| "General notions are generally wrong." |
| -- Lady Mary Wortley Montagu |
N AN EFFORT TO SIMPLIFY THINGS, we often reduce them to their most basic or general terms. Investing is, after all, buying low and selling high. What could be simpler than that? Why complicate the issue with complex trading rules or analyses?
The answer, of course, is that there are good reasons to step beyond the general truisms. For example, you might think if you know what sectors are hot, you can beat the market. While this may be partially true, as you'll see in Size Really Does Matter there's a lot more to it than just that.
You might also be willing to accept the Efficient Market Hypothesis and write off technical analysis as just so much superstition. Although the goofiness of 
some technicians and some of the silliness they follow may make this a tempting course (see Fundamental Technical Analysis and How Can I Tell When the Bear is Gone?), it's probably a mistake to entirely write it off.
Technical analysis plays a role -- albeit minor -- in the timing of purchases and sales for this site's portfolios. Our indicator's signals are updated each Sunday on the Home Page. Our Technical Index gives a description of our indicators and how they are combined to create our technical index.
What do you think? In general, we'd like to hear from you. Specifically, send us an e-mail.
All three. That's right, all three. While Communications Services finished a respectable second in the MidCap S&P 400, it was only eighth in the 500 and dead last in the S&P SmallCap 600.
And no, this wasn't a trick question. In fact, it brings home an important point: Sectors perform differently based on capitalization. To see the extent, just take a look at the following chart.
Larger companies also have more irons in the fire. Larger communications companies (think AT&T) may provide a number of different services such as telephone, cable, and wireless. Smaller-cap issues are frequently one-hit-wonders, offering only one product or service. If it runs into production or distribution problems, there isn't another to fall back on and the quarter is lost.
Of course, there's a lot to be said for doing one thing and doing it well. One-hit-wonders (look at Qualcomm, no longer a small or even mid cap) can have tremendous runs, leaving larger-caps behind. Sure, there's more risk there, but there's also more potential rewards.
When Dan Rather reports that Communication Services led the market higher, he's probably talking about large caps since that's the media's usual measure of market activity. If you act on this information but buy a small cap stock in the same sector, you'll probably be disappointed.
Even if the fundamentals tell you your small cap stock should be a great performer, if investors are currently looking to other capitalizations, you'll probably have to wait awhile before it begins to perform. It's not a quality issue, it's a timing issue.
In essence, when screening for stocks -- ones you want to move in the next 6 - 12 months -- you should look at the capitalization as well as the sector. After all, you have a much better chance if your selection comes from the number two sector as opposed to the number eleven.
Actually, you ought to consider it. While we certainly don't advocate a purely technical trading strategy, we do feel technical information can and should play an important role in your investment timing. Technical analysis probably can't help you find a stock with great appreciation potential, but it can help you decide when to buy it.
Look at it this way: Wouldn't it make more sense to buy your stock when it's nearing a bottom than when it's approaching a top? That's where technical analysis can help. It can also give you an appraisal of the overall market sentiment and whether it's a good time to buy or sell. That's how we use it here.
Underlying technical analysis is the belief that the future will be like the past. If recurrent trends can be identified, you can predict their outcome when you detect them again in the future. That's why technicians spend a lot of time studying the price movement of individuals stocks and the market as a whole.
Technicians believe a stock's fundamentals really don't matter -- if people want to buy it, it'll go up, if they don't want to buy it, it'll go down. Stocks move like everything else, as a result of supply and demand. Trading volume is a good gauge of demand and investor conviction.
Contrary to the popular "efficient market hypothesis", technicians don't believe that all public information is immediately priced into the market. Instead, they feel it takes time for it to be acknowledged and assimilated. By identifying and studying market trends, they can use them to their advantage before other investors recognize and act on the information.
The next step is to devise a system or group of "indicators" that can tip off changes in market trends. The goal is to pick up changes in trends ("reversals" in technical language) so that you can quickly act on them before they become common knowledge. That was our goal when we created this page's technical index.
Charles Dow was one of the founders of the Wall Street Journal and (as the name would imply) the creator of the Dow Jones indexes. As one of the first technicians, he believed trends in the indexes could provide clues as to the future direction of the market. But he also believed that a combination of indexes could provide more accurate information.
More precisely, Dow relied upon the Industrial and Transportation Averages. He reasoned that if increased industrial production was to translate into earnings and not just increased inventories, products must be shipped so the Transportation Average would also have to rise. Similarly, without an increase in demand for manufactured goods, a rise in the transportation average could not be more than short lived.
From this, Dow concluded that in order to be meaningful, trends in the Industrial and Transportation indexes must "confirm" one another. Confirmation occurs when they both hit new highs or lows and continue moving in the same direction. Any other movements are just temporary market noise.
Dow's reliance on the Industrial and Transportation Indexes was probably justified when he proposed the theory at the turn of the century. But today, the economy and the markets are significantly different. Our indicators do use two indexes, but ours are market based -- one growth and one value. (Portfolio 1 -- see Historical Peformance -- is the proxy for the value component.)
The underlying theory is that bull markets -- true bull markets -- are very broadly based. While the 1970s were lucrative for the "nifty fifty", they certainly weren't for any other stocks. If the market is led by only a small number of "value" or "growth" issues, the advance is probably not sustainable and it isn't a true bull market. Similarly, if value investments languish while growth stocks soar, there's no discernible trend, just noise.
Specifically, our first two indicators are the 200-day moving averages of the value and growth indexes. If it moves up, it's a positive sign, if down, it's negative. We also compare the two 200-day moving averages to one another to create the third indicator. If they're both moving up, that's positive, if they're both moving down, that's negative, and if they move in different directions, that's neutral.
The fourth and fifth indicators are the weekly trends of the value and growth indexes relative to their 200-day moving averages. If both the weekly trend and the 200-day moving average are moving up and the weekly trend is above the 200-day moving average, that's positive. If they're both moving down and the weekly trend is below the 200-day moving average, that's negative. Any other combination is neutral.
The advance/decline line is simply the difference between the number of advancing issues and the number of declining issues. It's not an absolute measure so its value really isn't what's important. What is important is its trend. If it moves up by more than 5% from the previous week, that's positive. If it moves down by more than 5%, that's negative. Any other change is neutral.
The difference between new highs and new lows is also a relative measure. This figure changes from week to week, but in order to be more than neutral, it has to increase or decrease by more than 10% from the prior week.
The index gives a buy signal when it gives two readings of +8 or +9 without and intervening reading of -8 or -9. The opposite holds for a sell signal. The overall reading remains neutral until two confirming buy or sell signals are given. There's no limit to the time between the two signals.
As you can see from the accompanying chart, the index doesn't give a lot of conflicting signals -- in fact, it doesn't give many at all. On July 2, 1999, it sent a buy signal. This was a confirmation of the last +8 reading given on November 5, 1998. Prior to that, it had been neutral.
So can this be helpful? Yes, if you use it properly. Like most technical indicators, this is a timing index that can helpful when making buy and sell decisions. While you wouldn't want to use it as a means of getting completely in or out of the market, it can be helpful when making decisions about when to act on stocks you've already decided you want to buy or sell.
No, it won't get you out of having to do your fundamental homework, but then, did you expect it to?
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"It's just the same, only different." -- Beaver Cleaver
S&P divides stocks into eleven different sectors. How did the Communications Services sector finish the first quarter -- second, eighth, or eleventh?
Order of Performance
First Quarter 1999S&P 500
(Large-Cap)S&P 400
(Mid-Cap)S&P 600
(Small-Cap)1
Technology
Energy
Energy 2
Financials
Communication Services
Transportation 3
Consumer Cyclicals
Technology
Financials 4
Energy
Financials
Capital Goods 5
Transportation
Transportation
Utilities 6
Health Care
Consumer Cyclicals
Consumer Cyclicals 7
Capital Goods
Health Care
Health Care 8
Communication Services
Consumer Staples
Technology 9
Basic Materials
Basic Materials
Consumer Staples 10
Consumer Staples
Utilities
Basic Materials 11
Utilities
Capital Goods
Communication Services
Bigger, Not Necessarily Better
Larger companies tend to be better capitalized than their smaller brethren. The larger a company, the easier it trades. Smaller companies tend to be less liquid, trading far fewer shares. Uncertainty in the markets usually drives investors to the (perceived) relative safety of larger-cap issues.
Back to the Generalizations
In general, sectors don't move in unison across all market capitalizations. Usually larger companies outperform when investors are cautious, and smaller stocks take off when investors are comfortable taking on their additional risk -- typically during economic expansions.
"Chance is a word void of sense; nothing can exist without a cause." -- Voltaire
F YOUR INVESTING STYLE FOCUSES, on margins, P/E, and debt-to-equity ratios, even the language of technical analysis sounds peculiar. Technicians don't utilize mathematical ratios and company fundamentals in making investment decisions. Instead they rely on esoteric "indicators" such as advance/decline lines, moving averages, oscillators. Who in their right mind could make investment decisions based on a head-and-shoulders pattern or double bottom?
The Inefficient Market Hypothesis
A Variation of the Dow Theory
Four of our indicators are traditional technical tools, while the other five are a variation on the Dow Theory. The combination of their readings gives us our index.
Highs, Lows, and Advance/Decline Lines
The final four indicators are traditional technical indicators. To make sure we're really seeing a good cross-section of the market, we look at two things on both the Dow Industrials and the NASDAQ: the weekly advance/decline line and difference between the new highs and new lows on each index.
Reading the Tea Leaves
The index is simply the sum of the positive and negative indicators. Neutral indicators don't count. With nine indicators, the index ranges from +9 (bullish) to -9 (bearish). Most weeks it falls in the +7 to -7 range.
Signals from the Index Signal
Duration Sell
April 21, 1994 - June 2, 1994 Buy
August 4, 1994 - October 13, 1994 Buy
March 16, 1995 - October 26, 1995 Sell
January 6, 1996 - September 12, 1996 Buy
September 19, 1996 - September 11, 1998 Buy
July 2, 1999 - Present
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