 1984, it has been closer to its previous all time high 92% of trading days since 1984 and has always reached new highs.
2. The length of the current fall to its recent bottom is above both average and median duration of all falls of greater than 8% since 1984
3. The size of the current fall to its recent bottom is above both average and median duration of all falls of greater than 8% since 1984
4. My measure of volatility is in the 96th percentile, so near all time highs
5. Growth over 2 months and 1, 2, 3, 4, and 5 years is at significantly lower than median points being in the bottom 10th, 18th, 18th, 10th, absolute bottom and 2nd percentiles.
6. The market has, since 1984, hit a new record high within 5.5 years, so we might expect to be at 6850 by April 2013, which would be a rise of 60% over the next 20 months (personally I doubt it very much, but the September 1987 high was exceeded in January 2004 in spite of the fall of over 50% which took place in September 1987.
7. The percentage recovery of 37.7% at trading day 625 since the bottom is below average and below all but the 1987 recovery at day 625. Until this recent fall the current recovery had never been below average since day 20. But the 1987 recovery had a sustained period of relapse lower than the current 37.7% recovery after day 625. The 1987 recovery went through a further major downturn and spent only 170 of the next 586 days (the limit of my analysis) above the present level. So there is risk of being whipsawn for a loss if you buy now and get a sell signal later.
8. After the recent falls the market is significantly below its linear trend line on a simple scale and its logarithmic trend line on a logarithmic scale so mean reversion would indicate a likely future uptrend, although timing is always uncertain.

Risk indicators
1. the 30, 50, 100 and 200 smas are all still trending down.
2. there have been no bullish crosses of the 10/30, 10/50, 30/50, 30/100, 50/100 or 50/200 moving averages, so there is a real possibility that you will get whipsawn for a loss if you buy now. It may be too early.
3. You can't totally rule out a Japanese style situation of cyclical losses for another 10 years.
4. The 1987 situation went to a lower level of recovery for about 76% of the next 586 days
5. Periods earlier than 1984 (particularly the post 1929 years) will likely have worse results but are not included in my analysis.

My record
As for my record of profit, I only became an active manager of my funds since the peak of 2007 and I got in too early after missing some parts of the fall and from the top in 2007 I am now slightly ahead of the market in nominal terms.Measurement is complicated by withdrawals to fund retirement. When I add back my cash withdrawals for living expensesI am down approximately 12% from October 2007 compared to the market being down 37%.

My future strategy
I will sell again if there are falls resulting in a downturn of the 10 day moving SMA but not necessarily on the day of the downturn. I will buy more if more trend lines turn up and there are bullish crosses of some of the trendlines I monitor. I have not yet decided exactly what my buy actions will be based on.

Disclosure
I have a significant exposure to the All Ords established within the last 2 weeks (before the 10 day sma turned up but based upon the size of the fall and the percentiles of volatility and growth), but less than 50% of my investment pool, so at present I am almost ambivalent about the direction of the market. I have locked in some outperformace against the All Ords but can take advantage of any major falls to buy in at lower prices, but will regret not having bought more if prices rise and my 10 day SMA remains in an uptrend.

My 10 day SMA is based on the sum of the last 3 days minus the sum of the previous 3 days

When do I buy back in?

At the moment I am only about 30% invested in the stock market.

The question that is exercising my mind is "how will I know when to buy back in?

I am looking at using a cross of the 30 day Simple Moving Average (SMA) by the 10 day SMA from below (subject to the price being higher than the cross). The market has recently fallen up to 14% and is currently still down 10%. Unless we have a dramatic fall on Monday in response to the 3.4% fall on Wall Street S&P500 last Friday, the cross could happen this coming week.

There are risks to this approach. The risk is that the signals reverse several times without the market moving much between the crosses. That is called being whipsawn. It can cause losses and each transaction also has costs. The market is described as "trending sideways""or "in transition".

However, you need something to help you judge when to buy back in, or increase your weighting of stocks. Some would say the 200 SMA is more reliable, but you have much bigger losses in a major downturn or lost opportunities in a major upturn using such a long average.

So why would I use the 10 and 30 cross? Because it can be quite a profitable indicator. (If the market was down 25% I would likely use a much longer SMA than 30, maybe 100 - I feel that the deeper the fall, the longer the SMA for a buy signal should be to avoid whipsawing, but I have no backtesting to support this feel):

It gave a 10% rise from October 2001 to February 2002 with no whipsaws, and a 17% rise from March 2003 to March 2004 with 5 whipsaws. Using a 50 day SMA instead of a 30 day SMA would have given a 16% rise with no whipsaws and would have been a better choice on this example as the rise was gradual with 5 pullbacks. A sudden rise with no pullbacks would have been well suited to a shorter SMA like 30 Trading Days.

The chart above also shows how you can get whipsawn as the market goes through a 20% decline. If you used a 120 SMA instead of 30 you would have been whipsawn once on the way down and not at all on the way up. you would have been down 3% before your first sell signal, have lost 2% in the whipsaw and then picked up 14% for a net 9% gain compared to a zero gain over the same period if you had just continued to hold your stocks all through the period.

Here is a chart with two significant rises where there was no whipsawing using the 10 and 30 SMA cross. Note that we are down a similar amount now as was the case from both of the bottoms shown in this chart.



But what of the risks of multiple whipsaws with losses and transaction costs? Right click and open the next chart in a new window.


From Jan 91 to July 92 you would have had 7 roundtrip transactions for a total market movement of only +22%. a number of the round trips would have been loss making, reducing the 22% gain to one where on a net basis you captured only between 1/2 and 3/4 of the 22%. A 200 day SMA instead of a 30 would have given less whip sawing, but a higher first buy price, so there may not have been much benefit in using a longer SMA.

So not buying would have led to missing a profit of between 10 and 15 % in 18 months compared to being whipsawn by the 10 and 30 sma while a perfect buy at the bottom would have given 22% return - but how would you pcik the absolute bottom?

No one rings a bell at the top or bottom of the market! You have to have some basis on which to buy and sell, or adjust your portfolio weightings.

Choose the lengths of the SMA's you will use based on your own costs of transaction, loss aversion, ability to replenish funds and consider other factors as well, including fundamentals.

Before embarking on any strategy involving moving averages you should have a look at some recent work by Doug Short::

http://dshort.com/articles/2010/Nikkei-monthly-moving-averages.html

http://dshort.com/articles/2010/SP500-monthly-moving-average-history.html