Optimal Entry Points and Cycle Analysis

| October 30, 2011

The brilliant investor Benjamin Graham, author of the revolutionary investment guide Security Analysis and mentor to Warren Buffett, once asserted that “the essence of investment management is the management of risk, not the management of returns.” In other words, the key to success as an investor (and, we would assert, as a trader) over the long-term is maintaining focus on the things that can go wrong with a particular thesis or position and then taking steps to protect yourself from those risks. Many market participants become enamored with the potential rewards of a given investment or trade and do not properly plan for the “other side” of the position. Invariably, this common form of myopia is often caused by a misguided belief that only one scenario is possible. One of the primary reasons that many highly intelligent people fail as investors is because they place too much confidence in their own analysis and become fixated on one potential outcome, leaving themselves vulnerable to alternative scenarios. However, as we often note, there are no certainties when it comes to financial market forecasting, only possible scenarios and their associated probabilities. That is why we always identify bullish and bearish scenarios during our forecasting process and assess the relative likelihoods of both outcomes. In this manner, our methodology provides the means to assess the approximate reward and risk for a given position across all time frames in the markets that we monitor. Additionally, we audit every one of our outlooks and track the performance of our forecasting methodology over time, providing the required confidence in the assigned probabilities. After all, believing that a given scenario is ~70% likely is only useful if you have a large body of historical data that supports the accuracy of the underlying methodology.

Maintaining a balanced view that weighs the viability of multiple possibilities facilitates the identification of optimal entry points. By definition, an optimal entry point for an investment or trade provides the maximum amount of potential reward while also affording a minimal amount of risk. A recent example of an optimal entry point occurred in the stock market in July 2011 prior to the violent long-term breakdown in early August.

The displayed entry point was optimal because the likelihood of a sharp move lower was high and, equally important, a close stop level could be applied in order to minimize any potential losses. As usual, cycle analysis correctly identified the short-term high as an optimal entry point for a short swing trade, which brings up a very important point: optimal entry points always occur at temporal inflection points. Consequently, all investment and trading positions should be opened and closed at temporal inflection points as identified by properly applied cycle analysis. It does not matter if you are a long-term investor who only makes portfolio changes once every ten years or a short-term trader who maintains positions for only weeks at a time. Every trade should be performed at an optimal entry point and cycle analysis provides the most reliable way to identify them. At PMI, we use a two-step process to identify potential temporal inflection points and our methodology has proven to be very effective over the long-term, correctly identifying 95 percent of the cycle lows and highs across all time frames as they develop, while issuing false signals only 7 percent of the time. For example, the following weekly chart displays the recent performance of cycle analysis at predicting the formation of intermediate-term inflection points in the gold market.

Nearly every intermediate-term low and high was identified in real-time, as it occurred. However, as always, it is important to remain aware of the limitations of any forecasting methodology. There are no crystal balls when it comes to the financial markets and no system can provide 100% accuracy. For example, the most recent intermediate-term cycle low (ITCL) in the gold market likely formed in late September, much earlier than anticipated by the typical ITCL window. Additionally, our methodology did not identify this latest ITCL until this week, some four weeks after the fact.

Of course, forecasting certainty is not required to achieve long-term success as an investor or a trader. You simply need to reliably identify the most likely scenarios and their associated probabilities with consistency, and the judicious application of chart analysis enables you to do just that.

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