Style Performance for 2008

We saw two style-related themes in 2007: large caps outperforming small caps and growth outperforming value.

Above, we see the ETFs for Russell 1000 Growth (IWF), Russell 1000 Value (IWD), Russell 2000 Growth (IWO), and Russell 2000 Value (IWN). Note that the Russell 1000 universe covers the 1000 largest equity issues; the 2000 universe is largely comprised of mid cap and small cap stocks.

So far in 2008, we see weakness across all styles, but large caps still are outperforming small caps. Growth, however, is not outperforming value. This suggests that recessionary concerns are affecting investors, as they shift away from growth and prefer larger, safer issues.

RELEVANT POST:

Investment Style and 2007 Returns
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Stock Market Volume Increasing to the Downside

Here, immediately above, we see the ETF for the S&P 500 Index (SPY) plotted with its daily trading volume from 2007 to present.

We can see a few things from the chart:

1) Volume Rising on Declines - We can see a pattern of rising volume at intermediate-term market lows;

2) Current Volume Rising - We can see volume rising during this most recent decline;

3) No Capitulation - While rising, current volume is not at levels seen during the August decline;

4) Broken Support - The S&P 500 Index, like its smaller-cap counterparts, is now trading below the lows made for 2007.

The top chart comes from Decision Point and plots the Advance-Decline Line for the S&P 500 Index over the last three years (blue line). You can see we've broken well below the August lows, as weakness has caught up to the large caps.

Note, however, the Advance-Decline Volume Line (green line, top chart) for the S&P 500 Index. This adds and subtracts volume rather than number of issues traded. Here we see that the line is approaching multi-year lows (and support). What that tells us is that we're seeing a consistent pattern of increasing volume on declines ever since July, 2007.

As I've stressed in the past, volume is largely dictated by financial institutions, not small traders. It is sobering that the institutions closest to the current turmoil in credit markets and housing (banks, hedge funds) are voting with their feet and heading for the exits.

RELEVANT POSTS:

* Price-Volume Correlations

* Intraday Volume Analysis
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ETF Resources for Traders and Investors

Exchange-Traded Funds (ETFs) enable share traders, for the first time, to actively participate in multiple equity sectors and styles, international markets, and asset classes. This makes it possible more now than ever for traders to assemble sophisticated and diversified portfolios.

Here are a few resources that I find to be helpful for understanding ETFs and their applications:

1) Create Your Own ETF Hedge Fund by David H. Fry - This new book is unusual in that it describes common hedge fund strategies (long/short, global macro, etc.) and how to implement those strategies using ETFs. The author includes a large list of resources at the end of the book and identifies the ETFs he recommends for the various strategies. The book does not go into the heavy-duty mathematics of portfolio construction and management, but is an excellent primer for traders and investors that want to become their own portfolio managers. See also David's site, where he offers podcasts and portfolios.

2) The ETF Book by Richard A. Ferri - This is also a new book that is subtitled, "All You Need to Know About Exchange-Traded Funds". It also contains quite a list of resources and discusses ETFs by categories (U.S., global equity, fixed income, etc.). A second section of the text deals with passive and active portfolio management with ETFs. The coverage of the range of available ETFs is quite extensive.

3) Seeking Alpha's ETF Page - A number of commentators (including David Fry above) contribute to SA's site, covering new ETFs, specialty ETFs, and asset allocation with ETFs.

4) Morningstar's ETF Page - Morningstar offers commentary, ETF research, and a very helpful listing of ETFs by trading volume, so that you can see the most liquid instruments.

5) ETF Connect - This site offers articles and a complete listing of ETFs, including a fund sorter. The site also helps you find funds by asset classes and lists end-of-day pricing for funds.

6) ETF Express - This site does a nice job of covering news on ETFs.

Market Sentiment and Weight of Evidence

* Blog Traffic - I've noted before that the periods of highest daily traffic on this blog have corresponded to periods of market weakness, particularly in March and August of last year. Interestingly, we have not had elevated traffic on the blog until this week. Three of the busiest traffic days of the past thirty have occurred this week, with traffic running 25% above average. I checked, and this can't be attributed to external links from other sites. Rather, it appears that periods of volatility, uncertainty, and falling prices lead people to seek out information--not only on this site, but across the board. In that sense, blog traffic represents a kind of sentiment measure. (Note yesterday's jump in VIX and recent elevated equity put/call readings). Although not precise timing indicators, such periods of elevated traffic have generally meant that an intermediate-term bottom is not far away.

* Weight of Evidence - I've also noted that we've seen unusual strength in the Adjusted NYSE TICK during the latter portion of this decline. Either the measure is quite early, or it is not doing as good a job with timing as it has in past cycles (which may be ways of saying the same thing). This is why I look at multiple indicators and base my decisions on the weight of evidence, not just the readings of any single measure. In a bear market, markets become oversold and stay that way. We're seeing that in many of the measures I'm following, such as Technical Strength and the number of stocks making new lows relative to new highs. We're also seeing weakness spread from small caps, housing, and financials to the broader list of stocks, including the large caps and consumer-related stocks. This is evident in the Advance-Decline lines specific to the common stocks traded on the NYSE and the S&P 500 Index, both of which are making new lows. Weakness has also spread to the international markets, as noted recently. It's the weight of evidence as a whole, not any single indicator reading, that is important in gauging market strength and weakness.

* Longer-Term Oversold - I've mentioned before that, over the last 20 years, bear market bottoms have not occurred until we have 20% of fewer NYSE stocks closing above their 200-day moving average. For the first time in this downward move, that occurred on Thursday, with 19% of NYSE issues hitting the criterion. That number can go lower to be sure--and the majority of lows have occurred with an even lower figure--but it's an indication that the downside has been significant historically and has me watching for evidence of bottoming going forward.

* Continued Divergences - No question the stock markets have been weak this week, yet we're seeing fewer stocks make new lows even after Thursday's rout than they did last week. Among NYSE common stocks, we had 8 new 52-week highs and 300 lows--weak to be sure. Last week, the new lows exceeded 500, however. Interestingly, among the S&P 600 small caps we're seeing some drying up of new lows. We had 4 new 52-week highs and 85 new lows on Thursday. That is fewer new lows than on Tuesday and far fewer than the 187 new lows last week. Among S&P 500 Index stocks, we had only half the number of 52-week new lows on Thursday as we did last week. Not all stocks are following this market lower: it's something I'm watching closely.

RELEVANT POST:

My Previous Indicator Review

More Indicators Posted to the Twitter App
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Emotionally Intelligent Trading - Part Three

In the two previous posts in this series, I advanced the notion that emotional intelligence—not the elimination or minimization of emotion—is essential to successful trading. Emotional intelligence, we have seen, requires attention to one’s feelings and clarity as to their nature and source. By understanding our experience, we are able to transcend it.

So how does emotional intelligence show up in trading practice? Below I offer pairs of behaviors contrasting emotionally intelligent and unintelligent trading.


Intelligent Trader: Notices frustration building and pulls back from the screen to figure out what’s going on in the market and what’s going on psychologically.

Unintelligent Trader: Becomes frustrated, does not attend to the feeling explicitly, and acts on the frustration by taking on too much risk.


Intelligent Trader: Has a strong degree of conviction in a trade idea, knows why that conviction is running so high, and acts decisively on the conviction.

Unintelligent Trader: Becomes overconfident after a winning streak and increases the frequency of trading, thereby changing what produced the streak in the first place.


Intelligent Trader: Feels fatigue or distraction, realizes that this could interfere with decision making, and does not make any major trading decisions.

Unintelligent Trader: Feels fatigue or distraction, tries to ignore or push past it, and makes poor decisions.


Intelligent Trader: Thinks through various market scenarios ahead of the open or ahead of economic reports and is prepared to act accordingly.

Unintelligent Trader: Does not think through market scenarios in advance and reacts impulsively to the market’s first move at the open or following a report.


Intelligent Trader: Is aware of subtle cognitive and emotional cues when a trade “feels right” and acts on the implicit pattern recognition.

Unintelligent Trader: Becomes so caught up in catching the exact high or low on entry that he misses entering the position on a good trade idea.


Intelligent Trader: Recognizes quickly when trade is wrong, accepts the disappointment, and channels attention toward learning from the failed trade and preparing for the next idea.

Unintelligent Trader: Perceives that the trade is wrong, cannot accept the disappointment and pushes it away, and turns the short-term losing position into a longer-term hold.


Intelligent Trader: Feels boredom, recognizes that nothing is happening in the market, stops trading for the day.

Unintelligent Trader: Feels boredom and tries to relieve it by putting on trades with a marginal risk/reward edge.


Intelligent Trader: Sees that the market is moving, feels eager to get in, recognizes that others are also feeling eager, so waits for a pullback to enter.

Unintelligent Trader: Sees that the market is moving, feels eager to get in, does not reflect on the feeling, and chases the market move.


Much of emotional intelligence boils down to a three-step process:

1) Pay attention to what you’re feeling
2) Figure out why you’re feeling that way
3) Use the information from your feelings to guide your next actions

The first step toward emotional intelligence is simply recognizing that feelings contain information, but that the information is not infallible. Only after recognizing and gaining clarity about our experience can we make wise decisions as to whether to trade, fade, or ignore those feelings.

RELEVANT POSTS:

Trading With Emotional Intelligence - Part Two

Trading With Emotional Intelligence - Part One
.

Weak Market, Weak VIX: What It Might Mean

A number of market commentators have observed the relative lack of action of the VIX during the recent falling market. Normally, in a declining market, we see a rise in the VIX. That indicates higher options premiums and often is interpreted as a sign of fear in the marketplace. So what does it mean when we have a falling market, but the VIX actually declines during that time?

Over the past ten trading sessions, we've dropped nearly 6% in the NYSE Composite Index. During that same period, the VIX has declined a bit more than 1%. I went back to the start of 2000 (N = 2012 trading days) and could not find a single other instance of a VIX dropping during a ten-day period in which stocks were down more than 5%. That suggests that the current action of the VIX truly is unique (which, of course, makes it difficult to interpret).

I went back to 2000 and identified all 10-day periods in which the NYSE Composite Index ($NYA) was down more than 4% and less than 7% (N = 110). The average VIX change during those periods was +26.6%. I then performed a median split, examining what happens ten days following relative small vs. relative large VIX moves during those falling periods in stocks.

When the VIX move was below average (N = 55), the next 10 days in $NYA averaged a loss of -.23% (23 up, 32 down). When the VIX move was above average (N = 55), the next 10 days in $NYA averaged a gain of .24% (31 up, 24 down).

What this suggests is that declines accompanied by relatively little fear have been more likely to continue their downward course than declines accompanied by a large expansion in the VIX. Note also, per my recent post, that we're also not seeing extreme levels of bearishness in the equity put/call ratio during the selling this week.

Is the market pricing in a Fed rescue? Is the market priced for perfection? These are the questions I'm mulling in light of the current action in the VIX.

RELEVANT POSTS:

How VIX and Put/Call Ratio are Related

The Volatility of the VIX
.

World Equity Returns for 2008 and More Views

Joining the Downside - Above we see the 2008 performance of the S&P 500 Index (SPY) representing U.S. equities; the iShares EAFE (Europe, Australasia, Far East) ETF (EFA); and the iShares Emerging Markets Index ETF (EEM). We saw distinct underperformance of the U.S. market in 2007, but so far in 2008 we're seeing downside from the international ETFs as well. A global recession theme has implications not only for equities, but for rates and commodity prices.

Recommended Book - What is the What is the novelized autobiography of Valentino Achak Deng, a young man who survived incredible conditions in southern Sudan and shared his story with Dave Eggers. A very personal view of a troubled part of the world and one person's will to survive.

What's Up With Volatility? - Or why isn't it up more, given stock market weakness? VIX and More takes a look at the issue. Here's Adam Warner's take on the "pathetic" VIX.

McClellan Oscillators - I see Broadmarket is tracking the McClellan Oscillator; Decision Point computes the oscillator (and its volume counterpart) for the stocks specific to each major index and sector. Small caps are showing particular weakness, especially relative to the Dow stocks.

Health Care Topics - SharpBrains posts health care questions from 40 bloggers as issues for whomever is elected U.S. President.

Stock Market Indicator Update for a Bearish Wednesday AM

* Momentum - With the break below the multi-day trading range on Tuesday, we saw a resumption of weak momentum numbers, with Demand at 18 and Supply at 101. That means that we have roughly six times as many stocks across the NYSE, NASDAQ, and ASE closing below their volatility envelopes surrounding their moving averages as closing above them. We're seeing 17% of NYSE issues trading above their 50 day MA--very weak--but we are not yet at that 20% benchmark for % issues trading above their 200 day MAs that has marked bear market lows (though we're getting closer at 25%).

* New Highs/Lows - On Tuesday we saw an expansion of stocks making fresh 20-day lows, with 615 new highs and 1926 new lows. Interestingly, this is fewer new lows than we saw last week. I will be watching carefully to see if this divergence continues. We continue to see an unusual divergence in the Cumulative TICK, which was only modestly weak Tuesday. Among common stocks only traded on the NYSE, we had 13 new 52-week highs and 277 lows. This also is weak, but represents fewer new lows than last week.

* Technical Strength - Among my basket of stocks, we have 7 issues ending Tuesday in uptrends, 6 neutral, and 27 in downtrends. Thus we see continued weakness, although not at the extreme levels seen last week. My Technical Strength Index finished at -1580.

* Advance-Decline - The Advance-Decline Line specific to NYSE common stocks continues to make new lows and is clearly bearish. Significantly, we saw new lows in the AD Line specific to S&P 500 stocks. The weakness has clearly spread to large caps, as the recent INTC weakness attests.

Bottom line is that we're seeing some interesting divergences, but the indicators remain in negative territory, we're not yet at bear market extremes in my longer-term momentum indicators, and we're seeing continued weakness in the advance-decline lines. I am not inclined to chase lows this AM--a lack of downside follow-through could lead to sharp short covering--but neither am I stepping up to the plate on the long side for anything more than short-term trades at this juncture, given the indicator status.

RELEVANT POST:

Most Recent Indicator Review
.

Trading With Emotional Intelligence - Part Two

My recent post suggested that traders don't need to eliminate or minimize emotion. Rather, they need to learn to trade with greater emotional intelligence.

But what does it mean to be emotionally intelligent?

In the book Emotion, Disclosure, and Health edited by James W. Pennebaker, a chapter on emotional intelligence research yields some valuable insights--and ways of assessing emotional intelligence. The chapter, written by Peter Salovey and colleagues, describes the Trait Meta-Mood Scale and its development as a research tool.

The authors report that emotional intelligence is composed of several interrelated capacities:

1) Attention - The degree to which people pay attention to their feelings and value them as sources of information;

2) Clarity - The degree to which people accurately identify and understand their feelings;

3) Mood Repair - The degree to which people can control and shift their emotional experience.

In their research, they found that subjects exposed to a stressful event were more likely to maintain a positive mood when they not only attended to their feelings, but had a high degree of clarity about those feelings. When these individuals attended to their feelings but had little clarity about those feelings, they were more likely to ruminate about the stressful event. Clarity about feelings enabled them to move beyond stress and return to a positive emotional state.

Moreover, those with the ability to repair mood tended to experience negative mood less intensely than those without the capacity for repair. The ability to shift mood states appears to have value as a coping mechanism.

This research suggests that it is not enough to pay attention to feelings. Understanding those emotions is important to moving beyond them. Ironically, attempts to dampen and minimize emotions in trading is apt to lead to less clarity, and thus less ability to move beyond the stresses of the moment. It's the ability to think about one's experience--and not get lost within it--that enables people to transcend stressful situations. In my next, and last, post in this series, we'll take a look at how emotional intelligence manifests itself in successful trading.

RELEVANT POST:

Somatic Markers and Trading Decisions
.

Building Strength and More Market Insights

* Building a Bit of Strength in Stocks - My recent indicator review noted increasing glimmers of strength. Monday followed through with some further strength. Demand finished the day at 67; Supply was 31. That means that over twice as many stocks closed above their volatility envelopes surrounding their moving averages as closed below their envelopes. Fresh 20-day highs rose to 808; 20-day lows fell to 839. We also saw further strengthening in the Technical Strength measure, with 10 stocks from the basket now in uptrends, 7 neutral, and 23 in downtrends. Of the SPX stocks, 26% closed above their 50-day moving averages, up from 21% on Friday. None of these measures have shown vigorous strength, however, as Demand has stayed below 100; new lows have outnumbered new highs; and Technical Strength remains skewed toward stocks in downtrends.

* Going Long Education - Wang's Happy Trading makes the case for going long education stocks in China. Demand is likely to be there even in the event of economic slowdown.

* Worthwhile Site - This one's worth spending some time and visiting, with posts in both Spanish and English and quite a broad market coverage. Here's a fine post tracking new lows specific to the S&P 500 stocks, which showed considerable weakness last week.

* Wisdom From Jesse Livermore - Chris Perruna passes along some timely gems. See also his bear/no-bear market links.

* Consolidating - Sideways action in the major stock indexes has Trader Mike looking at another possible leg down.

* More Treats - Kirk finds more treats among his links, including a Great Companies ETF that focuses on large cap growth at a reasonable price. Sounds like a promising theme for those sovereign wealth funds that need to put capital to work beyond low-yielding Treasuries.

* Do Follow Through Days Follow Through? - Quantifiable Edges takes a hard look at an IBD pattern; excellent blog.

* What Shipping is Telling Us - Barry Ritholtz tracks falling shipping worldwide and possible spread of economic weakness. I think he's right on in his analysis of possible effects on commodity prices.

Trading False Breakouts: An Example From Today's Trade

For you young traders out there early in your development, here's a nice example of an intraday pattern that shows up at multiple time frames. Once you train your eye, you can see many examples of these "false breakouts". The key to making this trade is:

1) Identifying a Trading Range
2) Identifying a Move Outside the Range in ES Futures Not Confirmed by Stocks as a Whole
3) Waiting for the Move to Stall Out
4) Fading the Move for a Reversion to at Least the Mean of the Prior Trading Range

So we have our overnight range on Monday, with the market opening strong. Indeed, near the open, we had advancing stocks on the NYSE outnumbering decliners by about 1600 issues (Point A on the chart). Soon after the open, however, the market sold off and moved back into the overnight range before bouncing higher between 9 and 10 AM CT. We made a new price high at Point B on the chart. To someone watching price only, it seemed as though we were breaking out and on our way to testing Friday's highs.

A quick look at some indicators, however, told us that the strength in the ES futures was selective. At Point B, we had only 1072 more advancers than decliners--weaker than at the open. Moreover, the new high in the ES was not confirmed by the Russell futures or by many sector averages (consumer staples, banks). We also see volume temporarily expand on the move to new highs, but then dry up as the move stalls out. That's the point to fade the (false) breakout in anticipation of a move back into the range.

In this particular case, I noted earlier support at Point C and anticipated that we'd at least test that support and wash out the weak longs. Taking profits below C (on the way to Point D) thus became the object of the trade. Given the drying up of volume as the morning progressed, I was not looking for a downside breakout move.

Knowing when to trade and when to fade breakout moves is a core competency of intraday trading. If you only look at price, you'll have little way of distinguishing the solid breakout moves from the false ones.

RELEVANT POSTS:

Trading Opening Range Breakouts

Trading Breakouts With NYSE TICK

Anatomy of a Breakout
.

Technical Strength by Sectors and Readings to Start the Week

* Technical Strength - As I noted in my recent indicator review, the market's technical strength remains weak, but ended the week with some strengthening. Here are the technical strength scores broken down by sector:

Materials: -280
Industrials: -300
Consumer Discretionary: -340
Consumer Staples: +100
Energy: -200
Health Care: +360
Financial: -240
Technology: -280

Once again, we see relative strength in defensive sectors, with other sectors showing concern about recession.

* Recession - A number of worthwhile readings from Abnormal Returns on the Fed and concerns over recession. The post re: Fed worry very much fits my thinking.

* Excellent Insight - The credit markets will improve before the economic picture improves: great post from Accrued Interest.

* Accounting for the Market - This post from Jeff Miller is worth reading a couple times, noting the effect of accounting changes on corporate behavior and questioning recent interpretations of the ABX.

* More Than Subprime - Calculated Risk on how the current credit problems are not limited to subprime.

* Discipline Before Feelings - I like this smart blog from David Merkel and his note about discipline and portfolio management.

* Getting an Edge - Excellent summaries of research into markets and strategies with edge from CXO Advisory. I was interested to see momentum as one of the strongest market anomalies.

Indicator Review: Glimmers of Stock Market Strength

* Interesting Divergence - We're continuing to see divergences between the Cumulative Adjusted TICK Line (blue line above) and stock prices, suggesting underlying buying pressure. When I drilled down, I found that this is indeed a function of above average buying, not simply reduced selling (very different from recent rallies). Eight of the past nine trading sessions have closed with a positive Cumulative Adjusted TICK on the day. Despite Friday's price weakness, we saw 672 stocks make fresh 20-day highs against only 1120 lows--many fewer lows than the 3138 registered on Wednesday. If we do see additional price weakness early this week, I'll be looking for further divergences. (Note also reduced bearishness in my relative sentiment indicator).

* Reduced Downside Momentum - The Demand/Supply figures showed maximum downside momentum back on December 27th, when we had Demand at 34 and Supply at 173. By January 4th, we had Demand at 18 and Supply at 126. (That means that seven times as many stocks were closing below their volatility envelopes as above them). When we hit further price lows on the 9th, Demand was 49 and Supply was 49. Friday, we had Demand at 34 and Supply at 56. It is very common for Supply figures to dry up during a bottoming process and for Demand to dry up ahead of cyclical price highs.

* Fresh Look at the Basket of Stocks - As regular readers know, I track 40 stocks from the S&P 500 universe that are evenly divided (and highly weighted) among eight sectors. On Friday, we had 7 stocks closing in uptrends, 4 neutral, and 29 in downtrends. Usually, prior to a turnaround in a downtrend, we'll see more stocks in that neutral category prior to any upside breakout. We're not there at this juncture. Among sectors, we see quite a bit of technical strength among health care issues and surprising weakness among tech stocks. At -1180, my Technical Strength Index is quite weak, but far stronger than the -2300 reading earlier in the week. So we're seeing strengthening in this measure, but not an outright bullish turnaround.

* Continued Defensiveness for the Advance-Decline Lines - We see fresh new lows for the Advance-Decline lines specific to the NASDAQ 100 stocks, the S&P 600 small caps, and the S&P 400 mid caps. Most ominously, we're seeing new lows for the Line specific to common stocks traded across the NYSE. The Advance-Decline lines that are still holding up are those for the Dow 30 Industrials and for a couple of S&P 500 sectors: health care and consumer staples. In short, we're seeing weakness in the broad market and among growth sectors; relative strength among defensive sectors. This seems to be a market that is indicating recession; while some of the indicators are strengthening, I'll need to see some buying conviction in those growth areas and across the broad market before putting significant long term capital to work on the long side.

* Good News, Bad News - On Friday, 20% of NYSE stocks closed above their 50-day moving averages, a level that has marked short-term bottoming over the last several years. That's the good news. The bad news is that we've never had a bear market over the last 20 years that hasn't ended before we've had 20% or fewer stocks closing above their *200* day moving averages. Right now, across the NYSE, that figure is 28%.

* Revealing Sectors - The S&P Consumer Discretionary stocks (XLY) are hovering at 3-year lows, with only 2% of them closing above their 50-day moving averages. Among S&P 500 Technology stocks (XLK), none closed on Friday above their 50-day moving average and only 11% are now trading above their 200-day MAs. This sector has seen considerable recent weakness, due in no small part to concerns over economic growth and recession.

RELEVANT POST:

My Indicator Review From Last Week

Daily Updates of Indicators are Posted to the Tweeter App.

Relative Sentiment and the Equity Put/Call Ratio

One implication of the recent post on psychological relativism is that absolute levels of sentiment are less important than shifts in sentiment from recent norms.

In the chart above, we see the five-day equity put/call ratio as a proportion of the 65-day ratio. When the pink line is above 1.0, it means that we are bearish relative to the past 65 trading days; when the line is below 1.0, it means that we are bullish relative to the most recent 65 days. Note how we've seen elevated relative bearish sentiment at market bottoms in 2007 and relative bullishness at intermediate-term peaks.

One very nice application is that you can monitor the current day's equity put-call ratio as the day unfolds and see if traders overall are more or less bullish than they've been over the past 65 days. Interestingly, in the wake of the Fed comments, sentiment for the past two trading sessions has been more bullish than the 65-day average. Friday's decline was notable in its lack of bearishness in that regard.

RELEVANT POSTS:

Spikes in the Relative Equity Put/Call Ratio

What We Can Learn From the Equity Put/Call Ratio

What Drives Investor Sentiment?
.

A Theory of Psychological Relativism

All perception is perception of difference.

I'll start with three premises:

1) All perception occurs within a context and is shaped by that context - The same meal tastes different to a starving man and to a sated one. A 50 degree (F.) noon temperature feels cold in summer, warm in winter. An automobile moving 55 miles an hour down a freeway seems to go slow; down a side street, it would feel like a race car. When I was a student, producing a 40 page paper was an ordeal; now it is a routine process. There is no perception independent of context: what we experience is inextricably wound with our histories and our environments.

2) We respond psychologically to difference: to situations that are contextual outliers - Events that are normal for our particular context are experienced as routine and fail to elicit strong emotional responses. When we experience something unique--something outside our normal context--we are most likely to respond with strong emotion: surprise, fear, curiosity, and excitement. A song or joke heard the first time is unique and may generate a strong reaction. On the 20th hearing, it no longer elicits emotion.

3) Markets elicit the strongest psychological responses--and display the greatest inefficiencies--when they depart from contextual norms - It isn't the absolute magnitude of price rise or fall or the absolute magnitude of bullishness or bearishness that impacts markets, but the degree to which current market behavior departs from recent norms. Markets that behave differently from their recent pasts elicit psychological responses from traders that bias their appraisals of value and skew decision making.

A good theory is one that, not only explains existing observations, but suggests new ones. In upcoming posts, I will explore some implications of psychological relativism in markets.

RELEVANT POSTS:

Relative Price

Relative Range

Relative Dollar Volume Flow
.

Volatility Has Become More Volatile

The above chart (click for greater detail) looks at the 20-day moving average of the high-low daily trading range of the S&P 500 Index (SPY). Note how we saw a breakout in volatility in August, signifying a shift in the volatility regime. We're now seeing wider swings in volatility--in other words, volatility is itself getting more volatile. That is creating shifting market trading conditions and considerable choppiness to the trade, where moves can extend farther than expected--and then retrace more than expected.

I'm finding the volatility of the NYSE TICK--the number of extreme readings during the day--to be an excellent proxy for gauging the day's price volatility. I'll write more on this topic shortly.

In the interim, note that we're seeing a kind of wedge pattern in the volatility measure: lower highs and higher lows. I would expect a resolution of this pattern to the upside to correspond to a nasty market downdraft; for that reason, I'm monitoring the daily ebb-and-flow of volatility closely.

BTW, here's an oldie but goodie post of mine on a very worthwhile topic that I need to follow up on.

RELATED POSTS:

When the VIX Becomes Volatile

VIX and Daytrading Opportunity
.

Feeling Our Way in the World

Well, it's Friday evening and Mali is hanging with me in the den. She came running when she heard Coheed and Cambria. She seems to like the upbeat music with a good bass line. It's the vibrations: because she's blind, she experiences the world through feel.

One of the things I realized as I wrote the post on emotional intelligence is that psychologists experience the world through feelings, not unlike Mali. It's the tuning into the emotional communications that tells you how to respond to what the other person is saying. Much of what I pick up from traders is not what they say, but *how* they say it. That's why I like to ask traders their view of the market. I don't care if they're bullish or bearish; I'm listening to how much conviction is in their voice.

That's also why I like to talk my thoughts out loud or write them down: I can read them as a psychologist--for their emotional content. That tells me whether to follow the feelings or not. Listening to one's own emotional communications: it's a form of emotional intelligence.

Well, Mali and I are going to crank the volume and listen to a little Paramore. A couple of blind friends feeling our way through the world.

Emotional Intelligence and Trading - Part One

Emotional intelligence is a term that has been popularized and, perhaps as a result, widely misunderstood. In point of fact, emotional intelligence is an active field of psychological research with strong underpinnings. It also conforms with our standard understandings of intelligence, as it describes a set of related abilities that develop over time. In the work of Mayer, Caruso, and Salovey, emotional intelligence is distinguished by four "branches":

1) The ability to perceive emotion;
2) The ability to use emotion to facilitate thought;
3) The ability to understand emotion;
4) The ability to manage emotion.

Discussions of the role of emotion in trading frequently emphasize the fourth of these branches, with "controlling" emotion or even minimizing/eliminating it a frequent goal. The risk of this approach is that it leaves traders emotionally unintelligent, without the ability to accurately perceive and understand emotion and utilize it to facilitate thinking.

Indeed, in this series of posts, I will suggest that it is not a lack of intelligence--but a lack of emotional intelligence--that frequently bedevils traders.

Research suggests that individuals who are emotionally intelligent tend to be more successful socially than their less emotionally intelligent counterparts. They are also less likely to engage in self-destructive behaviors, such as addictions. An emotionally intelligent person is more capable of reading the feelings of others and responding to them constructively. Might it be the case that emotional intelligence also mediates the ability to read sentiment changes in markets?

Many accounts of trading success--my own included--have emphasized cognitive skills (such as pattern recognition and reasoning) are essential ingredients. These are important to be sure, but perhaps it's the sensitivity to market shifts--the capacity to read these and respond appropriately, as one does in social situations--that also distinguishes the successful trader.

Psychological research finds that emotional intelligence is related to both understanding oneself and others. It is also involved in pattern recognition--the ability to detect when situations "feel right"--as well as the channeling of motivation. Indeed, much of what we call "discipline" in trading may be an expression of emotional intelligence as it relates to understanding, utilizing, and managing one's reactions under conditions of risk and uncertainty.

In short, the problem might not be that traders get emotional. The problem is that they can be emotionally unintelligent.

RELATED POSTS:

Controlling Emotion is Not the Goal of Trading Psychology

Personality Questionnaire for Traders

Emotion and Perceptual Bias in Trading
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A Trio of Currency Trends and Other Market Views

* A Trio of Trending Currency Pairs - Excellent charts from the Barchart site show a steady appreciation of the Yuan vs. the U.S. Dollar; considerable Euro strength vs. the British Pound; and a generally strengthening Yen vs. U.S. Dollar. Indeed, the U.S. Dollar has looked weak vs. the Euro and the Yen, reflecting diversification of currency reserves overseas.

* S&P Resistance - The broken trendline in the S&P 500 Index is now acting as resistance, as charted by Trader Mike.

* To the Rescue? - Kirk offers more fine links, including a very interesting one on the "plunge protection team" coming to the stock market's aid.

* Which Period Are We In? - Henry Carstens finds different expectations going forward depending if we view the current market as similar to 2000-2002 or similar to any time since 1982 other than 2000-2002.

* Rolling Over - Millionaire Now! looks for a big rollover, with an unwinding of leveraged assets. If Barry Ritholtz is correct, investors have further to go in their grief work.

* Bottoming? - Abnormal Returns links a number of excellent posts, including an indicator at bottoming levels and a view of the relationship between currency and stock markets.

* Top Research Stories - Research Recap highlights the top stories of 2007.

Three Resources Worth Checking Out

* Real-Time Trading Room - I had a nice conversation yesterday with Bill Duryea of the Institute of Auction Market Theory and Trevor Harnett of Market Delta. Bill offers a real-time trading room that bases trading decisions on the use of Market Profile and Market Delta. This page gives an idea of the kind of research that goes into the trade decisions. My sense is that Bill's approach to trading is surprisingly similar to my own (calculating odds of hitting various price points during the day and developing trade ideas from those based on ongoing supply/demand) and that his service is refreshingly free of hype and false promises. He offers a free five-day trial to the trading room.

* Quantifiable Edges - Another great conversation yesterday was with Rob Hanna, hedge fund manager and trader who is now offering his blog dealing with tested edges in the market. He has some excellent and practical trading ideas on the blog. For example, we saw a reversal in yesterday's stock market. Rob outlines what we might expect following such a reversal going forward. I'm encouraging him to consider offering a newsletter for traders that could provide some of the same edges that a hedge fund manager would employ in his own trading.

* The Value of Preparation - Ray Barros offers a series of articles on his blog dealing with routines and habits associated with good trading. These include business planning, planning for disasters, and money management planning. Great material on his blog site. I'll post on the preparation topic shortly; it's an important one.

* Cautionary Note - Apropos of my recent Twitter post, we got to a very oversold point, with new 20-day lows exceeding 3000 across the NYSE, NASDAQ, and ASE. I don't trust the commonly quoted 52-week new high/low stats for the NYSE, however. If you look at the figures, we made 709 new lows on Wednesday, fewer than the over 1100 new lows registered in August. But if we limit our look to common stocks only traded on the NYSE, we see that we made 545 new annual lows on Wednesday, much higher than the 300 seen in August. Across every major index--S&P 500 large caps; S&P 400 mid caps; S&P 600 small caps--new 52-week lows have expanded relative to August. Until we see a pattern of price lows with fewer stocks making new lows, I'm not jumping into this market for the long haul.

Profitable Trading: Focusing on What Works

I've posted many times, on the blog and in my book, about the importance of identifying and building upon strengths. Nine times out of ten, traders who come to me for help want to discuss their problems. Often, if they'd just cut out what isn't working and build upon their profitable markets and setups, they'd turn their trading around.

There are two occasions that prompt me to review what I'm doing:

1) Losing Money - Given my strict risk control, a 2% drawdown peak to trough requires me to stop trading and review markets, ideas, and my trading. This single rule has been the most important factor in a relatively smooth, upward equity curve over the past several years. I don't resume trading until my review is complete and I have some confidence and conviction about what I'm doing. Similarly, I'll stop trading for the day if my portfolio is down more than 50 bps. This, too, prompts a nightly review and specific goals for the next day.

2) Hitting New Equity Curve Highs - When my portfolio makes a new high, I will generally review what's been working and where my profits have been coming from. In the past, I used to get sloppy when I was making money, taking marginal trades. By thoroughly reviewing the trades that are making me money during a profitable period, I remind myself of core strengths and redouble my efforts to stick with those.

I hit an equity curve high today, so am beginning a review of recent "best practices". Here are a few:

* Sizing - I enter trades with one unit and wait to see how the market behaves before putting on a second and third unit. Many, many of my losing trades go under water very early, so I want to get stopped out when my size is smallest. If the market moves against my trade but can't hit my stop, that's when I put on the second unit; the same process will have me adding a third unit. What that means in practice is that I can be stopped out on a couple of trades, have one winning trade, and still end the day nicely profitable. It's the few trades that I nail with larger size that contribute a good portion of my profits.

* Waiting - Many of my losing trades have occurred early in the morning. By waiting for the market to show its hand--and by waiting to see how much action we're getting at the market bid vs. offer--I generally find higher percentage trades. I also find that starting my day with a losing trade makes me overly risk averse later on. I'm much better off waiting for those high percentage trades; that's when I can be most confident and aggressive later on.

* Dancin' With the One That Brung Ya - My indicators, many of which I post to this blog regularly, are my old friends. I've watched their behavior on a daily basis for years and have a pretty good sense for their patterns. If we're not seeing weakness in the NYSE TICK, the Market Delta, the number of stocks making fresh intraday lows, etc., I won't sell. If we're not seeing the reverse, I won't buy. Aligning my trades with the trend of the indicators has kept me out of many bad trades.

* Execution - I can't begin to describe how important this is. I've worked at it for a long time, and I still get into trades too early. But I don't chase strength if I'm buying, and I don't chase weakness if I'm selling. If I miss a trade that way, too bad. There will be others. But I've learned to buy on pullbacks in the NYSE TICK and sell on bounces. I've also learned to be patient and enter trades as close to my stop level as possible. That easily adds a point or more of profit to each winning trade.

In football, we often focus on the big plays: the long passes from the quarterback, the thrilling kickoff returns for touchdowns. What wins the game more often than not, however, is the blocking and tackling that make the big plays possible--and that prevent the big plays from opponents. My "best practices" aren't sexy--they're not home run trade ideas--but they're the blocking and tackling that make profitable trading possible over time.

RELEVANT POST:

Solution-Focused Trading
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A Few Market Observations for Wednesday

* Weakness Update - My last post updating indicators showed that a broadening range of stocks were weakening and so far that's proven to be the case. Interestingly, we had 771 new 20 day highs on Tuesday against 2234 new lows across the NYSE, NASDAQ, and ASE. Nearly half of those 20-day lows, however, were also 52-week new lows. There is a core group of stocks that are quite weak; small caps are notable in that regard; financials and homebuilders continue to lead the downside (and were an excellent tell for the late weakness on Tuesday). Among NYSE common issues, we had 40 new annual highs against 390 new lows. The failure of the weakness to attract any sustained buying has been worrisome: bottoms are usually formed when we get very strong buying on high volume at price lows, as institutions pick up bargains. No bargain hunting yet.

* Largest Caps Outperform - Among Dow 30 Industrials on Tuesday, 2 made new 52-week highs and only 5 made lows. Among S&P 600 small caps, we had 4 new highs against 133 new lows. Among the S&P 400 mid caps, we had 2 new highs against 93 lows. And if we look at the S&P 500 stocks, we had 23 new annual highs against 140 new lows. It's really only the largest of the large caps that have any remnant of strength; otherwise, we're seeing over 20% of stocks making 52-week lows.

* Bear Market Low? - The excellent Decision Point site is showing 28% of NYSE issues trading above their 200-day moving averages. A look back at bear market lows over the past 20 years, however, suggests that we haven't started to form bottoms until fewer than 20% of stocks hit that criterion. Meanwhile, amidst inflation concerns and a weak dollar, we can see (above) that commodities continue to rock.

Some Personal Thoughts on Embracing Trading Mistakes

Whenever I go to a new city, I go through a process that I heartily enjoy. I study maps of the city and then take off to find things--without the maps. Of course, I end up getting lost, but that's how I figure out where things are. After a few trials and errors on major interstate highways, I get a sense for how the city is laid out and then I begin exploring neighborhoods. And getting lost. And figuring out how they're laid out.

I can't tell you how many iterations of getting lost and figuring things out I did before I learned my way around Chicago. But it worked. By making enough mistakes, I learned my way around.

Trading, for me, is very similar. I strongly believe that my greatest credential as a trading coach is not the fact that I've written books or blogs, and it's certainly not having three letters attached to my name. No, my greatest credential is that, whatever mistakes and bad practices traders come to me with, I've been there and done that. I doubt there's a mistake a trader can make that I haven't made myself. In spades.

Having traded since the late 1970s, I guess I'm sort of like the old guys at the AA meetings. There's nothing the young guys can bring in that I can't relate to. I've made all the mistakes, worked all the steps, myself. And I continue to do so. So it's difficult for people to bullshit me, and a bit easier for me to offer the tough love to those who bullshit themselves. I have an uber-Ph.D. in leaving money on the table, missing entries, mis-sizing trades, ignoring stops. You name it, I've done it.

I guess that's how I learn. It's how I figure out markets and cities. I look back and marvel at how many bad relationships I was in. That's how I found my way to a good marriage. One unfulfilling job after another? It's how I found my way to a good career. I make mistakes. I get lost. I try things and watch them blow up. I never quite get blown out--I protect my personal, emotional, and financial capital to that degree--but I keep doing things wrong until, somehow, I get them right.

It's not failure. It's learning.

I still make lots of trading mistakes. Last week, I had 3-4 points of profit on three separate trades and watched every one evaporate because I thought we could hit preset targets. That's what happens when you keep your eye on targets instead of markets.

So that kind of targeting didn't work; I'll have to adjust my exit strategy for those short-term trades. And I'll probably get lost again. Most likely by taking the three-point profit--on a 12-point move. Another mistake, another attempt. Until I get it right.

Embracing your mistakes is the greater part of resilience.

RELEVANT POSTS:

Resilience and the Courage of Your Convictions

Blueprint for an Uncompromised Life

Four Overlooked Qualities of Successful Traders

The Limits of Self-Esteem

If there is an overworked notion in psychology, it's that individuals have problems because of "low self esteem". If only we can feel better about ourselves, the reasoning goes, all will be well and we'll perform up to our potentials.

As it turns out, this doesn't appear to be the case. Research suggests that improvements in our views of ourselves may not be an emotional cure-all. Indeed, the degree to which self-esteem is contingent upon other factors may be more psychologically important than a given level of esteem. Simply feeling good about oneself does not appear to lead to better performance in life.

While it is true that self-doubt and a lack of self-confidence can interfere with trading decisions, it is equally true that overconfidence and an unrealistic assesment of one's skills can lead to ruin. Research in behavioral finance suggests that, if you show traders charts generated by random number sequences, they will--as a whole--be more inclined to overestimate than underestimate their prowess at divining future market movements. And those with the greatest overestimation will be most susceptible to trading losses.

It is not at all unusual, in trading chat rooms and seminars, to find traders who have no problem valuing their own skills, despite no evidence of achieving consistent, superior returns and managing significant portfolios. On the other hand, most if not all of the very successful traders I've worked with are quite circumspect about their abilities. They are always seeing areas that need improvement, and they're always cognizant of risk, aware that large potential losses are only a trade away.

One of my favorite bumper stickers reads, "Forget world peace; visualize using your turn signal." That's pretty much how many fine traders approach their careers. They're not sitting around visualizing grand outcomes. They're immersed in the blocking and tackling--the sound trading practices--that make for the next profitable trade.

And maybe that's what has me writing this post. The really good traders aren't thinking good things or bad things about themselves. They're not thinking about themselves at all.

They're immersed in the markets.

If you're thinking about how good you're doing, how badly you're doing, your recent P/L, your hopes for future profits--all of that is a distraction from being focused on markets.

And *that* will affect performance.

RELATED POSTS:

Self Efficacy and Goal Attainment

Building Self-Efficacy

Self Confidence and Performance

Self Evaluation and Trading Success
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Stock Market Weakness and More Weekend Ideas

* Stocks in a Downtrend - Regular readers know that my measure of Technical Strength is a quantification of trending behavior in a stock. I follow a basket of 40 stocks from the S&P 500 universe; these are selected equally from 8 major sectors and represent many of the most highly weighted stocks within those sectors. As of Friday, my Technical Strength Index was an extremely low -2360, a level seen only at the August and November bottoms. All sectors are in solid downtrends, with the exception of Energy. In all, there are 3 stocks from my basket in uptrends, 2 neutral, and 35 in downtrends.

* Re-Viewing Yourself - This, my friends, is the kind of merciless self-analysis that is typical of people I work with who are very successful in the markets. I don't know what to respect more: that Charles engaged in the soul-searching or that he posted it.

* Good Reading - Abnormal Returns returns with more fine links, including a perspective on the bond market/stock market divergence. Trader Mike's Jan 4th post explains why he sees the potential for a lot of pain in the near future. Larry Nusbaum combs the Web to review the trading week.

* Favorite Blogs - Tim Sykes offers his top 10 list; I'll have a post on his interesting book shortly.

* Googling for Sentiment - Very creative post from Trader's Narrative uses Google data to track trading sentiment.

* New Blogs - Many thanks to Mark for his post and for his Trainee Trader blog site. I welcome hearing from traders starting new blogs, especially ones devoted to education and training. Also check out the psychology insights at the Trader's Edge blog.

Reviewing the Stock Market Indicators

* Beginning of Some Buying? - Despite the ferocious weakness on Friday, the Cumulative TICK line has held above its prior low and is holding, so far, above its November lows. I break down the TICK into separate buying and selling components; unlike the past two weeks, we're seeing an increase of buying, not just diminished selling.

* Twenty-Day New Highs/Lows - The nascent TICK strength notwithstanding, we've seen a steady expansion of new 20-day lows every day this past week, and it doesn't pay to stand in the way of that. On Friday, we registered 570 new 20-day highs and a whopping 2706 lows. The 1666 new 65-day lows were the highest we've seen since November 20th, when we hit 1944. It's when we see fresh price lows and fewer stocks making 20-day lows that I am more inclined to nibble at the buy side.

* Annual New Highs/Lows - Now for the bad news. New 52-week highs expanded dramatically on Friday. If we limit our look to common stocks trading on the NYSE, we see that we had 14 new annual highs and 433 new lows on Friday. By contrast, we only had about 300 new lows in November and back in August. This tells us that the market is weakening, not getting stronger. This is largely a function of weakness among small caps. Among the S&P 600 small caps, we had 1 new high on Friday and 165 new lows--much weaker than November or August. Among S&P 500 issues, we had 1 new high and 129 new lows, also exceeding the November and August readings. Among NASDAQ 100 stocks, we had 3 new highs and 23 new lows on Friday, also weaker than November and August. Nothing bullish in these data.

* Momentum - Among NYSE stocks, we're seeing 19% closing above their 50-day moving average on Friday; among SPX stocks that proportion is 18%. This has been a level at which we've seen rallies over the past several years. I note, however, that 34% of SPX stocks are trading above their 200-day moving average, and that's higher than levels we had at the last bear market lows in 2002-3.

* Advance-Decline Lines - The advance-decline line specific to common stocks traded on the NYSE has now moved below its August and November lows. Again, that reflects weakness among small caps. The AD Lines specific to S&P 500 stocks and for the NASDAQ 100 stocks are hovering right at their August lows and below November levels.

In sum, with expanding new lows, weak momentum, and weakening advance-decline lines, it's tough to step up to the plate and buy here. The fact that many of these indicators are breaking levels from August and November lends credence to the bear market hypothesis, even though large cap indexes are currently holding above those levels.

Herd Behavior in Markets: When Down Volume Swamps Up Volume

One way of assessing the bearishness of market participants is by examining the ratio of down volume to up volume. This tells us how much volume is concentrated in stocks moving lower in price vs. those moving higher. When large market participants dominate the sell side, as they did on Friday, the ratio of down volume to up volume becomes quite skewed.

I went back to the start of 1990 (N = 4535 trading days) and examined all occasions in which 85% or more of the directional volume was down volume. Interestingly, only 132 days met this very bearish criterion. Three days later, the S&P 500 Index ($SPX) was up by an average of .51% (79 up, 53 down), much stronger than the average three-day gain of .10% (2429 up, 1974 down).

Perhaps the most interesting finding, however, is that 25 of the 132 very bearish days occurred in 2007 alone! Three days later, $SPX has averaged a gain of .61% (16 up, 9 down). What we're finding is an increased tendency of the stock market to move in herds. Out of the 132 bearish days since 1990, 53--about 40%--have occurred since 2003. I believe this herd dynamic helps explain why intraday trading strategies such as Rennie Yang's trend catcher have been so successful. There is something of a bullish short-term bias following highly bearish days, but while you're in the middle of such a day, it pays to not fight the market.

RELEVANT POSTS:

Fading the Herd

Directionality and the Herd

Herding Sentiment in the Stock Market
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Stock Market Returns Following Up and Down Days

If you've been following the Twitter posts, you no doubt recognized that we've been seeing expanding 20-day new lows every trading session this week. That, along with the very weak Cumulative TICK Line, has been an excellent indication of weakness to come.

I went back to September, 2002--which is when I first began collating data on 20-day new highs and lows--and found something interesting. Essentially all of the bull market gains in the S&P 500 Index (SPY) have occurred following down days. If a trader waiting for an up day to enter the market, he would have lost money over that entire period!

Ah, but here's the catch. If you bought after a down day when 20-day new highs outnumbered new lows (N = 378), the average return the next day was .13%. If you bought a down day when 20-day new lows outnumbered new highs (N = 214), the average return was only .07%.

Similarly, if you bought after a down day when fewer stocks were making fresh 20-day lows (N = 176), your returns were about twice as large (.17%) as those obtained from buying a down day in which fresh 20-day lows expanded day over day (N = 416; .09%).

In the last few years, it's paid to think about buying the market the day after a decline. But this strategy has been most effective when--unlike the present--we're seeing strength in the 20 day new highs and lows.

RELEVANT POSTS:

What New Highs and Lows Tell Us

When New Lows Swell
.

Investment Wisdom From Dick Davis

I've been reading The Dick Davis Dividend, a recent book written by the well-known market commentator, and have to say that it offers some of the sanest perspectives on trading and investment I've encountered in a while. Davis began his newsletter in 1982 and has been offering commentary on the markets for the past forty years. This book is a distillation of the wisdom he's acquired over that period.

The book is divided roughly into two portions. The first summarizes market lessons and truisms, including six market absolutes, seven core convictions, and thirty-five nuggets of perspective. Each of these is explained in a clear, no-nonsense way. Some of the topics that stood out for me were:

* We're Predisposed to Fail, But Not Predestined
* The Market is King--News is Mostly Irrelevant
* Asset Allocation is Key to Managing Risk (I really like that one)
* Proper Entry Level is Crucial
* Losses are Inevitable--A Big Loss Unacceptable
* ETFs are a Beautiful Thing
* Rising Dividends are More Important than Big Dividends

Although Davis is not a blogger himself, he liberally cites blogs and other resources for traders. This is particularly helpful for traders who want to pursue a topic in greater depth. One very nice citation is the portfolio work of Charles Kirk, which Davis contrasts with the stock picking of Jim Cramer.

The second portion of the book addresses the question, "So What Do I Do With My Money?" Davis contrasts active and passive investing, offering numerous examples of both. These include "lazy" portfolios constructed with index funds, active approaches with mutual funds, and active stock picking. He offers 18 key pieces of insight into mutual funds and explores several stock picking methodologies, including growth and value strategies.

This is not a book for daytraders, but it is a book that is relevant for all professionals who will be making decisions regarding the investment of their capital. There are very few 20-year periods in the history of the U.S. stock market that have not offered favorable returns, particularly when dividends are considered alongside capital gains. With the advent of ETFs, it is now possible for retail stock investors to create highly diversified portfolios that exploit the dynamics of international markets, U.S. equities, fixed income, currencies, and commodities. Amidst the hype and shrill promises of the financial media, the "straight talk" of Davis' book is a welcome tonic and an excellent resource for traders who want to invest in their financial futures.

Retail in a Range and Blog Links for Thursday

* Retail Holders Holding Up - One facet of the bear thesis is that housing weakness will spill over to the broad economy as consumers retrench. Above we see the Retail Holder ETF (RTH) going back to May of 2001. What we see is that, during the recession of 2001-2002, retail stocks plunged precipitously. At present, we're not seeing such a decline. Rather, the retail stocks have been in a very lengthy trading range and are near the lower end of that range at present. That's something I'm watching carefully, both for implications re: the broad stock market and the economy.

* Overcoming Trading Fears - Corey offers a variety of resources across the trading blogosphere.

* Screening for Stock Reversals - The Short-Term Trading Blog offers an interesting implementation with TradeStation.

* Perspectives on Performance - Abnormal Returns finds some provocative posts on how much of what's written re: trading is untrue and how past outperformance doesn't lead to future outperformance.

* Blogger Predictions - Adam finds year end perspectives across the blogosphere, including predictions for the new year.

* Quite a Trading Track Record - Charles Kirk posts his trading track record. Maybe that stock screening machine really does work!!

* More on Housing - Barry Ritholtz takes a look at how far housing would have to fall to be in sync with rents.

Flight to Quality and Other Market Ideas

* Flight to Quality - This past week, we've seen 10-year Treasury yields fall over 7% and the S&P 500 Index (SPY) drop by nearly 3%. With fears of recession, traders and investors appear to be seeking the safe haven of Treasuries. I went back to 2002 (N = 1488 trading days) and found 51 occasions in which ten-year yields dropped more than 5% in a week during a stock market decline. Interestingly, the following week, the S&P 500 Index averaged a whopping gain of 1.73% (40 up, 11 down)--much stronger than the average five-day gain of .05% (766 up, 671 down) for the remainder of the sample. It appears that the flight to quality may also represent panic selling, something we see more at a short-term market bottom than a top.

* More From Dr. Lo - Here's a link to several studies from Dr. Andrew Lo at MIT and his research team, including an article we did together on the role of emotion among daytraders. I see Dr. Lo has a new article posted to his site, which looks at what went wrong for quantitative funds in August of this past year. It's an insightful paper, illustrating systemic risks among hedge funds that are not well appreciated.

* What We Can Learn From Neuroeconomics - I've long been convinced that trading has as much to do with brain hardware as software. This comprehensive review article includes a detailed look at emotion, cognition, and the brain--and what that means for economic decision-making.

* Shopping Centers in the Brain - What if the buying of stocks is not so different from the buying of goods at a mall? Apparently there's a link between shopping decisions and brain structures that are involved in addiction. And what if we think we make rational trading decisions, but actually base these on snap judgments? Research suggests that's how many of us make choices at election time.

Fixed Income Returns for 2007

Clicking the chart above will show the 2007 returns for several fixed income ETFs, including SHY (1-3 yr Treasuries); IEF (7-10 yr Treasuries); TLT (20+ yr Treasuries); and LQD (investment grade corporate bonds).

Two interesting themes emerged over the course of 2007. First, we see an inflection point around mid-year (which also was when we began to see considerable weakness among equities). Up to mid-year, longer-dated debt was underperforming the short end. With the flight to quality and increased concerns over economic weakness, the long end dramatically outperformed the short end in the second half of the year.

Second, we can see that Treasuries of all durations posted gains for 2007, but investment grade corporate bonds showed a modest loss. We can also see how the gap in performance between long-dated Treasuries and corporates widened as the year progressed. This reflected risk aversion in the face of credit concerns and economic weakness.

Fixed income traders and investors express their confidence and fears regarding the economy in their purchases and sales of short- and long-dated debt and the distribution of their holdings among Treasuries, investment grade corporates, and higher yielding debt. Understanding the sentiment expressed in these patterns of returns is helpful to traders in fixed income, currency, and equity markets.

RELATED POST:

Currency Returns for 2007
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Currency Returns for 2007

A click of the above chart will show how several major currencies traded versus the U.S. dollar during 2007. Note that, by year's end, every single currency finished higher than the U.S. dollar. The Canadian and Australian dollars were the winners, buoyed by strong, resource-based economies, followed closely by the euro.

Two themes stand out from the chart:

1) Yen Strength - The yen spent much of the first half of 2007 weaker than the U.S. dollar, but finished in an uptrend. This upmove in the yen also corresponded to bouts of unwinding of carry trades and selloffs in U.S. equities.

2) U.S. Dollar Strength - Note how the last two months of the year showed U.S. dollar strength versus all of the currencies. As fears of economic slowdown become global, the U.S. dollar could continue to gain interest.

Interestingly, the two weakest currencies finished the year with relative strength. That is a dynamic I'll be watching closely during the early portion of 2008, as we tease out global concerns over inflation vs. economic weakness.

RELATED POSTS:

2007 Stock Market Returns and Time of Day

2007 Stock Market Returns by Day of Week
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2007 Stock Market Returns as a Function of Time of Day

It's been my observation that many traders--including some very accomplished ones at hedge funds--began experiencing performance problems around July/August of this past year. Among these challenged traders have been some that rely upon historical, quantitative patterns in making trading decisions.

Above we see returns for the S&P 500 Index (SPY) as a function of time of day. We can see that, beginning in July, returns from the overnight session (close to open) greatly exceeded those from the day session (open to close). Indeed, it was as if the market split into two different markets: one trading overnight and one trading during regular hours.

This made it difficult to hold positions over time, as overnight moves and moves during the day tended to reverse one another. Holding short positions in stocks for more than a day trade was particularly difficult.

It is unclear whether this bifurcation of returns might be part of what tripped up many traders. The fact that the split occurred just at the time many traders reported having problems with returns, however, makes me think that those holding positions overnight and those counting on daytrades to follow short-term trends were adversely impacted.

RELEVANT POST:

2007 Returns by Day of Week
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2007 Stock Market Returns by Day of Week

When you think about the timing of economic reports, including Fed announcements, not all days are created equal. That raises the possibility of seeing different patterns of returns as a function of day of week.

Above we see 2007 returns in the cash Dow Jones Industrial Average as a function of day of week. Wednesday produced far and away the largest point gains, much of which was retraced on Thursday.

Interestingly, simply buying stocks at the close on Tuesday and selling at the close on Wednesday accounted for all of the market's gains for 2007--and then some. My look at the data suggests that this is not because returns were more volatile on Wednesdays. Rather, more of the big point days were winners on Wednesday than on other days.

RELEVANT POST:

Stock Market Performance by Hour of the Day
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