Wednesday, May 2, 2012

05/02/2012 Time Frames

“In the short run, the market is a voting machine but in the long run it is a weighing machine”
--Benjamin Graham

There are two things that will make a stock go up:
1)      technical money-flow into the stock, or
2)      fundamental money-flow into the company. 
Technicals are more powerful in the short run and fundamentals are more powerful in the long run. The boundary between the two experiences a good bit of whipsawing.
Consider a company that has an earnings miss.  The price may decline to such a point that it breaches a technical support level.  Once that occurs, those who sold for short term fundamental reasons have now created a technical sell signal.  But experienced technicians don’t like to sell on a sell signal.  They want a slight recovery first, so they’ll wait a week or two.  If the stock hits the top of a stochastic level they’ll sell, or if it falls too far it will trigger a stop loss and they will also sell.
Now the stock has established a new negative trend.
At this point some novice price reversion traders will buy the stock and set a stop loss, only to get stopped out as the stock continues to fall.
But the long term fundamentals probably haven’t changed much at all.  So, as the stock continues to fall more and more “retail” investors sell while fundamental analysts scratch their heads wondering if there’s some secret information that they don’t know about making this stock cheaper than it should be.  After a certain point the long term fundamental investors will hold their nose and put their foot in the water, only to watch the stock accelerate downward.
By this time the stock is making the cover of a major news magazine as a sign of the apocalypse.
Everyone who hasn’t been paying attention sells in a panic washout.
And then it reverses.  No news.  No change.  It just reverses. 
Those who favor the efficient market hypothesis neglect to observe that there are different kinds of investors.  We don’t buy stocks from nowhere.  We buy them from sellers.  Those sellers have their goals and we buyers have different goals.  And, strangely enough, each of our goals could be entirely rational and well informed.
The difference may simply be our time frames.
Let’s leave out the so called “dumb money” for a moment and just focus on efficient returns.  That still leaves the question: “efficient in what time frame?”  Four years?  Two? One?  What about the next two hours?  Each person wants to be “efficient” in his own time frame.
It is not efficient to be a fundamental investor if your time frame is a week.  You’ll lose your shirt.
Neither is it efficient to be a technical investor if your time frame is two years.
Here is an example of what kinds of investors are out there and what kinds of time frames they have:
Type of Investor
Popular Indicator
Time Frame
Daily Operations
Mid, Top
Mean Reversion Fundamentalists
P/E, Return on Total Capital
1 to 2 years
Momentum Fundamentalists
2 to 4 quarters
Mean Reversion Technicians
Bullish Percent Index
1 to 2 quarters
Momentum Technicians
Relative Strength, Volume
1 to 3 months
Price Reversion Traders
1 to 2 weeks

I sorted these in terms of time frame, with the “smart money” insiders at the top and the “dumb money” (i.e. Price Reversion Traders and Herd) at the bottom. The technicians and fundamentalists are neither “smart” nor “dumb” but “skilled” (if they know what they are doing).

Insiders are not evaluating a stock; they just know their own company. And the bottom two simply have no idea what they are doing.

This looks more complicated than it is.  Basically, when you ignore the "smart" and "dumb" money, what's left are two types of evaluating a stock: fundamental and technical...  and two types of trade: mean reversion and momentum.  Mean reversion is longer term than momentum.  Fundamental is longer term than technical.

There are dozens of good indicators (and even more bad ones) for each time frame, but I just gave some simple popular ones. Each indicator has a frame of reference it works best in, and can be disastrous if used for any other length of time.  Skilled fundamentalists and skilled technicians will both profit, while the vast majority of traders will lose.
And the reason those investors lose is that they are not matching their reasons to their time frames.  Some, for instance, are trying to buy a fundamental stock with a stop loss in place, but fundamental investments almost always lose money in the extreme short term. 
Those who use indicators that match their time frames will make money; those who do not will lose money.
I noted the other day that I was rotating my stocks too quickly at the beginning of this beta test.  The model has performed well, but not as well as it would have if I had rotated slower.  At the end of this month my beta test will be complete and I will be using an optimized time frame for each stock.
If you use an indicator, track it.  Select stocks based on the indicator, and then track their performance until you reach a maximum return rate.  For technical indicators this will be less than a year regardless of taxes.  For fundamental indicators it will be more than a year because of taxes.  But the only way to know is to record the progress, track it, and optimize based on the results.
Anything less isn’t investing; it’s gambling.

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