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[dc]T[/dc]oday I want to follow up on my previous posts on the rally in the Indian stock market and think a bit about how to balance technical and fundamental factors. Not so long ago, the idea that anyone could figure out anything from looking at patterns on charts was largely dismissed as silliness. Wall Street did not take most technical analysis seriously. (And, by the way, I think there’s good reason for that—most technical analysis does not have a statistical edge, provides no long term hope of making excess profits, and does not work as advertised. Most is not all. Some things work, and we must focus our attention on what works.) Still, many people assume that macro-style trading requires having political opinions, analyzing economic indicators, and predicting the outcome of elections. Though it might seem somewhat contradictory, simple technical patterns can presage significant moves in global markets, and the investor who learns to read those patterns can gain a significant advantage over his peers.

Traders and investors look for an edge in many ways. Let’s be clear what an edge is: it is simply a way to say something like “the market has a greater probability of doing A than B, based on ____”, and you can fill in the blank with any number of factors. I think that statement is simple, but profound, and many investors fail because they misunderstand what they are trying to do. I wish I had a dollar for every conversation I’ve had with a well-meaning, but green, market participant who is explaining to me why some stock or some other asset “has to” do something in the future. (If these newer traders are riding the emotional wave of early, lucky wins, they are in extreme peril that they cannot begin to full comprehend.) The market just doesn’t work like that. You can’t “figure it out” and anytime you think something “has to happen” you are like the cartoon monkey dancing on the edge of the erupting volcano, oblivious to the danger all around.

So many of the blog posts, articles, tweets, etc. I read are based on people “talking their book” (a term which means arguing for why their market position is correct). Furthermore, many people, amateurs and professionals alike, allow highly charged political convictions to cloud their vision; I would gently suggest that most investors could greatly improve the quality of their inputs if they simply removed politically opinionated material from the reading list. I think a more productive way to approach the market problem is with full humility—to realize that the best we can do with any analysis, whether you are looking at a technical pattern, have ripped a balance sheet apart and built a complex financial model, have met with and assessed a company’s management and understand their competitive position in the industry, or have built a non-linear multifactor model—whatever analysis you have possibly done can only, at best, give you a slight tilt to the probabilities.
There is always a significant chance that you are wrong, even if you have made no mistakes, so why would you be upset when you are wrong? (This is a big part of the key to managing trading psychology, but more on that later.)

Weekly chart of Indian stocks published 4/14/14 by Waverly Advisors

In our published research, we identified the bullish setup in India long before the rally began, and had been advising our clients to buy upside breakouts in India for several weeks. (The chart above was from our report published 4/14/14, nearly a full month before the breakout occurred.) Technical tools are certainly “enough”—time and again, we find trades and spots well in advance of political and economic developments. Of course, there is a matter of style here, but if you struggle to deal with reading thousands of pages a week (not unusual, for a dedicated investor) and aren’t sure how to balance many, potentially conflicting, inputs, consider simplifying. I’ve found great clarity, and much better results, the more I have simplified my process and inputs.

In this case, what were the technical factors that supported a long trade? There is an element of subtlety, because I do spend a significant percentage of my waking time thinking about global markets, analyzing them both quantitatively and subjectively. I also read an enormous amount of macro and economic data (generally avoiding opinionated commentary), but usually do not factor that information into the analysis as a primary driver. We had been watching shifts in relative strength among global indexes for many months, and things were “slippery” with no clear leadership. Emerging markets started to show some signs of strength, and then India made a thrust that demanded attention. If I’m simplifying a bit it is because there is an element of this analysis that probably can’t be properly communicated. Sometimes I wonder if this is what a spider experiences, perched in the middle of a web and feeling vibrations and tremors coming from all directions, eventually coming together to make a clear picture at times, but I digress. Once we saw the behavior of volatility, a specific pattern of expansion and contraction, factoring in moves in related economies and currencies, the final trigger was the simple consolidation marked in the chart above. You also might see two upthrusts above the Keltners, the first followed by a clean upside break, and the second perhaps setting up another upside breakout. This analysis would not be wrong, but it might miss some of the subtlety that comes from the larger-scale global perspective.

There are two points to take away from this post. First, simple technical patterns work as well and any complex analysis, but you have to understand those patterns, what they are, how to read them, and how they fit in context. For decades, I’ve been amazed to see technical patterns set up key inflections in markets. (Too many to list here, but a good example is I clearly remember my trading partner turning to me late one afternoon in March 2009 and saying “that’s it. It’s over,” and he was right. Within minutes, he had called the low of that nasty bear market just by watching price action.) I think you have to build your methodology and understand it, but it’s hard to have faith in it until you’ve seen it work through a market cycle, and that takes most of a decade, at least. The second point is that there really is an element of subjective analysis, an intuitive element that can be a tremendous support to your methodology. I tried (probably unsuccessfully) to give some insight into that process in the previous paragraph. It is difficult because it is a non-linear thought process, and it is very difficult to fully communicate the nuance involved. Regardless, the most important thing for developing traders to know is that this intuitive element can only grow on the support of a strong trading methodology.

The rally in India still has a bit more to teach us. I’ll come back in a few days and we will look at some trade management issues, and some of the most important questions most traders should be asking themselves.