Wednesday, October 11, 2006

Putting the Market on the Shrink's Couch

How does a psychoanalyst analyze a patient? Contrary to popular image, it takes a bit more than sitting behind a couch, puffing a pipe, and giving occasional prods to, "Tell me more about that." What the analyst is doing is sampling streams of conversation from the patient, listening for tone and meaning, and gaining an appreciation for how those meanings are changing over time. This is particularly important after a major life event: very often before and after samples of a person's speech will reveal precisely how that event is being processed and how it has affected the individual.

So it is with markets. We sample one-minute streams of price and volume data and get a sense for where traders and investors place value, how those placements are shifting, and whether those estimates are relatively stable or volatile. By tracking market data streams before and after a major economic release, we can put the market on the couch and gain some insight for how investors are reading the tea leaves.

The chart above displays the S&P 500 (ES) futures three days prior to and three days after the release of the jobs data on 10/6/06. What we see is that the character of the market changed significantly following the release. Where we had been trending upward, we now entered a choppy trading range. Where the market had traded with reasonable volatility (the standard deviation of prices before the release was 7.53) prior to the release, volatility waned (standard deviation of prices of 2.06) after the release.

Prior to the release, on 10/4, I counted 794 stocks that closed above the volatility envelope surrounding their 20-day moving averages. Only 123 issues closed below their envelopes. The respective numbers on 10/5 were 494 and 154. For the three days following the release, only 188, 314, and 284 stocks closed above those envelopes, but 387, 198, and 259 closed below. In short, upside momentum among individual equities has waned since the jobs data.

And what's been happening in other markets during this transition? For the three days prior to the release, the yield on the 10-year note dipped from 4.616% to 4.608%. During the three days after, yields have climbed to 4.748%. The Euro, which moved narrowly against the dollar in the three days before the release, has steadily moved lower (i.e., the dollar has appreciated) from 1.27650 to 1.25880.

What might market shrinks conclude? Perhaps this: The markets have interpreted the jobs numbers as signs of economic strength. They were less taken with the modest increase in jobs reported and more impressed by the 50% upward revision of the prior data. With the indication of strength, expectations of Fed easing were reduced, rates backed up, and this helped support the dollar. Stocks, however, have not found additional buyers in the face of rising rates and a firmer dollar. Interestingly, the average one-minute volume in those S&P 500 futures has been about a third lower (2532 vs 1765) after the release compared with after. The average NYSE TICK reading before the release (showing how many stocks at each moment are upticking vs. downticking) dropped from 343 to 264.

Yes, the presence of a holiday might account for some of this, but somehow I think traders could have mustered more enthusiasm had they loved the jobs data. When a patient's stream of conversation changes after an event, the analyst concludes that the event has special meaning and impact. This creates a window into the mind of the individual. This market shrink looks at the jobs data release and finds a similar window into the mind of the market.