Weight of Evidence
Life or stock picking is similar, both need decision making. Decision making is connected with psychology, skill, research method, etc. I should give it to the technicians, or to the brilliant John Murphy, who taught me about the linkage of decision making with weight of evidence.
What is evidence? The decision making process involves study of pros and cons, strengths and weaknesses and technical elements. Simply speaking, decision making is like a weighing process, we balance positive variables vs. negative variables. It is about understanding, which variables can take prices down and which ones can take prices up?
The smart investor would know that there are numerous variables that can affect the market price, and it is impossible to understand or measure all of these. This is why decision making is about which of the sides (positive or negative) weighs more. This is called weight of evidence.
The process can start from anywhere. Price confirmation is a good place to start e.g. Dow is at the previous weekly high close or Sensex is above the previous multi week low. So, if the price confirmation holds, one can start compiling technical evidence. Is the weekly momentum positive or negative? Are the volumes confirming or non-confirming? Are the previous gaps filled or not?
One can move from regional variables to global variables? How many of the top 10 global indices are above key multi-year support? How many are still below key multi-year resistance?
One could also look at composite evidence. How many Dow (or Sensex) components are below price/book and price/sales less than one and price/ earnings less than 10? Are these also the stocks that are negative for year to date performance? Does the technical evidence confirm value buying for such stocks?
One can also connect market or personal sentiment with weight of evidence. “Am I standing alone or am I a part of the group?”, “Am I being greedy, or am I being fair?”, “Am I panicking?”
The summary of this checklist is the weight of evidence. Sometimes the weight of evidence suggests a continuity of the ongoing trend, as points in favour of the ongoing trend (positive or negative) are more than points against. But on other occasions, weight of evidence could be at a clear extreme. It’s skewed on the positive and negative sides. Whenever such a thing happens, the evidence is overwhelmingly positive (or negative). This overwhelming evidence pulls in the crowds, the believers. As delicate balancing is for the astute, while calling the obvious is for the naive. And when it’s the naive involved in the evidence, the chances of a reversal see an increase in probability.
Where are we now? One peculiar variable we study (not very popular among technicians) is the inversion technique. We took Dow, gold, crude oil, Sensex, SSEC Shanghai, Brazilian Bovespa, dollar and we inverted their charts. When you invert a chart you kill the bias, any bias that may come with a current or anticipated holding. When an inverted chart falls it suggests strengthening in the respective asset and vice versa.
All of the inverted charts we studied suggested that prices were looking to strengthen rather than weaken. The conclusion of my story, “Try challenging your charts like your personal sentiment, you might just tip the weight of evidence to the other side”.