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Tharp's Thoughts Weekly Newsletter (View On-Line)

January 21, 2009 — Issue #407
  
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The Four Principles of the Van Tharp Institute by Van K. Tharp

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January’s First Five Days Indicator—Forewarned is Forearmed  by D.R. Barton, Jr.

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 It's Not Bad to Be Wrong; It's Only Bad to STAY Wrong

 

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Feature

The Four Principles of the Van Tharp Institute

by 
Van K. Tharp, Ph.D.

 

“Dr. Tharp, how can you write such a pessimistic outlook on the economy?  You are scaring everyone and that’s just not right.”

Several people made similar comments regarding my last article about my outlook on the economy for 2009.  However, if you really understand our entire program, you would never make a statement like this.  Our programs at the Van Tharp Institute encompass four areas:  (1) understanding what is going on in the market, including the current market type, and planning for it; (2) understanding systems and designing systems to fit you and the current market type; (3) using position sizing to meet your objectives; and (4) understanding yourself and how you create your own results.  In response to the comment above, I’d like to review each of the four areas.  While I stand by every one of the statements I made in my Outlook for 2009 article, it’s important for you to understand that I’m not fearful at all.  I’m very happy and joyful, and you should be to.  If you are fearful about what might happen, then you are not living in the now.  Instead, you are creating a future you have judged to be negative.  And that’s not a useful way to live.

Understanding the Big Picture and the Current Market Type, and Planning for It

I can remember thinking when our official debt went to a trillion dollars, “How can we do that?  How can we survive with that kind of debt?”  Well, the Bush administration managed to produce yearly deficits of a trillion dollars and a total debt (including future obligations) of over $100 trillion.  The Federal Reserve actually produced a study saying that the U.S. was bankrupt, and when I looked at the suggested solutions, none of them were palatable.

When you have a high debt, the only thing that makes sense is to inflate it out of existence, meaning that the debt becomes worth less and less.  For example, I recently bought a Zimbabwe 100 Billion note for about a dollar.  That note, I understand, will buy about two loaves of bread in Zimbabwe.  Now, if we somehow balance the budget, stop spending, and inflate to the point where 100 billion will buy a loaf of bread, then our debt will be quite manageable.  I’m being a little facetious, of course, but only a little.

However, there is another thing about debt.  As it gets bigger, it becomes riskier.  And risky debt must pay a high amount of interest in order to keep people interested in owning it.  Buy we are not paying a high amount of interest for our federal debt.  It’s effectively zero.  And who will buy t-bills without a decent return?  Our debt and our dollar are both risky.  Thus, my prediction is that the dollar will go down in value and our debt has reached bubble bursting stage.

But why should this evoke fear?  It’s just a statement.  It’s neutral.  If you feel fear reading it, it simply means that you have a lot of stored fear inside of you and its starting to come out.  If that doesn’t make sense to you, it’s explained in both the Peak Performance Home Study Course and in the Peak Performance Workshop.

It’s important to remember is that crisis means opportunity!  There will be lots of opportunity in the current crisis, which will become apparent soon.  I’ve already mentioned some of the interesting opportunities that have surfaced as a result of this crisis (see the Outlook for 2009 article).

It is also important is that you understand what’s going on.  If you pay attention to the media and think this recession is over and the market will start going up, then you could easily put yourself in harm’s way.  If you think a bull market is starting when we’re in a volatile sideways or volatile bear market, then you could easily put yourself in harm’s way.  Thus, it’s important to know what’s going on and how to plan for it.

Understand Low Risk Ideas and that It’s Possible to Develop a Holy Grail System to Fit Any Particular Market Type

There are some market systems that made a great deal of money during the last three months:  1) some currency systems during great moves in the U.S. dollar and the Japanese Yen; 2) being long in bonds as interest rates plunged to an all time low, especially if you were leveraged; and 3) various option strategies that capitalized on high volatility.  One newsletter claims to be up 1400% as a result of trading various complex option strategies in 2008. 

Generally, if you understand the golden rules of trading, you should never be hurt too much in any market.  Cut your losses short and let your profits run.  Know how your system will perform in various market types and only trade when the market type is appropriate for your system.

If you put what’s going on into perspective, you’ll understand that there are plenty of ways to make money if you are prepared for them.  And if you are not prepared, then you should stay out of the market until you are.  So the future is just the chance for more opportunity if you are prepared.  It’s nothing to be fearful about. 

You Achieve Your Objectives Through Position Sizing Based Upon Your System Quality NumberSM for that Market Type

Very few professional traders understand this concept—only a few of the best.  The key concept you must understand is that you achieve YOUR objectives (and your objectives are probably different from someone else’s objectives) through position sizing.  Every system you have will have a different System Quality Number for each market type.  But your system itself has nothing to do with achieving your objectives.  The only thing that is critical is that the higher the System Quality Number, the easier it will be to achieve your objectives using position sizing.  If your objective is to not lose much money, then you can make sure that you do that through position sizing.  If you lost 40% or more of your portfolio in 2008, it is only because your position sizing was way too large.  For example, if you had all your money in a mutual fund that lost 50% in 2008, then you had no exit plan and your position sizing (at 100%) was too large…especially if your objective was to never lose more than 10%.

You Create Your Own Experience in the Market

This is the most important concept of all and you can understand it from three different viewpoints. 

First, if you understand the previous three concepts the way I’ve laid them out, then you should have no problem understanding how someone creates success.  Doing almost anything else will not produce consistent success. 

Second, if you make lots of mistakes, where a mistake is not following your rules, then you will subtract from your performance.  You could even create a losing performance if you make enough mistakes.  Repeating the same mistakes over and over again, no matter what the  reason, is an excellent definition of self-sabotage.  If you have a lot of fear, then through that fear, you could create a lot of mistakes.

Third, you attract into your life what you think about.  If you are full of fear, then you will attract things into your life that justify that fear.  If you are full of gratitude, then you will attract massive reasons to be grateful.  Furthermore, if you believe this works, then it will.  And if you believe it won’t work, then it won’t because you will always find ways to justify your beliefs.

One of my Super Traders was an Irish mortgage broker.  And at our Super Trader meeting in December, he asked everyone, “What’s the difference between an Irish mortgage broker and a large pepperoni pizza?”  The answer was that a pizza could feed a family of four.  At the time of our meeting, his business had shrunk to about 85% of its former level and the buildings he owned were suddenly worth much less than the mortgages he had on them.  Under those circumstances, he could no longer afford to remain in the Super Trader program and make his semi-annual payments.  Instead, I gave him a free 90 day extension in which he was to do a lesson each day of A Course in Miracles, listen to The Secret audio book, and each day make entries into a gratitude journal.  Lastly, he was to send me an email each day, telling me about what he’d done and his experiences that day.  Within one month he was offered a great opportunity out of the blue.  He didn’t immediately accept the opportunity, but instead asked for better terms—something he never would have done had he not been going through the process that I had prescribed for him.  And when the terms were redone, he was given a new offer that was even better for him than what he had proposed.

So let’s look at my Outlook for 2009 from a different perspective.  Yes, the outlook is rather gloomy from the perspective of what has been. It suggests that we are about to go through massive change.  But perhaps that change will bring about a revolution of the system.  A system in which half the people in the world work for a few hundred thousand people while the other half live in abject poverty is not the best system.  A system in which one group of people think they are right and others are wrong and seek to impose their will on the others is not the best system.  Perhaps this change will bring about a revolution where we are all brothers and sisters.  Perhaps it will bring about a revolution where there is no “right” viewpoint, but rather a sense of oneness.  Perhaps it will be about a revolution where everyone is willing to love one another rather than dominate one another.  Perhaps it will bring about a revolution in which we can all be happy.  And if that is the case, then every hardship that we might go through to get the better system will be worth it.

Incidentally, the four points that I talk about in this article are clearly laid out in our Blueprint workshop.  We will be holding that workshop in Australia.  If you have been considering it, now is the time to enroll.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

 

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Trading Tip

January’s First Five Days Indicator—Forewarned is Forearmed

by
D. R. Barton, Jr. 

Oft expectation fails, and most oft where most it promises.

– William Shakespeare

Let’s do a little myth busting today—that savory task of uncovering another of the indicators that just don’t indicate what they’re supposed to. An indicator that gets lots of press early each year is the First Five Days indicator. Rest assured it just doesn’t work.

At the core of human nature is the desire to understand complex systems in simple terms. The problem is this: we tend to apply this simplistic cause and effect model to very intricate problems, and expect similar easy-to-understand answers.

One good example is the Groundhog Day Indicator.  Like the financial markets, weather systems are complex and difficult to predict.  But we have devised many simplistic ways to predict the weather, including the infamous groundhog, Punxsutawney Phil.  If he sees his shadow on February 2, there will be six more weeks of winter weather.

Because we like simple explanations, we are more than willing to believe cause-and-effect explanations that really don’t make logical sense.

Maybe that’s why there are so many stock forecasting tools that use shaky logic and even shakier statistics to predict what will happen in the market in the days and months to come. 

So let’s look at one of the most hyped indicators this week… 

January’s First Five Days—It’s Popular, But it Ain’t Useful

Many market watchers and analysts are looking at the well-known First Five Days indicator, which has been popularized by Yale Hirsch’s Stock Trader’s Almanac. 

For the record, I think the Almanac contains a wealth of useful information.  I keep one on my desk and gave two as Christmas gifts to friends and family.  But back to our indicator…

The First Five Days indicator holds loosely that the direction of the first five trading days of the year is a valid predictor of the direction of the market for the remainder of the year.

As proof of the indicator’s effectiveness, it’s proponents look at a 59-year record and state that of 36 First Five Days that finished up, the stock market finished up in 31 of those years—an impressive 89% win rate for the predictor. 

It has been quoted by such venerable sources as The New York Times, U.S. News & World Report, CNN and Money Magazine.  Nevertheless, it’s a useless indicator, or worse, it’s potentially dangerous to your wealth.

Don’t Waste Your Time on This Meaningless Myth

Let me be blunt.  The First Five Days indicator is the lowest form of analysis.  It is the opposite of cause and effect.  This is the type of analysis that looks for any cause to tie to an end effect, regardless of logic, and as we shall see, regardless of statistical support.

The indicator is no more valid or useful than predicting the stock market based on Super Bowl winners or groundhog shadows.  Here are three reasons why:

1. The logic is arbitrary.  The raw numbers for this indicator show that the market has gone down during the first five days of January 23 times in the last 59 years. In those 23 occurrences, the market finished the year up 11 times and down 12 times. 

So, the authors conclude that the indicator has no predictive value if it starts out to the downside.   Looking at the same data, they like the results if the market starts out to the upside where it has “been right” 31 out of 36 times.  Working in one direction but not the other is too arbitrary for me! 

If the data doesn’t fit our hypothesis, then change the hypothesis to fit the data.  This is classic “curve fitting” mentality.  Do you want to risk any of your money based on that logic?

2. The triggering event is not statistically significant.  For this indicator, all you need to trigger a yearlong market prediction is any up move for five days.  This means that trivial moves in the market could shape your outlook for the coming year. 

Suppose after five days the market was up only one quarter of a point.  This would still trigger the indicator’s prediction for an up year.

What’s the problem with having a move of any magnitude trigger an indicator?  A tiny move doesn’t tell us anything about what the market is doing.  A small move either up or down is just random; it’s just part of the background “noise” of the market.

So how do we decide what is meaningful and what is just background noise?  One measure that many analysts use is the average volatility of a price movement.  Long-time readers know that I use the Average True Range (ATR) of price as a measure of volatility.  (In simple terms, ATR measures the average size of the daily range, the high minus the low, while accounting for gaps between bars.)

If we look at the ATR for a five-day move, we would want our trigger to move up or down at least half of the average.  Anything less would almost have to be considered random.

With that in mind, your industrious writer dug deep into the details of the First Five Days indicator’s raw data.  I calculated the S&P 500 index’s ATR during the first five days for the last 25 years and checked to see how many of the First Five Days trigger signals could be considered more than random.  The answer: only 7!

3. The sample population is too small.  When we eliminate the trigger signals that are mere noise, we now only have 13 to 16 triggers of the indicator over the last 55 years.  This is not a statistically significant sample to base any predictions on, and this indicator is uncovered as just some simplistic curve fitting that doesn’t mean a thing for traders and investors.

There is plenty of good analysis for you to use to help guide your trading and investing decisions.  So it makes a lot of sense to throw out the overly simplistic, statistically meaningless ones like the First Five Days indicator. 

One last note of caution—the indicator worked last year. This brings another psychological bias into play: we tend to assign an excessive amount of meaning to the most recent data points.  Don’t fall into this trap with the First Five Days indicator.

You can still use it for cocktail party discussions, but don’t waste any money trying to use it to help you make sense of the markets.  We’ll pick back up on our volatility series next week.  Until then…

Great Trading,

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

D.R. is presenting the upcoming How to Develop a Winning Trading System That Fits You Workshop, January '09.

Mailbag

Mailbag

In this new section, we'll share comments from readers. We encourage you to click below if you have feedback to submit for Dr. Tharp. 

I've just finished my 3rd book by Dr. Tharp and am about to begin going through the new book on position sizing. After studying both trading systems and *myself* for 6-8 months, I had a system for me ready to go. I made a list of all the things most traders do wrong and how I was going to avoid them. Then, after a couple of weeks of successful trading in a simulation account, I turned the button to my live account and started trading. 

As you would expect from a fairly new trader, I proceeded in admirable fashion to implement almost every one of the bad habits successful traders DON'T do! Thankfully, I corrected them the next day, went back to study and more simulation work, and have gotten very close to working out most all of the bugs in *me* as a trader. And, thanks to your insight and communication Dr. Tharp, I've accomplished this feat with a positive balance remaining in my trading account!

As you are well aware, I'm sure, trading live accounts has a very different level of anxiety and behavior associated with it compared to the relative calm and security of the Sim101 account when trading. Thank you profusely for teaching me that it's not bad to be wrong, it's only bad to STAY wrong.

Learning, Correcting & (now) Profiting,
Dwayne

 

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