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Equity investment: stock market investors have a wide range of forecasting tools to choose from, but even the most accurate method has its limitations.

Is it possible to predict the stock market accurately? If it is, surely you could make a fortune over a period of years. Let's look at a range of methods of anticipating turning points in a market and whether they work or not.

Despite the apparent absurdity of astrology, a surprisingly large number of intelligent and well-educated investors take it into account when making investment decisions. Unsurprisingly, there's no record of anyone making a substantial amount of money using this approach.

A slightly less controversial method is the wave theory developed by Ralph Elliott in the 1930s. Its guiding principle is that the market moves in waves of different lengths from 70 years or longer, down to a few days, hours and minutes. The patterns often conform to specific numerical sequences and percentages, such as Fibonacci constants.

According to the FT, some fans of the Elliott wave theory reckon that the market peak in 2000 was the top of a five-wave pattern that began at the market's low point in 1932, meaning that a massive setback is imminent. It will, they believe, take the Dow Jones industrial average down to about the 1,000 mark and hit the FTSE 100 by a comparable amount. Apparently, this is likely to happen in a bear market that could last for a decade or more. The only problem is that they have been predicting disaster for years. Is it going to be any different this time?

It has been said that chartists usually have dirty raincoats and large overdrafts, but some of them have actually made a lot of money. The technique must, therefore, have a certain amount of credibility. Chartists believe that a chart showing the history of a share price reflects the hopes and fears of all investors and is based on the one indisputable factor: how a share has performed in the market. The market's perception of the share is a constantly changing illusion, according to the chartists, so it's more important to follow trends than to try to work out a company's likely earnings per share several years ahead.

Jim Slater, a legendarily successful stock market investor, states in his book The Zulu Principle that he uses charts as one tool in a whole kit. They either give him further confirmation that he is proceeding along the right lines or provide a warning signal, sometimes well in advance of any deterioration in the fundamentals.

A more anticipatory tool is the Coppock indicator, which has given exceptional results. In the depths of a bear market you should always look out for an upturn in the Coppock curve, which is normally a strong buy signal. It was devised by Edwin Coppock in the 1960s and based on a mechanical system known as the long-term buying guide.

Coppock, a devout Christian, was asked to work out a long-term low-risk buy signal for his church's lends. The administrators wanted to know when to step up purchases and when to stand aside. He asked the church ministers how long they thought it generally took for the human mind to adjust to bereavement, divorce, illness, unemployment, financial loss, relocation and retirement--the greatest stresses it has to handle. He adopted their answer of 11 to 14 months as a yardstick.

"Do major long-term buying of strong stocks when the curve first turns upwards from below the zero line," he wrote in his 1962 paper. Emotions Make Prices. But he added: "The technique is of no value whatever to an in-and-out trader; it is a technique for long-term investors--their low-risk buying guide."

The indicator is not a sign of a trend reversal, but it shows that the risk factor in the market is low and usually heralds a sustained advance. If you apply it to the Dow Jones industrial average from 1919, it gives only one false signal (1930). Brian Marber, a leading chartist, wrote in the FT that, although Coppock used his indicator only on the Dow, its principles make it applicable to all markets, although it doesn't seem to work on foreign exchange. If applied to the London markets since 1940, for example, it also gives only one false signal (1948).

The technique does not give a sell signal--Coppock would become incensed if his followers tried to use a trend-line downturn as one.

So how is the Coppock curve or trend line derived?

* Compare the Dow's end-month level with those prevailing 11 and 14 months earlier.

* Express the differences as percentages.

* Combine them and multiply by ten.

* Repeat this exercise the following month, multiplying the previous month's figure by nine. In the third month, multiply by eight and so on down to one.

After ten months you obtain a weighted average of the previous 22 months' data. A version of this calculation can be found, for all the world's major stock markets, in the first issue of Investors Chronicle of every month. This uses a rolling 12-month average rather than the 11- and 14-month figures that Coppock devised.

The general outlook for buying more shares is usually unattractive when a Coppock buy signal occurs, but history tells us to be guided by this signal rather than the outlook. The problem is that Coppock generates very few of these--only seven over the past 30 years. This is both a strength and weakness. It is a strength because a buy signal, when it comes, warrants serious consideration. It is a weakness--and one reason why Coppock is given Little attention--because if it were our only guide we would die of boredom waiting for a buy signal.

The Coppock indicator's few false signals also give cause for concern. In 1948 it would have encouraged London investors to buy, but a 20 per cent decline in the FT 30 index was to follow.

At least it took only four years for the market to recover in that case. The wrong message that Coppock would have given Dow investors in 1930 would have been much more serious. On November 13, 1929 the Dow crashed to its low for the year, losing 48 per cent of its value a mere ten weeks after it had peaked. Then came the so-called fools' rally: in the five months after November 13, the index recovered hall of the value it had lost. But in May 1930 the dreaded bear market was under way again and those caught in the rally knew they'd been duped. By the end of the year the market had plummeted 60 per cent from the peak of the rally. There were further downdraughts in 1931, but the final slaughter came a year later, when share prices plunged to depths visited half a century earlier.

From September 1929 to June 1932 the Dow's value fell by 89 per cent. Its peak of 381 points in 1929 would not be reached again liar 26 years. The Dow's fall from its 1929 low to the 1932 low was 79 per cent. If the Coppock indicator had existed at the time, that would have been the approximate percentage loss suffered by its users.

Most professional equity investors say it's virtually impossible to predict the stock market. They advocate pound-cost averaging for the private investor--ie, putting a fixed sum every month into equities. This has the advantage of buying more shares when the stock market is low and fewer shares when the market is high. But, when the Coppock indicator starts rising while the numbers are still negative, the buying signal it gives will be correct more than 90 per cent of the time.

When it comes to protecting your portfolio against future bear markets, Jim Slater's advice is to have 100 per cent of your patient money invested if you feel bullish and 50 per cent if you feel bearish. When pruning your portfolio down from to 50 per cent keep your more defensive stocks. This should happen naturally as you sell shares that fulfil your investment objectives.

In early January 1975, at the bottom of a bear market, the FT 30 ordinary share index had fallen to 146 points, the lowest it had been since May 1954. The UK market price/earnings ratio was 3.8 with a dividend yield of 13.4 per cent. At the end of that month the Coppock indicator gave a buy signal that was to prove a stupendous money-making opportunity for long-term investors. If such an opportunity occurs again, let's grasp it with both hands.

Michael Goddard is the former FD of Concorde Express Transport. Since his retirement he has become a journalist specialising in financial matters.
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Author:Goddard, Michael
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:May 1, 2005
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