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Markets Always Rise Over Time? It's a Myth: Chartist

One of the most dangerous market myths is that the market always rises over time.

Believers in this myth would trot out historical charts that have been reconstructed from the middle of the 18th century. And sure enough, the long term trend marches inexorably upwards. Even drammatic market crashes like that of 1929, 1987 and the tech wreck of 2000 all become just little blips in this overall magical rising trend.

To many investors, this underscores the buy-and-hold strategy. Just buy-and-hold and the market will bring you a windfall eventually. Right?

Wrong. Unfortunately, this is a pure myth and simply untrue.

The truth is that it's market index always rises, and not the market. The market index rises because the index only includes winners. This is called survivor-bias. The components of the index change on a regular basis, when market conditions warrant.

The Australia's S&P ASX 200 index, for example, is rebalanced every quarter by Standard and Poors' who compiles the index. Just in the last quarter, three stocks were dropped from the index because they were the worst performers. They were replaced by three others which were better performers.

When losers are dropped and winners added, it's no wonder that the market (index) always rises. Even blue chip stocks can be cut out from the list if they fail to perform. Too bad if you happen to own them and plan to keep them for the long haul.

GUPPY Perseus Mining.jpg

Perseus Mining was a stock recently added to the S&P ASX 200, which began trading on March 22. Its recent performance, as demonstrated on the chart, suggests several conclusions.

First is that some speculation or rumor may have developed in the market prior to the March 5 announcement. PRU shows a breakout from a 4-week downtrend and the development of a strong uptrend prior to the announcement. Secrets are difficult to keep in any market and there are always traders who make better guesses based on the same information that others also have.

Second is the acceleration and continuation of the uptrend when the Index rebalancing announcement is made. This is a tradable announcement because many fund managers will need to buy this stock. The surge is volume is most evident on the last trading day before the stock is added to the index. The index pop can be traded directly or by using a derivative such as a CFD or option.

The third conclusion is not shown on this chart. There is a higher probability of a sustainable uptrend after the stock starts to trade as an index component. Stocks that are also components of the index change their tending characters because they enjoy more investor support.

Do stocks that are dropped from the index automatically fall? Surprisingly the answer is “No”, although often they been in a steady decline for months prior to being dropped from the index. These faded blue chips still offer some opportunities but they are rarely part of the myth that the market always rises.

Index component stocks have become more important in recent years because many funds have a mandate that requires them to hold the index stocks. When stocks are dropped, then the fund managers also drop the stock. When stocks are added, the fund managers pile-in as buyers because their fund mandate requires them to replicate the index stocks and their weightings.

So how should investors profit from market (index) rises? They should try investing in an Exchange Traded Fund (ETF) which replicates the performance of the index. Assuming the ETF instrument remains listed, then this provides an effective and realistic method of benefiting from the market index rise over time.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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