Wednesday, March 05, 2008

Thinking in Themes

When we think of trading "themes" in the markets, we naturally think of portfolio managers and longer-term investors: those who trade fundamentals and relationships among asset classes. But there is much to be said for theme-based thinking among shorter-term market participants as well.

In my recent post, I emphasized the importance of confirmations between movements of an index (such as the S&P 500 Index futures, above) and the movements of component sectors (such as the S&P 500 Index financial stocks, XLF, below). As you can see from the charts, the financial stocks (like the consumer staples, healthcare, and utilities sectors) did not confirm the 13:00 PM CT low in the ES contract. That led to a sharp reversal shortly thereafter, as selling pressure could not sustain a broad market decline.

But there's another way of thinking about this pattern. We know from the news (and my recent Twitter posts) that weakness among financial issues has been a major market theme. When sellers have aggressively pushed these stocks lower, the broad market has generally followed. In that sense, the financial stocks have been an excellent barometer for stock market sentiment, especially around risk-assumption and risk-aversion.

When we have a low in the broad index that is *not* confirmed by a bellwether sector, the market is telling us that--at least in the short run--the market theme is not operative. Despite the price lows in ES, there is some relative risk appetite among the weakest stocks, the most vulnerable sector. This is very important market information.

Knowing the market bellwethers at any given time and tracking their performance vis a vis the broad averages is a kind of thematic thinking that can lead to excellent intraday trade ideas. For the trader looking at the ES contract only, the afternoon rally came out of the blue. The thematic trader, however, saw the divergence and was not surprised by the reversal.


Trading by Intermarket Themes