Tuesday, August 14, 2007

A Bit of Perspective

Suppose you're contemplating a sailing trip. The weather forecast suggests only 10% chance of a thunderstorm, so you decide to set sail.

As you get out onto the ocean, you notice a few raindrops. Then you notice the sky darkening. The air pressure begins to fall rapidly.

What do you do: continue your voyage or pull into port?

When traders examine the historical record for what markets have done under particular conditions, they come up with their own weather forecasts for the market. When conditions have been bullish, the forecasts after market declines are apt to be bullish.

But suppose you begin to venture into the market and notice fewer stocks making new highs. Then you observe more selling pressure than buying with respect to the NYSE TICK. You see the advance-decline line making new lows. You see continued signs of risk aversion among institutional traders.

What do you do: continue buying the market or pull back?

A market that fails to live up to its recent historical precedents is providing useful information, just as there's useful information in weather patterns that violate a forecast.

The idea is not to blindly and grimly hold onto a position when you identify a possible historical edge. Rather, you use that information as a yardstick by which you gauge current market action.

When markets fail to rally when they have tended to move higher under similar circumstances, that's not just a failed forecast. That's a useful update to your forecast.

3 comments:

Bert Hancock said...

Hi again, Brett;

I've noticed on the S&P and the Nasdaq that we've about reached the 10% correction "standard" from the highs of a few weeks ago (though the Dow isn't quite there yet).

Do you anticipate a turnaround soon? It seems the downward path the last days is more due to a lack of buying than heavy selling. Maybe it'll look attractive enough to enough buyers to start pushing the prices back upward again.

Of course, whether such a resumption upward is sustainable or fizzles out would be a bigger question.

Thanks as always,

Bert

techfarmer said...

With today's drop on the $SPX below previous support of 1427 (it is now 1406), it looks like the edge is trading with a short bias on this particular index. Do you agree?

RSI on $SPX is still 33 (not below 30). However, other indicators, such as stocks above 200 day moving average is very low (under 40%), a contrarian indicator.

Brett Steenbarger, Ph.D. said...

Hi,

As long as we see continued risk aversion themes in the mkt, including weakness in financial issues, I continue in the sell bounces mode.

Brett