Ratio Charts and Tracking Sentiment in Real Time

In my recent post, I mentioned the behavior of key financial stocks as a sentiment measure. Today's trade gave us a nice example.

You may need to click the chart to see more clearly. This is a two day, five-minute ratio chart that is tracking the ratio of the price of MBIA stock (MBI) to the S&P 500 Index (SPY). So what we're really looking at is the relative strength of MBI in real time. When MBI is outperforming SPY, it suggests confidence in the credit situation and a willingness of traders to assume risk. When MBI is underperforming SPY, it suggests a lack of confidence in the credit situation and a risk aversion.

Note that we saw risk aversion going into the Fed meeting yesterday and then especially after the announcement. Credit concerns trumped the news of the 50 bps rate cut.

Today, we opened with a spike down, and it looked as though credit worries and risk aversion would dominate this session as well. Note, however, the dramatic reversal 15 minutes into the session, which completely altered the tone of the day. We never took out the overnight lows and, indeed, roared to a solid gain in SPY.

I'm using Real Tick to construct these ratio charts; they can be tracked in real time just as normal price charts. Trends and breakouts have important meanings in ratio charts, as in price charts. In this case, the reversal in the chart reflected an important reversal in sentiment that left bears scurrying to cover their shorts.

Quick Market Update

Twitter's down this AM, so I thought I'd post some of my pre-opening material to the blog directly. Reviewing market indicators, overseas markets, and key news items is a major part of my preparation for the day's trade.

At 7:30 AM CT we have Personal Income and Employment data coming out; at 8:45 AM CT, we have the Chicago NAPM numbers. I generally watch fixed income and the dollar as well as stock indexes to gauge whether the markets are treating the data as important new information.

Shares in Europe are down over 1%; the Nikkei was up a little less than 2%; Hong Kong was down almost a percent; and China was down almost 2%. The yield on the 10-yr Treasury is down to 3.61%. Crude is down; gold up. ES futures down almost 6 pts.

Bond insurer woes dominate the news; check my recent post.

Wednesday we saw continued expansion of new 20-day highs--up to 1056--but new lows also expanded to 360. I'll be watching to see if that expansion of lows continues. We have only 23% of SPX stocks trading above their 50-day MA and 21% above their 200 day MA, down from Tuesday. Interestingly, however, short-term momentum continued positive on Wednesday, with Demand at 87 and Supply at 57.

Note the above Advance-Decline Line specific to NYSE common stocks, one very helpful indicator tracked by Decision Point. While the recent rally has been impressive, it has made only a slight dent in this weak indicator.

We've been seeing dollar weakness of late; gold strength. Fed rate cuts amidst economic weakness are contributing to that relationship. This is another sentiment measure I'll be writing about.

Four of the five financial stocks that are part of my basket are trading in uptrends, according to my Technical Strength work; I'm watching that sector closely to see if we get deterioration. As those shares have gone, so has the market overall per my recent post.

Brett

Tracking Confidence in Financial Stocks: Identifying Short-Term Sentiment

I interviewed with a reporter from a German language magazine recently, and he asked a good question: With all this volatility, how can a short-term trader know whether to be buying or selling? He observed that it seems as though the market is down sharply one day, up sharply the next, and then down again.

There are many short-term sentiment gauges that can be helpful to the intraday trader. These include equity put/call ratios and the TICK (number of stocks traded at the market offer minus the number of those traded at the market bid).

A different way of assessing sentiment, I explained to the reporter, is to gauge whether the market is trading in a confident or frightened mode. We can identify this, I suggested, by tracking the market's most vulnerable issues.

Above we have three stocks that have been quite vulnerable: MBIA (MBI), which is a major insurer of bonds; Citigroup (C), which is dealing with the credit crisis; and Federal National Mortgage (Fannie Mae; FNM), which is reeling from the housing crisis. The trajectories of these shares has been breathtaking to the downside. They are the equivalent of the tech stocks during the 2000-2002 bust.

We have been seeing aggressive steps from the government and central bank to address the economy overall and the concerns affecting these shares specifically. When the market feels confident, it expresses this confidence by picking up financial stocks such as these in hopes of finding bargains. When the market is fearful of credit-related collapse, it dumps these shares.

If we look at the movement in MBI, C, and FNM as a kind of sentiment gauge, we find that sentiment swings have become exaggerated in 2008 thus far. The average size of the daily price changes in MBI, C, and FNM during 2007 were 2.59%, 1.28%, and 1.98% respectively. During 2008, those average daily swings have averaged 11.99%, 2.56%, and 4.30% respectively. It's not just that traders and investors have become more bearish on these shares; the variability of their assessments of the companies has become more volatile. Manic-depressive might not be a bad term for current sentiment regarding these financial stocks.

Why does this matter? It is difficult to imagine sustaining a fresh bull market while investors nurse concerns over the financial system. During 2008 to date, the daily correlation of price changes between the stocks and the S&P 500 Index (SPY) has been:

MBI and SPY: .42
C and SPY: .91
FNM and SPY: .61

That is, when these stocks rise, it's likely that the overall large cap market is rising; when the fall, the entire market tends to be falling. Correlation does not equal causation, but when these financial shares are acting weak, it's generally been a good sign that the market overall is harboring concerns worthy of attention. That was most recently evident when MBI failed to confirm the overall market strength prior to and immediately following the Fed announcement yesterday.

And how about volatility? Here's the day-to-day correlations between the absolute size of daily price moves in MBI, C, and FNM with SPY for 2008 to date:

MBI and SPY: .36
C and SPY: .79
FNM and SPY: .36

In other words, when these financial shares are more volatile--one way of detecting the degree of manic-depression in sentiment--the market as a whole tends to be more volatile. Again, correlation is not causation. Rather, it suggests that variability of sentiment regarding these shares is closely aligned with variability of market sentiment overall.

By tracking strength and weakness in these and similar shares intraday, we can identify confidence and fear regarding the financial system--and especially track the ebbing and flowing of these emotions. Along with the shares of homebuilders and Treasury prices (which reflect flight to quality vs. risk seeking movement out of bonds), these are among the short-term sentiment gauges I'm currently finding most useful.

The Key to Breaking Trading Slumps

I'd like to add just a few words of perspective to Chris Perruna's worthy post on the topic of focusing on decisions rather than outcomes. In a larger sense, I'm interested in using posts to initiate some cross-blog discussions of issues: sometimes to agree and elaborate, sometimes to respectfully disagree and offer alternatives. If you're a financial blogger taking a reasoned stand on an issue or taking the time to elaborate a point of importance to traders, by all means send me your URL and I'll do my best to include your work in a discussion post.

OK, back to Chris. He emphasizes that:

"...too many investors focus on the short term results or the money won and lost in each trade rather than the net result. The idea of the game is to make the right choices and understand that some of those choices will turn out to be losers. Losers are part of the game and must not affect you emotionally as long as the decision was correct."

This advice is spot on. Performance anxiety occurs when we become so concerned with the outcome of a performance that our worries interfere with the process of performing. Who hasn't had the experience of fretting over making a perfect entry, only to have the market make its move without you on board? Or seeing a market move away from your entry point and telling yourself you won't "chase" the market, only to see it make the extended move you expected all along? Those are manifestations of performance anxiety.

The cure for performance anxiety is twofold:

1) Temporarily reduce size - Take P/L out of the equation, at least for a short while. Once you don't have to worry about profits and losses, you're free to focus on the markets and what they're doing. When you get your rhythm back, gradually bump your size back up, maintaining the consistency of your execution and trade management.

2) Keep yourself focused on process goals - Your goals should focus on how you trade, not how much money you'll make. You cannot control the profitability of any single trade; at any time a news report or spate of program trades can stop you out. What you *can* control is *how* you trade: how you enter trades to maximize reward and minimize risk; how you set stop loss points; how you size positions; etc.

In my own trading, I have a minimum trade size (1 unit) and a maximum (6 units). Most trades, under conditions of average volatility, will enter with 3 units and build to the maximum if I have conviction in the trade. (When volatility is quite high, I'll enter with one or two units and build to 3 maximum. I prefer to keep my equity curve as constant as possible, having learned that--for me--high volatility does not always pose high opportunity).

If I'm in a losing spell, however, I'll cut my sizing in half until I regain my feel for the trade. That enables me to just focus on markets and how I'm trading. I'll review my most recent trades, identify what I'm doing right and set some goals to avoid doing what's lost me money.

In other words, during times of performance pressure, it is imperative to become process oriented. Many traders, as Chris points out, focus extra hard on performance during those times when they're not performing well. Imagine doing that in other areas of performance: public speaking or (perish the thought) sexual performance! The result would be a complete freeze-up. When we focus on outcomes, performance cannot naturally flow from our efforts. Work on process and outcome will follow. Chris' advice is key to breaking trading slumps.

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Continued Technical Strength: Revisiting the Sectors

My Technical Strength measure is a quantification of short-term trending in any stock or index; it assesses both slope and the stock's goodness of fit to that slope. A perfect uptrending stock would merit a reading of +100; a perfect downtrending stock would be -100. A zero score, or a score near zero, would be considered neutral (no trend).

By monitoring Technical Strength across 40 stocks (five highly weighted issues from each of eight S&P sectors), I get a sense for whether the market is picking up or losing strength over time.

At last week's market bottom, we saw only 1 stock in an uptrend and 39 in downtrends, with the 40 stocks providing a Technical Strength Reading below -2300. That means that the average score for each stock was below -55.

At present, we have bounced nicely off the bottom. At Tuesday's close we have 14 stocks displaying technical strength (DOW, BA, AA, UTX, CMCSK, HD, WMT, WAG, AMGN, C, WFC, BAC, JPM, and IBM). Note that three are from the Financial sector that had been among the weakest of the sectors throughout the decline.

We're also seeing 10 stocks in neutral mode: DD, IP, UPS, WY, MO, COP, OXY, LLY, AIG, and MSFT.

That leaves 16 stocks still in downtrends: GE, MMM, TWX, DIS, MCD, PG, KO, XOM, CVX, SLB, PFE, JNJ, MRK, INTC, CSCO, and VZ.

Overall that leaves us with a Technical Strength score of -380, a considerable improvement over the last several trading sessions. That means that the average stock rates above -10, a neutral reading.

The Technical Strength breakdowns by sector are as follows:

Materials: +120
Industrials: -20
Consumer Discretionary: -120
Consumer Staples: -80
Energy: -120
Health Care: -200
Financials: +200
Technology: -160

Note that sectors that had been very weak (Financials and Consumer Discretionary) have strengthened considerably. Areas that had been strong (Health Care, Energy, Technology) are now weaker. Much of the recent strength has also brought a shift of assets among sectors, with the leaders on the downside now outpacing to the upside.

Reviewing Markets Ahead of a Fed Day

* Finding Hope - We've seen ferocious rallies off the lows for two of the most beaten down sectors: homebuilders and banking issues. Both are up over 20% over just six trading sessions. The housing sector has recovered nearly all of its drop since December, suggesting that some on Wall Street may be looking beyond the anticipated continuation of weakness in 2008.

* Continued Strength - On Tuesday, we saw an expansion of fresh 20-day highs to 797. New 20-day lows remained low at 215. Momentum remains positive as well: We're now seeing 26% of $SPX stocks trading above their 50-day moving averages, up from 8% at the market lows. Shorter-term, my measure of Demand closed Tuesday at 109; Supply was 23.

* Market Ideas - Abnormal Returns offers more fine links, including the possibility of a bottom being put into place and a reflection on trading goals for the year.

* Wave Analysis - Ray Barros offers his take on the market's wave structure and his updated targets for the S&P 500 Index.

* The Business of Trading - Thanks to a reader for pointing out this interesting book review from the Alea blog. The absence of high quality training for traders, even in high-level settings, is amazing. I've yet to see a trading organization embrace the research on expertise and seek to develop traders accordingly.

* Disjointed Markets - The Quantifiable Edges blog examines what happens when the NASDAQ and Russell 2000 Indexes become disjointed.

* Trading Ideas - The Actionable Ideas blog offers trading ideas in tech and healthcare, as well as macro ideas.

* Not Such a Bargain? John Mauldin's latest offering, summarizing James Montier, finds valuations historically high among stocks, even with the latest decline.

What Makes an Expert? Three Surprising Research Conclusions

The goal of every serious trader is to acquire expertise: the ability to succeed across a variety of market conditions over time. A recent study that I reviewed found that such expertise is rare indeed, perhaps as uncommon as 1 in a thousand. The same researchers, however, found that such expertise *does* exist: a small core group of traders persist in their success year after year.

So what makes an expert? How can traders guide their own development and become expert traders?

A research summary from K. Anders Ericsson, a leading researcher in the field, offers three surprising conclusions:

1) "Measures of general basic capacities do not predict success in a domain" - Experts cannot be distinguished by their superior intellects or other cognitive talents. This suggests that, while certain inborn traits and lack of capacities might prevent the development of trading expertise, the presence of particular native talents cannot ensure success.

2) "The superior performance of experts is often very domain specific and transfer outside their narrow area of expertise is surprisingly limited" - Being an expert in one domain does not predict expertise in others; a person can be a highly accomplished trader, but not expert in other areas. Moreover, a person can be an expert scalper or portfolio manager and yet fail at other forms of trading. This is the notion of "niche" that I describe in my book: the successful trader has found a particular sphere of success that expresses his or her skills and interests.

3) "Systematic differences between experts and less proficient individuals nearly always reflect attributes acquired by the experts during their lengthy training"- A saying among expertise researchers is that practice does not make perfect; perfect practice makes perfect. The expert is one who has undergone a structured, deliberate process of training that builds competencies, offers extensive feedback, and draws upon intensive effort over time to internalize knowledge and skills.

What does this mean for traders? Here are three conclusions of my own:

1) The majority of traders are looking for expertise in all the wrong places. They look for *the* right trading charts, indicators, setups, or systems. They are like beginning golfers who think they'll succeed if they only get the right set of clubs. Because they hope to get "the answer", they expect success in a year or two. The research is unequivocal: expertise develops over a period of many years. If those years are not structured properly, traders will repeat a single year's experience ten times; they won't acquire ten years of experience.

2) The vast majority of offerings in trader education are not structured for expertise development. Seminars, books, Web articles and blogs, weekend courses--all can be useful in imparting information. But expertise development is not simply about the accumulation of information; it is about skill development under realistic, challenging conditions. No doctor, athlete, or musician could acquire expertise by attending seminars or reading books alone. The same is true for traders.

3) The reason most traders fail is that they never enter a path of expertise development. It is rare to find training programs of any quality and substance at proprietary trading firms; one finds mentorship at investment banks and some hedge funds, but this is very hit or miss depending upon the commitment of the mentor and his/her skill in imparting skills and structuring a learning process. The independent trader has even fewer resources to generate and sustain an accelerated learning curve. There is much more to acquiring expertise than keeping a journal and trying to follow a simple plan.

So what does a trader need to progress from being a novice toward becoming competent toward exhibiting expertise? A curriculum: a structured process, like physicians undergo, that begins with information and understanding and then progresses steadily through skill development. In my next post on this topic, I'll explore what such a curriculum might look like.

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When Bearish Sentiment Hits an Extreme

The American Association of Individual Investors (AAII) conducts a weekly poll of investor sentiment that, over the years, has been reasonably good as a contrary indicator. This past week, the percentage of bears in the survey hit 59%, a historically high number.

Going back to 1987, which is when my weekly AAII data begins, we've only seen one other period with similar bearishness: very late August and mid October, 1990. Other periods with more than 50% bears have included February, 2003; July, 2006; October, 1992; October, 2002; May, 2007; and November, 2007. Most of these were superior opportunities to be buying stocks for at least the intermediate term.

The chart above takes the percentage of bears minus bulls in each weekly survey since 2002 and plots the resulting difference against the S&P 500 Index (SPY). We can see that bearishness has been increasing of late--including the current period--which is why three of the highest bearish readings since 1987 have occurred within the last year.

Going back to 2002 (N = 307 weeks), we had 88 occasions in which bearish sentiment has been greater than bullish sentiment in the AAII poll. Five weeks later, the S&P 500 Index (SPY) has averaged a gain of .90% (60 up, 28 down)--much stronger than the average five-week gain of .39% (127 up, 92 down) for the remainder of the sample.

Indeed, when bears have outnumber bulls by 20% or more since 2002 (N = 14; as is the case at present), SPY has been higher on 13 occasions, by a whopping average of 3.63%.

When bearish sentiment hits an extreme, it generally means that the bears have largely done their selling, setting up conditions for short-covering and some value-oriented buying.

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Indicator Update for Monday

Every week I go over my major indicators and try to get a bigger-picture view of the markets and what they're doing. I find this perspective helpful in framing shorter-term trades. This morning we're looking at equity weakness in Europe and in the premarket U.S. trading; Hong Kong and Shanghai were particularly weak overnight. The big issue is whether we weaken day-over-day and retest last week's lows or strengthen and retest the highs. It's a very wide trading range, and it wouldn't surprise me to see us stay rangebound ahead of the Fed announcement. I'll be tracking markets and news on the Twitter app as usual this week, with AM updates of indicators. The latest five Twitter posts appear on the blog home page under "Twitter Trader".

* Sentiment - We had very strong Adjusted NYSE TICK readings last week. Even Friday's decline yielded a reading of only -81. Accordingly, the Cumulative TICK Line has turned up sharply from the recent lows. One thing I've noticed of late with the TICK is that we get raw value readings of around +500 on short-covering; readings of +800 and above have been signifying initiation of buying--especially when those heightened readings have been sustained. Because we're looking at TICK as a sentiment measure, we want to see how spikes in TICK--up and down--affect price. In a trending market, we'll see TICK peaks at higher price highs (in bull swings) and TICK valleys at lower lows (in bear swings). It's when we get extreme TICK readings that cannot move price to new highs or lows that we've seen some significant reversals.

* New Highs/Lows - As I recently posted, we've seen new 20-day highs outnumber new lows the past two trading sessions. I'll be watching carefully this week to see if we get an expansion of new lows day-over-day. That's the scenario that would lead me to expect a retest of recent lows. If we expand upon Friday's 663 new highs, I would be less inclined to chase the downside and would act on some longer-term expectations of strength following recent volatility. At this juncture, we're seeing day-over-day new high/low strength, even after Friday's weakness. That has me cautious about chasing the downside early today until I get a good read of the TICK distribution.

* Momentum - This, too, has been improving. Demand has closed higher than Supply for three consecutive trading sessions, despite Friday's pullback. That means that more stocks are closing above their volatility envelopes surrounding their moving averages that closing below them. I have not found it profitable overall to hold longer-term short positions when momentum has been positive. Friday saw Demand at 60; Supply at 44. In a rangebound market, we tend to see attenuated readings for Demand *and* Supply (which is consistent with Friday's reading). Looking at momentum longer-term, we're still very weak. Only 11% of SPX stocks are trading above their 50-day moving averages, weakening from 15% on Thursday. Looking a bit shorter term, we see 26% of SPX stocks trading above their 20-day moving averages (down from 33% on Thursday), up from a dismal 8% at last week's lows. I need to see this number expanding to play the long side from anything other than a day trade.

* Technical Strength - Among my basket of 40 SPX stocks drawn equally from 8 sectors, five are displaying technical strength (a quantitative measure of trending); 9 are neutral; and 26 are displaying technical weakness. The Technical Strength Index overall is -1540, still in bearish territory. What that's telling us is that, despite the strength of the rally off last week's lows, the rally was still small compared to the magnitude of the prior decline. The rise in the number of stocks with neutral readings is encouraging--that typically occurs when a downtrend transitions to an uptrend--but it is too soon to jump on the bull's bandwagon. Once again, it's day-over-day strength or weakness that is key here; in a range market we'll see a large number of neutral readings.

I found it helpful last week to track the financial stocks, semiconductors, and the homebuilders. Optimism about economic stabilization, the impact of the Fed, and efforts to stimulate the economy has been showing up in those beaten-down sectors. Conversely, renewed weakness in those areas suggests concerns of a more lasting recession and has weighed on stocks overall. Tracking 10-year bond strength (falling yields) and rising yen/dollar has also been helpful in identifying the market's relative risk-seeking vs. risk aversion. Overall, I did not see high bearish conviction in Friday's drop, so will be watching this morning's weakness closely. I am sensitive to the possibility of a range market as we get closer to the Fed announcement.

Have a great week--

Brett

Relative Volatility and Other Weekend Perspectives

* Spikes in Volatility - Above we see a chart from 1990 to the present, mapping out the ratio of the average daily high-low range over the past five sessions in the S&P 500 Index ($SPX) to the average daily range over the past 200 days. Spikes in this measure of relative volatility have occurred in August, 1990; April, 1994; July, 1996; October, 1997; September/October, 1998; July, 2002; and August, 2007. On the whole, these were good times for intermediate-term stock purchase. We are currently seeing another such spike at present. Going back to 1990 (N = 4535 trading days), we have had 80 occasions in which the ratio of five-day volatility to 200-day volatility was above 2.0. Ten days later, the S&P 500 Index averaged a sizable gain of 1.95% (57 up, 23 down). That is much stronger than the average ten-day gain of .32% (2584 up, 1871 down) for the remainder of the sample.

* Fed Perspectives - We're coming up on a Fed announcement this week, and Charles Kirk has linked several perspectives on what to expect; see also the link to the shocking list of large companies that may go away in 2008.

* Textbook Pattern - Trader Mike charts the support that is now acting as resistance across the major averages.

* Share Buybacks - Abnormal Returns returns with more interesting links, including a look at whether stock buybacks live up to their promise.

* Discipline - Thanks to El Mercadillo de Europa for their Spanish language post on trading discipline.

* Weekly Wrap-Up - Phil summarizes the wild week that was; see also the Optionsage posts that are part of the site.

From Trader to Hedge Fund

I receive a fair amount of mail from experienced traders who express an interest in affiliating with a hedge fund. It's an understandable desire; there are many benefits to working at a fund. These include access to capital and research, superior trading infrastructure, and (often, but not always) the availability of colleagues for mutual learning and support. Timothy Sykes book An American Hedge Fund is an engaging and interesting account of his development as a trader in the heady late 1990s and his subsequent (and ultimately failed) foray into the hedge fund world.

Before I launch into discussion of Tim's book, let me provide some background for those readers not familiar with hedge funds.

As it happens, few traders end up making the leap to funds, even when they have talent. The reason is that most hedge funds are looking for multifaceted portfolio managers, not directional traders of single asset classes. That is, a portfolio manager (PM) will carry a number of positions in his or her book, many of which are not correlated and some of which may hedge other positions. Compensation for the PM is based on the performance of the portfolio, with a premium placed on risk-adjusted returns (i.e., the fund does not want a PM taking massive risks to make returns, a lesson recently exemplified in the SocGen episode). The portfolio, as a result, has to be diversified, and it has to hedge risk. Such hedging is often accomplished with options, futures, and other derivative instruments, not simply by adding to or taking off of positions.

For this reason, much of the day-to-day work of the PM is managing the portfolio--adjusting hedges, adding to positions at good prices, taking profits at good prices, stopping positions out at preset levels, keeping up to date on news and research affecting the portfolio, scouring for ideas to add to the portfolio; it is not taken up with daytrading. PMs may hold positions for a few days, a few weeks, or many months: much depends on their core strategies and competencies. At a good fund, traders will have expertise across a variety of strategies and markets, which provides the firm with diversification.

You can see why this is challenging for the average trader--even one who has been successful in a proprietary trading environment. At the prop environment, the game tends to be swinging leverage and trading a very limited number of positions at one time for short time frames. Very often the prop trader will trade one asset class only, such as bonds, currencies, or stocks. The trade for the prop trader is usually directional--they're expecting stocks or currencies to rise or fall over the life of the trade. It is not common to see prop and individual traders executing market neutral strategies, such as long/short stock trading; trades that exploit the yield curve; or relative value trades that look for deviations from (and returns to) modeled fair/historical value. It is also uncommon to find hedging strategies among individual and prop traders; quite often, they're either all in or all out and--if not--they're adjusting position size, not hedging with other instruments.

All of this is to say that being a successful trader and being a successful portfolio manager are different skill sets. A trader knows his or her market in depth--particularly at a short time frame--and masters particular strategies or setups. A portfolio manager has to know multiple markets and trade multiple strategies often across multiple time frames. Some of the best daytraders I know would make horrible PMs; and I've never met a PM who understands very short-term market movement as well as the best traders.

So now for An American Hedge Fund. Tim Sykes chronicles his rise as a short-term stock trader during the momentum-driven period of the tech stock boom and then after the market peak. That he was able to succeed in the markets even after the 2000 high is much to his credit; many traders blew up once the momentum game faded (and, ultimately, once volatility itself faded). Tim's book is subtitled, "How I Made $2 Million as a Stock Operator and Created a Hedge Fund". In an well-written narrative, he takes us through this journey.

Tim recounts his individual trades, as well as the lessons learned following (and leading) chat rooms and dealing with boiler room pump-and-dump operations. We learn about the strategies that worked for him--and then that stopped working. Against this backdrop is the growing optimism of a trader who found that college was more useful for its high-speed Internet connection than its courses. I found Sykes' story to be a nostalgic trip back to a unique period of market history; he captures its spirit well.

During the transition to hedge fund, Tim found himself overwhelmed with the paperwork associated with legal filings, documentation of compliance mechanisms, and the like. He had superior returns to show potential investors, but was frustrated by rules limiting hedge fund investment to high net-worth investors. Lacking the strong network of personal and professional contacts that would have come from a background in investment banking, he found it difficult to raise funds.

(Here's where it gets a bit tricky: Even without the SEC regs, Sykes would have found it difficult to raise significant capital. Just as hedge funds seek diversification among traders, very high net worth individuals and institutions--pension funds, etc.--seek diversification among funds. If a fund's returns are highly correlated with the general direction of the stock market, they can be easily replicated at low cost and will not add incremental "alpha" to the investors' returns. In a sense, Tim was not operating a hedge fund; he was continuing his trading under a hedge fund structure. This would not appeal to many money managers.)

As Tim chronicles, his ego got the better of him and led him to take very large short positions that put him in the hole early in his hedge fund career. This would have made it doubly difficult for him to raise funds; a 10%+ blowup over a short time period is not acceptable to investors that seek steady, positive returns. Sykes began his fund with only $1 million in trading capital--a very small amount in hedge fund terms. This by itself would limit the number of positions and strategies that he could employ, particularly after the early loss. After subsequent large losses, he tried returning to his bread-and-butter of trading microcap and high-beta stocks on a short-term basis, which brought some success and a degree of investor interest and participation.

(Here, again, it gets a bit tricky: large investors would not be able to participate in Sykes' fund because they would not perceive his strategies to be "scalable": you can't pour hundreds of millions of dollars into very small stocks without drastically influencing execution and performance. Even with success, his fund would be limited in size simply by this scalability concern.)

Eventually, a heavy loss in a single issue (Cygnus) damaged Tim's profitability and ability to continue raising funds. With media exposure, however, Tim found considerable interest from traders who were drawn to his story. Indeed, it's a valuable, cautionary story for traders, both in terms of the importance of checking ego and risk and from the vantage point of the importance of understanding your industry thoroughly before launching a business.

Tim currently resides in cyberspace at his own personal site, where he tracks his trades in a blog and advocates for changes in SEC regulations regarding funds and their ability to advertise and raise funds. For the record, I do think the time will come when small investors participate in hedge fund returns and strategies, but this will occur through specialty ETFs and further public offerings of stock in large funds--not by making individual funds available to Mom and Pop.

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Gauging Market Strength With Cumulative New Highs and Lows

I typically follow the number of stocks making fresh 20-day highs and lows across the NYSE, NASDAQ, and ASE. This is an excellent way of detecting day-to-day strengthening or weakening in the broad market.

At a longer time frame, however, it's instructive to examine the cumulative line of new highs minus new lows. Above we see the cumulative high-low line plotted against the S&P 500 Index (SPY). Note that new highs topped out in early June, 2007, well ahead of the market index.

Similarly, we can look for an upturn in the cumulative high-low line to confirm a bottoming process in stocks. Thus far, we've seen two consecutive days in which new 20-day highs have outnumbered new lows: on Thursday (649 vs. 401) and on Friday (663 vs. 364). This week I'll be looking for evidence of continued expansion in new highs vs. a resumption of the expansion in the number of new lows to gauge the likelihood of retesting this past week's lows.

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Detaching From the World

It is no coincidence that the great religions of the world embrace the idea of detachment. In Buddhism, non-attachment to the things of this world brings freedom and an end of suffering. Fasting during the month of Ramadan is an obligatory practice in Islam; we also see Jews fasting during the Yom Kippur day of atonement and Hindus fasting for the month of Shravan by abstaining from meat. A tradition of silence and celibacy has accompanied the training of priests and nuns in monasteries and convents. Even within the secular world, we find ourselves detaching from our daily lives by hiking in woods or mountains, vacationing to exotic or remote destinations, or meditating.

Detachment is really a detachment from routine. Routines bring efficiencies to life, but they also leave us living life in auto-pilot mode. Rarely in routines do we notice our surroundings or feel the depth of our connections to our loved ones or our work. Routines are, in a sense, a kind of addiction: we crave the familiar, but are ultimately dulled by it. Outside of routine on a mountain camping trip, we lose the day-to-day worries and reconnect with what is really important. During a getaway vacation, we connect with our spouses in fresh ways. After a session in the immersion tank, the sights, sounds, and smells of the world are more vivid; we feel more alive.

It's one reason I like to break from trading periodically. There's value in getting away from the screen during the day, and there's value to getting away from markets. Some of my best trading has occurred when I've gained fresh energy and perspective after a time away.

Today I've begun one of my multi-day fasts. No food; no caffeine; no sugar; just water. I break all my work routines. The metabolism slows down, I slow down, and regain a little perspective.

Life is just too short to live on auto-pilot.

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A Cardinal Virtue of Trading

The novelist/philosopher Ayn Rand considered the willingness to face and deal with reality to be among the cardinal human virtues. While other animals can survive through their ability to forage or hunt prey, the human animal can survive only through reason and the use of the mind. To blank out reality--or fake it--is to betray what makes us unique; it is a moral failing and not just a psychological one.

I've interviewed and worked with some very experienced and successful traders at investment banks, hedge funds, and proprietary trading firms. One common ingredient in their success is their willingness to acknowledge when they're wrong. If a trade goes against them and hits their stop point, they get out. They don't fudge reality, they don't turn the trade into a longer-term position, and they certainly don't add to the loser in hopes of making the money back.

These very successful traders are often quite confident, but they accept losing. They can face drawdowns, cut their risk, and keep themselves from blowing up. There's no head in the sand, no excuses, no revenge trading. For them, losing is a normal event, not a threat.

In a recent interview for a Reuters story, I emphasized that the SocGen trader who nearly brought his firm down with $7 billion in losses merely enacted on a larger (and illegal) scale what we see among traders during volatile times. The failure to acknowledge a loss leads to efforts to make up for the loss and eventually to a blow up. How often do we see the same kinds of blowups when people fail to face other kinds of problems, with their health, their marriages, or their careers?

It all boils down to acknowledgment of reality vs. denial.

There aren't many occupations that require participants to face loss every single day. That requires a kind of steadfast integrity: a rare ability to see consistently see things as they are, rather than as we'd like them to be. It sounds paradoxical, but normalizing failure and accepting loss are the prerequisites for achieving success and gain in the markets.

RELEVANT POST:

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The Most Important Reason Individual Investors Lose Money

Trading coaches and psychologists are particularly apt to speculate as to the major reasons traders and investors lose money. Among the usual suspects are: failure to plan trades or operate from a trading plan; loss of discipline with respect to risk management; impulsive (over)trading; and failure to trade reliable, tested ideas. Having worked with quite a few traders and portfolio managers, I can vouch for all of these as valid reasons for poor performance among traders.

I was very interested to see, therefore, that recent research identifies a different factor as a signature reason for the failure of individual investors. A 2006 study by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrence Odean, entitled "Just How Much Do Individual Investors Lose by Trading?" finds that losing market participants owe much of their losses to the way in which they execute their trades.

Studying five years of trade-by-trade history for the Taiwan Stock Exchange--a mammoth undertaking--the authors find that individual investors overall not only lose money, but lose significant sums. Overall, the average annual loss from trading from the individual investors was -3.8%. This is not a small sum; it represents 2.2% of the entire GDP of Taiwan.

Conversely, institutional market participants averaged a gain of 1.5% per year after trading costs were factored in. A large body of research reviewed by the authors confirms this finding: over time, individual investors tend to lose money; institutional ones tend to be profitable. (As mentioned in my recent post, there is a small group of individual traders that appears to be consistently profitable after expenses; one can also find unsuccessful traders at various banking and financial institutions).

The surprising finding from the study is that virtually all of the losses of individual investors can be attributed to their use of aggressive orders. In other words, they are trying to buy into strength and sell into weakness. At short time frames, the institutions derive significant profit from their use of passive orders: buying bids and selling offers. "The profits associated with passive trades," the authors explain, "are realized quickly, as institutions provide liquidity to aggressive, but apparently uninformed, investors."

This very much fits with my experience: in the recent U.S. markets, much of this profiting from the provision of liquidity close to the market is accomplished by algorithmic (automated) trading. (When I first began working with traders in Chicago it was more common to see individual traders at proprietary firms providing this liquidity close to the market. Such scalping has become less profitable on average for traders as computers have speed of computation and execution on their side. Nonetheless, this has simply changed *who* is benefiting from passive orders, not whether such orders are effective in the very short run).

Supporting the idea that execution is crucial to the success or failure of individual traders is the finding that the average returns of individual traders are negative over time horizons of one to ten days, but close to zero 25 days and out. In other words, the individual traders are tending to lose money on their shortest-term trades. Getting a bad price due to aggressively entering markets could be a reason for that: it would lead to a greater probability of a trader's getting stopped out of positions.

Interestingly, over those short time horizons, the passive trades of individual traders tend to be profitable. The advantage of executing with passive orders tends to erode over time. When, however, the individual trader executes aggressive orders, these have resulted in significant losses. The authors speculate:

"Apparently, individual investors are demanding liquidity when they have no information about the future prospects of a stock. This observation is quite consistent with models that assume investors are overconfident and, as a result, trade too aggressively and to their detriment. In striking contrast, institutions immediately profit from their aggressive trades and these profits grow dramatically at longer horizon--perhaps as the information that institutions possess about the prospects for a stock are more widely appreciated by market participants."

By executing trades aggressively, the active trader immediately loses a tick; were he or she to turn around and immediately unwind the trade, they would be out the bid/offer spread. Those ticks add up. A trader who trades five-lots just once a day in the ES (S&P 500 e-mini futures contract) on a portfolio of $50,000 would lose five ticks a day just through aggressive entries. Over 250 trading days in a year, this would lead to a loss of more than 300 ES points or $15,000--30% of the trader's portfolio! What this points out is that an individual trader who executes aggressively in markets with relatively wide bid-offer spreads needs to be quite successful in order to just break even after a year.

The research suggests that aggressive trading of markets can be successful if traders possess unique, valuable information. In the absence of such information, it seems as though chasing rising and falling markets, on average, enriches the market makers who profit from the bid/offer spread and their ability to control movement close to the market with their large size. It's not just the idea you trade, but how you execute the idea--and how consistently you execute well--that seems to matter in the long run.

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Pervasive Myths of Trading Psychology
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How Common Is Elite Talent Among Day Traders?

In my recent post, I reviewed research that suggests that the great majority of individual traders fail to make money, particularly after commission costs are factored into returns.

Still, the research finds that a small group of individual traders possess a high degree of skill and can earn returns far above those expected by chance. This is precisely my experience working with proprietary trading firms: a small proportion of traders accumulate the lion's share of the returns. Moreover, those same traders tend to dominate the earnings list from one year to the next.

According to the authors of the research, their findings "paint a rather dim portrait of day traders." "Over the typical six month horizon," they note, "using lower range assumptions regarding transaction costs, less than 20% of day traders earn profits net of transaction costs." What that suggests is that the proportion of day traders who can actually make a living from their trading is surely quite small.

That is exactly what the authors report: "We identify day traders who earn substantial profits over a six-month period and analyze the performance of their subsequent trades. These profitable day traders continue to earn stellar returns." Indeed, the very top traders in the research sample averaged earning over $ 1 million NT per six month period, far greater than the average income in Taiwan. Interestingly, however, the *median* six-month earnings for these top traders was $125,761 NT. What that means is that a relative handful of the top traders accounted for the lion's share of the profits.

And how elite was this top group? The authors studied over 50,000 individual traders for their study, and only 386 were part of the top group--less than 1%. When you see how returns were distributed within the top group, however--with the mean so greatly exceeding the median--it is clear that truly top traders are probably about 1 in 1000.

Is this a depressing finding? I do not find it so. Would the distribution of elite talent look any different for musicians, basketball players, research scientists, or chess players? A high and sustained level of success in any of these domains is rare, but it *is* attained and attainable. It is achieved as the result of a developmental process, not as the uncovering of any magic setup or indicator. The single greatest challenge for traders and trading psychologists alike is to harness this developmental process. Are you on a learning curve that can lead to the acquisition of expertise? I can think of no more important question for self-evaluation.

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Bears and Bulls: Perspectives for Thursday

* Is it a Bear Market? - Above we see a perspective from 2000 to the present re: the percentage of S&P 500 stocks trading above their 200-day moving averages. (Mad props to Decision Point for the chart). When we were in bull mode, corrections stopped when we had only about 40% of stocks trading above that benchmark. In bear mode, we have dropped below 20%, similar to levels seen during the 2001-2002 period.

* Indicator Update - A ferocious rally on Wednesday followed a successful test of Tuesday's lows, with buying once again very strong in the sectors that had been most oversold: banks and homebuilders. We saw 502 stocks make fresh 20-day highs across the NYSE, ASE, and NASDAQ; new lows were 2154. Demand was a very strong 137; Supply was only 16. This means that the number of stocks finishing the day with strong upside momentum outnumbered those with strong downside momentum by over 8:1. When we see such surges in bullish short-term momentum, there is usually follow through to the upside the next trading session, and that's what we're seeing so far in pre-opening trade.

* What's Strong - Technical Strength also improved on the heels of Wednesday's rally. We now have 8 of the 40 stocks in my basket showing bullish trending strength: DD, UPS, HD, WMT, WAG, WFC, JPM, and IBM. Interesting to see two banking names on the rather diverse list.

* Bottom Pattern? - Trader Mike posts a couple of interesting patterns in the wake of yesterday's market and finds a 2004 analogue. See also Declan Fallond's look at patterns, especially in the semiconductors.

* Bail Out - A Dash of Insight finds a dash of bullishness in the news of a bond insurer bailout and examines a bullish market pattern.

* Selling Short - Chris Perruna offers perspectives on when to go after longer-term short positions.

* Views on the Bear - How this market is like 1987 and what the most successful market timers are thinking are among the latest links from The Kirk Report.

* Review of a Volatile Day - WSJ MarketBeat examines the dynamics of the recent market and why bonds may not be a good place for long-term investment at these levels.

* Favorite American Idol Tryout So Far - Thought I was watching my daughter. Whatevs.

Tracking Stock Market Weakness: Indicator Review

* Perspective - The Fed rate cut news dominated the trading landscape yesterday, but make no mistake, it was a weak market. The extreme level of new lows reached by stocks is typical of a momentum low and that often leads to a sizable bounce short-term. That having been said, very weak momentum lows are typically followed by further price lows. As long as advance-decline lines are falling, momentum is weakening, and new lows are expanding, it's dangerous to go bottom fishing.

* New Highs/Lows - The market is washing out the broad list of stocks, creating a huge spike in the number of stocks making new lows. Specifically, we see 299 issues making new 20-day highs and 4786 new lows. When we look across the NYSE, NASDAQ, and ASE, we also see 95 new 52-week highs and 2576 new lows. These are extreme levels that exceed the weakness seen in August of last year. If we just look at NYSE common stocks, we also find expansion in the number of new lows, with 6 new 52-week highs and 707 new lows. Among S&P 500 stocks, 209 made fresh annual lows; among S&P 600 small caps, we had 218 new lows.

* Momentum - My measure of Demand finished at 44, while Supply was 88. It surprised me to see twice as many stocks closing below their volatility envelopes compared to those closing above. Yesterday's bounce was strongest in the sectors that had been weakest: homebuilders and banks, a sign of short-covering more than fresh, sustained buying across the stock universe. We now see only 15% of SPX and NYSE stocks trading above their 200-day moving averages, a level seen near many bear market lows in the past 20 years.

* Advance-Decline Lines - We saw new lows for the A-D Lines specific to NYSE common stocks, S&P 500 issues, and NASDAQ 100 shares.

* Technical Strength - Within my basket of 40 stocks from the S&P 500 universe (evenly divided among eight sectors), we had 2 stocks trading in uptrends (HD, WMT), none neutral, and 38 in downtrends. This is the weakest reading I've seen since I began collecting the data last year.

* Quick Reminder - I am updating news stories on major market themes, as well as premarket review, via the Twitter app. The last five Twitter posts appear on the blog; the full list appears on my Twitter page and can be accessed via RSS.

Do Individual Day Traders Make Money?

Trading lore has it that the average trader loses money in the markets. Some estimates put the proportion at 80% or even higher. When we think of all the potential disadvantages of the individual day trader, it's not hard to believe those numbers. After all, the individual day trader as a whole:

* Does not participate in the long-term upward drift in stock prices exhibited by equities;
* Does not have a team of analysts providing researched trade ideas;
* Does not have a dedicated IT and programming staff to support and automate trading;
* Does not have a rich array of colleagues to share ideas and learn from;
* Does not have access to the best trading software and news services;
* Does not enjoy preferential commission rates available to exchange members.

Those are formidable obstacles. But what does research tell us about the success of individual day traders?

A 2004 study from Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrence Odean was noteworthy in that it studied the complete transaction history of the Taiwan Stock Exchange over a five-year period. From that mass of data, they were able to identify specific market participants and categorize their trading as day trading vs. investing. Moreover, they were able to separate active day traders from others.

Interestingly, day trading accounted for 22% of the volume of individual traders, but only 5% of the volume of institutional participants. Moreover, volume in day trading is highly concentrated in their sample: the 1% of largest day traders accounted for half of all day trading volume.

The major conclusion of the authors is that "day trading is treacherous, but not entirely a fool's game." Specifically, "a large fraction of day traders, more than eight out of ten, lose money, though a small fraction of day traders earn large persistent profits." Not surprisingly, the heaviest (largest) day traders were most likely to be profitable; as a group they made money before transaction costs but not after. The smaller, less active day traders lost money even before transaction costs were factored in.

I believe that the results of the research suggest a Darwinian mechanism at work. The largest day traders are likely to be the best capitalized, and hence the best able to survive their learning curves in markets. The most active day traders are also those who are most apt to lose their money simply due to the cumulative impact of slippage and commission costs. The least active traders (part-time, occasional) get the fewest looks at markets and hence are least likely to learn and internalize pattern recognition skills essential to day trading. This creates a selection mechanism in which a relatively small number of large, frequent day traders survive to dominate volume and profitability.

So what keeps new traders coming to an arena in which far fewer than 20% of participants are profitable after costs? Odean's research suggests that overconfidence plays an important role. Just as participants in lotteries and casinos overestimate their odds of winning, individual day traders may place too much confidence in their ability to read market patterns out of the gate. If that is true, the majority of individual day traders should fail relatively early in their careers, something that has been mentioned to me by executives at brokerage firms.

But this only scratches the surface of the authors' findings regarding success and failure in the day trading arena. My next post in this series will take a closer look at what separates the winners from the losers.

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Just How Worried is the Fed?

During times of credit crisis and threatened economic slowdown, reductions by the Federal Reserve in the discount rate help to stimulate economic activity by enabling commercial banks to borrow money at a favorable rate. This aids the profitability of banks and encourages loan activity, which makes money more widely available to the economy and stimulates economic activity. The Fed does not necessarily reduce the discount rate all at once; rather, cuts may come in stages as economic data roll in. If the data are ominous and the Fed is particularly worried about deflation, recession, and/or credit crises, we can expect sizable cuts in the discount rate over time. For that reason, changes in the discount rate might be viewed as an indicator of Fed sentiment: the degree to which the Fed is worried about economic slowdown (leading to aggressive discount rate cutting) or overheating (leading to aggressive discount rate hiking).

So how worried is the current Fed, based on historical norms for discount rate cuts? I went back to 1965 (2248 weeks of data) and examined the rate of change for the discount rate over moving 26-week periods.

Interestingly, we're currently seeing a 36% drop in the discount rate over the latest 26-week period. Only one other period since 1965 has seen such aggressive discount rate cutting--and that was the 2001-2002 recession. (We saw a 45% drop in the discount rate during late 2001 and a 42% drop during early 2002).

Other periods of Fed worry and 26-week discount rate declines have been:

* Late 1991/Early 1992 - Down 28%
* Late 1982/Early 1983 - Down 26%
* August 1986 - Down 22%
* May 1975 - Down 21%
* August/September, 1980 - Down 21%
* May/June 1991 - Down 18%
* February-May 1971 - Down 17%
* May/June 1992 - Down 17%

Note that the vast majority of these time periods ended up being good times to buy stocks for longer-term positions. Interestingly, however, the extensive rate cutting by the Fed during the 2001-2002 period is now being blamed for the housing bubble and credit recklessness that ensued. Given that we are now seeing Fed worry (and discount rate cutting) of similar proportions, we can only speculate as to the bubbles that could arise from the latest rate actions.

NYSE TICK and Intraday Trending

Note the distribution of the NYSE TICK through the morning per the above. We see higher highs and lower lows, suggesting more stocks being accumulated at the market offer; fewer transacted at the market bid. That tells us that sentiment has been steadily improving over that period. Note the blue moving average line (30 min) for the TICK; it shows an uptrend and is a nice, quick visual way of seeing how the TICK distribution is changing over time.

Because the NYSE TICK assesses transactions at offer and bid for all NYSE issues, it tracks buying and selling pressure in the broad market quite well. Above we can see that the Russell futures were particularly responsive to the positive sentiment (TICK lows occur at higher price lows). The fact that the Russell stocks have been outperforming the large caps this morning is also a sentiment indication per my recent post.

Shortly after writing this the market and TICK distribution turned downward, breaking the pattern of higher TICK highs and higher lows. Shifts in the TICK distribution don't catch exact market tops or bottoms, but are useful indications that intraday trends are coming to an end.

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Assessing Trend With NYSE TICK

NYSE TICK: Small Caps and Large Caps
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Large Downside Opening Gaps: A Look at Fear and Uncertainty in the Stock Market

As markets continue their declines this morning, traffic on this blog is running about 60% above normal--something we don't see in rising, low VIX markets. As I've mentioned in the past, one coping mechanism for uncertainty and fear is seeking information, so blog traffic becomes a kind of sentiment measure. We are seeing elevations of traffic comparable to those at the market drops of March, August, and November of 2007, for example.

The fear and uncertainty are understandable: Opening drops of over 3% are quite rare in market history. I looked at first-hour changes in the Dow (change from the prior day's close to the end of the first hour of the next day) going back to 1960 and could only find 7 drops of 3% or more. Five of these occurred in the October, 1987 debacle, one following the 9/11/01 event, and one in October, 1991. Four of the 7 opening declines dropped further from the end of the first hour to the close. More broadly, we've seen 46 declines of over 2% from the prior close to the end of the first hour of trading since 1960; 22 of those traded lower from the first hour to the close.

Yet, once again, when we look at the historical periods of those historic opening declines, some dates stand out: October, 1987; September-November, 1974; October and December, 1978; October, 1982; August, 1990; April, 1994; August/September, 1998; September, 2001; September, 2002; and March, 2003. All in all, not a bad list of times when it paid to be a buyer over the longer haul.

The moral of the story is that, in the short run, panicky markets can decline further. Investors with longer time horizons, however, have generally done well by putting money to work when panic fills the air.

RELEVANT POST:

Historic Declines in Stocks
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Historic Five-Day Declines in U.S. Stocks: What Happens Next

We're on pace this morning to be down over 10% on a five-day basis in the S&P 500 Index. I went all the way back to 1960 (N = 12,074 trading days) and examined what happened after historic five-day drops in $SPX.

To give an idea of how rare it is for stocks to drop more than 10% in a five-day period, we've only had 11 such instances since 1960. Five of the greatest five-day declines were registered on October 19, 20, 21, 22, and 23 of 1987. Two of the instances occurred on July 22 and 23 of 2002. So, really, we've only had six periods of negative five-day returns exceeding 10%:

October, 1987
May, 1962
August, 1998
September, 2001
July, 2002
April, 2000

On 10 of those 11 occasions, the S&P 500 Index was higher 10 days later by a very large average of 5.62%.

When I loosened the criteria and looked at all five-day drops in the average of over 6% (N = 83), we find that, ten days later, the market was up by an average of 2.8% (53 up, 30 down). By contrast, the average 10-day gain over the rest of the period was .29% (6870 up, 5121 down).

To be sure, a weak market can get weaker: Of the 83 occasions in which we had five-day drops of 6% or more, 14 drew down another 3% or more over the next five trading days. Five of those instances were drops of over 5%. By contrast, however, 40 of the 83 occasions were up over 3% over the next five trading days.

The takeaway is that periods of great short-term crisis have, on average, been periods of opportunity. If you look at those occasions of 10+% declines, all have occurred at times in which it would have paid handsomely to be a buyer for the long-term. That doesn't mean that there can't be further turbulence ahead, but--as a rule--selling into panic has lost investors money.

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Euphoria and Panic in the Stock Market
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Personal Crises and Market Crises

When I watched High Probability Trader's (HPT's) recent video, it brought back so many painful memories of my own market debacle in 1982. The pain, the loss, the self-loathing: it literally hurt for me to watch the video. But I respect him tremendously for posting it. It's a side of trading no one really likes talking about.

Markets go through crises of confidence and so do people. And, for markets as for people, the downside is always so much quicker than the upside.

Markets crash when there's something fundamentally amiss. We see it now in the housing and credit markets; at other times in market history we've had other catalysts. Our personal crises also come when something is fundamentally amiss. My own trading meltdown in 1982 was a reflection of a much larger dead end that I had created for myself in relationships and career.

That led me to change everything in 1983. I laid the groundwork for a new job that would start me on a path toward working with healthy people using a little-known set of techniques called brief therapy. I tossed the weed, cut way back on the alcohol, and finished the year at a New Year's party where I met Margie, my wife now of 24 years. I also took a long break from the markets and only returned after a lengthy period of study--and a new approach to money management.

Tomorrow morning I'll take a long historical look and tell you what tends to happen after market declines of the magnitude we've seen lately. I don't want to spoil the ending, but the gist is that crisis very often brings opportunity.

And so it is in life--IF we muster the heroic spirit to change what's fundamentally amiss. Maybe someday, HPT, you'll be a 53 year old guy writing about the painful crisis that made the turnaround possible. That will make it all worthwhile--

Brett

Retracing the Bull Move and Other Insights for a Bearish Holiday

* Those Weak Bank Stocks - The Banking Index ($BKX) is well on its way toward retracing its entire bull market move from 2002. In the wake of very weak global equity markets today, it will be interesting to see how the banks respond to any Fed intervention. The interventions so far have hardly proved reassuring.

* Looking at History - Jason Goepfert's SentimenTrader service is one of the ones I respect for its research. In his recent posting for subscribers, he compares the current decline to 1998 and 1987 crashes. Very interesting potential parallels, including a Fed pushed into action, a sizable bounce following the declines, and then further weakness.

* Reviewing Markets - Trader Mike offers his updated links, including an excellent Stockcharts review and a look at deflation. See also the links on recession and equity valuations from Abnormal Returns.

* Market Delta - I see Trevor at Market Delta is giving a free webinar for the Tradethemarkets site. He's developed some new indicators that might be of interest: Delta divergence and The Profile Direction Index.

* Capitulation and a Bounce? - The Quantifiable Edges site takes a historical look.

* Historical Perspectives on Bear Markets and Recessions - Calculated Risk examines where we stand with respect to past market plunges.

Reading Investor Sentiment From Stock Indexes

One of the most important questions active traders can ask is whether the majority of participants in the market are risk-seeking or risk averse. This basic question of sentiment will be reflected in the relative performance of stocks and stock sectors.

In an environment of relative bullish sentiment, investors will seek growth and will be inclined to pursue riskier stocks in the hopes of greater returns. When the environment is relatively bearish, investors seek safety and move their capital to the largest, most stable issues.

Above we see two versions of the S&P 500 Index: the usual, weighted version (SPY; blue line) and the Rydex unweighted ETF (RSP; pink line).

In an environment of bullish sentiment, we'd expect the unweighted version of the S&P 500 Index to outperform its weighted counterpart. That reflects investor interest in the smaller, more volatile, more growth-oriented components of the Index. When sentiment turns bearish, we'd expect investors to seek the safety of the largest cap, most stable shares. That results in the weighted S&P 500 Index outperforming the unweighted version.

From the above chart, we see that mid-year 2007 marked an important shift in investor sentiment. To that point, the unweighted S&P 500 Index (RSP) was outperforming the standard, weighted version (SPY). Since that time, we've seen the unweighted index consistently underperforming the weighted version. During 2008 alone, RSP has fallen 1% more than SPY.

Such measures of sentiment are more reliable than simple polls of traders and investors, because they reflect the actual market behavior of the institutional investors and traders that dominate the trading of large cap equities. In my next post, we'll look at how the relative behavior of sector indexes also reflects investor and trader sentiment.

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Last Hour of Trading as a Sentiment Gauge

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Equity Weakness: A Global Look

Here we see 2008-to-date international equity returns for the ETFs representing Japan (EWJ); Hong Kong (EWH); China (FXI); Singapore (EWS); Australia (EWA); Taiwan (EWT); U.S. (SPY); and EuroStoxx (FEZ).

Asian weakness has been on a par with weakness in the U.S. and Europe. What is noteworthy is the degree to which we're seeing negative returns worldwide, including the markets hot in 2007 (Hong Kong, China). Also interesting is that the market that underperformed in 2007 (Japan) is now displaying a bit of relative strength. (Note also recent yen strength).

Should we be looking at global recession--not just slowdown in the U.S.--the implications would be significant for economies (and markets) dependent upon exports and commodity inflation.

RELEVANT POST:

World Equity Returns for 2008
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S&P 500 Sector Performance for 2008

Here we see the performance of nine S&P sectors so far in 2008, as measured by their ETFs: XLB (Materials); XLI (Industrials); XLY (Consumer Discretionary); XLP (Consumer Staples); XLV (Health Care); XLE (Energy); XLF (Financials); XLK (Technology); and XLU (Utilities).

Several themes stick out:

1) Negative Performance - All sectors are down on the year. My basket of 40 stocks drawn from the highly weighted stocks in the first eight sectors shows one stock in an uptrend, four neutral, and 35 in downtrends. This is an unusually weak reading and suggests broad selling that--at least in recent times--has led to at least a temporary bounce short-term.

2) Defensive Themes Outperforming Growth - The strongest sectors include Utilities, Health Care, and Consumer Staples, all of which are perceived as being more recession-resistant than Technology and Consumer Discretionary issues.

3) Financials Continue to Underperform - We've seen steps taken the Fed, by outside investors putting money into the banks, and by the government to stimulate the economy. So far, financials continue to deteriorate.

4) Weak Energy Stocks - Despite recent strength in the oil price, we're seeing surprising weakness in energy shares. The inflation theme may be losing out to the recession theme, which has implications for a variety of commodity prices.

RELEVANT POST:

My Prior Look at Technical Strength by Sectors
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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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