Paul the oracle octopus update

In my last blog posting, Paul the oracle octopus in western Germany was mentioned for accurately predicting 2010 World Cup soccer games. The post was before the tournament's final and semifinal games. Well, Paul proved his psychic prowess by accurately picking Spain as champion and Germany as 3rd place. Paul was 100 % accurate in German team World Cup predictions. This article gives further information that Paul is going to retire. No more Paul in the limelight. He is going back to entertaining children as a day job.

I am guessing what you are not seeing behind the scenes is Paul is really being squidnapped by powerful authorities during aquarium off hours to predict other big sporting events. They will then bet big in Las Vegas and make millions. This octopus is worth big money!! Well, there is my half-baked conspiracy theory. Please take it with a grain of salt.

It is time to go visit my folks in Washington State next week, so it will be a while before any more posts.

The wave of pain

In previous posts, I gave a brief outline of Elliot Wave principle and how it pertains to investor psychology in stock markets (click here and here for the postings). I also spoke about the sovereign debt crisis in Greece along with the problems of the PIIGS. This post will bring together these two concepts and what is currently happening on the US stock exchanges.

Today was a massacre. The three major indexes (Dow, NASDAQ and S&P 500) all fell more than 3%. One major factor roiling the market is the continued debt crisis in Europe. Even after ~$1 trillion USD bail out a few weeks ago from the European Central Bank (ECB) and the International Monetary Fund (IMF), the European Union (EU) is still not economically stable. More debt does not solve Europe's fundemental marcroeconomic issues. The country that is the focus of attention is Hungary. Hungary is not part of the EU, but the former communist block country received significant amounts of loans from EU based banks. Hungary is threatening to default and the potential massive losses to those EU banks are both enormous and destablizing. The jobs report for May also came out worst than expected. These events contribute to the main stream media's story to why the market sell off occured.

Was this sell off predictable? It is impossible to determine the exact movement or level of the stock market on any given day. Anyone who says they can is a liar or an insider. Insiders can only predict with a certain stock for limited amounts of time (insider trading is illegal). For us average folk, it is possible to approximate the direction and pattern a market may take using Elliot Wave principle (EW) which is a technical analysis method based on the Dow Theory. EW prescribes potential outcomes. The EW community tends to believe we are in Primary wave 3 of a secular bear market. We are a heavily indebted society with a debt bubble that needs bursting. Accordingly, I believe we are at this stage in the bear market as of today:

Cycle 3 of 5 (Primary wave 3)
Intermediate 1 of 5
Minor 3 of 5
Minute 3 of 5

Remember, each wave is further divided into 5 subwaves in the repetitious fractal form. The minor 3 of 5 represents the largest 3rd wave of a fractal. I was skeptical about any waves smaller than the minors, but the last couple of weeks made me a believer. The 3rd wave is also the most violent in action. The sell off today represents the sudden movement expected in this bear market stage.

The answer for the predictability question is yes. The massive sell off was predictable being limited to approximate dates and amplitudes. I was prepared by going long on inverse ETFs or funds that respond in an inverse manner to the market movement (represented stocks go down, fund goes up). This current downturn should continue on for a least a few more trading days.

Market observations

In a prior post, Markets and psychology, I mentioned a market theory known as Elliot wave principle. Elliot wave principle states the markets move in five wave fractal shapes dependent upon investor sentiment. It is a tool based upon probabilities estimating future outcomes. The theory gives investors windows of buying and selling opportunities.

I have encountered difficulty using this theory within the last week. If one examines stock charts over long periods of time, the wave can be easily identified in the data. Sometimes, the waves are not clear as they are being formed. For example, on February 9 I predicted we were on this step in the current Cycle:

Primary = 3 of 5
Intermediate = 1 of 5
Minor = 2 of 3
Minute (not sure)

After about a week of market action, this stage in the Cycle has yet to be fulfilled. My current guess as of today's close (2/17) is:
Primary = 3 of 5
Intermediate = 1 of 5
Minor = end of 2
Minute (still not sure)
I was assuming the Minor 2 of 3 was unfolding as we had entered into the 3rd Minor wave. Further market action completed a nice rebound 2nd Minor wave demonstrating we were not that far into the overall wave structure yet. The 3rd Minor is coming at a later date.

What went wrong? Two things come to mind.
1. I had my investments ready for a 3 of 3 Minor movement. My bias.
2. Other more experienced bloggers I follow came to the same conclusion. The waves were unclear as they were being traced.

It is now obvious what the wave patterns are, not so in real time. Stock market investing in general follows this unknown path. Mr. Market will move as Mr. Market chooses. As Yogi Berra said, "It's tough to make predictions, especially about the future."

Markets and psychology

This post covers a topic of interest to me, the stock market. I mentioned in a previous post, driving with the rearview mirror, about some basic concepts of the stock market. Several months have passed since my last market posting. Accordingly, I have been studying and stock trading resulting in both failure and success. The more I watch the market, the easier it is to understand that investor psychology drives the market.

One technique that I am studying is Elliot wave principle (EWP) developed in the 1930's by Ralph Nelson Elliot. Elliot observed that markets move in 5 distinct sets of waves according to prevalent market psychology. When in a bull market, impulse waves move the market up. In a bear market, impulse waves move it down. Waves 1, 3 and 5 are the impulse waves, while 2 and 4 are the corrective waves. Impulse waves are further subdivided into smaller sets of 5 fractal waves. Corrective waves have an a-b-c wedge like pattern and are also subdivided into smaller waves. The time span of the waves are from decades to hours on ticker charts. To be honest, the larger waves on the order of days (Minute) up to years (Primary) follow this pattern making distinctive patterns on ticker charts. Time spans greater than several years and less than several days tend not to fit into exact scenarios. It is just wishful thinking putting noisy or irrelevant data into such a pattern in my opinion. The take home message is Elliot wave principle follows what truly drives a market, investor sentiment.

Elliot wave principle is a loose theory, it has multiple outcomes during any given situation. Market timing and wave amplitudes are based upon Fibonacci numbers. Exact values fit into a range. Here is where EWP is useful, it tells us approximately when the market will turn and to the approximate degree a rally or sell-off will carry a market. It determines buying or selling windows ahead of time. I suggest using other technical indicators (MACD, stochastic and etc.) as complimentary tools when waves are not clear, which often waves are unclear. Investigation of the stock's price movement (who owns it and why) will further help an investor.

In practical application, I believe as of February 9, 2010 we are in a bear market at the following point in a Cycle. This means the overall market movement is downward.
Primary = 1 of 3
Intermediate = 1 of 5
Minor = 2 of 3
Minute (not sure)
Using this, I made a successful and unsuccessful trade. The unsuccessful trade occurred because of undesired price movement premarket. My blunder even as the stock moved in the desired predicted direction. This is why the system is not going to make anyone rich without following good trading practices.

I will post further on this topic to see if my evaluation and Elliot wave principle holds true.

Limitations of dreams

My scientific training is as an experimentalist surface scientist in a materials science related study. I spent a significant amount of time in the lab. It is one of my secondary homes. One bone of contention in the scientific world is the clash between experimentalist (us) versus theorist (what is a lab?). Both disciplines take large amounts training, rigorous work and deep thought. In an ideal world, theory should follow after experimental data. Occasionally, theory should predict a result like nuclear weapons is a great example. This post is going to cover a potential dark side associated with theory.

Theory is based upon experimental data sets and observations. Most experimental data fits into trends following mathematical relations. New data usually has previous bodies of work to support the new theoretical idea or concept. Over time, a story is built within a given area of study. It becomes easier to predict experimental outcomes ahead of time. New chapters in the story are written as evidence is presented with a theorist entering the wording.

One very basic concept that is the basis of all theory are assumptions. The theory holds true if for example in a chemistry experiment, the temperature, pressure and etc. are at certain levels. Note, these are serious limitations. All related conditions have to be met for the theory to be true. One assumption is not met, the theoretical framework fails. During initial theory development, many pieces are missing and often all assumptions are not yet known. This will often lead to semi-independent theories. In science and engineering fields, this learning process is benign. Trouble comes with other less easily quantifiable subjects such as sociology, psychology and history for several reasons. First, many subtle factors come into play. Second, not all of the necessary pieces are known. Finally, if a theory is not correct and taken by public policy makers as gospel, significant damage to society may occur. One of the worst historical outcomes from a theory comes from the false science (accepted in the past) known as Eugenics. Eugenics is the idea of keeping a genetic stock pure without undesired genes like genetic diseases. Sterilization of those with less than desirable traits was the main cure. Sometimes death was the their cure. Eugenics was one of the main driving forces behind the Nazi concentration camps.

Groupthink is when a group of individuals comes to a consensus without any serious debate leading to the suppression of all opposing ideas. This is not a fault of theory itself, but of those who are authorities on a given subject. It promotes continuation of false ideals and is a greater threat to any organization than an incomplete theory. Development of a theoretical framework requires legitimate questioning of an idea or concept. If the theory can not comprehensively address a proper inquiry, the theory has serious problems. The problem can often be fixed with a slight refinement. Other times, the theory is then disproven and a new concept is proposed. Groupthink suppresses all questioning, thus, faulty theories are allowed to live and often thrive. Some faulty theories cause serious damage if applied without any moderation to public venues touching us all.

Driving with the rearview mirror

One source of continuous fascination is the stock market. Why not? Put in a little money, it grows, and in the end profit without labor. How can you not like that! Billions of dollars is exchanged on the world's stock exchanges daily. Stock markets exist as an easy way for companies to raise money through a collective public ownership. Of course, the market operation is much more complex.

The psychology behind this money for nothing concept supports the main market drivers, fear and greed. Everyone who has struggled to make a dollar and put it into an online brokerage account understands this. They love when the market goes up and make money. Optimism pushes buying, the market rises. They absolutely hate when the market goes down with money evaporation. Pessimism leads to selling, the market craters. In the end, the market is a sentiment machine driven by the various kinds of investors summarized by this site.

Excluding day traders, two main kinds of investors exist: fundamentals and technical. Fundamental trading is based upon the idea that a stock is worth a certain value according to corporate size and revenues. Profitable companies are worth more than unprofitable entities. The other investors are technical traders and their trading is dependent upon derived indicators. Some of the best known indicators are:
Moving Average Convergence-Divergence (MACD)
Fast and Slow Stochastics
Relative Strength Index
Bollinger Bands.
The basic concept behind all of these indicators is to identify the point at which a stock changes momentum, i.e. stops going down in price and begins to appreciate.

The movement of the markets has thousands of traders everyday bidding prices up and down. Buying and selling stock. One school of thought has stock market movement being random. Looking over years of stock market data, patterns appear. Typically in upward movements followed with an occasional sell off forming a wave pattern. Personally, I believe the day-to-day patterns are random, but over time patterns do exist. Technical trading is supposed to clue an investor into these patterns identifying momentum changes. Honest traders admit they are lagging indicators or tools that tell investors when to buy (or sell) after the momentum has already changed. I agree, but another serious issue that is a fly in my ointment is these indicators all use past data. What happened yesterday, may not necessarily happen tomorrow. Yes, the indicators show stock price going up. If another disaster like 9/11 hits New York, will the indicators show this. NO!!!!!! As we discussed earlier, the market tends to be a sentiment indicator. One frustrated mutual fund manager has heart burn from his favorite Indian restaurant may drive down a stock. The indicators will not pick this up until it is too late. I think the best analogy is driving down the road using the rearview mirror instead of looking through the windshield. That crash ahead is pretty rough.