Another Type of Bull

What do candlesticks, oscillators, and Elliot waves have in common? Give up? They're technical indicators—charting analysis recording past market activity used by some to predict future market direction. Rather than balance sheets and economic data, technical analysts use price, volume, and open interest as information sources. If you aren't familiar with Elliot waves, you likely don't know about bullish percent indicators either—which are typically illustrated using point and figure charts.

In point and figure charting, price movement is plotted on a grid using vertical columns of Xs and Os moving left to right. Xs represent upward price movement, and Os denote downward movement. Xs and Os don't share the same column, so when market activity dictates a switch, a new X or O column is started accordingly. The charts resemble nothing so much as a tic-tac-toe game gone haywire. Many technical analysis junkies find these much cooler than boring old line and bar charts—easier to follow too.

Bullish percents can be constructed for any index or group of stocks. The most popular is the NYSE bullish percent index, which adherents view as a reliable indicator of future broad market trends and risk. Put simply, a shift from Xs to a column of Os suggests further broad market downside, whereas a shift from Os to Xs suggests more upside ahead. Historically, the NYSE bullish percent hasn't shifted columns much—roughly three times a year on average. But when it does, many loyal followers duly make significant strategy changes, getting bearish on shifts to Os and bullish on shifts to Xs.

And who wouldn't like an indicator that helps you time market swings? Seems like such a thing could help deliver more upside while avoiding more downside. So, is the index truly reliable? Or is this merely another type of stock market bull?

Advocates highlight many examples when the NYSE bullish percent rightly signaled ahead of major upturns and downturns (perhaps not at the exact bottom or top, but close enough). Indeed, the index shifted to a column of Xs on October 21, 2002, and stocks climbed nicely from 2003 through 2007. Also, the index shifted to Os on July 24, 2007—recall the S&P 500 peaked slightly higher in October 2007. In retrospect, that July 2007 signal was a great time to sell.

Those two examples alone are probably enough to convert any long-term investor into a full time chartist. But before you become a chart-hugger, let's examine the indicator's other signals during that period.

Say you adhere strictly, following every signal from October 2002 through May 15, 2009. The indicator is calculated every day after market close, so I'll give you the benefit of the doubt and assume you act as soon as possible—the next trading day after a plotted column shift. When bullish, you're fully invested in the S&P 500, capturing any upside. When bearish, you're neutral (cash or cash equivalent), avoiding any potential downside.

Adhering to each signal over that period would dictate 38 major strategy shifts—21 of those in roughly the past 21 months. Yikes! Check it out for yourself. But if you're not bothered by all that futzing around you've gained 11.1%! (Though all that activity isn't free, so knock off a little for commissions and taxes.) To boot, you were probably out of the market during some pretty rough periods and in the market for some nice runs. So, was all that rigmarole worth 11.1%? Seems like it—especially after last year.

Alas, poor technician! You're no better off, in fact worse off, than if you simply bought and held the S&P 500 during the period, which returned 12.9%. Doesn't that seem a more sensible (and profitable) option versus the aforementioned futzing? Particularly when you factor in the tax and transaction haircut—which is sizable for 38 moves in and out of the market.

Few hard-core chartists will admit this fact: For every one signal that, in hindsight, led to seemingly the right short-term move, there are two or three head fakes that would have led you astray. Also, "major signals" typically occur after big market moves, not before them. And while it's nice to avoid big downside, big up moves are typically much stronger, and precious upside is missed while waiting for some chart's "buy" signal.

Though perhaps appropriate for sophisticated institutional traders with very short-term objectives, it's not practical (rather, potentially dangerous) for long-term investors to make frequent chart-driven changes. In doing so, it's also not absurd to assume the onset of emotional obstructions, further diverting you from otherwise prudent long-term strategies. Blindly following a chart is akin to emotional investing—both tug you along, rarely letting you get ahead.

Charts merely illustrate history. History can be used to determine future probabilities, but not future certainties. You must realize markets move on the unexpected. Charts don't predict the unexpected—they don't predict anything. Those who believe they do are investing in the wrong type of bull.

Source: Stockcharts.com, Thomson Reuters
S&P 500 Index performance figures represent total return