Stock Picking and the Value of Sub-Sector Perspectives

The excellent Barchart site divides the stock market into 232 sub-sectors and tracks their performance relative to the broad market. The charts above represent the relative strength of the sub-sectors, not price. A zero value means that the sub-sector matches the strength of the broad market. Negative readings signify underperformance; positive readings indicate relative strength.

From these sub-sector perspectives, we can gain unique stock picking insights. Note, for instance, how the independent oil and gas companies are significantly outperforming the majors. Similarly, regional banks in the Northeastern part of the U.S. (which has been less hit by the housing crisis) are significantly outperforming regional banks in the Pacific region (which have been affected by housing weakness in California).

Themes dominate markets, not only at the sector level, but also among sub-sectors. This has important implications for traders and investors alike.

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The Importance of Stock Picking
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The Importance of Stock Picking

If a commodity is hot, stocks of companies that deal in that commodity should be hot as well, right? Well, not necessarily so. To be sure, energy shares have outperformed the stock market indexes during the recent period of oil price strength. Take a look at relative performance of two energy shares (XOM, top chart; VLO, third chart down) vs. oil itself (DBO). From these charts (kudos to the MSN Money site), it's clear that the stocks have greatly underperformed the commodity.

In the two money flow charts (XOM, second chart down; VLO, bottom chart), you can see the reason for this: as a whole, funds have been flowing out of these issues over the past six months. Forays above the neutral, blue line (the point separating five-day inflows from outflows) have been relatively brief and contained.

With oil making fresh price highs over the past two weeks, one would expect these stocks to be making new peaks as well. XOM, however, has moved from 92.45 to 88.82 in that time, with only one day out of the last ten displaying positive money flows. VLO has seen a particular sharp outflow over this period (as the money flow chart above displays), and the stock has moved from 52.93 to 44.56. Only three in the last ten sessions have shown positive money flows for VLO.

The moral of the story is twofold:

1) Assuming a stock will be strong just because a related commodity is strong is surface reasoning that can get you in trouble. Oil prices might be strong, but it doesn't mean that particular oil companies are drilling or refining more of it.

2) Money flows matter. Regardless of the attractiveness of the story, if investors are taking money out of a stock over time, it is going to be difficult for that issue to perform strongly.

I notice that HAL and XTO have seen net inflows to their shares for five of the past ten trading sessions; both of those energy issues are higher over the last ten days, unlike XOM and VLO. Stock picking matters, and the flows of funds in and out of shares and sectors is one important factor in determining relative stock performance.

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This Post Explains Dollar Volume (Money) Flows

Money Flows and Sector Rotation
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What the Cumulative NYSE TICK is Telling Us About Market Psychology

Recall that the NYSE TICK is a measure of very short term sentiment across the broad universe of NYSE issues. When a stock trades at its offer price, that contributes +1 to the NYSE TICK. When a stock trades at its bid price, -1 is added to the TICK. These readings are summed for all NYSE stocks every five seconds. As a result, a TICK reading of +500 means that, at that moment, 500 more stocks are trading at their offer price than at their bid. This means that traders are sufficiently bullish on stocks that they're more willing, on balance, to be paying the offer price than the bid. When sellers are more aggressive, we'll see negative TICK readings, suggesting that traders are sufficiently motivated to get out of stocks that they'll settle for the bid price.

The adjusted TICK takes the raw one-minute TICK values and subtracts from each of them the average TICK one-minute TICK reading over the past 20 trading sessions. As a result, the adjusted TICK tells us whether we're seeing more or less buying sentiment *on a relative basis*: relative to the past four weeks of trading.

If we cumulate these adjusted TICK readings over time, the resulting line (see chart above) provides an excellent picture of how sentiment is unfolding from day to day. Note that sentiment turned sharply positive from mid-March through early April, with the cumulative adjusted TICK trending steadily higher.

Since that time, the S&P 500 Index has moved to new highs, but the cumulative adjusted TICK line has not. Interestingly, we are also seeing weaker money flow readings and fewer stocks making fresh 52-week highs over this same period. Not surprisingly, the index has had difficulty sustaining its move above the 1400 resistance region.

We've had a nice move from the March lows. It will take an influx of buying sentiment to keep that move going, however.

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The Cumulative NYSE TICK

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Shady Proprietary (Prop) Trading Firms

I just received a call asking about a nearby proprietary trading firm that trains their traders. The catch is that they charge tens of thousands of dollars for the training.

We got a taste of this particular scam when Devon was doing some modeling in the Chicago area before heading off to college. After getting on some mailing lists, she received mail and phone solicitations from "agencies" that promised fantastic modeling assignments. To qualify, models had to enroll in their training programs (costing thousands of dollars). There were plenty of anecdotal success stories, but no hard indications that concrete jobs ever came of these "agencies".

Hey, if a modeling agency thinks you're talented, they'll sign you to an exclusive contract, get you lots of work, and make money from each job that you take.

Similarly, proprietary trading firms make money by splitting profits with their traders. If a prop firm is skilled at training traders, they'll make plenty of money by sharing in the traders' success. Yes, there will be "desk fees" to cover overhead and a pass-through of commission expenses, but the lion's share of a prop firm's profits should come from trader profits. That's what aligns the interests of the firm and the trader.

I assure you, any prop firm that is confident of their ability to grow and support talent won't need to make their money from charging sky-high commissions to their traders or by saddling them with huge fees for training and overhead. Their interests are *not* aligned with those of traders. Like the pseudo modeling agencies, they try to get as many people in and out of their doors, paying the big fees.

In short, the shady firms are selling a dream and a fantasy, not a career.

Please exercise due diligence before committing yourself to an expensive and disappointing venture. If you can display promise, prop firms will want you; you won't need to pay them to get in the door.

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Steps Toward Joining a Prop Firm

Things to Consider When Joining a Trading Firm
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Worthwhile Readings to Kick Off the Weekend

Self-Efficacy - It's difficult to achieve something if you don't experience yourself as capable of achieving. Thanks to trading coach Doug Hirschhorn for pointing out this excellent Wall St. Journal article on self-efficacy. Here's one of my posts on self-efficacy and why it's important, and here's my favorite framework for building self-efficacy.

Range Markets - I recently wrote about how to identify slow, range markets. Today, Trader Mike's favorite indicator of range markets was quite helpful as the day wore on.

Learning How to Trade - This is just a great post, with quite a bit of wisdom and experience from Globetrader. There's a lot to be said for learning how to trade by learning how others have learned.

Good Reading - Kirk links the best investments of the decade, the case for the end of the housing crisis, and more. See also his review of a website resource that tracks sector rotation and more.

Building Expertise - While we're on the topic of learning to trade, thanks to an alert reader for pointing out this blog entry on deliberate practice. Here are some implications for trading.

Credit Crunch Goes to School - Research Recap notes the crunch in student loan issuance.

Chop, Chop - Quantifiable Edges notes the chopfest, but finds a pattern in the noise.

Links Galore - Looking for more links? Abnormal Returns links the linkfests.

Beating the Market House - Suppose there was a market indicator that had a stationary distribution and that was significantly associated with price behavior. The distribution need not be normal; it would only need to be stable over time. In that event, the search for trading edges would be very similar to card counting in blackjack. Just a thought... ;-)
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Six Signs of a Range Bound Market

Several traders emailed me yesterday, tripped up by the narrow, range market. After a period of volatility such as we had during the first quarter of 2008, it is understandable that traders expect moves to extend. In a range market, however, reversals of market moves are the order of the day. If traders don't recognize the character of the day early, it's easy to get chopped up in those reversals.

Here are several cues I rely upon in gauging a possible range day. Not all of these are present on all of the days, and not all of these pertain to yesterday. As a whole, however, I've found these to be relatively accurate guides that help me pull back my trading, enter trades only near range extremes, and take profits more quickly than I would in a trending market.

1) Other, related markets are range bound - If the interest rate markets are in a narrow range, there may be little reason for investors to reprice equities;

2) Little news - Either there is no news and no economic reports, or the news and reports that come out fail to move interest rates, currencies, etc. Per number one above, that means that the news has not significantly impacted investor expectations, and there's little reason to move value;

3) Decreased volume - Often this is a first signal: Volume either starts the day well below recent norms, or quickly tails off to below average as the day goes on. This means that the large institutional participants that move markets (and ultimately set value) are not active and trade will be dominated, in relative terms, by market makers;

4) Narrow breadth - When we get an initial market move for the morning, it occurs on narrow breadth, with advancing and declining issues relatively balanced. That tells us that the move is not a broad trend;

5) Sector rotation - When we get that initial market move in the morning, some sectors may be up quite a bit (energy, for instance) and some might be down quite a bit (financials). When sectors are taking their separate paths, there is no general trend to the market;

6) Initial trades don't work - A scratched trade often provides market information. If you catch an early market move and then it reverses on you before it hits an expectable price target, you have an early indication of the character of the day. It's worth paying attention to good trade ideas that don't pay you out.

The main thing is to not overtrade these narrow days. If a market is trading in a range, the best trades are to fade moves around the range extremes. Since moves tend not to extend, it's necessary to take profits more aggressively than you ordinarily would.

As the VIX grinds to new lows and we get closer to possible summer doldrums, we may see an increasing number of these narrow days. If you can recognize them early, you can preserve your capital and maybe even make a little money.

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A Quarterly Performance Review for Traders

Any given trade and any given day may or may not go a trader’s way, depending upon personal and market circumstances. A three-month period, however, is ample opportunity for frequent traders to demonstrate progress in their development. Here’s a quarterly report card that you might find helpful in tracking your own performance improvement:

1) Have I been profitable after expenses over the last quarter? If so, which markets and trading ideas have contributed most to my profitability? How can I maximize those markets and ideas going forward? If I haven’t been profitable, which markets and trading ideas have contributed most to my losses? How can I minimize or modify those markets and ideas going forward?

2) Have I improved my P/L over the prior quarter? Over the average of the prior three quarters? If so, what changes did I make in the last quarter that contributed to my improved performance? What changes in the markets have aided my recent performance? If I have not improved my P/L over the last quarter and/or over the average of the prior three quarters, what have I been doing differently that has been holding me back? What has changed about the markets that’s hampered my performance?

3) Have I managed risk well compared with other quarters? Have I made more in my largest winning days than I’ve lost in my largest losing ones? If so, what has worked for me in capping my losses that I can carry forward to the next quarter? If not, what do I need to do to limit my losses better in the next quarter?

4) Have I adapted well to market changes? How have my markets changed over the last quarter, and what did I do to adapt? Which of those adaptations do I need to emphasize in the next quarter? Which further adaptations can I make next quarter to deal with market changes?

5) How have I improved myself as a trader over the last quarter? What improvements have I made in my trading? In my finding opportunities? In my discipline and self-management? Which improvements do I most want to emphasize and carry forward to the next three months? What improvements haven’t I made in the last quarter that I need to focus on during the coming months?

Notice that the follow up questions are as important as the lead questions. It is those follow ups that turn the quarterly assessment into next quarter's goals. It is not enough to plan trades. Career success also means planning your development.

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Ten Core Ideas of Trading Psychology

1) We are most likely to behave in inhibited or impulsive ways, violating trading rules and plans, when we perceive events to be threatening;

2) What we perceive to be threatening is a joint function of events themselves and how we think about those events;

3) A key to gaining control over trading and maintaining consistency is to be able to reduce the threat associated with market events and process adverse outcomes in normal, routine ways;

4) We can reduce the threat associated with adverse market events through proper money management (position sizing) and through proper risk management (limits on losses per position);

5) We can reduce the threat associated with adverse market events by training ourselves to respond calmly to adverse outcomes (exposure methods) and by restructuring how we think about those outcomes (cognitive methods);

6) Optimal skill development in trading will occur in non-threatening environments in which learners can sustain concentration, optimism, and motivation;

7) A proper mindset is therefore necessary to the development of trading skills, but does not substitute for such development;

8) The cultivation of trading expertise is a function of the amount of time and effort devoted to learning and the proper structuring of that time and effort;

9) Proper structuring of learning involves the setting of specific, doable, cumulative goals and the provision of rapid feedback and correction regarding the achievement of those goals;

10) Practice does not make perfect in trading or anything else; perfect practice makes perfect. Training must gradually build competencies and correct deficiencies in a manner that sustains a positive mindset and optimal concentration and motivation.

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Series of Posts on Becoming Your Own Trading Coach

Programming Our Own Experience
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Fannie Mae...or May Not

So let's say that I take a large position in the market and wind up with a harrowing loss that forces me to cut back my lifestyle. What would you think of my decision to borrow additional funds to add to that losing position?

Few rookie traders would engage in such dismal risk management. That, however, describes the situation of Fannie Mae (FNM), which today reported large losses and a dividend cut, but rose nicely on news that their regulator is giving them greater rein to expand their mortgage portfolios.

If the housing market stabilizes, the decision to go "all in" will be hailed as a ballsy vote of confidence in the U.S. economy. (It also might set an interesting moral hazard precedent, when the next crises hit).

If, however, the housing market experiences a deeper drop than is currently projected, the liabilities incurred by FNM are truly mind-boggling. This is because billions of dollars of equity are supporting trillions of dollars of debt, as recently reported by the New York Times in an excellent article.

I'll be tracking price performance for FNM and money flows into the stock as a way of staying on top of this theme. I'm not a bear by temperament, but it makes me nervous to see our government engaging in actions that are characteristic of losing traders.
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Perspectives on Achieving Greatness as a Trader

I want to thank Abnormal Returns for passing along this excellent New York Times article on the role of habits in learning and creativity.

The article highlighted a few ideas that I think are very relevant to the development of trading expertise:

1) Much of performance learning is the cultivation of positive habit patterns - If you have to make efforts to follow trading rules, that is effort not devoted to tracking markets. The key to success is turning rules into habits, so that they can be followed without effort, preserving mental capital for analysis and decision-making.

2) The development of new habits opens the door to fresh ways of thinking and behaving - I've long noticed that successful traders periodically remake themselves and their trading, adapting to changing market conditions. They cultivate new habits, which aids them in developing new skills and ways of making money.

3) We will learn and perform best by making maximum use of our learning strengths - This is an extension of the notion of operating within a trading niche. If we're engaged in a concerted program of learning and development, it makes sense to ground our efforts in learning competencies.

4) Performance improvement often occurs in small, continuous steps forward - This is an idea central to quality and performance improvement among manufacturing firms. The successful trader may set a single goal each trading session and track progress faithfully. Over the course of a year, that is hundreds of opportunities missed by the trader who lacks such goals. Take a look at this excellent New Yorker article on Toyota and the notion of kaizen. The path of kaizen is difficult to follow, but it's a sure path to excellence.

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Trading Psychology Observations
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Ideas, Inspirations, and Resources for a Monday

* Implications of Sector Rotation - A reader emailed me with the idea that the market was weak because the recent rise was accompanied by greater than normal sector rotation. That's intuitively appealing, but may not match historical precedent. I went back to 1990 and examined all five day periods in which the S&P 500 Index (SPY) was up more than 1% but not more than 2% (N = 792). This matches the five-day period that ended on Friday. I then split the sample in half based upon the five-day proportion of advancing stocks to declining stocks on the NYSE. The rationale was that a high degree of sector rotation should suggest greater balance among rising and declining stocks. If the rise is occurring across all sectors (i.e., without rotation), advancing stocks should dominate decliners. When we've risen in SPY and advancing stocks have strongly led declining issues, the next five days in SPY have averaged a loss of -.11% (192 up, 204 down). When we've had a similar rise in SPY and advancing stocks have been more in balance with declining issues, the next five days in SPY have averaged a gain of .13% (205 up, 191 down). This, of course, is not an exhaustive study of the topic, but it suggests that rotation may not be bearish for a rising market in the short run.

* Primary Bull Market? - David Korn, in his excellent newsletter, notes the implications of the view that we made a bear market low in August, 2006 and still remain in a primary bull market: "The implication that we are in a secular bull market is important because if you follow that belief then you should be expecting record all time new highs in the major indices BEFORE ANY BEAR MARKET ARRIVES. That would mean significant gains, even from these levels." I think there's merit to this view and will be tracking money flows carefully to look for support or disconfirmation of the idea.

* Trading Insights - Gap trading, the psychology of consecutive losses, and more link updates from Trader Mike.

* Stocks With Energy - Kirk, with an excellent observation on the value of stock screening.

* A Look at Management Integrity - A very interesting post from Research Recap identifies five stocks with particular risks related to accounting and governance.

* Themes - Thanks to readers for emails and comments on my recent post concerning theme-based trading. I see that over 400 traders are now subscribed to the Twitter posts that track themes each day. My hope is that those links help keep you posted on what traders and investors are looking at each day.

* Inflation Matters - Eddy Elfenbein posts a couple of excellent charts that show how we remain below the 2000 peak in the S&P 500 Index, when adjusted for inflation. While on the Eddy topic, here's his interview conducted by Tim Sykes.
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Indicator Review for May 5th

Last week's indicator review found strength in the stock market, but also selectivity within that strength. That view was most recently supported in my look at sector rotation within the market rise. While we've continued to see rising prices--and firming of many of the indicators--the gains in some sectors (technology, financial) have been at the expense of others (materials, energy).

We can see from the top chart that the number of stocks registering fresh 20-day highs minus lows has remained firm as the market has moved higher. The selectivity, however, is evident in the new 52-week high/low numbers. Among NYSE common stocks only, Friday's move to new price highs saw only 59 issues making fresh annual highs and 11 making new lows. We had over 100 new highs three weeks ago. Many of the issues that were making fresh highs at that time (commodity-related stocks) have since retreated.

We've also seen firming in the Cumulative NYSE TICK (bottom chart), but that, too, has lagged as buying sentiment has been selective. Demand/Supply numbers, while positive on Friday, were relatively modest as well, suggesting that upside momentum is waning. It would not surprise me to see a modest correction this week prior to any important resumption of a bull move.

That having been said, it's important to stress that, on the heels of the drying up of selling noted in prior indicator reviews, we are seeing positive money flows into stocks and an increase of strength in the market this past week. 52% of S&P 500 issues are now trading above their 200-day moving averages, and 77% are above their 50-day benchmarks. Those are both the strongest readings of 2008. The percentage of issues above their moving averages typically tops out ahead of price in any intermediate-term bull move, which suggests that we are likely to see further gains after any pause/correction in the recent rally.

As I recently explained, I do not see this as a vigorous bull move and, for that reason, am not expecting a fresh bull market to take us to all time highs. Still, an important bottom was put into place during the January-March period, and I need to see distinct weakening of the indicators before assuming that the recent market strength will reverse in any meaningful way.
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