Figure 11.9 S&P 500 index, a composite of 12 indices listed in Figure 7.8. Figure 11 .shows how subsequent performance analysis for both buy signals and sell signals can be used together in an indicator. For each time span, the charts box lists the markets performance

after buy signals, after sell signals, and for all periods.

one-year gains. But the analysis takes an additional step in assessing the chances for a bull market peak within the one- and two-year periods after the years with market gains, or a bear market bottom within the one- and two-year periods after the years with market declines.

This analysis requires the use of tops and bottoms identified with objective criteria for bull and bear markets in the Dow Industrials.2 The reversal dates show that starting with 1900, there have been 30 bull market peaks and 30 bear market bottoms, with no more than a single peak and a single trough in any year. This means that for any given year until 1995, there was a 31 percent chance for the year to contain a bull market peak and a 31 percent chance for the year to contain a bear market bottom (30 years with reversals/95 years).

Using this percentage as a benchmark, it can then be determined whether there has been a significant increase in the chances for a peak or trough in the year after a

Figure 11.10 DJIA yearly close and the DJIA year-to-year change. For assessing the chances of a market reversal, the signal is the markets year-to-year change at the end of the year, with the signals (years) categorized by the amount of change-years with any amount of change, those with gains of more than 5 percent, and so on.

Dow Jones Industrial Average Yearly

Yttrlt Dau 12/31/1899 - 12111/96 (Lot Seal/)

4391 3400 2632 2038 1978 1222 946 733 567 439 340 263 204 158 122 95 73 57 44

4391 3400 2632 2038 1578 1222 946 733 567 439 340 263 204 158 122 95 73 57 44

70 60 50 40 30

-10 -20 -30

Through 7/30/96. Th« DJIA Changa to 7.1 % For II» Yur

P- mod Trough Dot* Bond on NOR-oatinod fluff end Boor

-20 -30 -40 -50

DJIA Year-to-Year Change

Source: Ned Davis Research. Used by permission.

one-year gain or loss of at least a certain amount. The charts boxes show the peak chances following up years and the trough chances following down years, dividing the number of cases by the number of peaks or troughs. For example, prior to 1995, there had been 31 years with gains in excess of 15 percent starting with 1899. After those years, there was a 52 percent chance for a bull market peak in the subsequent year (16 following-years with peaks/31 years with gains of more than 15%). The chances for a peak within two years increased to 74 percent, which can be compared to the benchmark chance for at least one peak in 61 percent of the two-year periods (since several two-year periods contained more than one top, this is not the exact double of the chances for a peak in any given year). The analysis could also be applied to peaks and troughs identified using criteria for identifying shorter term peaks and troughs.

A major difference in this analysis is that in contrast to signals and zones, which depend on the action of an indicator, this approach depends entirely on time. Each

Conclusion

Each one of these methods can help in assessing a markets upside and downside potential, with the method selected having a lot to do with the nature of the indicator, the time frame, and the frequency of occurrences. The different analytical methods could be used to confirm one another, the confirmation building as the green lights appeared. alternative would be a common-denominator approach in which several of the approaches would be applied to an indicator using a common parameter (i.e., a buy signal at 100). Although the parameter would most likely be less than optimal for any of the individual methods, excessive optimization would be held in check. But whatever approaches are used, it needs to be stressed that each one of them has its own means of deceiving. By better understanding the potential pitfalls of each approach, indicator development can be enhanced, indicator attributes and drawbacks can be better assessed, and the indicator messages can be better interpreted, resulting in more profitable trading.

The process of developing a market outlook must be based entirely on research, not sales. The goal of research is to determine /something works. The goal of sales is to show that it does work. Yet in market analysis, the lines can blur if the trader decides how the market is supposed to perform, then selling himself on this view by focusing only on the evidence that supports it. What is worse is the potential to sell yourself on the value of an indicator by focusing only on those statistics that support your view, regardless of their statistical validity. As shown by the hazards associated with the methods described in this chapter, such self-deception is not difficult.

As a trader, your research goals should be objectivity, accuracy, and thoroughness. Using a sound research approach, you can determine the relative value of using any particular indicator in various ways. And you can assess the indicators value and role relative to all the other indicators analyzed and quantified in a similar way. The indicator spectrum can then provide more useful, profit-building input toward a research-based market view.

Endnotes

1. This is a reference to Burton Malkiels A Random Walk down Wall Street (New York: Norton, 1990), which argues that stock prices move randomly and thus cannot be forecasted through technical means.

2. A bull market requires a Dow Industrials rise of 30 percent after 50 days or 13 percent after 155 days. A bear market requires a 30 percent decline after 50 days or a 13 percent decline after 145 days. Value Line Composite reversals of 30 percent since 1965 also qualify. This applied to the 1990 high and low. Results use the equivalent high and low dates in the Dow Industrials.

signal occurs after a fixed amount of time (one year), with the signals classified by what they show (a gain of more than 5%, etc.). Depending on the classification, the risk of a peak or trough can then be assessed.