Squire Approach

4 Ways You Can Use Historical Data to Develop a Risk Management Strategy

Is predicting stock market or individual stock price trends tricky – or impossible? Some stock market theories, such as the Efficient Market Hypothesis and the Random Walk, posit that the stock market is either so efficient or so random that attempts to predict it are pointless.

Why the Stock Market Isn't Random

Like the markets, company growth also trends up and down in measurable ways. You can’t get to $5 million in revenue without first getting to $1 million, and so on. Usually the stock price moves up and down a little, but mostly up and to the right over time as the company grows revenues and profits. This pattern stands the test of time. When companies stop growing revenue or earnings for short or long term reasons, generally the stock price declines.

Thus, fluctuations in the stock market aren’t truly random. Astute investors can use this to their advantage and make an educated guess as to what might happen tomorrow.

Here's how:

  1. Look for trends. Trends can be analyzed with moving averages. A moving average of a stock’s price takes all the prices over the last say 50 or 200 days and averages them to form a line. Tracking this data repeatedly generates a trend line.

    Thus, on a graph or stock chart you might see the actual price of the company, as well as a couple of colored lines showing the trend both short and long term.

  2. Figure 1: West Texas Intermediate Crude Oil Price Graph 2011-2016

    trendline

    Source: Bloomberg

  3. Use trend lines as indicators.The trend line is just an indicator, though typically a good one. Trend lines move in one of three directions: up, down, or sideways. The direction of the trend line forms a basis for predicting stock market prices.

    If a market price goes below a 50 day trend or short-term trend, that is normal and rarely, in fact, bad. However when the market or price goes below the 200 day trend, that is the next level of severity, and should be cause for some concern. If the market and the 50 day trend both dip below the 200 day trend, this is extremely severe. This has only occurred approximately 69 times over 116 years of recorded market history.

    Investors can use trend lines with decline percentages to help distinguish between corrections and crashes. Without them, the severity of a downturn is difficult -- if not impossible -- to predict.

  4. Use trend lines to avoid mistakes. Trend lines demonstrate repeated patterns. Markets cannot “rebound” back up to their previous high prices with a similar crossing of trend lines going back up – no matter what an investor might personally hope for.

    Let’s examine the price of oil in 2015:

    Figure 2: West Texas Intermediate Crude Oil Price Graph 2013-2016

    Depicting decreasing stock prices.

    Source: Bloomberg

    In the summer of 2015, many investors contemplated investing in oil. As the chart indicates, the price of oil was rising off the bottom at around 55 headed to 65 in the first half of the year. Both the 50 day trend line (green) and the oil price (white) were still below the longer 200 day trend line (blue). Savvy investment advisors could safely say there was no “official” buy signal yet.

    In this circumstance, using trend line guidance and avoiding emotional decision-making saved the client approximately a 50% loss, had he or she invested.

No one can predict stock market movement with absolute certainty. However, the stock market, much like company growth, does trend up and down in measurable ways. Understanding trend lines – and being able to analyze them accurately -- can help investors to develop a loss mitigation strategy to assist in stock market crash management.

Article tracking number 1-466039

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