Technical Analyst Offers Guidance on How to Play Reversion

Technical Analysis

Technical analysis is supposed to be belief-neutral, where the data itself tells the story as it unfolds. The idea of a technical analyst preparing us for a reversion to the mean is just odd.

Technical analysis is an evolving field in the study of the movement in prices of assets, stocks for instance, that does not derive its insights from company or other external data but instead looks at the prices of an asset itself and studies what actually happens and is going on with stocks.

Just knowing that we should be looking at what goes on with stocks themselves rather than in the world outside their window that may affect their behavior in various ways at least has us looking at what really matters. What we do with this data is what separates the good among those who practice this craft with those who do not, and this is very much a field where there is a wide divergence of skill.

We tend to want to make this analysis far more complicated than it needs to be, and this is especially evident when we look at how just about all technical analysis seeks to take a lot bigger bite out of the right side of charts than they need to, what is sensible to do.

On charts, each bar represents a time interval, whether that be a minute, an hour, a day, a week, or a month. Charts are a technical analyst’s easel, although unlike a painter who looks to paint on this, the analyst uses it to view all the data that goes into the matter on a screen.

There is a strong temptation to try to do too much with technical analysis, and this is its Achilles heel really. Provided that we have set the scale of the chart, how much time a bar represents, to our liking, the maximum number of bars that we should be seeking to predict isn’t many, it is actually only one.

The most we should be claiming is an idea of what the next bar will bring, on a preponderance of probability, and we need to realize that while we may wish to go a bar further, having ideas about this is fine but these aren’t actionable ideas.

When we get to the next bar that we have predicted, that bar now gets colored in and we are now in a better position to decide what the bar that will be coming after this one looks like. Trying to do this a bar earlier does not even make sense, at least if our goal is to put ourselves in the best position to decide. Predicting price movements involve acting on incomplete information, but it’s just better to have it more complete than less.

This lack worsens when they use not just two but a whole lot of bars, and do so in a way that suggests we act on this analysis. Technical analysts make all sorts of other mistakes, which we could describe as a lack of the optimal use of the price data they use, which we will continue to discuss in future articles on the subject, but the one of trying to do too much is the one that we want to elucidate more in this article.

It turns out that there is a valuable lesson here for all investors, as virtually all investors make this mistake as well and make even bigger ones. For them, the old hymn One Day at a Time would serve as a good choice for background music as they come to realize how much more that they are trying to do as well that isn’t needed.

This only should apply to investors who are actually looking to time their positions or at least are open to doing so, and does not include those who do not really plan on doing anything but have nonetheless chosen to pretend. There are plenty of them that see shorter-term market forecasts that do not apply to them but still manage to work themselves up over these things.

There are all sorts of people out there who want to tell you all about where they think that the stock market is going, based upon various things, but it’s quite out of character for a technical analyst to do such a thing, although they do get out of character often times.

Sometimes people can’t help themselves, and just seeing something like this wouldn’t really be noteworthy, but basing this forecast upon fundamentals certainly is. Some analysts use both, but separately, not together.

When we read that technical analyst Andrew Addison of the Institutional View wants to take a technical approach to the reversion to the mean that he sees, that certainly grabbed our attention, given that fundamental and technical analysis make such strange bedfellows and are entirely opposed theoretically.

The reversion to the mean idea is one based entirely upon fundamentals, where they use this data to affix a certain value upon a stock and then claim that, over time, a stock’s price will move toward that.

The idea here is that stocks priced above that are overvalued, and those below are seen as undervalued. As stocks rise, this creates a tendency to extend beyond the assumed fair value and this will somehow yield a correction, although now this is supposed to happen is left unexamined.

The Whole Idea That Stocks Can Revert Themselves is Absurd

The opposite is supposed to happen when a stock is below their line, where the gods whose job it is to promote the valuation of stocks by way of fundamentals step in when they misalign too much.

Never mind that these gods do not exist, as with gods, mere belief is usually sufficient. To these believers, stock prices move themselves apparently, and no one needs to even wonder where these corrections are even supposed to come from.

There is only one proximate cause of stock prices, the behavior of the market. We may think that the market is misbehaving, and needs remediation, but their changing their behavior to that which these folks find more suitable requires something to cause it apart from magic.

If these corrections actually happened, if we actually had more and not less of a tendency for stocks to revert to the mean, then perhaps they could tell a better story, but this is an idea that died long ago, and its death is marked by its utter lack of correlation with reality now.

Stock prices move by way of perception, and in the old days, the perception of stocks reverting to the mean was much more prevalent. This even worked fairly well back then, because it captured what the market would do, where a beat-up stock would attract a lot more flies than in recent history.

That hasn’t been a force in what moves markets for a long time, and the idea has burned to ashes today. There are still people who keep them in urns though and perhaps even long for the good old days, before time left their investing ideas so behind.

Although there is a considerable divergence of views among technical analysts, seeing one try to predict the coming reversion to the mean is a divergence of a different sort, one that diverts from the profession of technical analysis itself.

We measure trends with this form of analysis, and this involves all sorts of trends, including the trend toward momentum that we see now, far away from anything resembling a reversion to the mean. The lack of a trend supporting this reversion is what a technical analyst would look at, and be the first ones to pronounce this idea dead, not chart a course toward it.

Addison tells us that he is looking to guide investors to be able to tweak their holdings when the inevitable reversion comes, where value stocks are to seize the throne and see growth stocks give it up to them. People always talk of such a thing, but he’s got charts to show us as well.

He compares the Russell 1000 Growth with the Russell 1000 and shows us that the growth index has been widening its lead. He then draws a resistance line with just one other point, in 2000, and this whole thing rests on presuming that the Russell 1000 growth cannot exceed its levels 20 years ago.

This is not good technical analysis, and it’s even silly to think that anything that happened 20 years ago even matters at all today. It may or may not stall here, but this line won’t be what stops it, and has no predictive value.

It is also worth pointing out that during that fateful time 20 years ago, where they hit this ceiling, the main index dropped right along with the growth one. When it was all over, they both ended up in the same place, at the bottom.

If this were a legitimate reason for a call to arms, we need to be telling people to run and not just switch. It doesn’t matter which parachute you choose if they both are broken.

He also points out that, with momentum at record levels, he expects it to fall off. We’re not sure though why momentum being at any level would provide a constraint on it, as this is another fundamentalist assumption that requires that we look away from the technical data to even make sense of.

The Russell 1000 also comes in the value variety, what we’re supposed to want to switch away from our growth stocks into, has been particularly hammered lately. Rather than putting in a good-sized recovery, value stocks haven’t shown much value during this time either, especially the small-cap ones that are in the Russell 1000 Value.

Small cap value stocks have two big knocks against them, the fact that they are small caps and the fact that they are value stocks. This is the poorest performing category there is among stocks, in a world where size matters and the fact a stock grows more matters as far as how much it grows.

Addison’s Claims to Using Technical Analysis is Just a Ruse to Hide False Beliefs

Addison cautions against investors looking to make their move too soon, but his presentation on its own takes us very close, where momentum will be knocked off their horse while allowing value to gallop past them.

Both momentum and value really got knocked off of their horses lately, but it was momentum that galloped away and value really was left behind.

This view is completely independent of whatever we may think is going to happen with the stock market, whether we think it will continue to go up, trade in a range, or take the tumble many think it deserves.

If we actually use technical analysis here, we’d be looking for trend reversals between these two types of stocks, enough to be able to draw enough confidence on to want to base our investment decisions upon. When we look at the past that is close enough away to matter, we will find no such trend.

Our transition from value stocks to growth stocks has been a natural and predictable one, where we have come to better understand that what we call value just cashes out below-average prospects in the future. The growth ones have the better prospects, which is why they grow more than stocks that are defined by their lack of growth.

While this doesn’t mean that we may infer that this trend will continue, the most basic principle of technical analysis says that a trend will continue until it doesn’t. Based upon yesterday, tomorrow may be better or not, but as long as it is good, something needs to happen to reverse this, to cause some sort of reversion.

Of the three, watch, wait, and hope, we watch and wait but we do not rely on hope to guide us. The Messiah of the value stocks may come one day and empower them, but we need to see it happen first, something or anything that would lead us to believe that such a revival is underway.

Technical analysis teaches us that we need not worry so much so far out, as if you are worried about your growth stocks diminishing, you just need to watch and wait. Seeing value stocks outperform them in a way that we can determine is a genuine trend and not just over a brief period, even though that excites a lot of people, would be well worth noting, if we ever get to see such a thing again that is.

It you are looking to get out of your growth stocks at some point, you should insist on persuasive reasons and not just someone’s guess without good evidence to support it. There may be a lot to worry about if the market really goes south, but worrying about value stocks taking over is presently not on this list.

Charts are a valuable tool to keep tabs on these trends, but we have to use real trends, we aren’t just allowed to make them up. Should people wish to watch this all unfold, to see if growth can continue to outperform value or if things actually do get turned around, it’s pretty easy to do, one bar at a time.

Addison warns that growth’s edge over value will soon come to an end, but his argument for this is so fundamentally flawed that when you strip away the flaws, there is nothing left. The most he is telling us is that the bull market may be over, and it might be, even though you can never cite something doing well as the reason for it not to do well.

Still though, that’s not unreasonable, as there are a lot of challenges ahead for the economy over the next while, along with an election that almost certainly will add to the damage, which does influence stocks somewhat, although nowhere near as many assume, as we’re really seeing now.

The missing part of his thesis, and the part that is needed to support a movement toward value stocks, is to show that value stocks may be expected to rise in value during this time, which remains a mystery both in theory and in practice. There’s no reason to expect this, not even a foreseeable mechanism whereby it may reasonably occur, no chart action to support this, nothing. Nothing counts for a lot it seems if you just close your eyes tight enough and imagine a world where fairies perhaps direct this show, although we still need to find a path where this supernatural power exerts its force upon the market and compels it to change its mind.

We need to realize that, by definition, growth stocks are better stocks and value stocks are lesser stocks, and this is not by way of proclamation but by way of value instead, where value here is not defined by a lack of future prospects but by an abundance of it.

The gap here is widening, not narrowing, as more and more investors come to realize the price they pay from turning away from stocks that actually have value in favor of preferring stocks that have considerably less value, where value here becomes properly understood as the value of investments themselves, how much money we can expect we’ll make from them.

There is no reason why we will not continue to perceive this real value more and more and have this direct our investment decisions more and more. If this does come to an end or even takes a pause, we will know, as the world will indeed turn upside down and legions of investors who have been clinging to this broken conception will rejoice.

Until that day, this is just a ruse to direct people away from doing what would be sensible, to go with what is doing well and avoid what isn’t. We need to turn away from all the misunderstanding out there and seek to actually understand what goes on with stocks, and lift ourselves above this crazy world that seeks to direct us away from what works toward what doesn’t and does not understand the difference.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

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