Jesse Felder looks at the stock market from the vantage point of historical valuation and finds us in rarefied territory. Using other measures, Jesse Colombo arrives at a similar conclusion. This strikes me as tremendously relevant for investors. From a timing vantage point vis a vis shorter-term traders, I have more questions. Prior to the large drops we saw in 1998, 2000, and 2007, for example, we saw a ramping up of volatility (VIX) and stocks making fresh new lows. In other words, rises in volatility and weakness in leading sectors preceded those bear markets. I'm not seeing those things at present, but the possibility that we're operating on borrowed time strikes me as a valuable one to entertain. I'm just not sure we can expect historically normal market cycles when we have extraordinary global monetary policies. An extraordinary wealth of economic information and perspective is offered by Jeff Miller at Dash of Insight. Measures he tracks suggest a healthy degree of strength in the economy. He also raises the issue that bear markets tend to occur late in hiking cycles, not early. Again, it may be difficult to extrapolate from past cycles to this present, extraordinary one, but Miller also notes that overvalued markets can become quite further overvalued before they run into trouble, citing data from Capital Speculator.
What we see is that intelligent market observers see the market quite differently. My synthesis of all this is that we are historically overvalued *and* we're not yet seeing worrisome economic or market weakness. Perhaps the best synthesis of all, however, is to go to websites such as the above and track down the original sources of data and the links from recent posts. You are guaranteed to find intelligent perspectives that will broaden your own.
Here is a simple formula for developing yourself as a trader: Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they're generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them. Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people. That is how imitation turns into innovation. Take a look at who you're following in social media. If you're spending much time reading material from those you don't want to internalize, you'll wind up with little cumulative development. A great exercise would be to curate the $STUDY stream of StockTwits and immerse yourself in the educational offerings of only those you'd like to emulate.
You can't elevate your game unless you surround yourself with the best out there to challenge you, inspire you, and inform you. You win by studying winners.
The same is true for stock picking. How many people truly study the best performers during any given period and reverse engineer that performance? There are common features of best and worst performers among stocks and markets, just as there are common features of best and worst traders. You learn to select the best trades and investments by studying the best trades and investments.
Kudos to @ivanhoff and @howardlindzon for their recent offering on identifying the next Apple among market performers. The greatest investments don't start as the most optically appealing choices in many cases. Similarly, great trades to the long side often start as scarily weak markets--October, 2014 being a recent case in point. If you study one winning idea after another, however, you begin to see common threads. You immerse yourself in winning trades and, after a while, you recognize patterns as they emerge. It's great to focus on our mistakes and correct our errors. Reducing the negatives of performance, however, will never in itself generate elite positives. If you want to perform at high levels, you have to study--and internalize--high level performance. Further Reading: The Success Pyramid
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* Here are three charts that I use to track demand and supply in the broad stock market. I decompose the time series for the NYSE TICK (number of stocks upticking vs. downticking at each moment of the trading day) into a measure of Buying Pressure (top chart; a measure of upticks); Selling Pressure (middle chart; a measure of downticks); and Balance (bottom chart; the daily net of upticks vs. downticks). In recent sessions, we've seen relatively restrained buying interest and also relatively restrained selling. This is typical of low volume, low volatility markets. On a net basis, we've generally seen more buying than selling pressure and stocks have drifted toward their highs over this period. This is as much due to a relative absence of sellers as the positive presence of buyers. Institutional players--those that drive volume as buyers or sellers of baskets of stocks--have been quiet of late, creating few surges of either buying or selling activity. * When academic reviewers took a look at the profitability of traders, they were shocked by how poor the results looked. Here's my psychological look at what separates the winners from the losers.
* More evidence that active fund managers as a group fail to outperform their benchmark indexes. In fact, managers in every category fail to outperform. You would think that half would outperform by sheer chance. As the article emphasizes, however, the odds of such across-the-board underperformance occurring by chance are ridiculously small. It's not that managers lack a positive edge. They actually seem to have a significantly negative one.
* It's very difficult to not find good posts on the Quantocracy site. * It's also very difficult to not find something good in the weekly top clicks at Abnormal Returns, including an unusually good study of moving average rules--what works and doesn't work.
I propose that there are, at root, three basic paths to success in financial markets that correspond to three kinds of market participants. These are very different approaches to markets and require quite different skills, knowledge, and talents. The first path to success in markets is the path of the statistician. The statistician is one who identifies the probabilities of outcomes as a function of current and past conditions. A statistician, for example, might notice that two currencies are trading out of line with each other because of temporary flows attributable to mergers and acquisitions and place a bet that these will return to their historical relationship. The idea for the statistician is to construct a portfolio that consists of many distributed bets, each of which has a favorable probability of paying off.
The second path to market success is the path of the theorist. The theorist is a big picture thinker who identifies an antecedent set of conditions that, over time, should drive the price movements of financial assets. Macro money managers, those who look at geopolitical events and macroeconomic developments such as central bank policy shifts, are classic examples of theorists. Their approach to markets is top down: understand the big picture and then define a diversified set of bets from that understanding. For instance, the theorist will notice that central bank policies are notably more dovish--providing more liquidity--in some countries than others and will buy stocks in those countries and sell stocks in the more hawkish regions.
The third path to success in financial markets is the path of the trader. The trader is a pattern recognizer who exploits quick-developing shifts in sentiment, supply/demand, and relative movement. A trader, for example, might notice that episodes of selling pressure in a a few, visible large capitalization stocks are not accompanied by significant selling pressure across the broad market. When the selling slows down in the large caps and the broad market begins to catch a bid, the trader quickly joins that reversal for a move higher in the broad index. Diversification is achieved, not necessarily by making many independent, simultaneous bets, but by making many independent short-term bets over time.
These three paths are extremely different. Whereas the theorist is deductive in thinking, moving from big picture understanding to individual trades, the trader is inductive, noticing relatively minute patterns in order flow or price movement and generating trade ideas from those. The statistician is highly analytical in a quantitative way, emphasizing prediction. The theorist is more interested in a synthesis of information to achieve understanding. The trader is more likely to be adept at intuitive pattern recognition--in Kahneman's terms relying on fast, rather than slow thinking.
These differences call on very different skill sets, knowledge bases, and personality strengths. The action orientation of the trader is quite different from the analytical, cerebral orientation of the statistician. The theorist needs confidence in his or her big picture understanding of the world. The statistician relies on objective odds to take subjective appraisal entirely out of the trading process. Statisticians gain expertise from intensive quantitative research; theorists gain expertise from the qualitative assembly of many different facts and trends; traders gain expertise from immersion in market patterns.
While it is popular to speak of "hybrid" traders that combine elements of these different paths, my experience is that a successful combination of approaches is much less common than is typically recognized. Indeed, it is much more common for trading problems to emerge: a) when market participants don't clearly identify their path to success and hence meander among different approaches; and b) when they attempt to blend paths and ultimately don't play to their strengths.
A classic example of this is when big picture macro traders become overly concerned with limiting their risk and end up behaving like short-term traders. Similarly, statistical, quantitative traders can allow their priors to bias their research processes, skewing their results over time. Traders with a good feel for markets can suddenly trade in tone deaf ways when they become locked into big picture views. What generates success for one path can undermine success in the others.
Many market participants fail over time because they lack a consistent path to success and because they lack the self-understanding to chart the path that is right for them. In markets as in relationships, success often requires a commitment to one path and a willingness to leave other ones behind. Further Reading: Three Winning Trading Practices
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The recent post tracked the diminished strength of the stock market, with fewer stocks making new highs over time. But is a market with reduced strength necessarily one with increasing weakness? This is a very important question, as it gets at the heart of when breadth is and isn't a problem for the market.
Above we see a chart of SPY from the start of 2014 to the present. In red, we see the number of stocks across all exchanges that registered fresh one-month lows each day. (Raw data from the Barchart site.) Notice that we're only looking at new lows--a measure of weakness. We are not combining the new highs and lows, which can muddle the views of strength vs. weakness.
What we see are sharp elevations of new lows around important cyclical bottoms. What we also see is that new lows begin creeping higher before markets top out during these cycles. This was dramatically the case during the second half of 2014 but also occurred leading up to the March top of this year. While new highs have been waning per the recent posts, notice that we are seeing *very* few new lows most recently. The market has not been getting stronger in terms of breadth, but neither has it been weakening.
On Friday, we saw 168 shares post new monthly lows across all exchanges. That is well below the median value of 350. When we have had fewer than 200 stocks post new monthly lows since the start of 2014 (N=58), the next five days in SPY have averaged a gain of +.34% vs. an average gain of +.13 for the remainder of the sample. While a market without weakness might appear "overbought", in fact it is healthy in the short run. In order for the broad stock market to roll over, we have to see some leading stocks and sectors display weakness. At the moment, we are indeed "overbought", but not weak.
As a whole, the signals tend to top out ahead of price during intermediate-term market cycles and bottom shortly ahead of price. Of the three systems, the SAR tends to be the fastest moving (greatest lead times); the CCI the slowest. When all are in sync, turning lower or turning higher, we generally find ourselves in the relatively early phase of a trending move. I find the interplay among the signals to be helpful in identifying where we're at in those intermediate-term cycles.
Note that SAR has recently turned negative, despite the recent price strength. The Bollinger Band measure is coming off a high reading but remains positive. The CCI system recently gave a high reading, which has preceded the most recent market strength. It has fallen off that high but remains neutral. As a whole, the signals are showing reduced breadth of market strength, but not net weakness--consistent with the waning breadth readings noted in yesterday's post.
Here are the reasons I am cautious about the stock market at this juncture: 1) We are seeing good buying activity in stocks, as gauged by the NYSE TICK which has been making new highs on a cumulative basis. Among the large caps (top chart), that buying activity is no longer able to give us fresh price highs. (Credit for the top three charts to Index Indicators). Note that breadth in the large caps has continued to dwindle throughout 2015, with fewer 100-day new highs vs. lows.
2) We have seen greater recent price strength among mid-caps (second chart from top) and small caps (second chart from bottom), as we're hovering near price highs. Despite this, the breadth specific to mid-caps and small-caps has also been waning, with fewer shares making new highs vs. lows in April than March.
3) If you look at the cash VIX, it seems as though volatility remains crushed, as VIX is sub-15. Actual volatility, however, as measured by average true range over a rolling 100-day period, has been higher during 2015 than during the vast majority of the prior two trading years. Rising volatility in stocks historically has been associated with weakening markets, not strengthening ones. Indeed, volatility picked up at market highs in 2000 and 2007 well before the subsequent bear markets. While I don't expect that kind of bear market activity currently, any downside break from here would likely see greater volatility than recent corrections.
I also note that the volatility of realized volatility (vol of vol) has been higher recently than at any time since 2013. The recent rise in realized volatility and vol of vol helps to explain why short-term traders have had difficulty trading U.S. stocks: We've had movement, but not trend. It's been a choppy, volatile range trade. Buying strength or selling weakness--trading with a fear of missing out--has been a consistent way to lose money. Viewed on a longer time scale, however, this market appears to be one of narrowing breadth--even among those smaller cap sectors that have been strongest. That keeps me cautious.
I noticed that Bruce Bower, via SMB, has posted on the topic of what a winning trading methodology looks like and has released an e-book on the topic. Bruce emphasizes that a methodology must be grounded in a replicable process and that this process must fit well with the personality and skill sets of the trader. A very important observation from Jack Schwager in his Market Wizards series is that successful money managers have quite different skills, personalities, and workstyles. These result in very different trading styles. What creates success is not adherence to a particular style, but the ability to exploit market inefficiencies in a manner consistent with one's own abilities.
Replicability as a process and fit with a trader's skills and personality are necessary for a successful trading methodology, but not sufficient. Bruce points out that the method must also manage risk effectively and filter the many possible decisions into ones that offer a reward that is superior to the risk incurred. In short, a successful method must possess an "edge": positive expected returns over time that justify the risks incurred.
But there is one other ingredient in a successful methodology that tends to be overlooked: understanding.
If you think of a trading methodology as a core aspect of a business plan, the element of understanding becomes clear. A good business plan doesn't just describe a business with a process and a fit with the owner. Nor does it simply limit risks and pursue greater rewards. The good business plan starts with an understanding of the consumer and the drivers of demand in the marketplace. A startup business meets an identified need. Entrepreneurs must understand their markets. Too often I see trading plans/methods that describe "setups" that are devoid of market understanding: a shape on a chart, a reading on an indicator, a news development, a data release, etc. Missing from such an approach is a clear identification of what drives prices and how one's methodology will uniquely exploit such drivers. A very worthwhile text is this regard is Expected Returns from Antti Ilmanen. Ilmanen identifies specific factors that uniquely impact the pricing of markets, such as value, momentum/trend, carry/roll, volatility, seasonality, liquidity, and the like. Bender and colleagues break down factors into value, size, volatility, yield, quality, and momentum. If we think of trading methodologies as business plans and factors as defining opportunity sets, then the solid methodology should be grounded in an explicit understanding of the factors being targeted and the ways in which the trading approach uniquely exploits those factors. A simple example would be a breakout trading style that defines periods of market balance and pursues directional moves that emerge from this balance. That would be a strategy for exploiting momentum and possibly trend. That would be quite different from a value-oriented long/short strategy that buys undervalued companies and sells stocks of similar companies that are more richly valued.
Three simple tests for a sound trading methodology would be:
1) Can you clearly identify the factors that your methods/plans will be exploiting? 2) Can you clearly explain why your methods uniquely exploit these factors? 3) Can you demonstrate with research or trading evidence that the methods you're trading indeed do uniquely exploit the factors targeted?
If you were investing in a business as a potential venture capitalist, you'd ask those questions of anyone pitching their business to you: Can you identify the business opportunity? Can you clearly explain how your proposed business exploits that opportunity? Can you produce evidence that your business indeed does exploit that opportunity?
If you wouldn't invest in a business plan that lacked clear answers to these questions, why would you invest in a trading plan similarly devoid of understanding?
Traders are entrepreneurs: We're most likely to trade with confidence and conviction when we possess a deep understanding and belief in what we're doing. Further Reading: The Proactive Personality of the Trader
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I noticed a couple of good articles on Duke coach Mike Krzyzewski in the wake of Duke's win for the 2015 NCAA championship. The first article outlined how he adapted to different times in recruitment by going after players who weren't committed to four years of college. The second article pointed out Coach K's time with USA basketball and how coaching pros helped him change the way he coached his new players. When you put the articles together, you realize that the coach who won his fifth national championship was quite different from the one who won his first.
The winning team at Duke was dominated by freshmen, many of whom will almost certainly jump to the pros after this year. The opposing coach, no doubt unhappy in defeat, mentioned that his team doesn't do "rent-a-player"--a clear swipe at how professionalized the game has become. Gone is the idea that these are student athletes. They are athletes who are students for a while.
That is what makes adapting to the future and making changes so difficult--and so rare. When you deeply believe in what you do and then have to adapt to a new future, it feels like self-betrayal. It seems as though you're going against everything you believed in. And in a sense you are.
I was trained in longer-term psychodynamic therapy during my graduate internship. It was great training and informs my work to this day. When I began working in student counseling at Cornell, however, I realized that my training in mental illness had left me poorly prepared to work with mental health. Out of that, I researched and learned brief therapies to help healthy people make changes in their lives. The psychodynamic model stressed building a relationship and working with people over months and even years. The brief model assumed that the first session could well be the last one and emphasized rapid change over long-term insight.
I was accused of being superficial and betraying my training. At times I felt that way. The only way to work with a new group, however, was to work in new ways. No one adapts to the future without leaving parts of the past behind. A trader I'm currently working with--he'll know I'm talking about him!--has made extraordinary strides in remaking himself. He used to trade remarkably short-term for a big trader, but he found that the short-term drivers of price in a QE world no longer held up. Extending his holding periods, he has changed his way of generating trade ideas and managing the resulting positions. He reminds me of Coach K.; he is so invested in winning that he's been willing to lose the past. That ability--not to stick to a process, but reinvent one--is what is also returning him to the winner's circle. Further Reading: Performance and Creativity
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* This time is different? Money flow into the SPY index ETF has notably dwindled during 2015 after having tracked price pretty well for most of 2014. Money flow reflects price times the number of ETF shares outstanding. My figures show significant flow differences from sector to sector. I will be posting those numbers this week. In general I've found money flows to be a good (contrary) sentiment measure that is independent of options-related sentiment indicators. * Thanks to a savvy trader for pointing out this portable biofeedback unit measuring brain waves. The idea is to directly measure brain activity related to concentration/focus, stress, relaxation, etc. What's unusual about the unit is that it allows measurement even when the wearer is moving around. I'll look into this further, particularly for validation studies that show a high correlation between the readings of the portable unit and those of standard EEG machines. * Here's another new tool on the market that looks quite interesting: The Edgewonk electronic journal is integrated into Excel and integrates your trading observations (mood/psychology; thoughts about markets) with your P/L. The journal also tracks performance metrics, so that you can see where your trading has been strongest and weakest. Over time, this could form a great database for learning and performance improvement. * Podcasts have been gaining in popularity, and a number of worthwhile sites are out there. Abnormal Returns curates excellent podcasts each week, including the recent selection that includes discussions on creativity and technical analysis. A wide ranging collection of podcasts related to positive psychology can be found here. * Here is the collection of Forbes blog posts related to positive psychology, with a particularly look at the factors that contribute to success in performance-related fields such as trading. Have a great start to the week! Brett
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Thanks to a savvy trader for pointing out this Lewis Howes podcast with Eric Greitens on the topic of resiliency and falling in love with pain. A former Navy SEAL, Greitens learned about resilience first-hand during his training. In his book, he points out, "If we are trapped in a life where everything is provided for us, our minds fail to grow, our relationships atrophy, and our spirits deteriorate." We grow through challenges, including those that are hardships. Greitens points out that we never bounce back from adversity; rather, we find healthy ways to integrate those experiences into our lives. When we do what we are afraid to do, we don't return to the person we were. We find ourselves just a bit more fearless.
When Angela Duckworth researched the phenomenon of grit, she found that it wasn't the highly successful children who were most able to sustain effort in the service of long-term goals. Those who knew little other than success and were frequently praised by parents had very little experience with adversity. That made it difficult to persevere. When children experienced setbacks and challenges, they were more likely to develop the internal resources needed to sustain efforts. Grit is resilience sustained over time. As Duckworth explains, "grit...entails having and working assiduously toward a single challenging superordinate goal through thick and thin, on a timescale of years or even decades."
Trading financial markets is unique in that it regularly forces us to experience loss and setback. The uncertainty built into markets ensures that we will go through drawdowns. The ever-changing nature of markets ensures that what worked today may not work tomorrow. There can be no successful trading without resilience, and there can be no successful trading career without grit.
When we approach life as a gymnasium, even the most routine activities can be approached as workouts that challenge and develop us. Every item in our daily planner--even those connected to recreation--can be pursued in a conscious, effortful way or in a routine manner of going through the motions. It makes sense for us to undertake routine activities as routines, as this saves energy for more demanding situations. But if all of life becomes a series of routine activities, we become less capable of responding to demands. No one builds strength and endurance in life's gym by tackling the equivalent of ten-pound weights. What's the key to becoming a resilient, gritty person? I strongly suspect it's the ability to tap into hidden reserves of energy--that mental, emotional, physical, and spiritual second wind--that become available to us under conditions of high challenge. Emilia Lahti refers to this by the Finnish term sisu: "the second wind of mental toughness." The paradox here is that challenges drain us of energy. Extraordinary challenges--especially those that inspire us--help us tap into new and greater sources of energy. When we tackle normal efforts, our willpower powers down. When we reach for greater things, we find our willpower renewed. In the long run, we don't sustain perspiration without sustaining inspiration. Goals challenge us, but eventually wear us down unless they uplift us and pull from us the kinds of efforts that yield that second wind of sisu. If you're cold and exhausted after long days of workouts and little sleep and that's all that's on your mind, you're going to drop on request and ring that bell to get yourself out of the SEAL program and into a hot shower. The only thing that can move you past that place of pain is a commitment to your team, a commitment to your future, and a commitment to serving a larger cause.
Resilience begins with purpose. We tackle life as a gym when workouts become the path to a greater future.
We've all known traders who lack self-control. They react rather than act, making decisions impulsively, often based on those twin fears of missing out and losing money. It's no surprise when such traders draw down. In a very real sense, they trade their hopes and fears, not the markets in front of them. But how about traders with excellent self-control? I know many: experienced money managers with long histories of success. Once in a while they make mistakes that they describe as rookie errors. They don't seem fearful or reactive, yet they will chase bad prices or stick with losing trades too long. What's going on in such cases? Aren't discipline and self-control supposed to produce good trading outcomes? An interesting window of insight into the bad decisions of good traders comes from research conducted by Maria Konnikova that identifies the limits of self-control. Konnikova finds that people high in self-control tend to be more overconfident than others in situations where control over outcomes is limited, but perceived control is high. In other words, those with high self-control can also fall victim to an illusory sense of control. That leads to poor decisions.
What is particularly fascinating in Konnikova's work is that people with high self-control are most likely to overestimate their actual control in situations when they are experiencing positive emotions. Konnikova notes, "...the positive affect that usually accompanies both the illusion of control and high self-control can be an Achilles heel of high self-control in certain environments with limited actual control, creating a feeling of overconfidence that translates into suboptimal decision making." It's when traders are winning and feeling good that their confidence is most likely to morph into overconfidence. That leads them to overestimate their control over market outcomes and make decisions based upon illusory--not actual--control.
What is the solution to this dilemma? Konnikova explains that the self-awareness of those high in self-control can help them recognize that positive emotions are a threat to their control, thus cooling them down when their confidence is running hot. This fits very well with observations I have made in the course of working with traders: often the worst decisions are made when the trader has just made money, not when he or she has drawn down. We don't normally think of positive emotion as a risk factor, but in fact any experience that takes our attention from markets and leads us to focus on outcomes rather than process is likely to interfere with performance.
We commonly hear that traders should take the most risk when they have the highest conviction in their ideas. That can work as long as conviction doesn't come at the expense of self-awareness.
Hurdles seem small when we're on top of our game, and they can feel insurmountable when we're not. The best traders I've known are those that work on their performance when they're on top of their game and they work on it when they're not. Their competition is not just with markets, but with themselves. By focusing on getting better, they end up staying profitable. So when we're at those valley periods, the great things we see can be overwhelming obstacles or inspiring goals. Here are three things traders can do to turn discourage into courage: 1) Renew, re-energize - No one can deliver peak performance when they're mentally, physically, and spiritually exhausted. As the recent post points out, we are most likely to sustain the discipline to reach our goals if we renew our resources. There is no sustained work quality without life quality. 2) Reach beyond yourself - The best way to clear your head is to get out of your head and engage in something outside yourself. By finding a positive motivation far greater than the frustration you may be feeling, you tap into new sources of inspiration. Frustrated with your work? Double down on the parts of your life that mean even more to you than your work. 3) Set yourself up for success - What do basketball coaches do when a player goes into a shooting slump? They call a play that allows the player to take a high percentage shot. Make an easy basket or two and suddenly the rhythm and confidence come back. An important path to success is always having goals, always making sure they're challenging and meaningful, and always ensuring they're attainable. It boils down to this: Winners take care of themselves when they're down. Losers kick themselves when they're down. You are always coaching yourself, in how you approach success and in how you approach defeat. Peak performance requires peak self-coaching. Further Reading: Finding Your Zone
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Above is a chart of CBOE options skew for the S&P 500 Index from 2014 to the present. The skew index measures the degree to which index options traders are bidding up out of the money puts relative to calls. The index moves between 100 and 150, with 100 meaning that traders are not pricing in negative tail risk and 150 reflects a high degree of negative tail risk pricing. This can be viewed as a sentiment index, as it reflects the degree to which traders are hedging against market risk. Interestingly, we've tended to see low skew numbers near intermediate term lows in SPY and high skew number near intermediate-term tops. This is different from what we see with put/call ratios. Here we see a higher degree of tail risk hedging following strength rather than weakness, perhaps as a strategy to lock in gains. I divided the sample into quartiles. When the skew has been in its highest quartile, the next ten days in SPY have averaged a loss of -.76%. When skew has been in its lowest quartile, the next ten days in SPY have averaged a gain of +1.14%. The most current skew reading is in the lowest quartile. I will be refining this measure and looking at a longer history in the near future. It appears to be a worthwhile complement to other sentiment measures. Further Reading: Equity Put-Call Ratio
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Has the U.S. stock market been strong or weak so far in 2015? As the above three charts from the excellent FinViz site indicate, the answer very much depends on the segment of the market you've been following and trading. With respect to stock sectors, consumer discretionary and healthcare shares have performed well. Note the strength in housing stocks (XHB) and retail shares (XRT), for example. Commodity-related shares have been consistent underperformers. Global economic weakness has contributed to commodity weakness, particularly in oil, which has been perceived as a boost for consumers. Concerns over a normalization of interest rates by the Fed has hurt interest-rate sensitive shares such as utilities. Small and midcap stocks have performed well so far in 2015, but large cap stocks are relatively flat and mega cap shares are actually down on the year. The idea here is that a strong U.S. dollar hurts large companies that depend on overseas sales, but a strong consumer economy can benefit small and medium sized domestic firms. If you've equated the stock market with capitalization-weighted indexes, you've had a distorted picture of performance. Finally, on the bottom chart, take a look at U.S. listed shares as a function of their country of origin. Shares from Greece and Brazil have been hurt greatly; shares from much of Europe and Japan have performed well; and U.S. shares are relatively flat. Stocks in countries that have been implementing quantitative easing programs (Europe, Japan) have been stronger than those exiting those programs (U.S.). All this means that stocks, to a fair degree, have been hostage to macro themes. Two visions of the future collide: 1) The pace of economic growth in the U.S. slows and strong consumer and smaller cap shares roll over with the commodity shares and large caps; or 2) Global growth picks up and lifts the weaker segments of the market as part of a reflation trade. I'm watching the stock market leaders and laggards closely to handicap those scenarios.
Strangely, I find that traders who describe themselves as visual--i.e., they make extensive use of chart displays of prices and indicators--are among those who trade with the least vision. They make inferences from what they see; not from an understanding of what lies behind the displays. Take VIX, the popular measure of volatility implied by options pricing, as an example. We might make inferences about whether stocks will go up or down based upon VIX being stretched to the upside or downside. What we know, however, is that VIX tends to move inversely with index price. VIX also tends to move up or down with realized volatility. So when we look at a display of VIX, are we truly seeing a reading of options-implied volatility or are we seeing a conglomeration of several correlated variables? To illustrate the point, I built a simple model of VIX that eliminates the overlapping influence of previous price movement and recent realized volatility. This adjusted VIX measure captures the degree to which implied volatility is high or low relative to what we would expect based upon previous price movement and realized volatility. A high adjusted VIX means that options are pricing in more volatility than we would normally expect from the recent price movement; a low adjusted VIX means that options are pricing in less volatility that we would normally expect. I went back to 2012 and divided the adjusted VIX into quartiles. When the adjusted VIX was in its strongest quartile, the next five days in SPY averaged a gain of +.49%. When the adjusted VIX was in its weakest quartile, the next five days in SPY averaged a gain of +.72%. When the adjusted VIX was in its middle two quartiles (i.e., when VIX was pretty much in line with what we'd expect from recent price action), the next five days in SPY averaged a loss of -.01%. In other words, all the market's gains since 2012 can be attributed to "mispricing" of VIX. But you would never see that in a simple chart of VIX.
Trading by sight does not always bring vision. For those interested, the adjusted VIX is currently in its lowest quartile, understating the price movement we've seen recently. Further Reading: Pure Volatility
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* I've found it helpful to track the correlations among the various sectors of the SPX by using creating an overall correlation index from the sector ETFs. What you typically find is that, as cycles top out, there is divergence among the sectors. That shows up as a drop in correlation. Conversely, at market lows, there tends to be a risk-off washout across sectors. That results in a rise in correlation. I went back to the start of 2014 and divided the sector correlation data into quartiles. When correlation was in its highest quartile, the next 10 days in SPY averaged a gain of +1.87%. All other occasions averaged a loss of -.01%. In other words, periods of elevation in correlation have accounted for all of the market's gains over that time. We're not in that highest quartile at present. * The techniques I'm currently working on for improving concentration, mood, and performance are ones that involve a major shift in states of consciousness. When we are in radically different states, we can access new information (intuition) and fresh energy. We can also break old, undesirable patterns of thought and behavior. This post outlines the essence of the approach.
If you've followed the blog for a while, you know that tracking the number of stocks across all exchanges making fresh one- and three-month new highs versus lows is one of my favorite measures of broad stock market breadth. Above we see the three-month new highs vs. lows (raw data from Barchart) going back to the start of 2014. We can see that breadth improved recently, as small and mid-cap stocks outperformed large caps. Even with that improvement, however, we still see fewer stocks registering new high vs. low strength relative to the end of 2014. Contributing to recent weakness has been not just large caps, but also commodity-related shares. I continue to view this as a rotational, range environment and most likely part of a broad topping pattern that will eventually lead to a meaningful correction. Going back to 2012, the new high/low data have mattered. If we just look at one-month new highs and divide the data with a median split, we see that when new highs have been high, the next five days in SPY have averaged a gain of +.11%. When new highs have been low, the next five days in SPY have averaged a gain of +.55%. It's yet another great example of how markets that look the best yield the worst returns on average. The results are similar if we look at three-month new highs. When those have been high, the next five days in SPY have averaged a gain of only +.01%. When they have been low, the next five days in SPY have averaged a gain of +.64%. Overall, chasing new highs and stopping out of long positions on expansions of new lows has brought subnormal returns. We have had a trending environment since 2012, but not a momentum environment. Understanding that distinction has been crucial to stock market returns. Further Reading: VIX and Stock Market Returns
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A portfolio manager I recently met with was stressed out, frazzled from long--and frustrating--hours of following overseas markets. He wasn't concerned, however. He simply explained to me that he was going to engage in a vigorous workout in the gym--a rapid sequence of stretching, running, and lifting exercises. By the time he was finished, he explained, he was so pumped up that the endorphins overcame any sense of stress or distress. The light bulb went on in my head. His key to overcoming pressure and fatigue wasn't to chill out. Instead, he found a way of accessing a positive, pumped-up state that was more powerful than his state of stress. What enabled him to move from negative emotions to positive performance was emotional transformation: a gear-shift of experience that overwhelms negativity with positivity. The problem most of us make is that we address negative states by attempting to reduce our negative thoughts, feelings, and actions. That keeps us in our same form; it doesn't transform. When we are sad, trying to reduce our sadness will not bring happiness. When we are stressed and drained, trying to slow down will not re-energize. Counting to ten when we're angry can be helpful, but it won't bring gratitude. The key to self-mastery is to improve access to our most positive emotional states. What gets a trader out of a frustrated funk after taking losses? Doubling down on generating the next set of ideas and letting the excitement of discovery wash over the sense of frustration. Once we learn from negative experience, we want to put that learning into practice--but that requires a shift to a new and constructive mindframe. As the recent article suggests, we cannot access that mindframe from within our existing form; we need to transform. Here are five gateways to transformation that I have found useful: * Meditation, imagery, using music to achieve a different sense of mind and body; * Vigorous physical activity, exercise * Social activity, having fun, connecting with others in a meaningful way * Generating fresh experiences, going to new places, pursuing new ideas * Reaching out to others, engaging in activities that are larger than oneself The common ingredient is the creation of new experience that accesses new states of mind, body, and emotion. Turning negative emotion into positive performance means that we become very good at operating the gear-shift of consciousness, where we determine the states we're in and don't simply allow them to determine our course. Further Reading: Building Emotional and Physical Health
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Coach K has it right: a finger by itself is far less powerful than five fingers joined into a fist. When a championship basketball team prepares for a game, it doesn't just work on one thing today, another tomorrow, and focus on something else another day. Rather, it works on fundamental skills and strategies every single day of practice. That way, each finger of preparation makes a fist of preparation for success. Coaches know that if a team can't fire on all cylinders in practice, they won't be prepared to give their all at game time. During my time at Duke, one of the preparation drills for the basketball team was the requirement to make 10 consecutive free throws at the end of practice. In other words, you couldn't go to the locker room, take your nice hot shower, and get back to your dorm room until you made 10 consecutive shots from the line. Think about that: you're tired, sweaty, just wanting to get into that shower--and now you have to concentrate and nail 10 in a row. Imagine the frustration of making five and clanging the sixth--and then starting over. Imagine the frustration of seeing your teammates drain their 10th shot and you're still struggling on the line. It plays with your head. And that was the purpose of the drill: If you could pull it together and make those shots in a challenging practice situation, you'd be better prepared to make that key free throw down the stretch in the heat of a tournament game. *That* is preparation: placing yourself in realistic, challenging situations and training yourself to perform at your highest. Preparation is not simply writing in a journal or scanning a bunch of charts or reviewing various pieces of research. Each one of those things is a finger. Preparation joins the fingers into a fist through full-throttle practice. Imagine that, after every day, week, or month of poor trading in markets, you had to replay those periods one time unit at a time, make new decisions, and keep replaying those markets until you made the right decisions for the right reasons. You could not resume real time trading until you successfully relived the periods of bad trading and--in realistic simulation--corrected your errors. Such an exercise would force you to stay in the right mindset; focus on the right pieces of information; follow the right trading rules; make the right decisions; and manage the positions the right way. It would join those five fingers of preparation into a practice fist. It wouldn't be fun, but it would be a powerful way to ensure that bad trading doesn't turn into bad habits. Further Reading: NCAA and Trading Upsets
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Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), The Art and Science of Brief Psychotherapies (APPI, 2018) and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. Currently writing a book on performance psychology and spirituality. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014.
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