What I’ve Learned During 37 Years on Wall Street

Eddie: Thanks for joining us, Robert. I think our
readers would like to know how you became an authority on technical analysis,
what indicators you find give the best signals, what can give traders a
significant edge in today’s markets, and what works for you in your own trading.
First, how did you get into technical analysis and trading?

Eddie: Did you learn anything there that you would
apply in your career?

Robert: Finance professor Leo Stone told my Securities Markets class,
“Some people think technical analysis can give them an edge.” That was all I
needed to hear. Although he spoke these words with a somewhat skeptical tone
(still favored by finance professors when they refer to technical analysis
today), he offered it as a possible topic for the required term paper. I jumped
at the chance.

Eddie: How did you go about it?

Robert: Of course. You can’t track the indicators without calling the
market! I calculated win/loss statistics for my daily predictions. It did not
take long for me to start to get a feel for the day-to-day movements of the Dow
Jones Industrial Average.

Eddie: What kind of indicators were used 36 years
ago?

Robert: Many of the ones still used today, such as stock price indexes
and comparisons between them, including divergences, volume, up-down volume,
advance-decline line, overbought/oversold, new highs-new lows, moving averages,
seasonal tendencies, sentiment, speculation, and various momentum oscillators.
The 50-day and 200-day moving averages already were known and respected. Moving
averages of different lengths indicate trends in multiple time frames, which is
an important concept to understand for both investors and traders.

Eddie: Are there others that have fallen out of
favor?

Robert: Yes, specialist, member, and odd-lot short sales ratios, margin
debt, institutional cash levels, and Barron’s Confidence Index do not
work the same way they used to due to structural changes in the market.

Eddie: Before personal computers, back testing must
have been cumbersome.

Robert: Exactly. Back then, indicator research involved much hard and
tedious work for very little return. Pencil and paper and punching keys on
mechanical calculators were error prone, and it was hard to find your mistakes.
In the 1980s, the PC revolutionized indicator testing and systems development.

Eddie: What work did you find immediately after
studying finance in college?

Robert: I landed a rare position with a brokerage firm as a fundamental
analyst trainee, which paid $600 a month. I could have made more in another
industry, but I was focusing on my long-term career path. I crunched numbers in
the back room for about a year before they allowed me to analyze 10-Ks,
interview corporate management, and write original fundamental research
reports.

Eddie: How long were you a fundamental analyst?

Robert: My career went very well for a few years, especially in the
bullish stock market trend of 1971 into 1973, as the stocks I recommended went
up nicely. But 1974 was THE defining moment.

Eddie: What happened then?

Robert: I had been assigned by my brokerage firm to fundamentally cover a
mortgage REIT based in Houston, Texas, which was a building boomtown in 1973.
Today, some might call it a bubble. This REIT had done very well, but as
interest rates ran up steeply in the first half of 1974, I questioned the CFO
about the spreads between his borrowing costs and loan returns. When the term
structures of assets and liabilities are mismatched, that means risk The CFO
assured me that his company was very safely structured and hedged.
Unfortunately, his strategy turned out to be inadequate for the steep rise in
interest rates that was to come. Every time the stock broke down below a chart
support level, I phoned him. But it wasn’t until the stock had dropped in half
that he finally admitted that management had lost control of their borrowing
costs.

Eddie: Did that shake your confidence in talking to
management and pouring over their reported numbers?

Robert: Clearly, corporate managers don’t always know what they are
doing, they can’t predict the future, and they don’t always tell the unbiased
truth. Neither do reported numbers, which are always late and often manipulated.
From 1974 on, technical analysis was the ONLY unbiased truth for me. All my
experience told me that it worked, while I could clearly see that fundamental
analysis could run off the tracks in a major way.

Eddie: But weren’t most investors still biased
toward fundamental analysis?

Robert: They still are. Most investors feel that there is common sense
logic to fundamentals. They think they understand buy low and sell high. In
reality, most wind up buying high and selling low. And when they try to buy on
the cheap, they find that the cheap get cheaper, because cheap stocks are down
for good reasons. The valuation is not your friend. Rather, the trend is your
friend.

Eddie: So in 1974, you made a radical and complete
transition from fundamentalist to technician. How did you arrive at the level
where you felt confident enough write such an authoritative book on technical
analysis?

Robert: While working in Smith Barney’s technical research department,
Alan Shaw, Ron Daino, and I were asked to review 30 technical analysis software
programs for publication in PC Magazine in April 1986. That is how I met Tom
Meyers, who was the consulting editor on the project. Tom already had written
the first of its kind book about applying personal computers to technical
analysis, so he knew his way around the world of publishing. Later, at a
Computrac conference, Tom and I realized that we both wished we had one good
book with all the indicators in it, complete with back tested proof of
effectiveness, clearly showing which indicators were best and which ones didn’t
work. Nobody at that time had attempted such a big task. So, we published the
first edition of The Encyclopedia of Technical Market Indicators in 1988.

Eddie: But Meyers did not work with you on the
completely revised Second Edition, published in 2003.

Robert: By that time, more than a decade after the first one, Tom was too
busy with other work, so I had to produce the new edition by myself. It was a
lot of work, and this Second Edition is much more comprehensive than the first,
with 820-pages of thorough indicator descriptions, formulas, and test results
covering more than 100 indicators.

Eddie: Did you find indicators that worked well
before the 1990s continued to perform well in 1990s and beyond?

Robert: Yes. For example, the very popular 200-day moving average
continued to make money and is still relevant, whether you’re a long- or
short-term trader. As a general rule, your odds of success will be significantly
greater if you only go long stocks that are above the 200-day moving average.
That applies whether you are a swing trader or tend to hold stocks for many
months. By doing this, you’re keeping yourself on the side of the bigger trend,
which often dominates and overwhelms trends in shorter time frames. I apply this
myself in my own trading. I recall that Larry Connors in

How Markets Really Work also found that there has been a real
statistical edge to being a buyer when the market is above the 200-day moving
average.

Robert: I’ve seen traders do a lot of wild things and then blame bad luck
when they lose. You need to know that if you break these rules, you WILL pay the
price, sooner or later. The first two rules, “preserving capital” and “trading
in the direction of the larger trends”, are the most important.

Eddie: These days, traders use software that
contains well over a hundred indicators. It can be confusing. Which ones work
and which ones don’t?

Eddie: So, you used different look back periods for
parameters. What about the default settings, such as the 14-period RSI that
traders are accustomed to?

Robert: I took an entirely fresh look at each indicator, with no special
consideration for the most popular default settings. I’ve always felt that
default setting are like opinions and are subject to change. I back tested to
find the parameters that worked best, and those parameters are the ones I
published in my book.

Eddie: So, what you’re giving traders is not only
the best indicators but also the best settings to use for those indicators.

Robert: Right. In addition, I try to help traders understand of the
strengths and weaknesses of different indicators. For example, oscillators such
as RSI and stochastics were already oversold on the Friday before Black Monday,
October 19, 1987. Anyone who bought that oversold condition lost big the very
next trading day. I know traders who actually bought then based on some
oscillator, and it was an extremely costly and painful experience for them.

Eddie: Now let’s get into the top indicators list
itself. After you did all that testing, which ones did you find worked the best?

Robert: Based on 101 years of daily closing prices for the Dow
Industrials
(
DJX |
Quote |
Chart |
News |
PowerRating), short-term trend following maximized simulated profits.
The top-performing indicator strategy, going both long and short, stop and
reverse, that I found was a trend-following moving average crossover:

1. When the DJIA close today crosses above its 5-day Exponential Moving
Average (EMA) calculated as of yesterday’s close, cover shorts and buy long at
the current close today.

Robert: Keep in mind that we are talking about my findings based on pure
statistical research on historical data. There are other important
considerations for actual trading. For example, if your trading costs are high
or if you can’t execute an order precisely and consistently when the signal is
given, then short-term systems are not practical for you. Also, just because
short-term trend-following has worked best over the past 100 years, this does
not mean that there have not been long periods of drawdown. In fact, the 5-day
EMA crossover strategy has suffered a drawdown since 10/21/2002, shortly after
the DJIA made a bear market low. Also, there was a 3-year drawdown from 3/22/91
to 3/24/94.

Eddie: Why do short-term systematic-trend following systems go “off the
track” like that?

Robert: The cause is the lack of strength in the underlying trend. Trend
following works well when prices are trending, either up or down. But choppy
markets are never good for trend following. The whipsaws produce small losses
that add up. For more than a year now, there has not been much of a trend for
the major stock price indexes. Funds managed by some of the biggest systematic
trend followers have lost more than 20% this year. Still, if you are nimble
enough and can execute trades cheaply during the trading day, you can make a
profit trading the short-term trends. Of course, that requires more effort and
more finesse than the extremely simple end-of-day EMA crossover strategy we have
been talking about.

Eddie: Are there any indicators among the ones
you’ve ranked that have performed strongly in the past and have held up well in
the present?

Robert: Short-term oscillators, such as CCI, RSI, and Stochastics, when
used with longer time frame trend filters, such as a 200-day moving average,
have continued to perform profitably over the most recent choppy years.
Overbought and oversold works well most of the time in trading ranges.

Eddie: Can you give me a specific example, say on
the very popular RSI?

Eddie: But in your book, don’t you caution traders
about the dangers of using overbought/oversold oscillator signals?

Robert: Although OB/OS signals work well most of the time, they hurt
traders at unusual times of big market moves, such as the Crash of 1987 and
decline of 1998. Again, let me emphasize that acting on RSI OB/OS signals
mechanically without filters can cause large drawdowns. I doubt that Welles
Wilder (the developer of RSI) ever intended it to be used strictly mechanically.

Eddie: For your personal trading, what type of
trader are you?

Robert: I do exactly what we have been talking about here. I am a
systematic position trader of stocks. I don’t day trade. I often hold a position
for weeks or months, trying to capture a big move. You need to ride some big
moves to make trading pay. I trade filtered systems that buy when a stock dips
to oversold and sell when it jumps up to overbought. I use trend filters, so I
don’t take short-term positions that are against the main longer-term trend. I
don’t try to finesse entries or exits when I get a signal. I don’t wait for
short-term price confirmation when I enter or exit a trade on a signal. These
bad habits can lead to hesitation.

Eddie: You have worked for some of the biggest
names in the investment and trading business over the years. What services do
you offer your clients?