Sunday, February 21, 2016

Avoiding Confirmation Bias With Market Money Flow And Breadth

Confirmation bias is the tendency to seek information that fits our preexisting views.  The opposite of confirmation bias is open mindedness and the commitment to seek information that counters one's perspectives.  

At market highs and lows, there is no lack of information to confirm bullish and bearish biases.  At the highs, the economy looks strong, profits are solid, and sentiment is favorable.  At the lows, fears abound; talk of recession and crisis dominates.  

It's when actual market behavior deviates from these biases that we find opportunity.

Above is a chart of money flow for the SPY ETF, which is a function of the daily closing price and the number of SPY shares outstanding.  When traders are bullish, their demand creates new ETF shares; when bearish, we see a contraction in shares outstanding as shares are redeemed.

Note how money flow peaked in late 2014 and moved steadily lower during 2015 before the market declines late that year and early this year.  Bearish money flows, along with breadth declines, were among the factors leading me to fade strength during this period.

Now, however, we're seeing the opposite phenomenon.  With the 2016 market declines, SPY money flow is actually holding above its August, 2015 levels.  Moreover, at the February lows for SPY, we've seen fewer stocks register new lows relative to January.  Specifically, we had 1226 new three-month lows across all exchanges on February 11th, compared with 2663 lows on January 20th.  The February lows saw 19.36% of SPX shares trading above their 200-day moving averages, compared with 17.76% at the January lows.  Among SPX shares, we had 101 more 100-day new lows than new highs at the February lows, compared with 151 more lows than highs in January.

Bearishness has abounded, with concerns over high yield credit, oil prices, European banks, weak China and EM, and questions over the effectiveness of the monetary policies of central banks.  Despite these factors, it is difficult to find evidence of recent weakening in the U.S. stock market.  That leaves me open minded to the possibility that we've put in an intermediate-term low in stocks, even as I also share concerns over the global macro picture.

Further Reading:  Measuring Sentiment With Options