Don't get caught up in rallies

Don't get caught up in rallies

Is it too late to buy? Will the market run much further? I wish I had bought the January Blue Chip Portfolio! Should I take my profits on the banks? Investor psychology can be an excruciating influence. And don’t think it’s just you; everyone’s nemesis, Harry Hindsight, will rest contently on one’s shoulder and direct the brain to think useless thoughts, “I should have bought CBA in November” or “Why didn’t I cash in that term deposit and put it into shares last October like my wife told me to!”

But fear not! In five years’ time, when you look back over your long-term performance, this rally so far will appear as a bump in the road (for some of you a good bump, for others a bad one).

Rather than sit here and blindly guess how to best answer these questions, however, our Head of Global Advice, Oliver Gordon, takes a technical/statistical look at this rally.  After all, when sentiment is involved, we prefer to look at what the market is telling us rather than focus too much on valuations. 

Overview

With the ASX200 up over 17% from the middle of November 2012, plenty of investors are now asking themselves how much further this market advance will go, without a decent correction. It is a well known fact that the share market does not go up in a straight line forever, with periods of exuberance punctuated by temporary corrections or periods of consolidation, some being longer and deeper than others.

What is intriguing about the advance over the past three months is that from a low of 4334 on 16 November, the ASX200 has rallied some 772.3 points (17.81%) with barely a correction along the way, with the biggest decline being just 1.65% over a two day period.

Market advances of over 15% without a notable correction (defined in this case as 2% or greater) are very rare, occurring on just 8 occasions since the beginning of 1987. A full table of these examples can be seen to the right. 

The current rally, highlighted in the table in blue, is currently the 5th biggest, at 17.81%, still well short of the rally into the 1987 peak of 29.99%.

The two columns on the right hand side of the table plot the performance of the ASX200 beyond the respective peaks, showing returns after 1 and 3 months respectively. Excluding the current rally, which is yet to complete, we can see that on 5 out of 7 occasions, the ASX200 was lower a month from the highs, with the biggest decline being a modest 2.66%.

Looking at the performance of the ASX200 three months out from the peaks, and the variability of returns differs quite considerably, thanks mostly to the ‘1987 crash’ which shortly followed the strong advance between June and September of that year. In this instance, the Index was some 44.59% lower. However, excluding a decline of 9.66% in 1989, the ASX200 has been broadly higher three months out after a strong rally.

We highlight these figures more for interest sake, rather than trying to make a bold prediction about what will follow the current advance, something that is challenging to do with a limited set of data points.

Turning our attention back to the current rally, and a rise of over 700 Index points has definitely piqued the interest of many market watchers, many of whom are either extrapolating recent gains out many months in advance and calling for a move towards 6000, or trying to pick the highs.

As traders, we must make a conscious effort to avoid both types of thinking. 

A technical view

Using technical analysis (i.e., the study of price), however, we can make an assessment of the probability that a rally is ending, with the use of momentum indicators.  There are many such indicators out there, but we wish to highlight just one, being the RSI, which stands for Relative Strength Indicator.

Momentum indicators are generally used in two ways in an attempt to assess whether an up-trending market is at risk of correcting lower. The first is by simply looking at when the indicator moves into the classified overbought region, which in the case of the RSI is above 70. 

 

The first chart to the right highlights the problem with such an approach; that being, that a security can remain overbought for some time. In other words, the price continues to trend higher, despite the indicator suggesting that the price is overbought. Taking action on such a signal would see you either exit a long trade too early, or even worse, entry a short trade way too early.

The second approach is to wait for what is known as momentum divergence, which occurs when a new price high is accompanied by a lower reading on the momentum indicator; the theory being that before a trend will reverse, it will first lose momentum. Just like how a car must slow down before transitioning from driving forward, then into reverse. 


The current chart of the ASX200 shows the peak reading in the RSI occurring at the end of January, with new price highs occurring with a lower reading on the RSI, so momentum is beginning to wane here. For this divergence to be confirmed however, we must see the RSI break to new lows, as annotated with a red line.

For this to occur, the price must begin to decline, meaning that this approach is not about trying to pick the absolute high, but waiting for confirmation. 

Conclusion

Rivkin Global, with its average holding period of around 11 days, has the luxury of not having to pick medium-term trends in order to produce successful results. However, using statistics and technical analysis, it is hard to find a reading that suggests a pull-back is near. Global members will notice when our analysis changes, by virtue of our holdings.

We have been bullish equities (especially US equities) for months, and when this rally does come to an end, you’ll no doubt see us looking for a confirmation that a correction is in place and trade it accordingly.

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