April 2003 Vol

AIQ Opening BellNewsletter April 2003 Vol. 12 Issue 4 Equity Bubble Aftermath In This Issue Post-bubble problems for the Be Aware of Post-Bubble Problems technical analyst revealed .. 1 In Technical Analysis—Making Review of AIQ's March market timing signals ..................... 4 Adjustments Is Critical! Upcoming AIQ Seminars .... 4 By David Vomund Testing reveals the least creases in effective Expert Design Studio equal incre- rules--combine them for short- hese are extraordinary ments. For a Place selling strategies................. 5 times for the market. In given period Vomund Photo the last five years we’ve of time, the Data Maintenance .............. 8 experienced the largest graph en- Here S&P 500 Changes .............. 8 equity bubble in U.S. compasses historyT and have also experienced a the highest bear market that is arguably worse and lowest than that of the Great Depression. In stock price DAVID VOMUND the aftermath of the bubble, technical and the analysis remains valid as market vertical (price) scale is divided into movement is still based on the laws of equal increments. This style of graph supply and demand. works fine for short-term charting, but The bubble and the ensuing bear market does pose “In the aftermath of the bubble, problems to many technical analysis remains valid as forms of analysis, market movement is still based on the however. In this article, we are expos- laws of supply and demand. The ing three post-bubble bubble and the ensuing bear market The Opening Bell Newsletter problems in technical pose problems, however. In this is a publication of AIQ Systems analysis. By exposing article, we are exposing three post- P.O. Box 7530 these problems, our hope is that you’ll bubble problems in technical analysis” Incline Village, Nevada spot these issues in 89452 your own analysis and will make appropriate adjustments. problems exist when stocks are charted using a time period of more Problem #1 - Wild Price Swings than a year. Hide the Chart Patterns In early 2000, many Nasdaq Most people use arithmetic charts. growth stocks were near $100 but have That is, the price scale (y axis) in- since fallen below $20. That causes AIQ Opening Bell April 2003 problems for chartists using arithmetic charts. These charts exagger- ate the movement of the stock when the priceMarch is high 2002 but show little movement when the stock is low. Figure 1 shows Power One (PWER). Like many stocks in this extraordinary time period, PWER rocketed toward $100 only to fall back below $10 once the bubble burst. It looks like a big move when PWER fell from $80 to $70 (a 12.50% drop) but the fall from $10 to $5 (a 50% drop) looks like simple sideways movement. In fact, a chartist may look at Figure 1 and conclude the stock experienced a strong rally, an equally strong drop, and then a long sideways or consolidation movement. The flaws inherent in arith- Figure 1. Weekly chart of Power-One with arithmetic price scale. After major decline in late 2000 metic charting hide the true pattern and 2001, price appears to have moved sideways in 2002 and 2003. of the stock. Figure 2 graphs the same stock for the same time downtrend. To conclude that from $2 to $4 than it is to go from period but with a logarithmic scale Power One is in a consolidation $40 to $80. Reports that sort stocks range can be costly. based on relative strength often list Many software mainly low priced stocks near the “The flaws inherent in packages and internet top of the ranking. In the past, arithmetic charting hide the true sites have a log scale many analysts resolved this prob- pattern of the stock…Log scale charting option. To lem by excluding stocks that were priced below $10, thereby eliminat- charts show a truer picture of a convert a chart to logarithmic charting in ing the low priced issues. Unfortu- stock’s price movement.” TradingExpert Pro, nately, in the aftermath of the click the bubble there is now a long list of Log Scale chart. Rather than using equal button that is “Many relative strength increments, log scale charts use located just to the percentage-based increments. right of the ER calculations break the price action Notice the distance between $10 button on the Scroll of the last year into quarters and and $20 (a doubling in price) is the Bar. then give twice the weighting to same as the distance between $20 and $40, which in turn is the same With the wild the most recent quarter. The post as the distance between $40 and price swings of the bubble’s wild price swings pose a last few years, this $80. With log scale charts, the price problem to these calculations.” movement on an equity chart can style of charting has be compared across the entire become much more period of time displayed on the important. well-known and widely followed chart. Problem #2 - Relative Strength stocks that are below $10. Log scale charts provide a truer Analysis Favors Low Priced Looking at just the S&P 500 picture of a stock’s price move- Stocks stocks, high relative strength ment. Whereas Figure 1 shows a reports show stocks like Dynegy stock that is in a long consolidation Relative strength calculations (DYN), which has recently jumped period, Figure 2 shows a definite have always favored low priced from $0.68 to $2.50, at the top of the stocks. It is easier for a stock to go 2 April 2003 AIQ Opening Bell report while stocks like eBay (EBAY), which is hitting multi-year highs, get lost in the ranking. EBay, with its relatively consistent uptrend, has the type of chart pattern that most relative strength investors favor. However, the relative strength rankings are currently dominated by low priced stocks. Many relative strength calculations, including AIQ’s Relative Strength Long Term report, break the price action of the last year into quarters and then give twice the weighting to the most recent quarter. The post bubble’s wild price swings pose a problem to relative strength comparisons based on these calculations. There is also a bias inherent in the process of simply averaging Figure 2. Weekly chart of Power-One with logarithmic price scale. From this type of chart, it is percentage changes. The following clearly evident that a high rate of decline continued throughout most of 2002. example explains why. Consider a stock that moves resolved. In the meantime, use stocks are only purchased when from $20 to $10 and then rallies caution on high relative strength the Nasdaq's 28-day moving back to $20. In other words, it fell ratings on low priced stocks. average increases in value by at least 7% in the last 10 days. For by 50% and then rose by 100%. Problem #3 – Averaging the percentages shows a simplicity, stocks are held for a positive number but the stock is Over-Optimization fixed 22-business-day period break-even. There is an upside Over-optimization, or curve (approximately one month) and fitting, is always a concern when forming a trading “Over-optimization, or curve fitting, model. When AIQ Opening Bell Newsletter is always a concern when forming a you fit a model David Vomund, Publisher trading model…With the extreme too closely to G.R. Barbor, Editor market movement in the last five unique historical P.O. Box 7530 price movement, Incline Village, NV 89452 years, it is increasingly easy to go then the system AIQ Opening Bell does not intend to make too far in optimizing a system.” will have little trading recommendations, nor do we forecasting value. publish, keep or claim any track records. It is designed as a serious tool to aid investors With the extreme in their trading decisions through the use bias when you average percent- market movement in the last five of AIQ software and an increased ages. years, it is increasingly easy to go familiarity with technical indicators and too far in optimizing a system. trading strategies. AIQ reserves the right to Using the Dynegy (DYN) use or edit submissions. example, DYN has fallen from $30 Let’s show an example. We While the information in this newsletter is to $2.3, a 92% decrease, in the last created a system that only pur- believed to be reliable, accuracy cannot be year but its 260% jump in recent chases stocks based on two screen- guaranteed. Past performance does not guarantee future results. months makes it one of the S&P ing components. The first compo- 500’s highest rated relative strength nent in our model states that stocks For subscription information, phone stocks. must close in the upper half of 1-800-332-2999 or 1-775-831-2999. As we enter the next bull their daily trading ranges. The © 1992-2003, AIQ Systems market, this problem will get second component states that 3 AIQ Opening Bell April 2003 only Nasdaq 100 stocks are purchased. Figure 3 shows the summary results of everyMarch trade 2002 in our model for the five-year time period end- ing in December 2002. This strat- egy produced 192 trading signals (an average of 37 trades per year). The average trade gained 9.33% over its one-month holding period. On an annualized basis, you would have doubled your money each year! Unfortunately, the outstanding backtest of this system has no relevance to the future. Our rule stating that the Nasdaq’s 28-day moving average must increase by 7% in 10 days allowed the system to buy stocks in 1999 but produced no signals in the bear market and is unlikely to give many signals in Figure 3.

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