Further Signs of Stock Market Strength

Money flow for the Dow 30 industrial stocks recently turned positive, adding to the evidence of buying support for the current market. Across the NYSE, NASDAQ, and ASE, Friday registered 505 new 20-day highs against 194 lows--the first time since the decline began that we've seen more new highs than lows. My measure of Demand (an index of the number of stocks closing above their volatility envelopes) was 205 on Friday; Supply was 22. That means that over nine times as many stocks displayed significant upside price momentum as downside.

Throughout the decline, periods of positive money flow have been brief and have led to renewed selling. So far, the market has been able to feed on strength. While this action isn't sufficient to rule out future price weakness, it does constitute one necessary element in a bottoming process.
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Two Perspectives on Recent Stock Market Activity

I recently posted on the topic of record volatility in the stock market. Volume and volatility tend to be highly correlated; it takes the participation of large institutions to move markets. As we can see from the top chart, depicting the S&P 500 ETF (SPY; blue line) and the 20-day moving average of volume in SPY (pink line), volume has also greatly expanded with the recent decline and bounce back.

Meanwhile, we continue to see a bid underneath this market, as the Cumulative NYSE TICK line moves to new highs. For an explanation of the recent divergences between the TICK line and price during the market bottoming, check out this post.
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Historic Stock Market Volatility and the Concentration of Ownership in Stocks

Here's an update from an early October post; it helps illustrate how the recent stock market's volatility has been qualitatively and quantitatively unlike anything we've seen in years. Indeed, this is the highest level of 20-day average true range for the S&P 500 Index since my data began in 1962. That means that we've seen higher volatility than during the 1987 market crash and higher volatility during the major declines of 1970 and 1974.

The recent bout of extreme short-covering in Volkswagen stock is an illustration of the volatility that can result from a concentration of shares in institutional hands. According to recent estimates, institutions account for over three-quarters of all stock market ownership. By contrast, individuals owned 94% of stocks in 1950 and 63% of stocks in 1980. With the recent liquidations forced upon hedge funds, mutual funds, pension funds, insurers, and other financial institutions, we've seen historic levels of volatility as a function of historic levels of concentration of ownership among institutions.
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Asset Class Correlations Remain High

Here we see the bottom patterns for oil (USO; top chart), euro futures (middle chart), and S&P 500 futures (bottom chart). These moved in unison to the downside, and now are pretty much lockstep to the upside. One characteristic of crisis markets is that correlations among asset classes become quite high. One sign that we are emerging from crisis would be a decoupling of markets, as markets more efficiently differentiate winners and losers, within equities and across asset classes.
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Sector Performance: Before and After Recent Market Rally

A click on the chart above will show the S&P 500 Index (SPY) and 10 S&P 500 sectors, as they performed during the decline from 9/2/08 - 10/27/08 (blue bars), and as they performed over the rally of the last two trading sessions (red bars).

Note how some of the sectors that had been beaten up the worst--Materials (XLB), Energy (XLE), and Housing (XHB)--have bounced strongly during the last two trading sessions. Sectors that had held up better during the decline--Consumer Staples (XLP) and Health Care (XLV)--have bounced less over this recent rally.

Until I see solid evidence of follow through to this rally with solid breadth and positive money flows, I'm viewing the recent impressive rally as dominated by short covering, which enables the beaten down market segments to outperform those more defensive sectors.
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An Introduction to Trading - Market Auctions and Multiple Timeframes

The most recent post for the Introduction to Trading ebook introduced the idea of the auction market as a framework for understanding the stock market, using the simple illustration of an eBay auction. Now let's expand the conceptual framework to see how auction markets can bring together participants who operate at differing time frames.

Central to any auction process is the notion of value. Value is the price--or range of prices--that bring together buyers and sellers. Because the auction exists to facilitate trade, the auction process constantly hunts for value: that price level that will enable buyers and sellers to transact with one another.

It is important to recognize that value has both an objective and a subjective meaning. An objective definition of value in the Market Profile framework is that range of prices during a day or week that encompass approximately 2/3 of the volume for that period. This value range represents the prices that brought together the majority of buyers and sellers; it is objectively measurable as a function of time, price, and volume.

Value also has a subjective meaning to auction participants, as each has his or her own ideas of what a market is worth. A value investor may define value well below the market's current level, because that is what stocks are worth according to his or her metrics. A short-term trader may perceive value in an uptrend when a market pulls back to a 20-day moving average line. A longer-term trader might find value when there is a significant expansion of the number of stocks making fresh 52-week lows.

Trading occurs at the intersection of a trader's subjective definition of value and the market's objectively determined placement of value. If I think "true" value is well above or below the market's current assessment of value, I have an incentive to enter an order to take advantage of this discrepancy. My trade reflects my assumption that the market's assessed value will, over time, move toward my value assessment. If I place value where the market is currently trading, I may have no incentive to enter the market. By my subjective criteria, the market is fairly priced, and I will wait for the market to move below my value level to make buying profitable.

Imagine an auction with participants at many different time frames, each with very different subjective definitions of value. An automobile auction, for example, might feature active participation among people who have used cars to sell and others who wish to acquire used vehicles. Bidders and sellers have an idea of what constitutes fair wholesale and retail prices and try to obtain prices as close to those extremes as possible.

Suppose, however, that--lurking in the background of the wholesale car auction--is a group of dealerships that make their living by buying inexpensive used cars, fixing them up, and then selling at close to retail prices. They will only bid on cars when an oversupply situation pushes prices to or even below traditional wholesale levels; this enables them to make a nice profit, even after they put work into the vehicles. This means that a whole new source of demand--and volume--will enter the auction market when prices hit levels that constitute subjective value for large, longer-time frame participants.

Above and below the market, you always have value-oriented institutions (such as mutual funds) ready to acquire stocks when they're cheap (by the institutions' criteria) and sell them when they're priced above (the institution's definition of) value. No doubt you've seen markets that have traded in a narrow range on quiet volume, only to move higher on increased volume following a range breakout, and then reverse sharply on even stronger volume. During the narrow range bound action, market makers were dominating the action; technical traders (including short-term prop traders) jumped into the market on the breakout; and value-oriented traders (including hedge funds) sold into the strength as stock index futures went to sharp premium to cash. This is a simple example of how auctions bring together participants across different time frames.

When I first began work at a prop firm, I was surprised to observe that the traders focused on something quite different from the average traders I had run into. They used price and volume information (including information from the order book) to identify *who* was in the market. They wanted to know if there was above or below average institutional participation; if moves to new price highs or lows were attracting momentum participants; etc. By using "technical" market data to make inferences about underlying auction processes, they were able to make reasoned judgments as to whether market moves were likely to continue or reverse.

In the next segment of the book, we'll take a closer look at how savvy traders develop trading ideas from auction-generated market data.
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A Stock Market Breakout and Other Tuesday Observations

* Upside Breakout - The chart above shows the 2 hour moving average of NYSE TICK (pink line) versus the ES futures for the last four trading sessions. When we corrected back toward the ES 860 level during the 1-2 PM CT hour, the TICK moving average stayed positive, showing underlying buying interest. This accelerated through the afternoon, as buyers lifted offers--keeping the broad list of stocks trading on upticks--creating a powerful breakout move to multiday highs. The persistent, strong TICK readings were an excellent tell for those who might have been tempted to fade the move.

* Some Good Readings Suggested By Alert Readers:

-- Trader perspectives (incl. yours truly) on trading in tumultuous markets;

-- Fed. working paper: Much of what we hear about the credit crisis is based on myth;

-- An inside look at the credit market collapse;

-- Prospects for quantitative easing in the U.S.

* Some Good Blog Readings:

-- AlphaTrends video: flexibility of opinion the key to daytrading these markets.

-- Thoughts from GlobeTrader about creating an investment plan in the current beaten-down market.

-- Treasury's unprecedented financing needs, the capitulation myth, and much more from Kirk.

-- Fibs and the holy grail, crazy options market, and more updates from Trader Mike.
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Resources for Traders and Reflections on a Trading Career

During the past year, I've worked on two projects to help readers become more effective traders. The first is the book The Daily Trading Coach, which is scheduled for publication in the first quarter of 2009. This book consists of 101 short lessons that teach traders how to coach themselves for better performance, using practical psychological techniques. I believe it will be the most comprehensive self-help guide to trading psychology yet published.

The second project is a free online book that I am assembling post by post, entitled An Introduction to Trading. It is focused on the how-to's of short-term trading, from understanding markets to recognizing trading patterns and managing trading positions. Later today I will post the next installment to the book, as I resume weekly entries.

Supporting both these efforts will be the Become Your Own Trading Coach blog. I will be using this site increasingly to add material to the Daily Trading Coach book and to elaborate the Introduction to Trading with examples and explanations.

The idea is to work on yourself by working on your trading and to work on your trading by working on yourself. Trading, at its best, is a vehicle for self-development, as well as profits. Indeed, one of its enduring attractions is that it so richly rewards those with talent and skill, who master themselves.

Trading has a unique way of bringing the best and worst out in people. All the fear and greed, the destructive impulsivity and the swings between overconfidence and lack of confidence, come to the fore in the face of risk and reward. Also coming to the fore in trading, however, is the best of the entrepreneurial spirit. Traders are rewarded for their efforts and ideas: they develop their plans, execute them, and either profit or lose. They get no bailouts from government, nor do they ask for them. They don't lose themselves in mindless corporate team-speak. Traders eat what they kill; they seek to eat well, and they make no apologies for that.

My hope is that this blog, my first two books, and the resources above help developing traders find their way toward personal and financial success. Your path, ultimately, may or may not be that of a participant in the financial markets. That will depend on your values, interests, talents, and skills. But whatever your path, make sure it's one that challenges you personally and professionally to become more than you are; to develop the best within you. It's not important that you trade; it's important that you have a life of meaning, purpose, and fulfillment. Such a life will get you through the rockiest financial and economic periods.
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Recency Effects and the Fallibility of Bloggers

Well, another painful truism from the excellent Despair site, which specializes in "demotivational" posters and products.

What occasioned this skeptical look at self and colleagues was a recent post from Trader's Narrative, which points to the questionable accuracy of blogger sentiment. A careful analysis of blogger sentiment from CXO Advisory found that the correlation between changes in blogger sentiment and changes in market direction was .33. This suggests that 11% of the change in blogger sentiment can be explained by how the market behaved during the prior week.

I once conducted an informal experiment in which I asked traders to predict market direction from a chart. All traders saw the same chart, but for half the group the last bar was rising; for the other half, the last bar was falling. Not surprisingly, the group that saw the chart with the most recent bar rising was significantly more likely to predict a bullish trend for the market than the group that saw the same chart with the most recent bar falling.

We are all victims of recency effects: the tendency to overweight events that are most recent, because those are freshest in our minds. Before I start trading for the day, I review news, economic reports, readings, and market indicators. I noticed a while back that my initial trades tended to reflect what I had most recently reviewed. Although I thought I was objectively weighing evidence, I was unconsciously overweighting what stuck in my head. Chastened by the uncomfortable realization, I added a final step to my preparation: a summary review of everything I had looked at, in hopes of weighing evidence more evenly.

There are many knowledgeable and talented bloggers out there. They, including myself, are not exempt from the behavioral finance biases that bedevil traders. In times of turmoil, people tend to look to perceived experts for advice. My inbox is bursting at the seams, with the number of emails from traders I receive up easily by 50% in the last two months. While I hope that this blog provides some inspiration and insight, I even more fervently hope that you read it with a critical mind. The lesson of the sentiment polls is that what you read might just be a reflection of what just happened in markets. You can seek information and perspective, but ultimately there is no substitute for being one's own guru.
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What the Cumulative Adjusted NYSE TICK Line Is Telling Us

In the chart above, we have a plot of the Cumulative Adjusted NYSE TICK Line (blue line) plotted against the ES futures (pink line). Recall that this line simply adds together the one-minute readings of the adjusted NYSE TICK, much like an advance/decline line (see this post for calculation of the adjusted TICK). As we plunged to intraday lows on October 10th, we made a low in the cumulative TICK line; as we've now moved back to those lows, the line has held at much higher levels in a dramatic divergence. What gives?

The TICK is a measure of stocks trading on upticks versus downticks. It begins its calculations with the start of trading in NY and ends when the NYSE closes. As a result, the TICK does not account for action that occurs overnight, between the U.S. market close and the next day's open.
If we take a look at the S&P 500 Index (SPY) from the start of September, we find that the market lost almost 42 SPY points (approximately 420 ES points). From the start of September up to that October 10th inflection point at which the number of stocks making new lows hit its highest level (see chart), SPY lost 3.29 points between the NY close and the next day's open and lost 34.8 points between the NY open and close. From October 10th forward, SPY has lost 8.46 points during overnight trade and, during the day session, has actually gained 4.8 points.

The cumulative TICK is capturing the fact that buying pressure has been exceeding selling pressure during the day trading sessions from October 10th to the present. Indeed, during that time, the S&P 500 Index--if we look at day session only-- has risen in value. This is a clear shift in regime and suggests that weakness in equity markets from October 10th forward has shifted to the European and Asian markets. That weakness prompts the U.S. market to open lower, but has not led to further net selling initiated in the U.S.

This morning, as of my writing, we're seeing a potential repeat of this same pattern. Markets were very weak in Asia, opened quite weak in Europe, and are trading lower in preopening trading in the U.S. stock index futures. We made new bear market lows overnight in the ES futures but, as I write, are trading about 1.5% above those lows. Should we build value during the regular trading day above these lows, I will be leaning to the long side in my short-term trading, entertaining the hypothesis that, in this change of regime, the day markets in the U.S. have already seen their price lows, even as markets overall (due to overseas/overnight influence) have been weak.

What prompted this little investigation was a simple observation that a growing share of my intraday trading profits was coming from the long side, despite the overall weak market. That makes sense, given that many of my trades attempt to capture swings in the NYSE TICK (i.e., try to follow short-term buying/selling sentiment). I will continue to follow these swings in early action today, with a particular eye toward whether we sustain a positively or negatively sloped cumulative TICK line on the day. That will tell us whether U.S. traders during the day session are using overseas/overnight selling for bargain hunting, or whether they are succumbing to the global market weakness.

P.S. - On a related note, a very recent article just happens to look at overnight stock index futures action as a questionable gauge of day session strength and weakness. The posts below will provide some background on short-term trading and NYSE TICK. I'll send out a Twitter "tweet" during the AM to update how the day's cumulative TICK is behaving. For new visitors to TraderFeed, the Twitter feature provides a blog within a blog containing links to important market themes, news, and indicators. The last five Twitter posts appear on the blog under "Twitter Trader"; the entire list of posts (and automatic, free subscription to the Twitter feed) can be found here.

RELATED POSTS:

Cumulative TICK and Short-Term Sentiment

Trading With the TICK

Trading Breakouts With TICK
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Indicator Update for October 26th

Last week's indicator review concluded, "What this means is that we could see more broad, range-bound, whippy action as markets seek an intermediate-term bottom. Unless I see breakout strength in such indicators as money flow, NYSE TICK, and new highs/lows, my leaning will be to fade sharp market rallies, but also to fade tests of recent lows that are accompanied by non-confirmations in these indicators." We certainly did see the volatile, whippy action during the week and a seeking of a bottom by week's end. Did we see the non-confirmations that would lead us to believe, however, that we are near a bottom? The evidence, we shall see, is quite mixed on that score.

We continue to be oversold in the Cumulative Demand/Supply Index (bottom chart), which, if you recall, is a cumulative line of a daily index that compares the number of stocks closing above their volatility envelopes and those closing below. When we see persistently low Cumulative DSI numbers, it means that stocks are persistently closing closer to their lower envelopes than their top ones. That is a clear sign of broad market weakness, since the Cumulative DSI assesses all stocks traded on the NYSE, NASDAQ, and ASE. (I update the Demand/Supply numbers each weekday AM via the Twitter app, so that you can track emerging strength and weakness).

This indication of broad weakness is supported by the advance-decline line for NYSE common stocks, which has been making fresh bear market lows through the past week, as well as by the persistently weak money flows for the Dow industrial stocks. As I noted during the week, 38 of the 40 stocks I follow in my basket of highly weighted S&P 500 stocks across eight sectors are trading in downtrends based upon my Technical Strength measure. This is not what I'd look for in a market in which selling is drying up.

To be sure, the number of stocks making new lows vs. highs (top chart) were lower this past week than two weeks previous. Still, this number is quite elevated. For example, Decision Point reports that 228 of the 500 S&P large cap stocks made fresh 52-week lows on Friday. Among the 600 S&P small cap issues, 250 made fresh annual lows; among NASDAQ 100 stocks, fully 59 made new 52-week lows. While I'm making note of the divergences with respect to the number of new lows from two weeks ago, enough stocks continue to behave in weak ways to make me want to see confirmation of fresh buying interest before taking intermediate-term long positions in stocks.

I recently noted the weakness in the corporate bond market, particularly in the high-yield sector. This is important, because the current crisis is first and foremost a credit market event that has spilled over into the broad economy and affected stocks. As long as the credit markets continue to make new lows, it will be difficult to sustain a bull move in stocks. I am watching several market themes--corporate fixed income weakness, Treasury strength, U.S. dollar and yen strength, and commodity weakness--as a way of assessing likely moves in stocks. We'll need to see a reversal in those themes to begin any kind of bottoming in stocks.
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Gauging Intraday Swings With NYSE TICK

If you click on the chart above, you can see the ES futures (blue line) from October 23rd and 24th plotted against a 2 hour moving average of the adjusted NYSE TICK (pink line). I've found this intraday moving average of the NYSE TICK to be helpful in several respects:

1) The slope of the TICK moving average line tells me whether buying or selling interest is increasing or decreasing over the short term, providing a gauge of intraday sentiment;

2) The peaks and valleys of the TICK moving average line act as rough intraday overbought and oversold measures;

3) The degree to which the TICK moving average line spends time above or below the neutral zero line tells me whether the cumulative TICK over the entire period charted is moving up or down; i.e., whether buying or selling sentiment is dominating the period.

Some of the best selling opportunities occur when you get short term overbought readings in the TICK moving average when the cumulative TICK is falling. Good buying opportunities occur when you see short term oversold readings in the moving average when the cumulative TICK is rising. When very oversold readings are followed by very overbought ones and vice versa, we often see a sentiment shift that accompanies a change of trend.

Methodological note: The adjusted TICK is computed by taking the one-minute average high-low-close price for TICK and subtracting from that value the average one-minute TICK reading over the past 20 days. Once I adjust current TICK readings for the 20 day average, I then calculate a 2 hour moving average of those adjusted TICK values. By adjusting TICK readings for a 20-day average, you're measuring with the zero level whether the present level of buying or selling sentiment is greater or lesser than that seen over the last 20 days. This provides a *relative* sense for whether buying or selling pressure is rising or falling.
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What Is The High Yield Corporate Bond Market Telling Us?

I've spent a good amount of time looking at high yield corporate bond funds and their holdings; most of their charts look like Vanguard's VWEHX shown above: the majority of the year's price declines have occurred just since September.

Clearly, the high yield bond market is pricing in a high probability of defaults. According to a recent Financial Post article, default rates among high yield bonds through September has been 3.2%. During the last recession, in 2002, the default rate exceeded 16%. The iTraxx Crossover index, which reflects the cost of insuring against high yield defaults, hit new price highs last week, according to Financial Post. This insurance has become so expensive that two-thirds of all bonds in the index would have to default with a 40% recovery rate in order for the insurance purchaser to break even.

Have bond markets overshot the downside? Fitch Ratings is predicting the worst period of high-yield bond defaults ever, noting that fully 24% of the U.S. high-yield market is now accorded "junk" ratings and is at risk of default. Even these ratings may well understate the vulnerability of the high-yield market, however, as investors fear a repeat of overoptimistic ratings of subprime mortgage debt. Some will see the current high yields of oversold bond funds as a low-risk buying opportunity; others will see this as a harbinger of bad things to come in 2009 and 2010.

I find that the best time for longer-term investment is when bad news is coming out and markets are no longer making new lows on the news: the worst has been priced in. At this juncture in the high-yield market, the worst of the news hasn't even come out and we're in the midst of a price waterfall. At some point, this bond sector will be a great buy; I'll wait for the headline defaults--and an opportunity to gauge the reactions of stock and bond markets--before venturing into the business of catching falling sharp utensils.

RELATED POST:

Corporate Bond Price Performance
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Weakness Through the Week

Traders hoping to put in a bottom this week were disappointed as weakness expanded through the week. The advance-decline line for NYSE common stocks, helpfully tracked by Decision Point (top chart), shows us breaking down to new bear market lows. This was no doubt aided by weakness among secondary issues, as the Russell 2000 stock index made new bear market lows as well.

The new high/new low figures also found weakness expanding as the week moved along. Friday saw us register 99 new 20-day highs across the NYSE, NASDAQ, and ASE against 2564 new lows. While the new lows are still fewer than we saw a couple of weeks ago, so far the market's oversold condition has not brought significant buying interest, as can be seen from the money flow figures for the Dow industrial stocks (bottom chart). We have moved from very heavy selling to more neutral levels in the four-day average (pink line), but there is no evidence so far of sustained buying interest.

Among the 40 stocks in my basket divided evenly among eight S&P 500 sectors, my technical strength measure finds only one in a slight uptrend (AMGN), one neutral (WFC), and the remaining 38 in downtrends. What is significant is not just the broad weakness, but the way in which broad weakness has been sustained over time. We are seeing a historic liquidation of stocks and, so far, my indicators are not picking up any reversal of that trend.
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Visualizing Market Themes and Trends

The Futures Heat Map from Barchart shows red across the broad range of markets (above). Looking at a heat map of sectors within the S&P 500 universe from FinViz, as well as a world heat map, we also see losses across the board.

With further anticipations of a global economic slowdown, stocks and commodities have few places to hide. I find the heat maps to be helpful visualizations of what's strong and what's weak, both in absolute and relative terms. This can be extremely helpful in picking up short-term market themes--and shifts among these.
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Five Trading Behaviors I'm Seeing Among Traders Making Money Now

As I'm writing this, the ES futures are lock limit down and my email count is off the charts. Lots of fear, not much greed: fear, not only for one's trading, but for retirement savings and the economy. Most of people's money is tied up in some combination of stocks, bonds, and residential real estate. That means that many, many people are worth 25+% less than they had been just a year or so ago.

It is difficult to insulate those fears and concerns from one's trading. And yet, I do hear from traders who are making money in these markets. There *is* volatility, and there can be opportunity. Here are ten factors that stand out among the traders I talk with who are making money in the current environment:

1) Patience - The ones who are afraid of missing moves, who chase moves as a result, are getting hurt. The ones who wait for clear signals and good reward-to-risk opportunities can take advantage of the volatility. The successful traders aren't afraid of missing a move; they know, in this volatile environment, other opportunities will arise.

2) Position Sizing - Trading smaller when markets are moving more means that one or two losing trades won't knock you out for the day or the week. The successful traders tell me they're making plenty of money with smaller size simply because we're moving triple digits in the Dow just about every day.

3) Resilience - When you're wrong in these markets, you can really be wrong. My first trade yesterday lost over 20 S&P points; I wound up the day solidly in the green. By managing risk, you also manage emotions and can stay in the game. The successful traders are in there, making trades. They get off the canvas when they're wrong and they play defense, even as they look for opportunity.

4) Minimizing Distractions - One thing I noticed is that the successful traders in this environment have taken active measures to protect their personal finances. The less successful ones have been distracted by losses they're incurring outside of trading. It is difficult to focus on trading if you're worried about unemployment or loss of savings; addressing personal security helps maximize focus during trading.

5) Self-Maintenance - It's easy to get run down following markets through the day, every day, and then tracking them overnight and overseas. One troubled trader told me he was living, eating, and breathing trading. That is a risk factor for burnout, lessened concentration, and bad decision making. The successful traders aren't afraid to step away from the screens; once again, they know opportunity is not going to go away.

I'm finding that execution is the better part of success in these times. If you have a good idea, but the timing of your entry is wrong or your position is too large, you're likely to get stopped out at the worst conceivable time. By waiting for markets to put in a seeming high or low, waiting for a bounce or pullback that can't make a new price extreme, and *then* getting into a position, you can minimize the heat you take on trades. That, I'm finding, is half the battle.
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Ideas for a Turnaround Thursday

* Stress on the Floor - A Chicago Tribune article takes a look at how traders in the pits are handling the recent market volatility.

* Not All Panic Is Unjustified - Sometimes there's more to fear than fear itself.

* Changing the Consumer - Recent economic and market events are leaving their mark.

* How to Not Think About Markets - Great insights from Jeff Miller.

* Setting Goals - A look at the kinds of goals that further performance.

* Achieving Mastery - Ray Barros on the psychology of decision making.

* Correlations - Market Sci looks at how the Hong Kong and U.S. markets affect one another.

* Putting an Idea to the Test - CXO takes a critical look at margin debt as an indicator.
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On The Thursday Radar

* Testing the Lows - Stocks are once again moving lower, as we break below the closing lows of a couple of weeks ago. The advance-decline line for NYSE common stocks has broken to new lows, but the number of stocks registering fresh lows has remained below its level of two weeks ago. Specifically, we had 414 NYSE common stocks make fresh 52-week lows on Wednesday according to Decision Point; that compares to the earlier level of over 1400 new lows. I'm seeing some firmness in bonds also that hadn't been present a couple of weeks back. Should we see selling drying up with a number of sector non-confirmations of lows, I'll be tempted to nibble at the long side...the first time in a while for anything other than an intraday trade.

* Submerging Markets - Lots of chatter re: weakness in the emerging markets. A number of countries are requesting IMF aid (first Iceland and Hungary, then Pakistan, Ukraine, and Belarus); emerging market stocks (EEM) and debt are underperforming those of developed nations. As we look for signs of financial stabilization in the U.S., there are signs of considerable instability overseas. Looking for short-term stock market bottoms aside, I continue to operate on the assumption that these are not economic problems that will resolve over a period of days or weeks.

* What's Weak - Consumer discretionary stocks (XLY) continue to underperform consumer staples issues (XLP) and resource-related stocks (XLB, XLE) continue to underperform the broad stock market. These recessionary themes are worth watching; I strongly suspect they need to reverse to sustain any market upturn.

* Integrity and Its Absence - It's come to my attention that yet another website is lifting content from blogs (including this one) wholesale, posting to their site, and using whatever traffic they can generate for advertising revenue. If you're reading this post on a site other than TraderFeed (or Seeking Alpha, which has permission to selectively repost some material), you're on a site that engages in copyright theft for their own financial gain. My modest request is that you not patronize such sites; I find their ethics disgusting and hope their bots do steal this particular posting. :-)

* Trading Symmetrical Triangles - Trader Mike finds the market down, but not out.

* More Good Reading - Ethanol woes, looking behind high yield ETFs, and more views from Abnormal Returns. Recession, credit problems, and market decline haven't run their course and a host of other worthwhile perspectives from Charles Kirk. I continue to post major themes and market indicators daily via Twitter.

* Looking in the Mirror - Great post from SMB on asking the tough questions and reviewing your trading.

* When Volatility Contracts - Nice market study from Quantifiable Edges finds something interesting: reduced volatility is not always bearish.

* Getting Ready for Halloween - Financial Ninja shows scary Fed charts that have gotten scarier.

* Moral of the Story - When the financial crisis first really starting hitting markets hard, I looked and looked again at the implications of financial rescue for inflation and the U.S. dollar. I looked into buying gold as one way of playing the theme; I looked at ways of expressing dollar weakness versus other currencies. Each time I looked, the obvious trades looked horrible to me; they expressed *such* a consensus idea. Small investors were hoarding gold coins and bloggers were screaming about the terrible inflationary consequences of bailouts. Well, maybe these trades will eventually pan out, but I would have gotten smoked by following my gut. Joe Granville used to say, "If it's obvious, it's obviously wrong." Gold is way off its highs and the U.S. dollar continues to rally higher, especially versus euro; deflation and flights to safety are the operative themes for now. It really pays to know what other people are thinking, especially when they're thinking similarly and will have to bail out of ideas that don't come to fruition.
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Market Tells: A Worthwhile Trading Resource

Every so often, I alert readers to services and resources that I have found helpful. I am not compensated for mentioning these; in fact, the mentions are never directly solicited. But if it's a resource that I use and find helpful, I'm happy to pass the word along.

Today's resource post focuses on Market Tells, the advisory service run by Rennie Yang. Market Tells is one of the few advisory services I know that follows markets intraday as well as end-of-day; the email alerts during the day are quite useful observations. Also tracked intraday is one of my favorite indicators, the Cumulative TICK (see above), as well as a variety of intraday internals. The charting section of the site includes a wide range of indicators updated daily, including program trading activity, volatility measures, longer-term cumulative TICK, and new highs/lows.

A unique feature is the Trend Catcher trading system, which alerts traders to trend days (those that are likely to close near their day's high or low prices) as they unfold. Trend Catcher signals are sent by email; I find them quite worthwhile.

When I mentioned to Rennie that I'd be featuring his site, he kindly agreed to provide TraderFeed readers with free access to the Market Tells site (not including email alerts, sorry!) until November 7th. To take advantage of the offer, here's the login information:

username: traderfeed
password: demo

Are there other resources you find helpful to your trading? If so, feel free to make mention in the comment section to this post (please, no self-promotion). Thanks!
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Coping With Challenging Markets By Hedging Your Bets: Financial and Personal

Dear Readers,

It really has been an amazing time; I've traded the equity markets since late 1977, and I've never seen market and economic conditions like these. It's not just the ferocity of the decline: it's also the extended high volatility and the way that so many of the major asset classes: commodities, bonds, and stocks have been hit hard--and simultaneously. Add that to the decline in housing and more general concerns over recession and you have bearish sentiment that feels qualitatively different than at prior market drops. Polls show that the vast majority of Americans feel dissatisfied, convinced that the country is headed down the wrong path. Confidence in Congress and the White House is at all-time lows. Consumer confidence has tanked.

Traditional logic says that such pervasive bearishness should lead to favorable market returns going forward. After all, who's left to sell when everyone is bearish? In normal times, that logic holds. Although I'm currently working with a scenario of stock market bottoming and an eventual intermediate-term rally, I'm not sure the traditional logic makes for sound investment policy. At some point, qualitative differences yield quantitative ones: when negativity is pervasive, it affects future decision-making, with self-fulfilling effects for the economy. That's what we saw at important secular market bottoms in the 1930s/1940s and in the 1970s/early 1980s. Undervalued markets stayed undervalued for an extended time; bottoming took years.

That doesn't mean that civilization as we know it is over, that we will replay the Great Depression, etc. It does mean, as my friend Henry Carstens observed, that we're moving from a leveraged world to a deleveraged one, as credit is unwound throughout the financial system, from banks to homeowners and consumers. It's a bit like getting off amphetamines: there's quite an initial crash. Leverage has pumped up home sales, profits, real estate development, and consumer spending--and now deleverage is winding those down. Valuations from a leveraged world are transitioning to deleveraged valuations. In my personal financial planning, I'm assuming that such a transition will not occur in weeks or months. I am prepared for the possibility of subnormal stock market returns for years to come (just as market returns were subnormal following the massive declines of 1928 and 1974), and I am prepared for the scarcity of credit to keep corporate and municipal bond yields high for an extended period.

In times of stress, we tend to anchor our thinking in the most salient pieces of information; behavioral scientists refer to this as the availability bias. When volatile markets rise, we hear talk of "the worst is behind us"; when they fall, we hear of repeats of the 1930s. Worse still, financial planning--even among supposed professional financial planners--becomes simplistic: either hold on and wait for the turnaround or bail out of everything and rescue what capital you can. Little wonder that so many investors are frozen, not knowing whether to stay the course or jump ship.

Prudent investment planning, however, suggests that neither extreme is necessary. The important consideration is identifying which assets (stocks, bonds, etc.) are likely to outperform the general markets during any period of extended weakness and ground investment in those. Then, hedge your bets. If you think that some companies that offer value to consumers--or that offer necessities--will outperform those that do not, you can be long the attractive names and short the unattractive ones. Or you can be long the attractive names and short the broad stock market. You hedge your bet by reducing your exposure to overall market risk. Your investment becomes a relative value play, rather than an outright directional one. I almost never hear financial planners talk about that, and I almost never hear of such strategies from the general investment public.

Recently, in my investment accounts, I've been long some high-grade, insured municipal bonds and short stocks. My bonds have declined in value; my short position in stocks has helped compensate for that. Meanwhile, I collect the "carry": I make more in yield from the bonds than I pay out financing my short stock position. That's a kind of hedge (albeit not a perfect one). I'm looking for relative value, not just absolute market movement.

In difficult markets, there are always areas of relative opportunity. You might be long the U.S. and short some vulnerable emerging markets; you might be long gold and short base industrial metals. Getting away from availability biases and thinking multidimensionally is an excellent coping strategy for difficult markets.

That having been said, one antidote for abnormal markets is to ground ourselves in normal, daily life and the things we can control and enjoy. I've cut back on business travel and will be taking some extra family time in weeks ahead. I'll be getting back to editing my new trading psychology book and writing my free e-book. When you're hedged and can sleep with your portfolio, it frees you up to enjoy what's most important in life. And, psychologically, those important activities--whether they be family, writing, or other personal pursuits--are the best hedges of all, the most valuable sources of diversification.

Thanks as always for your interest and support--

Brett
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A Macro View: Economic Weakness Themes Continue to Dominate

With economic growth waning in China and other emerging markets (top chart), demand for commodities has plunged (second chart), weighing on raw materials stocks (third chart). Meanwhile, in a world where USD and JPY are carry currencies amidst risk aversion, the U.S. dollar (bottom chart) continues to make new highs against a basket of world currencies. Those looking for a turnaround in stocks will want to also see an unwinding of these economic weakness themes, which we're not seeing yet.
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Cross-Talk: Deleveraging the Consumer and the New Realities of a Pay-As-You-Go World

Margie and I were flipping through channels and happened to stop on financial guru Suze Orman making the case that we're now living in a pay-as-you-go society. Her point was that credit of all sorts--from credit cards to student, mortgage, and car loans--was going to be more difficult to come by and thus more expensive. In a world of constrained lending, we go from a credit card mentality to a debit card mind set. We pay out of money that we already have, not out of money that we can borrow.

At a broader level, this means that the deleveraging we've been seeing at banks is filtering down to the public. As Mish observes, this greatly affects consumer outlooks: it's no longer about keeping up with the Joneses. Rather, frugality becomes the operative priority. When employment, housing values, stock values, and bond values are contracting, the incentive is huge to hang on to what you've got. You certainly don't dig a hole for yourself by going into debt. Pay-as-you-go is the prudent alternative.

There have been many comparisons of the current market/economic period with the 1930s and the Great Depression. Most of those comparisons, understandably, focus on how bad market and economic conditions could get. A better comparison, however, would be the ways in which financial crises affect societal attitudes for an entire generation. From the Roaring 20s to the Depression 30s, we saw a dramatic shift in attitudes about saving, investment, and risk. My grandfather, who lost his fortune in the that crisis, never went back to investing in stocks and bonds. He became a frugal saver, who kept many different bank accounts lest there be problems at any one institution.

That is the way of psychological trauma: a single set of painful, powerful emotional events can reshape perception and action. As the deleveraging of the consumer unfolds, I believe we'll see a similar reshaping of views: fiscal prudence will become a mantra for households--and eventually will be expected of government. Not all of that will be for the worst. In the interim, however, that deleveraging--and the accompanying shift in attitudes--will create winners and losers on Wall St. Companies that produce necessities and that create unique value will prosper over those that connote luxury; firms that are well-capitalized and generate significant free cash flow will have the advantage over those that depend upon borrowing--their own, and that of consumers.

I was looking yesterday at companies in my basket of stocks that were making fresh 10-day closing highs. They included MRK, PFE, T, VZ, MO, and JNJ. All make products that, rightly or wrongly, are perceived as necessities--or at least affordable (and indispensable) luxuries. At the end of this month, we'll spend a little extra to get our kids the cell phones they want. We may very well, however, scale back our plans to buy them cars or travel abroad. As the recession unfolds, the companies that make the things you'll buy in a pay-as-you-go world may be the best place to look for market outperformers.
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Buying Interest in Stocks: Improved, But Still A Mixed Picture

The NYSE TICK assesses, at roughly six second intervals, the number of NYSE stocks trading on upticks minus those trading on downticks. By cumulating the one-minute NYSE TICK values, we can gain a longer-term sense for whether buying (trading on upticks) sentiment or selling (trading on downticks) sentiment is dominating. The cumulative TICK line (bottom chart; blue line above) bottomed with the ES futures (pink line) and, since then, has moved steadily higher as stocks have consolidated. This buying interest is showing up in my indicators; on Monday my Demand Index (an index of the number of NYSE, NASDAQ, and ASE stocks closing above their volatility envelopes) was 98; Supply (an index of stocks closing below their envelopes) was only 6.

As noted in my indicator review, the large majority of issues have rebounded from their lows; on Monday, for instance, we saw 80 NYSE stocks make new 20-day highs and 52 make fresh lows. At the market bottom, over three-quarters of NYSE issues made fresh 20-day lows. In spite of this, the money flow indicator for Dow stocks (top chart) continues to remain negative, as the four-day moving average (pink line) remains well below the neutral zero (blue) level. Money flow is very sensitive to the distribution of large trades transacted on upticks vs. downticks. So far, it continues to tell us that traders in size are hitting bids in Dow stocks more than they are lifting offers. It will be necessary to get those large traders on board if the recent market firmness is to develop into a full-fledged uptrend.
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Indicator Update for October 20th

Last week's indicator review concluded, "I will need to see evidence of a drying up of selling pressure before concluding that the worst is over for stocks. Thus far, every indicator tells us that weakness has been expanding, not drying up." This past week, we saw a dramatic move higher in stocks, followed by an almost equally dramatic move downward, as volatility continued at extreme levels. So how have indicators fared?

Money flow has continued weak and the advance-decline figures suggest that no broad-based price strength is yet evident. The cumulative Demand-Supply Index (top chart), which cumulates the daily index of stocks closing above vs. below their volatility envelopes, remains at oversold levels, albeit off its recent lows. Similarly, we see weakness in the number of stocks registering fresh 65-day highs vs. lows (bottom chart), but these numbers are also well off their lows. For example, we had 107 new 20-day highs on Friday against 383 new lows. At the market's momentum low to date, we registered over 6500 new 20-day lows across the NYSE, NASDAQ, and ASE. Also well off its momentum lows is the cumulative NYSE TICK.

Thus far, I am working with the following assumptions:

1) The market made a momentum low for the recent bear move, and we are now in the process of bottoming;

2) Significant market declines (1974, 1981-2, 1987, 1990, 1998, 2002-3) have taken weeks to months to form bottoms, and the current bottoming process could be similar;

3) Given the current volatility, any market rise from such bottoming could be quite sharp;

4) While such bottoming may bring a meaningful intermediate-term low, it is not at all clear to me that we've seen the ultimate lows for this secular bear market.

What this means is that we could see more broad, range-bound, whippy action as markets seek an intermediate-term bottom. Unless I see breakout strength in such indicators as money flow, NYSE TICK, and new highs/lows, my leaning will be to fade sharp market rallies, but also to fade tests of recent lows that are accompanied by non-confirmations in these indicators.
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Corporate Bonds: Year-to-Date Price Performance Along the Yield Curve

Above we see year-to-date price performance for four corporate bond funds in the Vanguard family: short-term investment grade (VFSTX); intermediate-term investment grade (VFICX); long-term investment grade (VWESX); and high yield (VWEHX).

What we see is that, as the yield curve has steepened, longer-term bonds have dramatically underperformed shorter-term ones.

Even more dramatic is the way that high-yield bonds have underperformed investment grade offerings. The bonds in VWEHX are roughly the same in maturity as those in VFICX, yet it has been almost twice as weak in price performance.

The bottom line is that reaching for yield--either by going further out on the curve or by compromising bond quality--has hurt investors. Conversely, short-, intermediate-, and long-term Vanguard funds for Treasuries have all seen price gains on the year. Safety has ruled the roost for 2008; this remains an excellent market sentiment indicator.
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Recession or Depression? It Might Depend On Where You Live

In a recent post, I found that the banking crisis was far from uniform within the U.S.. Many small communities continue to boast strong banking institutions, even as larger cities that experienced residential and commercial real estate booms host banks with lesser safety ratings.

As a follow-up to that theme, I went to the Bauer Financial site and looked up the number of "troubled" banks as a function of their state locations. Bauer awards up to five stars for bank safety, based on CAMELS criteria (capital adequacy, asset quality, management quality, earnings, liquidity, and sensitivity to market risk). They recommend banks with four and five stars; those with two stars and below pose safety concerns.

What we see in the chart above is that the number of troubled banks, broken down by the number of stars, is much higher in the states that experienced real estate booms (Florida, California, and Georgia) than in states that experienced less exponential growth (New York, Kansas, Wisconsin).

Out of 313 banks in Florida, 37 had ratings of two stars or less. The ratio was 28 out of 312 banks in California and 65 out of 358 in Georgia. Across the three states, about 13% of banks qualified as troubled as of June 30, 2008. (One can only surmise the proportions would be higher today).

Conversely, in New York, there were only 7 out of 198 banks with two or fewer stars. That ratio was 11 out of 353 for Kansas and 7 out of 293 for Wisconsin. Across these three states, only about 3% of banks qualified as troubled.

The financial health of banks is intimately tied to the financial well-being of communities. Banks that cannot lend due to capital constraints cannot fuel an economic rebound. Banks also reflect the health of the communities around them. Home owners, real estate developers, and businesses that cannot pay off loans will also be constrained in their ability to spur an economic comeback.

In many areas of the country, the current economic crisis may look and feel like an unpleasant recession. In other areas, it could feel much worse, with depressed housing and business growth for some time to come. The regions with the greatest credit booms are feeling the brunt of credit contraction; how bad the economy gets could depend very much on where you live.
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Not Much of a Bounce So Far

Although we had a very healthy bounce off the market lows, that was soon erased by follow-up selling last week. As a result, the advance-decline line for NYSE common stocks only, as tracked by the excellent Decision Point service, has barely lifted off its lows (bottom pane, above chart). On Friday, we had only 37 new 20-day highs on the NYSE, against 383 lows. The previous day, we registered 21 new 20-day highs on the NYSE against 487 new lows.

Among the 40 stocks in my basket that are evenly divided among eight S&P 500 sectors, none qualify as being in uptrends by my Technical Strength measure, three are neutral (MO, JPM, WFC), and the rest are in downtrends. Quite a bit of technical damage has been done to this market; it's going to take time--and greater follow through in buying interest--to reverse that.
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A Look At Fundamental Valuation: How Low Could We Go?

An interesting recent article asks the question, "How much is this market worth?" It turns out that, over the last 30 years, the S&P 500 Index has averaged about 2.4 times the combined book values of the component stocks. At the market peak in 2000, we traded at almost 5 times book value. In 1982, we actually dipped below book value.

Periods of overvaluation and undervaluation can persist for a considerable time. We were over 3 times book value from 1997 through 2002. We were below 1.2 times book value for much of the late 1970s through 1982.

At an estimated book value of 615, we're trading around 1.5 times book value, not quite the level noted by Ned Davis as "undervalued". Should the current market and economic weakness prove as troublesome as the late 1980s--a conclusion surely implied by those who call this the worst economic period since the Great Depression--a move below book value would certainly be in order before we could say stocks are a screaming bargain. That could be a meaningful decline, given that book values themselves can move lower as assets held by companies (real estate, receivables, etc.) are valued downward.

Back in the Great Depression, as Jason Zwieg notes, stocks sold for less than their cash and marketable securities. Should the ratio of stock price to cash and marketable securities in the current market return to the level of 10 that we saw in the late 1970s and early 1980s, he notes, that would take us to about 600 on the S&P 500 Index--back toward estimated book value. If we overshoot to the ratio of the market low in 1982, however, the S&P 500 Index would be closer to 400.

Interestingly, this fits with the recent analysis of market valuation based on Tobin's Q. Based upon the replacement cost for assets of the S&P 500 companies, the index should be trading around 910--roughly where it stands now. At historic market lows since 1920, however, indexes have tended to trade closer to somewhat above half their replacement cost.

If we look at this market from a trading vantage point, it is hard to escape the sense that we're tremendously oversold and due for a rally. In the short-to-intermediate term, that would not be surprising. If, however, we focus on fundamental valuations and historical norms, we're not at all at historically highly undervalued levels. There is a disconnect right now between how severe we say the economic problems are and how we think markets will move from here: most investors I talk with say the problems are quite severe *and* they say, with more than a little hope, that they think the worst of the market decline is behind us.

If this is indeed the worst economic crisis since the Depression, we will likely see book value in the major averages before we make a long-term bottom. That is not an extreme prediction of doom; it represents a level of valuation we've seen within the last 30 years. I don't see average investors and investment advisors thinking through or planning for this possibility--and that could lead to sorry retirements for a number of baby boomers.
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Cross-Talk: Volatility and Stock Market Returns

Here's a great blog post from Market Sci that builds upon an idea I wrote about a while back. Michael Stokes researched what happens in the market after relatively narrow range days versus wide range days. What he found was that markets historically have yielded superior returns following those wide range days compared with the narrow days. Another way of looking at this is that expansion of volatility has generally led to bullish returns going forward.

Michael also notes, "This approach defended well against the bear market of the early 2000’s and our most recent beginning in late 2007 (interestingly though, it crashed and burned in the most recent October death march)."

This gets back to the notion that "this time *has* been different". Many historical patterns--particularly ones in which extreme weakness have led to bullish prospective returns--have not panned out during this decline. Expanded volatility has led to even greater volatility and then record volatility, as prices have moved steadily lower.

Michael's research found that the high volatility/bullish returns relationship was noteworthy from 1993 through 2008, but less convincing when looking at history going back to 1970. This, too, fits with my experience in market research: rarely do patterns hold intact over all markets, across all market history. Rather, we see regimes in which patterns will manifest themselves for months and years, only to give way to different patterns and regimes--usually when market conditions change. I suspect that the crashing and burning noted by Market Sci with respect to the volatility pattern is one piece of evidence that regimes have shifted--and may stay different for a considerable period.

Thanks to Michael for an excellent site; check out his posts on market nuts and bolts and coping with abnormal markets.
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When Good Trading Leads to Bad Trading: Breaking Problem Cycles

Consider the following scenarios:

1) A woman is motivated to lose weight and goes on a diet, losing 20 pounds over time. As she becomes more comfortable with her weight, she relaxes the diet and begins to put the pounds back on. Only after she has returned to her original weight does she reinstate the diet with renewed motivation.

2) An alcoholic attends AA meetings every day and remains sober for months. He tells himself he can become a social drinker and control his intake, only to relapse into his prior pattern of overdrinking and erratic behavior. When he is given another DUI citation, he is in jeopardy of losing his driver's license and returns to his AA meetings and prior sobriety.

3) A trader has gone through losses and trades smaller and more cautiously, planning out trades carefully in advance to maximize reward and minimize risk. As he makes money, he relaxes his trading criteria and takes a number of unplanned trades, resulting in losses. Once he loses the money he had made during his good trading, he returns to trading smaller and more carefully.

Each of these is a situation in which problems occur in cycles. The cycle involves strict, conscious, and motivated attempts at self-control followed by lapses of self-control. During the periods of self-control, the unwanted behaviors are contained; during the lapses, they spiral out of control and bring undesired consequences. Think about the eating patterns of a bulimic patient or the interaction patterns of spouses who repeatedly fight and make up. The problems are different, but the cyclical quality of the problems is constant.

Much of my book The Psychology of Trading deals with this problem of "multiplicity": how people can behave one way, in one state or frame of mind, and quite the opposite when those states shift. Reviewing cognitive neuroscience research, I conclude in the book, "People lose money in the markets because the person who places the trade very often is not the same person who manages and closes the trade. Quite literally, another self has taken over--another mind...People cannot sustain purpose in their lives--and trading is certainly a purposeful act--because they are fundamentally divided beings" (p. 79).

It takes the shock of significant consequences to change people's feelings and state of mind and shift them into the self-controlling mode. Once those consequences are not salient, the mind state becomes more relaxed, the urgency of maintaining control is reduced, and old behavior patterns come to the fore.

Conversely, when consequences are *always* salient, there is no problem maintaining desired behavior patterns. Most of us don't feel particularly tempted to steal merchandise from stores or drive at high speeds on the wrong side of the highway. We're quite aware of the consequences and following rules and doing the right things take no particular act of effort or discipline. Similarly, when a heart attack patient realizes his fragile health status, he finds it relatively easy to stick to a regimen of medications and proper diet. Salience of consequences promotes consistency in behavior: in classrooms, at work, and in day to day life.

The first step in breaking problem cycles of behavior is to become aware of those cycles as they are occurring and to focus attention on the likely consequences of those cycles. In practice, this means being very sensitive to the triggers that set the problem cycles in motion. For the alcoholic, the triggers are cravings or thoughts that it might be possible to engage in controlled drinking. For the trader, the triggers often are frustration and perfectionistic thoughts about how much money one should have made (or shouldn't have lost). If those triggers are accompanied by alarm--a concern for consequences--it will be relatively easy to interrupt the problem cycle and, in the case of trading, step back from the screen, calm oneself, and redouble efforts at careful, planned trading. The entire key is attaching that sense of alarm to those triggers.

I'll have much more to say about this in my forthcoming book on self-coaching, including specific techniques for sustaining self-control. Readers of the Trader Performance book might want to consult the chapter on "Behavioral Techniques for Enhancing Performance", which outlines, step by step, how to identify triggers and use exposure techniques to interrupt and reprogram them. In the exposure method, you use relaxation and guided imagery to vividly walk yourself through specific trigger situations, while you keep yourself physically calm and cognitively focused and mentally rehearse the concrete actions you want to take in those trigger situations: recognizing the trigger, reminding yourself of the dire consequences of repeating the problem pattern, and redoubling your efforts at cautious, controlled trading.

In other words, you want to respond to the trigger situations--the frustration, the thoughts of needing to trade to make money back, the overconfidence--the same way that you respond to losses of significant money. Instead of waiting until you lose money to become virtuous in your trading, you train yourself to become virtuous when you recognize the trigger situations and feelings that would take you out of your game. The more you mentally rehearse the trigger situations in the right state of mind and body, the more prepared you'll be to respond to them in a calm and focused way when they arise in real time.

RELEVANT POSTS:

Problem and Solution Patterns

Breaking Trading Slumps

Top Reasons Why Traders Lose Discipline

Understanding Lapses in Trading Discipline
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Will We Know When We've Made A Low?

At some point, this stock market is going to overshoot to the downside, just as it overshot to the upside, and there will be tremendous money to be made. Of course, everyone wants to catch the bottom, so that creates violent rallies when it seems as though we've made a low and equally violent reversals when those hopes are dashed.

A look at some recent large market declines--1970, 1974, 1987, and 2002/2003 (charts above)--suggests that market bottoms following major drops tend to be complex affairs. Sometimes, as in 1970 and 1987, you get a washout selloff that marks intraday lows for the bear move, followed by retests that hold above that intraday low. Other times, as in 1974 and 2002/2003, you get the classic pattern of a momentum low (the point at which the number of stocks making fresh annual new lows hits a peak) followed by subsequent price lows on lower momentum (and fewer new lows).

Note how, in the charts above, there tend to be substantial rallies and sizable selloffs even after price lows have been made. This volatile choppiness makes it difficult for traders and investors to hold positions with conviction.

It is this tendency toward complex bottoms that means that investors can find good points for entry even after ultimate lows have been made. Indeed, traders who were too eager to catch market bottoms in early May, 1970; September, 1974; early October, 1987; and July, 2002 found themselves facing significant further declines. We really only know when we've made a low when we're able to assess subsequent buying interest after price and momentum lows have been made. That often means missing exact price lows, but it also avoids the discomfort of catching those proverbial falling knives.
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