Thursday, August 30, 2007

Trading by Herd: What Makes This Market Distinctive

We've now had four consecutive days in the stock market in which we have closed very near either the day's high price or the day's low. Even more surprising, all four days have seen either up volume or down volume as 75% of the day's total volume. What that means is that traders are trading in a herd. They're either jumping on the long side or the short side.

How unusual is such herd trading? Well, I went back to March, 1965: a total of 10,676 market days. Over that span, we've only had 17 occasions in which four consecutive days in have displayed either up volume or down volume equal to 75% of the day's total.

Those 17 occasions fell into several market periods:

* May, 1966
* August, 1966
* October, 1982
* October, 1987
* September, 1998
* Late July/Early August, 2002
* March, 2004
* May, 2004
* Late May/Early June, 2006
* June, 2007
* Late July, 2007

Following these 17 occasions, the S&P 500 cash index was higher 12 times, lower 5 after 20 trading days. The average gain was 3.20%, much larger than the average 20-day gain of .62% for the remainder of the sample.

Note also that many of these periods represented good buying opportunities in the market for at least the intermediate term.

But maybe it's not the directional bias that's the most important finding here. Observe the distribution of herd periods over the 1965 - 2007 period. Two occurred in the 1960s, none in the 1970s, two in the 1980s, one in the 1990s, and six since 2000!

In other words, we're seeing more herd like movement on the day time frame in this decade than in any prior recent decade. I attribute this to the concentration of funds in large institutions and the increasing involvement of those institutions in high frequency, algorithmic/program trading. If that's true, we can expect--especially in times of uncertainty--increasing trending and volatile behavior during the market day, as large traders either run for the exits or enter the markets simultaneously.


Who Controls the Markets?

Tracking the Market's Large Traders