Following the late 2003 market advance, the stock market resumed a more neutral track at the start of the following year. The stock market started 2004 well, but the price thrust weakened rapidly.
As matters turned out, the relative weakness of the RSI indicator during the cycle presaged the more severe market declme that took place in March 2004.
The cycle was very bullish in its development, with a small dip at the end of an early A segment followed by rising prices right into the end of the period. Sometimes cycles during very bullish market periods show patterns of price movement that make it very difficult to determine the completions of cycles that become more readily discernible in indicators that track the momentum of the price advance.
For example, the RSI dipped a few days before the end of the cycle, failing to confirm new highs made in the Standard & Poor’s 500 Index at the start of 2004.
Cycles that end as strongly as the cycle from November to early January are usually followed by very strong market action at the start of the following cycle, which is what took place in this instance. The RSI indicator, incidentally, clearly indicated the A, B sequence of the November-January cycle, which was not as apparent in the price pattern.
This was a slightly bullish cycle, with prices moving up gradually and more market time taking place in advance than in decline. The division into virtually equal A and B segments is very clear, as was the negative divergence between price movement and the patterns of RSI that closed the cycle with a classic negative divergence. The RSI indicator closed the cycle at its oversold zone, again with a double- bottom formation, confirming the start of the next cycle.
First, you can observe the level of RSI at the market low in early August, where this study begins. As you can see, RSI resided at the time in the 40 area, an oversold region for the 14-day RSI during neutral to bullish market periods. RSI advanced during the new cycle, ultimately peaking right at the cycle midway point. Prices continued to advance into the cycle, but the RSI failed to achieve new peaks along with price. This represented a negative divergence that, as we have seen, carries bearish implications.
Two developments took place as this 36-day cycle drew to its nominal close. First, the RSI, failing to reach a new high along with price (a sign of failing momentum] suggested near-term problems ahead. Second, both price and RSI turned down, price from a maximum peak and RSI from a secondary peak. Key elements were in negative harmony. The cycle was due to move into a low. The RSI had failed to achieve a new high along with price. The price level of the Standard &Poor’s 500 Index turned down as well.
Now, what took place as the cycle reached its nominal low at the end of September? A number of bullish elements supported that low area, indicating the likelihood of a tradeable market advance. For one thing, the cycle was due to reach its cyclical bottom. For another, the RSI had by then descended to the area that had been the launching pad for the September advance. For still another, as the bottoming process moved along, the RSI traced out a rising double-bottom pattern, a type of pattern that tends to be quite significant when it develops within areas that mark oversold levels during bullish market periods.
There is an important corollary to a perfect market. A market (or a price) is called “efficient” if this market has set the price using all available information. If a market is perfect, it will inevitably also be efficient. If it were inefficient, you could become rich too easily. For example, say the market wanted to offer you an expected rate of return of 15% on a particular stock (for whatever reason), and the expected value of the stock is $115. Then the price of the stock today would have to be $100 for this market to be efficient. This market would not be efficient set the price for this stock at $99 or $101, because the stock would then offer other than the 15% expected rate of return. Similarly, you should not be able to locate information that tells you today when/if/that the true expected value tomorrow is really $120 for the $100 stock. If you could find this information, you could on average earn more than 15%. If the market has overlooked this information, it is not efficient.
The application and use of the “efficient markets” concept faces a number of issues. First, where does the 15% come from? It will have to come from some model that tells you what rate of return a stock should have to offer (given its characteristics, such as risk). Without such a model, talking about market efficiency is meaningless. Second, what information exactly are we talking about? Insiders often have more information than the public. For example, a drug company executive may know before ordinary investors whether a drug is likely to work. Thus, the market may be efficient with respect to publicly available information, but not efficient with respect to insider information.
So, to be more accurate, when a market is perfect, we usually believe that it is also efficient with respect to public information. After all, if other buyers and sellers were to ignore a useful piece of information, you could likely earn a lot of money trading on it. For example, what would you do if you learned that the market always goes down on rainy days and up on sunny days? It is unlikely that the average investor requires extra return to hold stocks on sunny days—and, even if the average investor does, you would probably not! You would never buy stocks when the weather forecast predicts that rain is coming, and you would only buy stocks when the weather forecast predicts that the sun will be shining. Investors like yourself—and there are of course many such investors in perfect markets—would rapidly bid up the prices before the sun was shining, so that the prices would no longer systematically go up on sunny days. If markets are efficient, then you should not be able to earn abnormally good sunny-day returns—at least not this easily. To earn higher expected rates of return, you must be willing to take on something that other investors are reluctant to take on—such as higher risk (also the subject of Part III).
A belief in efficient markets is what defines classical finance. In contrast, behavioral finance believes that markets sometimes do not use all information. Depending on how strong a believer in classical finance vs. behavioral finance you are, you may believe that there are no such opportunities, that there are few such opportunities, or that there are plenty of such opportunities. Both camps agree, however, that market perfection (and especially competitiveness and transaction costs) play crucial roles in determining whether a market is efficient or not. We will dedicate a few posts to market efficiency and its consequences, which will also talk in greater length about classical vs. behavioral finance.