The Theory Of Fluctuation

What gives the trader the ability to presume that a stock bought under these
circumstances will go up in the relatively near future? A guiding principle
of contrarian investment thinking is that what goes down will usually come
back up.

The concept is called “reversion to the mean,” and it usually appears
to work. However, while we are certainly contrarian in our buying
strategy, we do not hold the conviction that what is at play in most cases is
a reversion to any mean. Such a concept assumes that there is some kind
of “fair price” of the stock and while the actual market price may deviate
upwards and downwards, the stock always finds itself drawn back to that
fair value pricing point as if pulled by some kind of irresistible gravitational
force.

Our difference of opinion with this view concerns the existence of
such a mean price or fair anchor price. We see the dynamic of what appears
to be a reversion to the mean at work in most if not in all stocks,
but we feel that what is really going on is a simple, natural fluctuation in
price. Any fluctuation, of course, has its mathematical mean or midpoint,
but we do not feel that there is any force pushing the stock price toward
that price point other than a statistical coincidence. This difference of opinion
with the “reversion to the mean” crowd may just amount to a splitting

of hairs. After all, the resulting contrarian buy signal is the same—buy low.

However, in the interest of understanding better the mechanics that drive
prices in the market, the concept of “reversion to the mean” is better replaced
by a “theory of fluctuation.” This posits that individual stocks as
well as the overall market itself move in waves or cycles, which are evident
in the very short-term, medium-term, and over the long-term, too. As
short-term traders, it is the short-term fluctuations that we take advantage of.
Read More : The Theory Of Fluctuation

The Elliot Wave Principle

The Elliott wave principle was first advanced by Ralph Nelson Elliott in
the 1930s in a series of articles and books. Elliott’s theory was rediscovered
and popularized by Robert Prechter who, together with stock market
analyst A. J. Frost, published Elliott Wave Principle: Key to Stock Market
Profits in 1978. Elliott’s wave principle has intriguing similarities to Dow
Theory, not least of which is its proposition that stock market prices move
in waves. In contrast to Dow Theory, Elliott considered his wave patterns
to be as valid a predictive device over any time period in the market that is
observed, from the entire history of the market down to a chart setting out
market price movements over just a 5- or 10-minute period.

Elliott’s theory bases itself on the same principle as Newton’s Third
Law of Motion in Physics—that every action is followed by a reaction. In
the financial markets this can probably be reduced to its most basic level
in the assertion that what goes up must come down. The Elliott wave principle
also claims an underlying correlation with the Golden Ratio (1.618)
associated with the Fibonacci Sequence of numbers, publicized by the 13th
century Italian mathematician Leonardo da Pisa, known as Fibonacci, and
derived from earlier mathematical theories developed in India. The supposed
scientific and arithmetic underpinnings of Elliott’s theory lead to a
very rigid principle that holds that market moves follow a constant pattern
of five waves in the direction of the main trend, bull or bear, followed
by three corrective waves. The cycle in a bull market runs up, down, up,
down, up, followed by down, up, down. In a bear market the five/three pattern
is neatly reversed. The wave pattern that is exhibited here is said to
reflect the constant swings of investor psychology from optimism to pessimism
and back again. We are certainly believers in this type of pendulum
swing from optimism to pessimism, as well as its effect on markets even
if we prefer to classify these primary emotional drives as “greed and fear”
(see Chapter 4). In common with many critics of the Elliott wave principle,
while we feel comfortable with the desire to replace outright chaos
or even a “random walk” with patterns that can help predict future price

movement, it is the rigidity of the five/three pattern that we find unrealistic
and a little too suggestive of an almost religious predetermination—as so
much that is Fibonacci-related tends to be. We like to mix our acceptance
of the existence of patterns in the markets with a judicious recognition of
the equally important existence of the more chaotic nature of the effects of
human emotional drives.

KONDRATIEFF WAVE
For those who like their waves or cycles in both the economy and markets
to be even more long-term, there is the Kondratieff Wave that originated
with the ideas of Russian economist Nikolai Kondratieff (1892–1938). This
school of thought posits a very long cycle, between 50 and 60 years, affecting
modern capitalist economies. Ironically, Kondratieff himself helped
develop the first Soviet Five Year Plan. But his writings were considered
critical of certain aspects of the Soviet planned economy and he was sentenced
to death by Stalinist officials and executed in 1938 after a period of
imprisonment in the Gulag. In our view, the waves of such long duration
that Kondratieff identified are probably of little more than academic interest.
Clearly the relevance of so-called supercycles to anyone
pursuing a short-term trading strategy would be minimal to nonexistent.

WATER, WATER, EVERYWHERE, BUT NOT
A DROP TO DRINK
As our comments here show, we do not hitch our wagon to any particular
theory based on market waves. We are, however, completely supportive of
the concept that market movements contain patterns that recur over and
over again and thus can be indicative of future trends in the market. Where
these patterns run over the longer term, such as bull or bear markets, they
can be considered cycles. Where they are short-term, lasting days, hours,
minutes, or perhaps even just a few seconds, they are better thought of as
fluctuations. In any case, the important thing to keep in mind is that they
are always there, constantly recurring and providing runes for the market
observer, whether trader or investor to ponder. One of the problems that
we see with these patterns, aptly given oceanic, or perhaps more properly
littoral metaphorical names, is that they may provide some useful guidance

to the market observer in his quest to understand where the market is
coming from and maybe in which direction it is going. As a result, those
writers who stand behind one or other of the wave theories generally set
out to advise their readers the best times to buy and the best times to sell
stocks as an asset class, based on the patterns that they have discerned.
However, they generally leave this important question unanswered: If this
is a good time to buy stocks, which particular individual stock or stocks
should I buy?

With the acknowledgment that there are patterns, trends, cycles, and
fluctuations in every market, in the next two chapters we look at some
of the reasons that they work in this way. We also examine how we take
that extra leap to use recurring market fluctuations to select individual
stocks to buy and how we choose the specific times at which we make
our purchases.
Read More : The Elliot Wave Principle

THE DOW THEORY

The theory had its beginnings in editorials written from 1900 to 1902 by
Charles H. Dow in the Wall Street Journal. Dow’s good friend S. A. Nelson
tried to persuade him to put these ideas into a book. Dow resisted, and
so Nelson wrote it himself. He published The ABC of Stock Speculation
in 1903 following Dow’s death the previous year. The book included 15 of
Dow’s seminal Wall Street Journal editorials on the subject of speculation
in the market. It was in this book too that Nelson first coined the term
“Dow Theory.” The theory was subsequently expanded upon and refined
by William Peter Hamilton, Dow’s understudy and the editor of the Wall
Street Journal, in editorials titled “The Price Movement,” as well as in his
book, The Stock Market Barometer, published in 1922. However, it was
left to Robert Rhea to organize and summarize the theory more fully. Rhea
was confined to bed for many years with tuberculosis and a damaged lung.

He used this time of enforced physical inactivity for study of business and
the markets and to hone his understanding of the trends that, according
to Dow and Hamilton, characterize the market. In his 1932 book, The Dow
Theory, Rhea wove together the various strands of the theory, including
252 editorials by both Dow and Hamilton, setting them out in a structured
way designed to be of practical use to the individual investor. As mentioned
above, it was in Rhea’s 1934 work The Story of the Averages, that he used
ocean metaphors to describe the three basic trends of Dow Theory. “I like
to think of Dow’s three movements as being the tide, the wave, and the
ripple, all acting, reacting, and interacting at the same time. Consider a
rising tide: as part of the tide we may have an oncoming or a receding
wave, but on the wave may be an incoming ripple, or perhaps a ripple acting
against the tide.”

According to both Hamilton and Rhea, there are certain key assumptions
that need to be accepted in order to understand and use Dow Theory.
The theory asserts that the primary trend of the overall market cannot
be altered through market manipulation, even though individual stocks
are subject to short-term and even medium-term manipulation. A focus
on market manipulation today seems a little antiquated and a reflection
of the times in which the Dow Theory was formulated, the late 19th century,
when market manipulation indeed was rife. Today the market is much
broader and deeper compared to what it was over 100 years ago or during
the Depression pre-World War II time of Rhea’s writing, so manipulation of
the entire stock market today would appear to be a much more ambitious
and probably impossible endeavor. It is true that individual stocks can be
manipulated, particularly smaller stocks, through accounting fraud, the deliberate
spreading of rumors, and big investors deciding to act in concert

while taking short positions. Also individual market manipulations such as
the Hunt brothers’ attempt to corner the silver market in 1980 or the manipulation
of California’s Energy market in 2000 and 2001 by Enron and
other energy trading companies are perfectly possible to envisage in modern
times. Manipulation of the overall U.S. stock market today, however,
appears to be a concept lacking any real feasibility.

Another major assumption that followers of the theory are advised
to accept is that every known fact is already discounted in the market.
In other words, stock prices reflect all available information, including all
hopes, disappointments, fears, and other emotions of market participants,
as well as all extant knowledge of economic factors. These include interest
rate trends and earnings expectations for all companies quoted on the
market. Political events such as presidential elections and domestic and
external strife are also included. Only the unknown and unknowable, such
as catastrophic “Acts of God” are not reflected in current prices.

A third assumption that adherents to Dow Theory accept is that the
Theory itself is not infallible. It can guide the investor in his understanding
of what the trends mean, but is not immutable science.
The Dow Theory concentrates on identifying the primary trend because
followers of the theory believe that the correct recognition of that
trend is the best means to making money in the market. As Rhea put it, “The
correct determination of the direction of this movement (primary trend)
is the most important factor in successful speculation.” These primary
trends can last many years, and correspond to what is usually termed either
a bull or bear market. In Dow’s day, these terms had not yet come into use
and the primary trends were still generally called “booms” and “panics.” In
Rhea’s parlance, the primary trend is like a “tide,” and the point at which
the primary trend changes from bull to bear or vice versa is described aptly
as a turning of the tide.

Secondary “reactions” move against the prevailing primary trend for a
time, with a life span of perhaps a few weeks to several months. These are
called market corrections when they are on the downside and go against
a prevailing bull market—or market rallies when on the upside against a
prevailing bear market. Robert Rhea dubbed these moves waves. For Dow
Theorists, secondary reaction moves are considered to be the means by
which the market ensures that excessive speculation and possible overheating
or cooling of markets is kept in check. Of course, there is always
the possibility that corrections and rallies are mistakenly identified as a
change in the primary trend; but it is one of the aims of Dow Theory to
identify these trends correctly in order to ensure that speculative market
activity takes advantage of them and is not stymied by them. This is not
very easy to do, however, as even the staunchest followers of the Dow

Theory would admit. Rhea considers the secondary reaction as the “most
deceptive” of trends.

Finally, there are daily fluctuations that can move with or against the
primary or secondary trend. Their defining characteristic is that they are
short-lived, lasting from a few hours to a few days, and then reverse themselves.
In Rhea’s lexicon, these fluctuations are the ripples. According to
Dow Theory, while short-term market movements can be useful when
grouped together to aid analysis of the bigger picture of secondary or even
primary moves, these ripples are insignificant when identified or analyzed
on their own. Followers of Dow Theory believe that these short-term fluctuations
have no real importance or value in pointing to primary or even
secondary trends and are no more than background noise. Rhea was certainly
very dismissive of any attempt to make money by exploiting these
short-term fluctuations:
It will be seen that these minor movements rally and decline, back
and fill, and generally perform in a manner most perplexing to the
man who is trying to watch each day’s fluctuations in hopes of scalping
a few dimes out of a few shares of stock while paying commissions,
taxes and brokerage.

In retrospect, Rhea can be viewed as the first observer of markets to have
provided a strong critique of day trading as a money-making practice.

Bulls and Bears
Dow Theory sets out three distinct stages to a primary trend bull market as
follows.

Stage 1: Accumulation. This is the first budding stage of a bull market or
“boom” in the vernacular of Dow’s day, when there is still great pessimism
regarding the future. As expectations rise that things will improve,
stock prices begin to rise also. There is increasing recognition
that a bull market is underway. Nevertheless, this growing optimism is
tempered by lingering fears and doubts that what is happening is simply
a rally within a continuing bear market. This is the stage when the
smartest and most perceptive of value investors see their opportunity
to come into the market at cheap levels.

Stage 2: General advance. This stage takes hold as improving business
conditions and a boost in business confidence increase valuations in
stocks. Here trend followers buy in as the market consistently makes
new highs and the investing public is filled with increasing confidence.


Stage 3: Excess. Speculation is rampant and pushes the market ever higher.
Valuations are excessive and the general public is fully involved in the
market. Everyone believes that a new era is at hand and all are overly
optimistic regarding the future. This sounds like Alan Greenspan’s “irrational
exuberance” and will be familiar to all who were watching
the market in the late 1990s into the year 2000.

For Dow Theorists, the primary trend bear market, or “panic” as was
still the accepted terminology in Charles Dow’s day, also has three stages
that mirror the three stages of the primary bull market.

Stage 1: Distribution. This is the point where the “smart money” starts
to move out of stocks; but the majority of investors are still willing
buyers because they feel that the market still has a long way to go on
the upside. The market, however, starts to look tired.

Stage 2: General decline. This downward trend is characterized by deteriorating
business conditions, falling revenues, and shrinking profits.

Stage 3: Despair. At this point, there is no good news around. The
economic outlook is bleak and nobody wants to be involved with
the stock market, which appears to be a loser’s game. There is
a generally pervasive lack of confidence in the future. The despair
stage continues until all of the bad news is fully priced into
stocks, then the cycle can begin again. It is at this stage that financial
reporting may adopt a very negative tone on the prospects
for the market. The most often quoted example of this is the
Business Week cover story of August 13, 1979, “The Death of Equities,”
which foretold the forthcoming demise of stocks as the
Dow languished at around 840, a prognosis that clearly now seems
somewhat premature with the Dow above 12,000, as of February
28, 2007.

Peaks and Troughs
Dow Theorists seek to identify the primary trend using what is known as
peak and trough analysis. An uptrend is detected by prices forming a
series of higher highs and higher lows. A downtrend is characterized by
prices setting a series of lower highs and lower lows. Additionally, it is also
an important part of the theory that the Dow Jones Industrial Average and
the Dow Jones Transportation Average both confirm the trend. Until 1897,
there had been just one stock average maintained by Dow Jones & Co., but
at the beginning of that year separate averages were established for railroad
and industrial stocks. Today’s equivalent of the early Rail Average is

the Dow Jones Transportation Average. It is normally to be expected that
the Transportations lead the confirmation of any trend, as stocks in that
index are especially cyclical and, by definition, highly susceptible to economic
changes. However, Dow Theory holds that the certainty of a new
trend can only be considered to have been firmly established when both
averages confirm each other’s evidence of it.

Trading volume is also said to provide additional evidence of which
trends are in place. “A market which has been overbought,” according
to Rhea, “becomes dull on rallies and develops actively on declines; conversely,
when a market is oversold, the tendency is to become dull on declines
and active on rallies. Both markets terminate in a period of excessive
activity and begin with comparatively light transactions.”

As previously mentioned, the Dow Theorists in no sense shy away
from looking at what they are trying to achieve as “speculation.” However,
they look rather askance at short-term speculation/trading. Rhea voices the
rather low level of importance he places on the ripples in his Story of the
Averages, asserting that the study of the ripple fluctuation, or the minor
trend as it is also termed, warrants only 10 percent of serious study time.8
As Dow Theorists see it, the study of ripple fluctuations provides little predictive
information from the price data to point to the trends that truly
interest them, the primary bull and bear trends.

For Dow Theorists, the principal reason that there should be any examination
of short-term fluctuations is to ascertain whether these start
to form patterns over time, which may be valuable in helping to identify
the more important primary and/or secondary trend. One of the patterns
that may be formed by ripple fluctuation movements is a so-called “line.”
Hamilton many times referred to “lines,” which were really trading ranges
where the market moves sideways for two to three weeks or longer. According
to Dow Theory, such trading ranges indicate either accumulation
or distribution, but which one it actually is will only become apparent once
the market breaks out to the upside or downside.
Read More : THE DOW THEORY

Modern Portfolio Theory

While the random walkmodel and EMT were being developed in the 1950s and 1960s, Harry Markowitz of the City University of New Yorkand yet another Nobel Prize recipient (in 1990, along with Sharpe) was developing modern portfolio theory (MPT).15 The basic idea here is that combining a group of noncorrelated stocks in a single portfolio results in a portfolio with less volatility than the average volatility of those individual stocks.

MPT proposes that all investments are reducible to two elements— riskand return—and assumes that investors are risk-averse in the sense that they will sacrifice returns to avoid riskand demand greater returns to assume risk. MPT says that such investors will best address their risk aversion by investing in a portfolio of investments in which they receive the greatest expected return for any given level of risk.

The expected return on an investment is simply the weighted average of all possible returns on it, and the riskof an investment is the dispersion of possible returns on that investment around the expected return. Under MPT, expected return on a portfolio of investments is simply the weighted sum of the expected returns on the individual investments; the risk, however, of a portfolio of invest ments is not necessarily the weighted sum of the risks (or dispersion in the returns) of the individual investments.

The central insight of MPT is thus that since variations in returns on individual investments may reduce the dispersion of returns on a portfolio of investments, portfolio riskis primarily a function of the degree of variance of individual investments compared to the portfolio as a whole. This means that portfolio riskis minimized through portfolio diversification.

MPT’s understanding of riskhas another important implication. With respect to any stock, two elements of risk can be distinguished: systematic riskand unsystematic risk. Systematic risk (also sometimes called market risk or undiversifiable risk) arises from the tendency of a stockto vary as the market in which it is traded varies.

Unsystematic risk (also sometimes called unique risk, residual risk, specific risk, or diversifiable risk) arises from the peculiarities of the particular stockbeing investigated.

Because under MPT’s diversification directive unsystematic risks can be diversified away to zero, market returns on a stock in a competitive market will not include any compensation for such risk.

Thus, market returns will be a function solely of the systematic risk, or the extent to which a particular stockvaries as the market of which it is a part varies. Measuring such riskand return is the main goal of capital asset pricing models.
Read More : Modern Portfolio Theory

The Efficient Market Theory

A trader strains his mind, his soul, his entire being trying to take profits out of the market when an unsettling piece of news comes down the pike—the efficient market theory. Its main adherents are academics, who are fond of pointing out that prices reflect all available market information. People buy and sell on the basis of their knowledge, and the latest price represents everything known about that market.

This is a valid observation, from which the efficient market gang draws the curious conclusion that no one can beat the market. Markets know everything, they say, and trading is like playing chess against someone who knows more than you. Don’t waste your time and money—simply index your portfolio and select stocks based on volatility.

What about traders who make money? The efficient market theorists say that winners are plain lucky. Most people make money at some point, before bleeding it back into the markets. What about those who keep outperforming markets year after year? Warren Buffett, one of the twentieth century’s great investors, says that investing in a market in which people believe in efficiency is like playing poker against those who believe it does not pay to look at cards.

I think that the efficient market theory offers one of the truest views of the markets. I also believe it is one of the largest pieces of theoretical garbage. The theory correctly observes that markets reflect the intelligence of all crowd members; it is fatally flawed in assuming that investors and traders are rational human beings who always strive to maximize gains and minimize losses. That is a very idealized view of human nature.

Most traders can be rational on a fine weekend when the markets are closed. They calmly study their charts and decide what to buy and sell, where to take profits, and when to cut losses. When the markets open on Monday, the best laid plans of mice and men get ripped up in the sweaty palms of traders.

Trading and investing are partly rational and partly emotional. People often act on an impulse even if they harm themselves in the process of doing so. A winning gambler brags about his positions and misses sell signals. A fearful trader beaten up by the market becomes cautious beyond measure. As soon as his stock ticks down a bit, he sells, violating his own rules. When that stock rises, overshooting his original profit target, he can no longer stand the pain of missing the rally and buys way above his planned entry point. The stock stalls and slides, and he watches, first with hope and later frozen in horror, as it sinks like a rock.

In the end, he can’t take any more pain and sells out at a loss—right near the bottom. What’s so rational about this process? The original plan to buy may have been rational, but implementing it created an emotional storm.

Emotional traders do not pursue their best long-term interests. They are too busy savoring the adrenaline rush or too twisted in fear, des- perate to extract their fingers from a mousetrap. Prices reflect intelligent behavior of rational investors and traders, but they also reflect screaming mass hysteria. The more active the market, the more traders are emotional. Rational individuals can become a minority, surrounded by those with sweaty palms, pounding hearts, and clouded minds.

Markets are more efficient during flat trading ranges, when people are apt to use their heads. They grow less efficient during trends, when people become more emotional. It is hard to make money in flat markets because your opponents are relatively calm. Rational people make dangerous enemies. It is easier to take money from traders who are excited by a fast-moving trend because emotional behavior is more primitive and easier to predict. To be a successful trader you must keep your cool at all times and take money from aroused amateurs.

People are more likely to be rational when alone, and grow more impulsive when they join crowds. A trader’s intense focus on the price of a stock, a currency, or a future pulls him into the crowd of all who trade that vehicle. As the price ticks up and down, the eyes, the heads, and the bodies of traders across the continents start moving up and down in unison. The market hypnotizes traders like a magician hypnotizes a snake, by moving his flute rhythmically up and down. The faster the price moves, the stronger the emotions. The more emotional a market, the less efficient it is, and inefficiency creates profit opportunities for calm, disciplined traders.

A rational trader can make money by remaining calm and following his rules. Around him, the crowd chases rallies, hard with greed. It sells into falling markets, squealing from pain and fear. All the while, the intelligent trader follows his rules. He may use a mechanical system or act as a discretionary trader, reading his markets and putting on trades.

Either way, he follows his rules rather than his gut—that is his great advantage. A mature trader pulls money through the big hole in the efficient market theory, its presumption that investors and traders are rational human beings. Most people aren’t; only winners are.



Read More : The Efficient Market Theory