Personally, I believe that it will be quite interesting to combine a technical trading system with a fundamental approach (may be we shall categorise it as the “funtech” trading methodology). In this posting, we will explore the Earnings Band Method.
What is the Earnings Band Method (EBM)?
EBM is a very simple trading approach. It applies Bollinger Band to the price-earnings trend of a particular underlying instrument / security. Using the Malaysia’s FBMKLCI index as an example, the following parameters are assumed:
- 60-day mean of the trailing price-earnings (PER) of FBMKLCI (note: a 60 day period has been employed to account for quarterly results reporting by the listed companies in Malaysia as well as non-trading days)
- Upper and low band are defined as 2-standard deviation from the 60-day mean
Overall broad principle of EBM is that if trailing PER of the underlying exceeds the upper PER band, this may imply potential downward reversal and vice-versa for the breaching the lower PER band.
Based on the actual data of the FBMKLCI (since 2010), the followings have been observed:
Observation 1: If the lower PER band has been breached, there is a likelihood that the instrument / security will re-bound upward
If you see points such as A, B, C, D and E (i.e FBMKLCI’s trailing PER broke the lower band of PER), it is observed that there were subsequent rebounds in the FBMKLCI. The breaks usually occur during the reporting seasons.
Observation 2: If the upper PER band has been breached, there are mixed signals on whether there will be subsequent downward reversal
- Point F and G: Even if there was a breach, the index went even higher thereafter.
- Point H: After the breach at point H, the index went lower.
- Point I: After the breach at point I, the index went on a side-way trading range.
Observation 3: Reversal in the trend of the band may signal reversal in the underlying
For the period of between Mar 10 and Mar 13, the FBMKLCI’s PER band was heading on a downward trend. There was a subsequent upward reversal in the PER band from Apr 13 onwards, followed by the peaking of the FBMKLCI in July 2014.
Logically, when the trend of the PER band is heading downward, the risk of overvaluation may be potentially lower. When there is a reversal in the trend of the PER band, investors should exercise caution. Nevertheless, in spite of a reversal in the PER band, there is a time lag in the reversal of the underlying.
Observation 4: Expanding band signifies volatility in earnings
From early 2015 onwards, it is observed that the FBMKLCI’s PER band was relatively volatile (i.e wider PER band) despite the fact that FBMKLCI has been trading range-bound. This signifies volatility in the earnings of the underlying (i.e the earnings of the constituents of the FBMKLCI).
Unlike Bollinger Bands, the expanding or narrowing of the PER band may not have any significant implication. If the underlying is trading range-bound and the PER band is heading on a downward trend, this may potentially minimise the downward risk of the underlying.
In conclusion, with every trading system, the EBM has its limitations. Whatever that has been presented in this posting is only a conceptual approach and it has not been verified via a comprehensive back-testing. Further refinements of the method are required. Nevertheless, I may potentially treat EBM as contributing toward the balance of evidence in order to support an investment decision.
Book Corner: Investing In Knowledge
John Bollinger is a giant in today’s trading community. His Bollinger Bands sharpen the sensitivity of fixed indicators, allowing them to more precisely reflect a market’s volatility. By more accurately indicating the existing market environment, they are seen by many as today’s standard―and most reliable―tool for plotting expected price action.
Now, in Bollinger on Bollinger Bands, Bollinger himself explains how to use this extraordinary technique to compare price and indicator action and make sound, sensible, and profitable trading decisions.
Concise, straightforward, and filled with instructive charts and graphs, this remarkable book will be essential reading for all serious traders, regardless of market. Bollinger includes his simple system for implementation, and techniques for combining bands and indicators.
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