Technical Thoughts: Evidence-Based Trading

Written by Jeff Miller, A Dash of Insight

Our last Technical Thoughts asked whether traders were joining the yield chase. If so, we might be seeing another rotation as energy and financials have taken the lead. Congratulations to traders who made bets on the bank stress tests.

This Week – Should You be Trying “Evidence-Based” Trading?

This important topic has already attracted expert attention, as we see in today’s Trading Tips.

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Trading Tips

• Dr. Brett Steenbarger, as usual, provides leadership on this subject. Traders should carefully read his entire post as well as the prior article in Forbes. There is no good way to summarize all the excellent points, but let me highlight two of them:

  If you read old texts on technical analysis, you’ll encounter generalizations such as “this is a bullish pattern”. No actual evidence is produced to document this. It is the “clinical judgment” of the practitioner. Similarly, a fundamental analyst might assert that the price of a stock or index will rise because of increasing consumer spending or a growing GDP. Once again, no evidence is provided for those links.

  The alternative to technical analysis is not fundamental analysis. The alternative to technical and fundamental analysis is evidence-based decision-making.

And also, this….

It starts with what Victor Niederhoffer calls “counting”. When we see a pattern that we believe has some implications for non-random forward returns, we look back in time and see if that pattern indeed has led to those anticipated results. Cherry-picked examples supporting our inference does not constitute an evidence-basis. Rather, we look back over a meaningful sample and count the times when the pattern has and has not led to expected returns.

• Steve Burns cites Colibri Trader on the four levels of trading. What is your level? Will you be one of the 5% who makes it. If you think this is not related to Dr. Brett’s post, read it again.
• Ian Huntsley warns about the temptations of excessive trading, providing a helpful catalog of reasons. Like the Burns post, you can consider whether you see yourself. It is both useful and fun.

I’ll share my own observations in the conclusion.

Expert Picks from the Models

This week’s choices cover a wide range – different sectors, market caps and risk-reward.

Felix: It’s been a long year for Hertz (HTZ). This stock has been on a steep decline for nine months, but there’s a good reason to like it in the long run. The chart shows why:

Apart from a small bump in early November, this is pretty ugly. Now that the price has declined from $50 to $11, this is a buying opportunity. The segment from mid-May to late June could be something Jeff calls a “reverse head and shoulders.”

J: It requires a lot of imagination to see an upside-down-head and shoulders in that chart! I suggest you read my post from earlier this week – The Limits of Technical Analysis. The Seeking Alpha version had a spirited debate in the comments. There are some examples of chart-reading like yours.

F: I suppose that you will next show a chart from a fundamental analyst, like Chuck Carnevale.

J: Of course. His tools are the best! Anyone serious about buying a stock should begin with a look at Chuck’s analysis.

J: You can see the huge decline in earnings both last year and this year. The soft market for used cars, which they depend upon to turn over their fleet, is a problem. The rise of Uber is another. Many are choosing the inexpensive ride service rather than a car rental.

F: That may be the reason for the decline, which I do not care about. I am focused on the rebound.

J: Are you paying any attention to the SEC?

F: Why would I do that?

J: Your purchase of the stock at nine and change was within hours of the company’s announcement of an agreement with Apple. The SEC monitors “insider trading.” The stock spiked $2.

F: You mean the story about Apple leasing six (count ’em, six) cars for testing?

J: That might not impress you, but rightly or wrongly, the stock soared after that news.

F: Sometimes the prior chart action provides a clue. That was the case here. I had no inside information, but some other buyers might have. That is often the reason behind technical buy signals.

J: Would you still buy the stock now – after the instant gain? Most traders would be selling, and moving on to the next trade.

F: At the moment, the stock still meets my buying criteria.

J: How did you do today?

F: My portfolio was unchanged – not bad on a tough day.

J: How did you do so well?

F: I hold some energy names, which did well, and little in technology.

J: That is not completely reflected in your rankings.

F: I wish that readers would submit more diverse questions. You and Vince will not let me just post a list of the top stocks.

J: That would be OK, if we were charging for a newsletter or something. We invested a lot in developing your method, and we execute it in a timely fashion for our clients – just as you would expect. What we publish here is a sample. No one should expect it to work as well as our own trades.

Athena: My pick this week is the biotech company, Incyte Corporation (INCY). I know Holmes and RoadRunner have held this earlier. I also see this stock has been through quite a lot of ups and downs over the last six months. I made my pick when the stock showed some strength in the face of the short-term downtrend. In my mind, that is a strong reason to buy. I expect upward price slopes for the stock in the coming weeks.

Jeff: I will not even bother with the earnings chart. This is strictly a “story stock.” The pipeline will come through, or it will not.

A: My holding time will me much shorter than the resolution of the pipeline question.

J: How did you do today?

A: In line with the market. It is normal trading.

Holmes: This week, my pick is Oceaneering International, Inc. (OII). Early this week, the stock touched new lows trading at just above the 20-mark. I found this a good point to buy-in at its lowest point. The stock has since picked up and is now hovering around its previous-week levels. I certainly look forward to more upside gains from here.

J: Here is the F.A.S.T. Graphs chart. Enough said.

H: I have no concern for the earnings picture in that time frame. As usual, I just look for a rebound.

J: How did you do today? Almost no change. My stocks have already sold off, so I had little tech exposure.

Roadrunner: My most recent pick is NetEase (NTES). Others might not think this is the world’s most attractive chart, but I like it. Let’s have a look:

As you can see, this stock nearly hit the very top of its channel twice in the last month. It also scraped along the bottom of its channel twice. This suggests to me that this could be an attractive target for a 2-week holding. We’ve already moved from the June 27 low up to the current price. For me, this is just a question of how high this can move in the next 8 days.

J: Haven’t you picked this stock twice before?

RR: Yes. The first time, in March resulted in a decline of about 3%. The last time, earlier this month, featured a gain of over 10%. It is a good channel.

J: Very good. We should not expect winners every time.

Oscar:

This week I have no new choices.

J: You had a tough day today.

O: Yes, although my biotech holdings had given me a good lift going into today.

J: Last week you featured bonds. How are those working?

O: Not so well. I do not choose based upon diversification, but I do follow the action. Bonds and stocks are getting hit together. Normally I would expect better results from my position.

J: You do not hold tech stocks or chip stocks, even though those are at the top of the ratings.

O: The list shows requests from readers. With those in hand, I report results.

J: You are saying that they are not asking the right questions?

O: Let us just say that the list reveals the interest of readers – which might be misdirected. I do report honestly, each week, on a featured sector.

Conclusion

The buzz over basing decisions on evidence is rather surprising. This has been the standard practice of many, including us. I certainly endorse the improvement in methods. What I do not understand is why those who are so late to the party have such pride in their discovery. There also is a bit of confusion about what evidence tells us. Evidence should provide a strong, quantitative basis for finding undervalued stocks. It can provide a warning about “storms ahead” in economic conditions. It can highlight attractive technical setups.

There are many ways to profit in the markets, including all of the above.

What Dr. Brett accurately calls “counting” and looking at winners versus losers is a routine procedure for a good system developer. All of our models are trained on one period for setups, with thousands of cases. They are then tested on an out-of-sample data set on thousands of other potential cases. We monitor the real-time results closely to make sure that each model is trading as expected.

Anyone who reports a super-high level of winners is probably making a rookie mistake or pulling a Madoff-style move. Our models show a modest +/- ratio usually accompanied by greater wins than losses. That is what you should expect.

Here is a summary of the cast of our characters. Find your own favorite!

Stock Exchange Character Guide

Background on the Stock Exchange

Each week Felix and Oscar host a poker game for some of their friends. Since they are all traders they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!