How technicals could assist investors ride a bear market

Performance of the stock market over the past one year can only be best described as a bear-run, that is, month-after-month, many stock market participants want to sell their stocks relative to the number of participants who want to buy.

Indeed, the benchmark Nairobi Securities Exchange 20-share index, an index consisting of the 20 most capitalised, highly traded blue-chip companies, crossed below 2,500 points in mid-August, being the first time it did so in a decade.

Many theories have been advanced to explain stock market movements. The two most outstanding are (i) efficient market hypothesis (EMH) and (ii) random walk theory.

The EMH, whose origins go back to 1960s, states that, at any given time, security prices fully reflect all available information.

The implication of this hypothesis is that if current prices fully reflect all information, the market price of a security will be a good estimate of its intrinsic value, and no investment strategy can outperform the market.

Essentially, the market is always right!

The Random walk theory, on the other hand, states that security prices move in a random fashion and have no memory, and past performance is not a reflection of future performance.

Random walk theory was advanced in the popular book, A Random Walk Down Wall Street, by Burton Malkiel in his criticism of technical analysis as a (day) trading tool (of which I’m a student).

In fact, he referred to technical analysis as “sharing a pedestal with an alchemy” (whatever he meant!). In a nutshell, my point is that sometimes it may be difficult to wrap your hands on the cause of the bear run, since it entails several (constantly) moving levers.

The criticisms notwithstanding, there are simple technical analysis indicators that can help an investor profit in a bear run.

I will focus on two indicators that measure market breadth, namely advance-decline ratio and Hughes breadth oscillator.

On a given day, a stock price can do one of three things—close higher (than the previous day’s close), lower, or unchanged.

If a closing price is above the previous day’s close, it is said to have advanced. Similarly, a stock that closes below the previous day’s close is a declining stock. A stock that closes at the same price as previous day’s close is unchanged.

Advance/decline data is called the breadth of the market because it measures the internal strength of the market by way of stock prices advancing or declining.

As I aforementioned, the advance/decline ratio is simply the ratio between advancing and declining stocks while the Hughes breadth oscillator, which is the ratio of the difference between advance and declines and total issues traded.

James F Hughes, the inventor of the signal, was a 1930s co-pioneer of the tabulation of advances and declines to interpret stock market movements.

To remove the daily wild swings, the two signals are traditionally smoothed using a moving average.

When either signal rises above or decline below zero, a buy or sell signal is generated respectively. I analysed the two signals against the NSE 20-Share Index (by employing a 30-day and 60-day simple moving averages on the advance/decline ratio and Hughes oscillator respectively).

If you invested Sh100, the advance/decline ratio would have generated 75 percent in total returns (excluding fees and commissions) between 2017 and August 2019.

On the other hand, the Hughes breadth oscillator would have generated 45 percent in total returns. In a bear market, it pays to day-trade and the technical can help you ride the wave.