Indicators, Schmindicators! MTA's Dow Award Winner Says Flows Are What Matter
by: Kira McCaffrey Brecht
Top on my list of questions to ask Gary Anderson, this year’s recipient of the Market Technicians Association (MTA) annual Charles H. Dow Award was “What are your favorite methods of technical analysis, and which indicators do you rely on most?” Imagine my surprise to hear Anderson say, “I have given up all indicators. None of them work.”
Anderson relies on his own methods, which involve studying the spread between laggards and leaders, the direction of relative strength leaders and the direction of relative strength laggards. He has been a principal of Anderson & Loe since 1990, and he publishes a weekly market comment at www.equitypm.com
. In November, Anderson was awarded the MTA’s annual award for his paper entitled “The Janus Factor,” which can be found in its entirety on his website.
Anderson launches his recent award-winning paper with a quote from Victor Niederhoffer’s book, The Education of a Speculator : “In some seasons, trend following is good; in others reversing is good. The problem is how to differentiate the two seasons in advance.”
Having given up on all traditional technical indicators, he details how he utilizes capital flows to determine what he calls positive and negative feedback loops and how traders alternate between trend following and contrarian types of behavior in a Janus-like fashion. (For readers who aren’t up on their Roman mythology, Janus is not only a major mutual fund company, but also an early Roman god of gates and portals, represented by two opposing faces, suggesting the two sides of a door. Janus symbolizes the two-sided nature of things, Anderson wrote in his paper.)
“If we know the direction of capital flow, we can benefit from swimming with the current,” Anderson explains.
Go with the Flow
The basic premise of Anderson’s paper is that capital tends to flow in one of two directions, depending on the mental or psychological state of the trader. The way a trader directs capital flow depends on the confidence level traders have in that trend. “There are times when traders are quite confident in the trend. If the market is going higher, they tend to defer profits in strong stocks and tend to buy into strength. Capital is raised to purchase stronger stocks by selling weaker stocks,” Anderson contends. In a rising market when traders are buying, it creates a “positive feedback loop” between what the market is doing (in this case, rising) and what traders are doing. “Buying begets buying, begets buying begets buying. All positive feedback loops create accelerating trends,” he adds. It is under these conditions that Anderson believes a trending market develops.
This situation continues until whatever is fueling the positive feedback loop is gone, in this case when traders run out of capital to buy or run out of stock to sell. Anderson sees this as similar to, “I drop a match on the floor and the carpet starts to burn. The fire creates more fire. Fire begets fire. That process continues until all available fuel is exhausted.”
In his paper, Anderson writes, “During periods of positive feedback, traders buy into strength and sell into weakness. Whether the overall market is rising or falling, capital flows from weaker to stronger issues. As the process continues, relatively strong stocks become even stronger, and relatively weak stocks become still weaker.”
Capital Flows Go Both Directions
This same process can occur in either a bull or a bear market. According to Anderson, there are two positive feedback loops – when traders are confident of a buying trend or confident in a selling trend. “Whether the market is moving higher or lower, if you have a positive feedback loop, capital is moving out of weak stocks into strong stocks, on a relative basis,” he said. In a falling market, traders express their preference for strong stocks. “Traders focus in on stocks that are falling the most and either short them or exit a long position. They sell weak stocks aggressively. Once again, capital moves out of weak stocks into strong stocks, on a relative basis. Strong stocks become an island of defensiveness.”
While most traders tend to think of U.S. stocks as either in a rising or falling market, Anderson sees stocks as either in a positive or negative feedback mode. The positive feedback loop comprises both bull and bear markets, so, yep, you guessed right – a negative feedback loop means a “non-trending market.” During these times, “price action becomes turbulent,” he explains. “The flow of capital reverses. Traders fade the trend and sell into strength and buy into weakness because they lack confidence.”
And, as Anderson makes clear in his paper, “Traders alternate between two modes. At times, traders exhibit trend-following behavior. Relatively strong stocks are favored, while laggards are sold or ignored. At other times, the reverse is true. Traders in the aggregate turn contrarian. Profits are taken in stocks that have been strong, and proceeds are redirected into relative-strength laggards.”
Once a trader has identified that a market is currently in a negative feedback loop, or a trendless environment, Anderson says it’s best to step aside for a while. “Even close risk control will eat you alive. Bull markets are profitable. Bear markets are profitable. But, negative feedback markets will nickel and dime you to death,” he warned.
Anderson calls the first rally, a “contrarian rally” fueled by negative feedback. After all, how many times during the past several years did traders get burned on corrective bounces in U.S. stocks? “Over the last three years we had several episodes of contrarian buying, which were not followed up by positive feedback at all. They fizzled out because traders couldn’t develop confidence in a rising trend, and the market turned back down, driven by momentum,” .
“The only way to make money in the stock market is to swim with the flow of capital. It then becomes of paramount interest to determine the flow of capital.
If a market is rising, capital is flowing in. In a falling market, capital is flowing out. Price is an indicator as to whether capital is flowing in or out of the market,” Anderson says. His paper stresses that “Markets make sense” and that “Price series are not chaotic, but are carried along on currents of underlying capital flow.”
“Traders are Janus-like. At certain times they are confident in the trend. And, the dynamics of the stock market are completely different from when they lack confidence. Are they confident or not confident? That is the key dynamic in the market. It took me years to figure out it’s not about being smarter than the next guy. You just need to go with the flow,” he concluded.