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Introduction to Using Technical Analysis to Interpret Economic Data

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Charles D. Kirkpatrick introduces his book, which offers guidance in timing the stock market specifically and provides advice to those are nervous about looking at markets strictly from a technical point of view without some understanding of the relationship between fundamental information and the markets.
This chapter is from the book

Introduction

This is a book about market timing. It applies using technical analysis on fundamental, economic, monetary, sentiment, and price data to determine the optimal times for buying and selling the stock market over the normal business cycle. Most professional analysts are bound to one of two disciplines: fundamental or technical. Fundamental is the study of economic, corporate, and monetary factors, and technical is the study of prices, especially market prices. There seems to be little common ground, and this is too bad because both have their merits. I think one of the reasons is that fundamental analysts do not understand technical methods, and vice versa; technicians distrust fundamental data as being too late. This book will change that attitude. I look at historical economic and financial data and apply some methods common to technical analysis of prices. These methods directly correlate economic information to the stock market, generate signals based on that information, and combine successful results into a market timing model based on fundamental information.

I write this book to aid those of you who need guidance in timing the stock market specifically and who are nervous about looking at markets strictly from a technical point of view without some understanding of the relationship between fundamental information and the markets. It comes from my personal experience of over 40 years in the stock market. At various times in my life, I have traded blocks on an institutional block desk, traded options as a member of the CBOE, traded stocks in a hedge fund, and provided technical research, some of which was original, to major investing institutions. I have seen almost every method, technique, indicator, theory, and scheme you could imagine. I have also seen where the markets are made more complicated than they really are for the purpose of making a mystery out of products sold to the public. Markets are not complicated, and with proper discipline they can be analyzed and profited from with the right tools and common sense.

In this book you will look at investment timing rather than trading timing. This means you will look at the markets from the primary perspective of the U.S. business cycle. The economic and fundamental information you will see is not short-term. As an investment horizon approaches shorter periods, the analysis methods become more technical and oriented solely toward price-behavior because economic information is not timely and often is reported only monthly or quarterly. To profit in the short term, swing traders must rely on changing price behavior in line with sporadic news announcements, and day traders eventually reach the intraday extreme when almost all decisions arrive from price behavior alone. Trading is the subject for another book. For present purposes we focus on timing the period of roughly four years, the average of the business cycle, and look at what types of reliable evidence you need to determine where within that business cycle the stock market may be. Forecasting markets is almost impossible in itself. This has been demonstrated repeatedly in studies of investment "gurus" and economists. I have also found that maxim to be true through painful and expensive experiences of my own, and I challenge anyone to disagree. However, you need not forecast markets to profit from them. If you can determine the direction and risk of direction reversal, you have the material necessary to capture profits and reduce the risk of capital loss.

I have also found that many analysts watch far too many indicators. There is no need for this. You do not improve your results by watching a laundry list of data. There are five areas of importance in determining stock market direction: corporate data (earnings yield, dividend yield, price-to-sales, etc.); economic data (leading economic indicators); monetary data (interest rates, money supply, Fed policy); sentiment (are investors optimistic or pessimistic?); and technical factors such as breadth, volume, cycles, and trend. Only a few examples in each category are necessary. Any more becomes redundant, time-consuming, and only marginally helpful. This book focuses on those few indicators that I have found can be systematized and for which data is publicly available.

The first section of the book is devoted to why market timing is necessary to reduce risk, evidence for and against the ability to time the markets, and, briefly, other methods that neutralize the risk of market declines. It is the major declines that you need to avoid. In the past ten years, market declines have reduced wealth by trillions of dollars, and as I write this book in late 2010, the stock market averages are still below their highs of eight years earlier.

The second section introduces you to some technical analysis methods and concepts that can be helpful in analyzing the data you will gather from different sources, both from markets and from the economy. These methods do not include the traditional chart-pattern culture of technical analysis. They are more concerned with establishing where trends and oscillations along trends are beginning or ending. They involve the confluence of moving averages in economic data and the use of protective and trailing price stops in the market. The calculations involved in these techniques are relatively simple, easy to understand, and even more easily applied. My purpose is to keep this analysis as effortless and accurate as possible.

The third section of the book devises systems based on economic indicators that reliably signal when the stock market is likely to change direction. These systems give actual signals. Otherwise, they would be of little value. Having been tested with real data, they are as reliable as I can make them. In this respect, the results differ from most economic models that presuppose relationships between data and market performance without testing the significance, reliability, or even existence of such relationships.

Each of these systems is tested, using special computer software that conducts a series of statistical tests called "walk-forward optimization." Many indicators are rejected for failing to satisfy stringent requirements of reliability and predictability. The survivors are then ranked, and in the final chapter, I construct a market timing model that uses the best systems from each of the economic and technical indicator sections.

In markets, there is no specific date or time when an actual price top or bottom occurred. Tops and bottoms are progressions that in retrospect may be obvious, but at the time of their occurrence, with all the coexisting emotional swings and conflicting evidence, provide no ringing bell or buzzer to tell you that a major change in direction has occurred. Likewise, there are no mystical, foolproof indicators that give perfect signals. You will see some very good indicators, but none of them 100 percent accurate. The ability to recognize a major market change in direction is an evolving thought process that depends on the evidence available but not a "thunderbolt" moment of inspiration.

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