A Peek Inside the Market

As has likely been quite apparent from my posting here these last few months I’ve been having a total blast developing a trading system. I had no idea what Amibroker was about at the beginning of this year. I’d downloaded a trial version some time last year and looked at it very briefly. To be honest I didn’t think it was that crash hot as my modus operandi at the time was marking up analysis on charts for discretionary trading and I’d become quite proficient at that using Market Analyst. Working in the IT industry I just saw it as another piece of technology I had to learn and that’s why everything just stopped right there. Oh what little did I know!

Contrary to what some have thought, I studied IT and Marketing at university, not psychology. I started with psych and dropped it in favour of marketing which I found to be a form of applied business psychology...far more useful as it turned out. Contrary to what most IT degrees educate you to be I am not a computer programmer either, but it was lot of fun to dust off my C++ skills and make good use of them again.

Something I’ve come to very much appreciate through this journey are the discoveries I have made of the many new ways to perceive the market (all of it!) and the different ways we all go about trying to measure it. Until very recently I’d thought of the greater share market as a fairly risky place. I didn’t journey outside of the ASX300. As a stock becomes less widely followed and usually as a consequence less liquid, the flowing trends and patterns that I’d been taught to identify and trade often become less clear.

I was told this area of the market was scary because it was not liquid and by inference was also highly speculative. Conservative in life I’m also conservative in trading and this did not sound like the place I wanted to be. Speculation reminded me of ‘dotcom’ and I knew what had happened there…at least I thought I did; I was a reader of the Fin Review after all!

That’s the point here though. Once you get access to market data that covers the entire market and includes delisted securities you have an opportunity to know what a non-market-cap-weighted journey through the entire market could have been like. You can experience how your system would have handled ‘dotcom’. The reality seems to be that even while the NASDAQ collapse and its aftermath had an effect on local technology companies and the ASX there were still a considerable number of trend-following opportunities during the mania and as my analysis should later show, in many cases plenty of opportunity to hop-off before any actual collapse.

When the equity curve of a system I am testing goes flat just as a sharp decline is getting under way then I’m all smiles. This is one of my favourite things to discover in back testing. If the mix of open and closed equity starts shifting from light blue to green then I’m even happier: open equity profits are being taken off the table and banked.It means that my trailing stop losses have done their job and are effectively locking in profits.

I recently did this arbitrarily with the method I was trading and I can say straight out that even trading with relatively small amounts of capital and a moderate degree of leverage can be stressful. Making big returns is enthralling but it can still be a welcome relief when the market imposes on you a rest period.

From my testing it seems that the boom on the ASX that accompanied ‘dotcom’ was not nearly as lucrative as this resources oriented boom has been. And that stands to reason as Australia is not an IT or R&D based economy and back then all eyes were on the US. Now all eyes are on China and by extrapolation of that theme, Australia. What I have observed in the performance results from my back testing of both periods makes macro-eco sense.

What I have found interesting is that without exception the two periods where my system experiences its worst drawdowns is during the May ’06 correction and the very latest correction. I can drive my system through until the end of 2005 and with 50% leverage the worst drawdown is 16%. If I continue testing through until today that Max DD. figure blows out to 20%.

Looking at this log chart of the XSO (Small Ords Index) covering the last ten or so years we can see clearly why. It’s to do with the nature of the corrections. They’re extremely sharp. They really are like mini-crashes and if you have a non-cap-weighted exposure to the market, particularly the growth sectors that many of us are going after, then you're really going to feel it.

On a monthy chart they show up as some candle stick pattern with long wicks (which I don’t know the name of…and are they even called wicks??) or what Dr Alexander Elders refers to as a kangaroo tail. It’s an irony that these patterns are actually bullish as they signify that within a short period of time bidders arrived deciding that they would buy at the price levels probed down to by the initial panic. Within a few weeks prices are often back up to around pre-panic levels.

Compare this style of correction with 1997 for example. Then the index went largely flat for around 5 months. As prices go sideways time is presenting an opportunity for trailing stops like moving averages to tighten against price. By the time the 1997 panic had arrived in force my system was already 45% in cash. Contrast this with the height of the May 06 or the recent corrections where the system was 95+% invested.

The other crash people often think about is April 2000. Whilst this was more so an event on the NASDAQ it’s worth studying how that panic played out. The market had actually peaked back at the beginning of the year. By the time April had arrived it had traced a very clear lower high and in the last week of March closed down strongly, more or less confirming a lower low.

Whilst to a non-technical analyst it might have seemed as if the index was merely going sideways, my system had progressively moved from being 100% invested to 33% invested in the 5 weeks leading up to this point. Trends were breaking down and stops being triggered. At the same time my equity balance appreciated around 15%. Clearly some pundits took some convincing that it wasn’t going to be different this time. The attached chart from CGF might be an appropriate illustration to this story. A month later the system was 85% in cash with my equity balance down about 2% (note this is not Max DD, that was more like 15%).

So when I look at the major indexes over the last five years and think of the waves of panic that appeared to over come people when the indexes corrected a mere 10% (or less!) I realise that these corrections were actually more serious than a cursory glace at the cap-weighted index charts might suggest. I suspect that massive amounts of funds being driven into the top end of the market in a more or less market-cap-weighted fashion (think super funds), has gone a long way toward obscuring the carnage that has tended to occur at the fringes.

ASX.G