Well, hope your weekend was a gift at the very least. Here are links to useful views that just might provide a bit of stimulation for the start of the week: * How the U.S. is outperforming the world and other excellent perspectives from Abnormal Returns. Also check out views on robo-advisors and smart beta from Abnormal Returns. Increasingly, the AR site covers a far broader range of topics than markets. Great way to keep up with the world. * Excellent perspectives on strategy from Daily Speculations; * Now this is absolutely fascinating: From Eric Scott Hunsader, a video visualization of how the average trade size has declined in recent years. If you doubted the impact of algos on the stock market, this should open your eyes.
Quick question: Has 2014 been an up year or a down year for U.S. stocks? Chances are good that, if you anchor your view of the market to the Standard and Poors 500 Index or the Dow Industrials, you'd answer correctly that it's been an up year. Less well appreciated is that the smallest capitalization stocks (IWC) are actually a bit down on the year, even given the recent rally from the October lows. Indeed, as you can see from the chart above (January, 2 2014 = 100), 2014 returns to date have been a linear function of capitalization, with the largest companies (SPY) showing the highest return, followed by the midcaps (MDY); the small caps (IJR); and the microcaps (IWC). This effect is striking, because it shows that only the largest capitalization companies have been making new highs during the current rally. Why might this be the case? Large caps with yield, such as utilities shares, have been outperformers, given the crushing of interest rates across the globe thanks to zero interest rate policies from central banks. Stock buybacks also have been dominant among the large caps, contributing to returns. Finally, in the wake of global economic weakness and recent U.S. dollar strength, large caps could be benefiting from a flight to perceived stability and quality. Let's now bring in a different perspective and look at U.S. large caps versus other international stock markets. Sure enough, we see a similar pattern: U.S. large caps have made strong new highs, while equities outside the U.S. (EFA) and specifically within Europe (FEZ) and emerging markets (EEM) are actually down on the year. So, in short, the money has been moving toward U.S. large caps and away from overseas shares and away from the smaller capitalization companies. From this perspective, the broad asset class of stocks has a major breadth problem. The rising tide has lifted one boat. Nor do I see this dynamic changing since the October lows. During that period, SPY has gained 9.65%, while MDY is up 9.08%, IJR is up 8.48%, and IWC is up 6.71%. Healthy increases to be sure, but the pattern of relative returns remains intact. I've emphasized the strength of the recent rally and the fact that I don't see outright weakness manifesting itself among U.S. stocks. That being said, should we begin to see diminished interest in U.S. shares--and particularly the large caps--in the wake of an anticipated end to quantitative easing; in response to global economic weakness; and/or in the face of geopolitical turmoil (Russia is a mess and may have every incentive to use the Ukraine conflict to deflect attention from a falling oil market, a weakening economy, and a crashing ruble), then suddenly 2014 begins to look like a broad topping period late in a long-term market cycle.
That's enough to bring out the bear even in this generally optimistic soul.
My recent post suggested that we were seeing diminished strength in the U.S. stock market, but not distinct signs of weakness. Above we see three charts that update the view on market strength. The top chart tracks the number of common stocks across all exchanges that have made three month new highs vs. lows. Typically this measure peaks ahead of price during bullish intermediate-term cycles. We can see that new highs have indeed peaked and, though we have been trading at or near price highs lately, the number of shares hitting fresh peaks has diminished. Still, we're not seeing net new lows as we did prior to peaks in April, July, and September. (Raw data from the Barchart site). The middle chart follows the number of stocks listed on the NYSE that close above vs. below their upper and lower Bollinger Bands. This has tended to peak and trough ahead of price during the up and down phases of market cycles. Again, we've seen a peak in this measure, but as yet not the negative readings that preceded the July and September peaks. (Raw data from the Stock Charts site). The bottom chart tracks the number of stocks listed on the NYSE that give buy vs. sell signals on the Commodity Channel Index (CCI) per the Stock Charts site. Once again we see a peak in buy signals, but not as yet an expansion of sell signals as we saw prior to the September peak. In sum, we're seeing signs of waning upside momentum, but not yet a pickup in downside momentum. For that reason, I believe it's premature to assume that this market is on the verge of a correction on the order of August or October. Further Reading: Will this Market Roll Over?
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In this post, I thought I would step back and pass along worthwhile ideas from a variety of trading coaches who post to social media. Ultimately, my hope is that the ideas on this blog--and the ones that I link--can become fuel for your own self-coaching. The more I stay in this business, the more I realize that the really successful money managers and traders are those who spend as much time studying themselves (and their trading) as they do studying markets. For them, self-mastery is as much the motivation to compete in markets as making money. As we launch into a weekend, these posts might spark some self-coaching insights: * Self-coaching and lessons from basketball - From TraderFeed
In response to the post on training as the missing ingredient in the development of traders, an inquiring reader asks: "Can you please offer us from your own experiences as a trader and as a
traders coach some ways to practice, some drills or what ever you think
is suitable, to help us evolve as traders?"
It's a very good question, because it highlights that, before we can intensively drill skills, we have to clearly identify the specific skills that comprise our best trading. Those skills will be different for a relative value trader of rates, a directional global macro trader, and a daytrader of stocks. Just as soccer players will have different drills from basketball players and gymnasts, longer-term investors will benefit from different rehearsal than shorter-term traders. Understanding how you make money precedes any formal structuring of deliberate practice. In an upcoming post, I will address a general process for achieving self-understanding. I do, however, want to respond concretely to the reader's query, because it speaks to the need to translate ideas about performance into daily practices that make a positive performance difference. So what is the one thing you can do to improve your trading right now? Imagine that you could eliminate the one worst trading practice that you have observed in yourself over the past month or two. How much difference would that make to your overall profitability? In many cases, the return on investment for working on eliminating that one worst practice would be very high. Indeed, it can make the difference between profitability and drawdown. Once you identify that one worst practice, you want to clearly map out the situations in which it occurs. What is happening in markets at those times, and what is going through your mind at those times? What are you thinking? Feeling? In other words, you want to become as aware of the "setup" for your trading mistakes as you are about trading setups: you are focusing on your patterns now, not just market patterns. The result of your reflection should result in an actual map: a flow chart that captures the sequence of events leading to the bad trade. For example, the sequence might start with getting out of a trade because it has hit your stop; then seeing the trade return to the original intended direction; then thinking and fearing that you have missed another opportunity (again!!); then chasing the move at a bad entry point; and then stopping out again on a normal retracement. In that sequence, you now want to insert an additional set of steps that will derail the pattern and prevent the poor trading practice. Your negative pattern is trading reactively based on the frustration of potentially missing a market move. Your additional steps will be, following a stop out, to take a quick break from screens, regulate your breathing, and review your planned criteria for any re-entry. In other words, you are mentally rehearsing your rules for good entry execution and planning any possible return to the position, rather than staring at the screen and fretting that you're missing a move.
Taking a loss ====> Fresh planning That is the new pattern you will be "drilling". You are creating psychological conditions in which the poor trading cannot survive. Mentally rehearsing the new pattern and actually enacting it in trading creates a highly focused deliberate practice.
So here's the process: 1) identify your one worst trading practice; 2) map the sequence of events (internal and external) leading to that worst practice; 3) insert into the map a set of steps that will make that worst practice impossible; and 4) mentally rehearse and then actually enact the new, inserted steps in your trading. It is not necessary to change many things all at once. Intensive work on changing the single pattern most responsible for your poor trading creates positive changes that will energize future focused efforts. Most of us, once in a while, trade like idiots. Targeting those occasions and slimming down the left tail of returns can make a huge difference to overall profitability. Further Reading: Drills for Intraday Trading
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Thanks to @brussbowman for pointing out this interesting article on how the brain performs better when it slows down. Steven Kotler makes the case that we can optimize our thought processes by more consistently placing ourselves in flow states. During these flow states, Kotler observes, active parts of our brain slow down. This helps account for a distinctive aspect of flow states: we become so absorbed in what we are doing that we lose sense of time. Kotler's recent book, The Rise of Superman, explains how the flow state is the foundation for performance success in fields as different as athletics and jazz music. Adventure athletes, he notes, are especially good at hacking the flow state, utilizing a variety of environmental, internal, and social triggers. One of the reasons adventure athletics can produce flow is that "flow follows focus, and taking risks drives focus into the now."
What is perhaps most interesting about the flow state is that it is achieved through heightened concentration and yet is a relaxed cognitive state. When we encounter a situation that is difficult to deal with, we typically intensify our thinking and respond with emotional frustration. Both, ironically, interfere with accessing the flow state. Kotler points out that meditation--a loosening of cognitive constraints and entry into a different mode of processing--may be much more successful in helping us deal with challenges. There is a fascinating connection between deliberate practice and achieving the flow state: tackling challenging tasks and receiving timely feedback creates an immersion in performance that helps us access flow. Conversely, when we are stuck in routine activities, there is little immersion and little flow. We commonly hear advice for traders to "stick to their process". It may be the case, however, that we need to go beyond routine process to achieve the flow state routinely. Once we're in flow, there is no need for externally imposed discipline. Years of working with traders have taught me that we know more than we know we know. That implicit knowledge manifests itself as intuition. Most traders have experienced a "gut feel" in which patterns and meaning suddenly jump out from the seeming chaos of market movement. Csikszentmihalyi's initial work on flow state suggests that it is closely linked to creativity. It may well be the case that emotional disruption is most damaging to good trading, not because it necessarily leads to impulsive, destructive behavior, but because it denies us access to what we know, but don't necessarily know that we know.
In one study, subjects were given a difficult brain teaser. In their normal state, none could solve it. When a flow state was artificially induced, over half of the subjects achieved the solution. Perhaps Kotler is right. We have a Superman within, if only we can access the proper state of consciousness.
It's been quite a rally off the October lows for U.S. stocks. My most recent update showed continued buying interest in stocks, based upon the upticking vs. downticking of shares across the broad market. Above is an update focused on market breadth.
The top chart is my intermediate-term measure of breadth, which is a 10-day moving average of the number of stocks in the SPX that are making fresh 5, 20, and 100-day highs vs. lows. This measure tends to peak ahead of price during intermediate-term market cycles. What we've been seeing lately is that intermediate-term breadth has been quite strong during this rally and is now starting to roll over. That doesn't mean that we are about to have a major correction, but it is the first indication we've seen in a while that the rally is maturing.
The middle chart is a composite measure of SPX stocks trading above their 3, 5, 10, and 20-day moving averages. (Both the top and middle charts come from data provided by the Index Indicators site.) Notice that this breadth measure also tends to peak ahead of price during market cycles and we're seeing a cresting in it as well. Again, this doesn't mean we're seeing outright weakness in stocks; just that strength has been waning. One way we can observe the waning strength is by counting the number of common stocks across all indexes that have been making fresh three-month highs vs. lows. That number stood at 1024 highs and 168 lows on October 31st. Yesterday, we saw new highs in the major averages but only 502 highs versus 139 lows. I don't get concerned about a bull market until we begin to see an outright expansion of short-term new lows. The breadth data are suggesting a loss of strength in the rally; not the beginning of weakness. The reason for this can be observed in the daily balance of upticking vs. downticking among all NYSE shares. That balance has also been declining in recent days after an extremely strong move off the October lows. The net balance, however, has remained firmly bullish. We are seeing fewer buyers in this market, but are not as yet seeing an influx of sellers. In practical terms, that can set us up for rangebound, corrective action in the near term, but if precedent holds, we should see price highs ahead even if the recent levels end up representing momentum peaks. It's not enough to see reduced buying strength to get a fresh bear leg; we have to see an affirmative expansion of selling pressure. Further Reading: Finding Opportunity in Stock Market Cycles
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Thanks to Crosshairs Trader for pointing out this excellent article on why people choke under pressure. It turns out that how we frame situations helps determine our choke potential. If we tend to be risk averse, we can handle losing situations, but can freeze up in the face of large possible wins. Conversely, if we are risk seeking, we can handle gains, but fall down in the face of large potential losses. In a sense, it's the outcomes we're least prepared for that can most interfere with our mindset and subsequent behavior. Putting in golf is a great activity for studying choking. Research suggests that skilled golfers have made their putting automatic. They have done it so many times in so many situations that it is not a skill they need to think about. It's when they start to think about (and overthink) the putting--perhaps because of the importance of the situation--that the automatic skill falls prey to cognitive and emotional interference. A review of the research on choking in performance situations finds that many factors may lead to reduced performance under pressure, not just overthinking particular outcomes. How we think about performance outcomes helps to determine the pressure that we experience. Also, research finds that tasks that allow for the possibility of distraction may lead to choking for different reasons than tasks that encourage (over) monitoring of one's own performance. My general experience is that strategies to reduce or remove pressure are effective in addressing performance anxiety and choking. If a trader clearly identifies risk and reward in advance and mentally prepares himself or herself for both, the odds are greatly increased that any outcome won't disrupt performance. The key is emotional preparation for winning and losing, not just writing down price stops and targets. Actively visualizing outcomes and making sure that you are comfortable with them is a great way to proactively address choking in trading situations. It is very difficult to choke in situations in which you have "been there and done that" many times. Making winning and losing routine normalizes our emotional responses and frees us to fully employ our skills. Further Reading: Overcoming Performance Anxiety
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In the wake of much discussion of "V-bottoms", given the August and October experiences, I decided to take a look at V candidates and their prospective returns. Above we see an overbought/oversold indicator, which consists of 20-day price change adjusted for the market's volatility. So what we're seeing is how much directional movement up and down we're getting per unit of market realized vol. Notice how this normalizes the overbought/oversold levels across very different markets from 2010 to the present. When the volatility-adjusted OBOS measure is quite high, it means that we've traveled a good distance upward with relatively little corrective movement along the way. When we have a very low reading, it means that the market has come down a great deal with relatively little upward bouncing. Those latter occasions are truly butt ugly markets: ones in which short term oversold conditions stay oversold for weeks. By the time we get readings that are very low in the OBOS measure, we can identify a V candidate without hindsight bias. As you can see above, we are in overbought territory on the measure, but not at peak levels that have typified recent market cycles. So how do overbought and oversold readings affect future market returns? The top quartile of OBOS readings are the relative beauty pageant winners: those markets have been trending strongly higher over a number of weeks. Over the next five trading days, they have averaged a gain of only +.04%, significantly lower than the average gain of +.29% for the remainder of the sample. Over the next 20 days, they have averaged a gain of +.38%, meaningfully lower than the average return of +1.20% for the rest of the sample. And the bottom quartile of OBOS readings? Those are the butt ugly markets and the V candidates. Over the next five trading sessions, they have averaged a gain of +.46%, quite a bit higher than the average gain of +.15% for the remainder of the sample. Across the next 20 days, the ugly markets have averaged a sizable gain of +2.12%, far higher than the average gain of +.62% for the rest of the sample. So there you have it: over the past several years, if you had bought the most attractive markets when things have looked best, you have dramatically underperformed. If you had bought the ugliest markets when things have looked worst, you have dramatically outperformed. Now, of course, there have been historical periods when ugly markets have gotten uglier before giving good returns; the 2008-2009 period comes to mind. I strongly suspect, however, that ugly markets below a threshold VIX level are pretty good buying candidates on average, as those are most likely to represent ugly shakeouts in otherwise attractive markets.
* Above is a chart that tracks the balance between buying and selling activity across NYSE shares, derived from uptick/downtick data. You can see that downticks dominated during the peaking process in September and bottomed ahead of price in October, before a significant burst of buying off the October lows. Net buying has diminished from that initial burst, but we are not yet seeing the kind of selling pressure that was present at the September highs. * Excellent post from The Mathematical Investor on false claims to precision in financial data. * Abnormal Returns continues to find excellent podcast resources for traders, including an interview with Matt McClusky on the training of elite athletes.
To become part of elite military units, soldiers need to pass rigorous training programs. There is a great deal we can learn from these programs, as they have a solid record of producing soldiers operating at high performance levels. I took a look at the Fort Benning site for the Army's Airborne and Ranger Training Brigade and was surprised to learn that 60% of all training failures occur within the first four days of the program. (About half of all those who begin training ultimately complete the sequence successfully). The reason I was surprised was that soldiers who undertake the training are typically those interested in furthering their performance and their careers. Why would they drop within a few days? The answer lies in the structure of the training program, which is laid out in detail on the Ranger School Preparation site. The first week of training (Ranger Assessment Phase, or RAP week) consists of a physical assessment; combat water survival assessment; day and night land navigation tests; and a 12 mile foot march. As the site emphasizes, "RAP Week Attrition is the direct result of students that are physically unprepared to achieve the minimum standards." However, there is more to dropout than just lack of physical conditioning and preparation. The site makes clear that "The physical RAP Week events, when taken individually, are not very difficult. However, RAP Week's cumulative effect will make each task a serious challenge for any Ranger. You must train to the maximum standard on all events to mitigate the cumulative effect produced by these events over a one week period. Lack of sleep, food deprivation, heat and/or cold weather, and the overall stress induced in Ranger School will add to this cumulative effect." In other words, it's not just that you have to pass several tests to move on in your training. The tests are intensive; they are crammed into a single week, and that week is filled with mental and emotional stresses, including lost sleep, little food, and very uncomfortable conditions. After several days of such rigor, many seemingly motivated recruits drop out. They are not just physically unprepared: they are not mentally prepared for the rigors of warfare. There is an important performance principle at work here: Effective training programs demand a higher level of skill enactment and incorporate a higher level of stress than trainees are likely to see in the field. This is the idea of boot camp; it is also why team athletic practices push players harder than they will be pushed during actual competition. Take a look at medical residents: they typically function with longer hours and more responsibilities than they are likely to encounter in normal clinical practice. By drilling at high levels of demand, training programs prepare recruits to mobilize their skills and coping resources under the most challenging conditions. Very few training offerings for traders recognize and incorporate this performance principle. Much trader education takes place in the form of conference presentations, webinars, courses, videos, podcasts, and/or websites. Even when trading simulations are employed to actually apply the information derived from these sources, it is almost never the case that the simulations systematically push students to apply skills under progressively demanding conditions. The missing ingredient in the training of traders is grit: the development of cognitive and emotional fortitude in the face of high demand and high stress.
Can you imagine a soldier, physician, or athlete training primarily via videos, seminars, and courses? Why would we think that the challenges and rigors of trading can be adequately addressed in the comfort of an auditorium seat or in front of a computer screen? Education is necessary but not sufficient for elite performance. Developing traders need training, not mere information.
Recent posts have taken a look at relative market indicators, including those from fixed income and from different stock market sectors. In this post, we look at the relative performance of international stock markets and what that might be telling us. The top post charts U.S. large cap stocks (SPY); a broad list of non-U.S. shares from Europe, Australasia, and the Far East (EFA); European stocks (FEZ); and shares from emerging markets (EEM). All have been set to a value of 100 for the start of 2012 for easy visual comparison. When all international equity markets are rising, we clearly see indications of global economic expansion. When performance among international markets is mixed, we see that economic performance is uneven across the globe. It's the latter that we are facing presently. Note how U.S. stocks (SPY) have been strongly outperforming the other international markets. Indeed, emerging market shares have made relatively little headway over the past three years, and European shares have collapsed in 2014 relative to the U.S. Given the uneven economic recovery implied by these markets, we now see the U.S. winding down its quantitative easing, even as monetary stimulus has been ramped up in Japan and is being pursued by the European Central Bank.
A result of this relative economic strength and the handoff of monetary easing from the U.S. to the international central banks is that major overseas currencies have been weakening relative to the U.S. dollar. Indeed, take a look at the bottom chart, which shows how an portfolio consisting of U.S. stocks and short the currencies in the U.S. dollar index has performed since 2012. Particularly note the recent, near-vertical ascent. U.S. assets have been massively outperforming those abroad.
What does all this mean? With weak economic conditions abroad; monetary policy continuing to weaken the yen and euro; and interest rates in the U.S. still meaningfully higher than in Japan and Europe, it is difficult to see what, in the near term, will keep investors away from U.S. assets. Those macro dynamics are an important underpinning of the significant strength in the U.S. stock market. Gauging those dynamics by tracking the relative performance of international markets is quite helpful in understanding global macroeconomic shifts.
Recent looks at breadth and sentiment and the strength of the market rally suggested that the current move higher in the U.S. stock market was unlike recent ones, with significant upside momentum. So far, that has proven to be the case. Let's now update the view. First, however, a quick review of basics: Market cycles typically begin with a liftoff from lows on very strong breadth and momentum. As the upward phase of the cycle matures, we begin to see increasing differentiation among stock sectors, with the strongest continuing higher and the weaker ones diverging. During this maturation, volumes tend to drop and, with them both volatility and correlation. During the more mature phases of a cycle, the intensity of buying pressure wanes, but selling pressure also remains low. It is when selling pressure picks up that we begin an actual down phase to the cycle. One of the ways I track the net buying and selling activity in the stock market is through the cumulative upticking vs. downticking of a wide variety of shares. You can think of this as an instantaneous advance-decline line, where every transaction across every stock is counted as a buy (uptick) or sell (downtick). When the cumulative line moves steadily higher, we have strong net buying interest. When it flattens out, we know that a greater balance of buying and selling is present. Please note that the job of a trader is not to shill for the bull or bear side of the market. Rather, the trader's job is to accurately assess what the market is doing now and adapt to the environment that is presented. Grounding a view of the environment in a wide variety of data is a way of staying cognitively and emotionally grounded and avoiding, as much as possible, biases in one's desires for upward or downward movement. Some of the best tools for trading psychology are tools for accurate market analysis.
The top three charts represent the cumulative upticking vs. downticking for all NYSE shares (top chart); all U.S. stocks traded on major and regional exchanges (second chart); and the Dow 30 stocks (third chart). (Data obtained from e-Signal). This gives us three perspectives, from the large caps (Dow stocks) to the broad market (NYSE stocks) to the entire stock universe (U.S. stocks). Note that all three display a notable sharp upward trajectory from the October lows. Quite simply, buying interest has consistently outweighed selling interest, and that has not abated. From that perspective, the rally is quite intact.
Does that mean all is rosy in the stock universe? Not quite. As the bottom chart illustrates, fewer shares have been closing above their upper Bollinger Bands as we've moved higher recently. Similarly, fewer shares have been registering fresh new highs vs. lows. For example, we closed at a new high on Thursday, but only 897 common stocks across all exchanges registered fresh monthly highs. Just a few days earlier, on October 31st, we rang up 1975 new monthly highs. We're just starting to see some divergences in the upside activity of stocks, with Russell and NASDAQ shares lagging the SPX of late. Such divergences can continue for a while during the maturation phase of a market cycle, so I don't expect any new bear leg in the immediate future. It is when we see cumulative selling interest start to equal and exceed buying pressure that we know that a cycle is getting long in the tooth. The top two charts illustrate that quite nicely during the September topping. Nothing like that is happening quite yet, but we are seeing glimmers of differentiation in the patterning of market strength. Further Reading: Measuring Buying and Selling Power in the Stock Market
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Thanks to Bella at SMB for pointing out this excellent article on getting better at getting better across multiple areas of performance. As the author of the article points out, "Today in sports, what you are is what you make yourself into. Innate athletic ability matters, but it's the base from which you have to ascend. Training efforts that forty years ago would have seemed unimaginably sophisticated and obsessive are now what it takes to stay in the game." The article refers to this high performance trend as "the mainstreaming of excellent habits". Because conditioning, practice, and training are now routine aspects of many performance activities, the average level of ability has risen significantly in recent decades. As Mark McClusky points out in his book Faster, Higher, Stronger, this has created a competitive landscape in which many tiny, continuous improvements compound to create world-class success. The heart of successful performance improvement is constant measurement of processes and outcomes and frequent feedback to performers to facilitate learning. Consider an example from the article: athletes wear special training goggles that temporarily interfere with their vision while they perform a computer task. This trains them to adapt to situations in which vision becomes hazy and make the right, rapid responses. It's a small, focused improvement but, combined with many other small, focused improvements, it makes the difference between good and great.
Continuous performance improvement in trading begins with the collection of informative metrics. Metrics can reveal our patterns of success and failure; they can also anchor goal-setting for improvement. My experience is that trading is more like teaching in the U.S. and less like athletics, in that the collection of detailed metrics is rarely undertaken in a systematic way. Take a very simple example: Many traders enter a trade with a particular size and add to the position as it goes their way. Does this entry execution, over time, add value or detract compared to entering all at once with a larger, standard size? Does one method of entry execution work better in higher volatility vs. lower volatility markets? In breakouts from ranges vs. ongoing trends?
The point is that most traders don't know the answers to these--and so many similar--questions. The difference between one approach to entry execution and other might amount to a few basis points of return per trade. Consider, however, that the same could be true of exit execution, position sizing, and holding periods. Cumulatively, seemingly small and mundane changes in money management can easily make the difference between profitability and looking for a different line of work.
Here's another example: When many traders have an idea (go long stocks; buy the dollar), they express their view with a particular index or currency pair (SPX, EUR/USD). Suppose, however, the view was expressed across multiple indexes or currencies. How would that affect performance over time? What if the view was expressed with the index or currency displaying the highest relative performance at that time? Would this enhance or detract from results? Few traders gather the data needed to answer these questions.
Meanwhile, computers can test all of those possibilities. A good system designer can make a small, meaningful performance improvement in a matter of hours. This enables systems to adapt and learn from experience, while the average discretionary trader relies on untested rules and embedded traditions.
The bottom line is that if you're a performance athlete of trading, you have to spend as much time studying yourself and your performance as you spend studying markets. It's no longer enough to get better haphazardly. The peak performers are those who keep getting better at getting better.
I recently conducted my own mental survey: I identified the young traders I had seen grow into successful money managers with superior track records of risk-adjusted returns. I then asked myself how they achieved their success. What were the ingredients that enabled them to evolve from junior roles to ones of unusual achievement? Three factors stood out: 1) Diligence - All of the successful young traders were workhorses and not show horses. They put significant time into studying markets, learning from others, and learning from their mistakes. All spent much more time in preparation, research, and idea generation than in trading. They also displayed diligence in managing their capital. All were very good at being open-minded, recognizing when a trade was not working out, and limiting losses. This diligence in preserving capital helped them not lose too much money during their learning curves. 2) Mentorship - Every single young trader I've seen go from zero to hero, where I directly observed the evolution, has benefited from a high degree of mentorship. I am not talking about taking trading courses, reading trading books, or working with "coaches". Rather, I'm referring to working side by side with a talented senior trader; observing their preparation, research, trading, and risk management; and absorbing the lessons of those observations. There is a reason mentorship is embedded in most professional training programs, from the apprenticeships of master plumbers and electricians to the clinical rotations of medical students and the training of fine artists. Role modeling channels and accelerates performance development.
3) Originality - Every successful young trader I've observed and worked with has been "out of the box". They do not look at the same things as other traders, and when they do look at the same things, they see them in different ways. Their originality might show up in trading unique markets, unique strategies, or finding unique expressions of ideas. While they learn a great deal from mentorship, their creativity enables them to absorb the *process* of the successful mentor, but apply that process in ways that make it entirely their own. They do not follow the herd and they have enough confidence in their judgment that they can act on their unique views.
I believe the combination of these factors helps explain why success eludes many new traders. Some lack diligence and look to trading as a way to avoid working for a living. Others are hard-working, but have not found the mentorship needed to guide their development. Still others are easily swayed by media and those around them and fail to cultivate signature strategies with an edge.
I was recently reading a report from Charles Kirk to the traders that he mentors. A decent portion of the report outlined a trade setup that he had missed. Kirk clearly identified the error, owned it, and explained how he would learn from it. That's the difference between a genuine mentor and a would-be guru. Mentors are talented, but they are not perfect. They offer learning experiences from their expertise, but they also aid learning via their mistakes. You're most likely to learn from others if they themselves embody diligence, the capacity for teaching, and originality.
Here are two charts that display the extremity of the moves we've recently seen in the U.S. stock market. The top chart shows the percentage of SPX stocks that close each day above their 20-day moving averages. (Data from the Index Indicators site). Notice how deeply oversold we became at the October lows and the sharp breadth thrust upward we've seen since then. More than 90% of all stocks in the index are now trading above their 20-day averages, the highest level we've seen in 2014. That is not what we'd expect from a weakening market. The bottom chart displays a five-day moving average of the equity put-call ratio across all options exchanges. (Data from e-Signal). Again notice how extremely bearish sentiment became at the October lows and how quickly we've snapped back to normal sentiment levels.
In general, sentiment tends to hit a bullish extreme prior to price highs during intermediate-term market cycles, and breadth also tends to crest ahead of price. Given that we have seen strong upward momentum lately, my expectation is that a price peak for this cycle still lies ahead of us. While sentiment is nowhere near as bearish as it was at the middle of last month, neither is it at a bullish extreme, despite the recent strength.
Immortality may be a stretch goal, but is it possible to live longer lives with more quality to our years? A collaboration among Dan Buettner, National Geographic, and a research team resulted in the identification of a group of "Blue Zones" around the world, in which people lived to the age of 100 ten times more often than occurs in the U.S. They examined what differentiated the people who lived in the Blue Zones from those in countries with less longevity and found nine important factors:
1) Physical activity; 2) A strong sense of purpose; 3) Daily downshifting and relaxing; 4) Eating in moderation, with least intake late in the day; 5) Less eating of meat and more consumption of fruits and vegetables; 6) Moderate consumption of alcohol; 7) Participation in a faith-based community; 8) Strong family ties; 9) Strong social support system. What I find fascinating is that many of these factors boil down to physical, emotional, and social well-being. I recently posted on the topic of a training program for happiness. If you combine such a program with healthy eating and physical fitness, you have most of the ingredients of a longevity program. Especially interesting are factors two and seven above: possessing a strong sense of purpose and participation in a faith-based community. What this suggests is that values matter when they are lived: we are most likely to live healthy lives when we are acting upon our deepest values and beliefs. A meaningful life tends to be a healthier, longer life.
I was interested to see that Buettner has teamed up with researcher Ed Diener to create an online test of happiness based upon the Blue Zone findings. I took the test and scored A-. The feedback report gave suggestions of improvements I could make to bring my score higher. Most pertained to improving the nature and quality of my social life--suggestions that make good sense to me.
* Above is a chart I constructed that is a running, cumulative total of NYSE stocks giving buy vs. sell signals for Wilder's Parabolic measure (raw data from Stock Charts). You can see that the measure tends to peak and valley ahead of the overall market during intermediate-term cycles. It is but one measure I track that is at or near levels that have corresponded to past momentum peaks. If, however, this recent move higher truly is a fresh bull leg up in the market and not part of a broader topping picture, then we should see this and similar measures stay persistently above the zero line. * Here is a different perspective on breadth from the very savvy Trader Hacks site. David points out that not all market indexes are displaying strength. I find when people vocally disagree with something I write and offer no evidence whatsoever, it usually makes sense to double down on my positions. When people disagree and offer a variety of evidence, it usually makes sense to revisit my positions.
* Some great links from Abnormal Returns, including a very thoughtful account of how passive investing is impacting the nature of stock market corrections.
* Excellent video from Marcos Lopez de Prado on the dangers of backtest overfitting, selection bias, and other biases that affect quantitative finance. If you conduct enough tests, you're likely to find something "significant". And if you find enough "significant" results, you'll eventually find ones that accord with your views! * Here is a very clearly laid out argument for raising income tax rates to 80% for the highest earners. Here is a well-constructed counter argument debunking the notion of income inequality. I won't reveal where I stand on the issue, but do note that I find it fascinating that confiscation of 100% of the fruits of a person's productive labor is slavery, but confiscation of 80% constitutes progressivism.
I recently noted that we can learn quite a bit from the relative performance of stock market sectors. The same is true for the relative performance of financial assets in general. How traders and investors deploy their capital speaks volumes regarding sentiment and perceived opportunity. Today's post begins a series on using ETFs to create informative relative indicators. In this post, we're looking at a few relevant fixed income ETFs and what we can learn from their relative performance. The top chart is a relative measure I've tracked for a while: the relative performance of high-yielding corporate bonds (JNK) to high quality corporate bonds (LQD). In general, when investors are risk-seeking and feel secure about economic conditions, they are willing to reach to pursue lower quality fixed income assets and obtain higher yields. Conversely, in a risk-averse posture, investors will flee lower quality assets and seek the safety of high quality. This is precisely what we see in the relationship between JNK and LQD. Dips in that relationship have generally corresponded to risk-off periods in the stock market. Note that JNK:LQD topped out well ahead of the stock market and, indeed, is below the peaks seen in 2010 and 2011. It appears that the reach for lower quality yield has been diminishing in recent years relative to the reach for stock market returns. More on that in a bit. The second chart takes a look at the relative performance of high quality bonds (LQD) to stocks (SPY) overall. Again, we see the pattern of bonds outperforming during risk-off periods in the stock market, but notice how very attenuated this pattern has become in recent years. Quite simply, high quality bonds have been in a downtrend relative to stocks in the past few years, in part reflecting the crushing of yields due to the zero interest rate policies of the Fed. (A chart of stocks versus international bonds looks quite similar). As bonds have gone out of relative favor, the volatility of the stock/bond relationship has decreased notably, so that--during risk-off periods--we're seeing less flight to quality vis a vis bonds than during 2010 and 2011. The bottom chart looks at the relative performance of a higher yielding stock sector (XLU) versus stocks overall (SPY). Note a similar downtrend and declining volatility, though not as pronounced. The defensive sector still tends to outperform during risk-off periods, but as these periods have been milder in recent years, we're seeing less investor flight to safety. I believe tracking the relative performance of fixed income to stocks continues to provide information, but anchoring our expectations on relationships we observed pre-2012 would be a mistake. Swamping the relative rotations from stocks into yielding instruments has been that Great Rotation that has been anticipated for years: with artificially low interest rates, money has systematically moved from fixed income into equities. This is a major dynamic underpinning the current bull market. After all, even with the recent bull market action, stocks still yield more than most bond funds. Amidst very low bond returns, the flight to quality has been replaced by a flight to opportunity. I suspect this, too, shall end badly at some point. With commodity prices on their back and inflation nowhere in sight--and with central banks overseas in further asset-buying modes--it is difficult to see yields rising in the near term. Should this continue to fuel stock market interest, we could see shares move from generous valuations (and rich ones in some cases) to unsustainable ones. One sign of this would be a similar flight to stocks across Europe and Asia, whose stock markets have lately underperformed the U.S., but who now are further embarking on their own currency-devaluing, yield-crushing rounds of asset purchases.
We live in strange times. One takeaway from the relative fixed income indicators may be this: In a global world, the old stock market wisdom of "Don't fight the Fed" has been replaced by "Don't fight the banks." Further Reading: Risk Management and Learning from Losses .
I know when the bears are hurting, because out come the daggers for the central banks. I've been in the business quite a while and I've yet to hear a trader attribute his or her profits to central bank manipulations. That being said, the ferocity of this rally has taken many traders by surprise, and that certainly includes me. My most recent look at market breadth suggested that market strength was actually expanding, not contracting as it had done from much of June through September. I suggested some give back was to be expected, as many of my measures were approaching levels associated with past momentum peaks, but the news from Japan on Friday only lifted stocks further.
Meanwhile, correlations and volatility remain high--not what we normally see when rallies are sputtering and about to turn over. We are accustomed to seeing stocks fall on increases in volatility and rise on decreasing volatility. In terms of realized volatility--not the implied volatility measure of VIX--this has not been the case. We have rallied on actual price volatility that is much greater than would normally be expected at the current level of VIX.
While there are clear risks to assuming "this time is different", there are also risks in assuming that the future will faithfully replicate the past. This rally has not been replicating recent ones, and that is why I and others have been surprised. In the past, a several day pullback during an uptrend has provided a reasonably good risk:reward entry for traders wanting to ride the trend. Waiting for the pullback in the current market would have meant missing the rally altogether. Short-term overbought levels have stayed overbought far more persistently than usual. To give but one example, we have had 11 straight trading sessions in which more than half of all SPX shares have closed above their three-day moving averages.
The above charts puts this rally into perspective. Note the cumulative line of upticks vs. downticks for all NYSE stocks (top chart) and for all stocks trading on U.S. exchanges (including NASDAQ, NYSE MKT LLC, and regional exchanges). In both cases, we see a dramatic turnaround and persistent buying across the broad range of shares. Interestingly, the broadest measure of TICK, representing all U.S. shares, has made the strongest comeback, reflecting renewed buying interest among smaller cap shares, which had been laggards.
The bottom chart shows the explosion of stocks making new three-month highs vs. lows across all U.S. common stocks. When looking at 52-week new highs/lows, that measure is the strongest we've seen since late 2013. This reinforces the earlier conclusion that the current market has been gaining strength, not topping out.
In short, the data support the notion that this is a fresh bull market leg, not a bounce in a topping market. If that is the case, we can expect further price gains, even after momentum has crested. I will be tracking the above measures and others to update the rally's trajectory.
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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), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. 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, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused "therapies for the mentally well". Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.
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