How To Study and Think About the Stock Market Like a Professional

Everybody wants to be the next great investor or trader.

But only a few really understand how much work goes into that goal. large-1432635791It involves countless hours of research, reading, and analysis.

Meet Dana Lyons. Each day you can find him sharing fascinating studies, charts, and insights about the stock market. All of it is his own research, too. We follow him from his profile @JLyonsFundMgmt and recently asked him a few questions. We wanted to show everyone how much work and analysis goes into being a true market professional.

1. For anyone who has seen your charts, they know how much data you are able to crunch and backtest. Why do you think it’s important to backtest certain market events?

The key to success in this business, in my opinion, is A) to have an investment process that is objective, and B) to follow that process with discipline. An alarming percentage of “analysis” that takes place in our industry is reliant solely on subjective or qualitative analysis, e.g., what somebody “thinks” prices will do based on developments that they “think” will unfold. This assumes that one can forecast both what will transpire (typically a very difficult proposition) and, in turn, how prices will react (an equally difficult proposition).

By back-testing events, at least we can ascertain how prices have reacted to similar circumstances historically, even if we know they are not guaranteed to respond the same way in the future. Having that knowledge at least prepares us better for “expected” outcomes and, just as importantly, gives us a head’s up that conditions may be different than originally thought when prices react counter to the norm. To that point, our goal behind the back-tested studies that we run is as much to dispel any pre-conceived biases we may have based on market conditions as it is to confirm them. It is actually quite surprising the number of back-tests, even in the most “obvious” of circumstances, which produce results counter to those expected.

Therefore, as much as possible, we attempt to quantify or automate our investment process in an effort to eliminate subjective analysis and human natural tendencies (which, more times than not, will be off base). Back-testing is a crucial component to constructing such an objective process. Back-testing instructs us, in an unbiased manner, as to how markets have typically reacted to various inputs or circumstances – including the posture of one’s quantitative model. Obviously back-testing is an imperfect methodology and future markets may respond differently than they have in the past. However, on-going rigorous testing on a system is all part of the process.

2. How did you get started and how do you know what to look for? We read, for example, your Presidential Cycle blog post. There’s some great insights there about Presidential elections and the stock market.

The charts, statistics and blog posts that we publish all have the same origin: we ascertain, to the best of our abilities what is driving, or at least occurring in, the market at a given time. Then we base our offerings upon that. We do not strive to seek out obscure developments for the sake of conversation. We are not into trivia for trivia’s sake nor do we have time for that. The main criteria driving our charts and posts is relevancy, i.e., Is it important or at least pertinent to the market action currently?

From there, we do attempt to bring some additional value added components to the relevant topics. For one, we try to offer an original take or angle on the relevant developments that you probably won’t see anywhere else. It’s not always easy since everyone is working with the same data but it helps to look at issues creatively and originally. We also like to present items, if we can find them, that may be under the radar, but which have the potential to become very relevant factors in the marketplace. And, of course, we like our charts and posts to be as entertaining as possible. Let’s face it, this can be a fairly dry industry so if we can offer an original chart or post in an entertaining way, we are adding some value to our viewership and, hopefully, piquing their interest in coming back for more.

3. Is there any one metric you always follow or find significance in? If so, what is it and why do you like it?

Our #1 investment tenet is to align our investment posture with the direction of the overall broad market, a.k.a., “don’t fight the tape”. Research has borne out the fact that 70%-80% of the direction of a stock or index is explained by the direction of the overall market as a whole. Therefore, there is much greater margin for error in aligning your investment positioning with the current broad market trend.

Of course, determining that trend, and changes therein, is the biggest challenge. Our main focus is on what we label the “intermediate-term”, which we typically consider between 2-6 months. In our view, that is the shortest time frame that still produces market moves large enough to either attempt to profit from (to the upside), or avoid (to the downside). Therefore, we constructed a quantitative model to determine the broad market direction within that time frame.

As, again, it is the overall market trend we are after, breadth is given a significant weight within our model. Our favorite breadth metrics are proprietary indicators that we built. And probably the most reliable or valuable one is based on a tally of a measure of momentum among all stocks within the market, or within a particular index.

4. Why do you sometimes share Log charts over Arithmetic charts? This is a debate we often see people having. Let’s see if we can put an end to it.

I don’t see any need for a debate pitting log charts vs. arithmetic charts. As a chartist, why rule out the use of any potential analytical tools? We use both types of charts and our rationale for determining which to use is not complicated: use whichever one best fits the present circumstances. I’ll even switch back and forth between the two types on the same exact chart if I find that prices are respecting analysis on both.

The two criteria that typically play the biggest role in determining whether an arithmetic or log chart is the best fit is 1) time frame and 2) price rate-of-change. In general, I have found arithmetic charts to be most helpful in shorter time frames (i.e., intraday up to a few years). And I have found log charts to provide the greatest added value when dealing with either A) long-term charts (i.e., several years to decades or centuries) or/and B) charts with parabolic price moves (up or down).

5 . Speaking of charts, what is your opinion of technical analysis and how does it fit into your work?

Unlike any other securities analysis, TA provides a framework for determining when one is right in the market and when they are wrong. Of course, finding a successful TA strategy is the million-dollar challenge. However, even a poor TA strategy managed with discipline is superior to investing by other means. At the VERY least, TA can provide a structure to reduce one’s losses and enable them to remain in the “game”. Other analyses do not provide that. In fact, when investing based on valuation metrics, for example, one’s position actually becomes more attractive the more money it loses.

As mentioned, most of the indicators that we use are proprietary metrics. While the calculations involved in our investment selection model are fairly complex, the main component is a measure of risk-adjusted performance. Many of the indicators in our risk model involve measures of market breadth while other inputs involve various measures of money flows and investor positioning, etc. These types of metrics can add a lot of value when ascertaining a macro view of the stock market. While price is truth, it is not predictive. Adding these other metrics can aid in determining the likelihood of prices continuing on their current path or potentially setting up for a reversal.

Most of our charting work is geared toward aiding in entry and exit points on predetermined positions. On the charts, we like to keep it simple. Prices themselves are the most important factor. Thus, we find price-based derivative indicators to be largely redundant and do not utilize them too much. The types of charting tools we use most often involve Fibonacci measures, basic support, resistance and trendline analysis and, to a lesser extent, moving averages.


We hope you enjoyed this Q&A! If you have any additional questions, please share them in the comments below.

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