The U.S. stock market has played out the weakness discussed in recent blog posts. We've also seen weakness in overseas equity markets, weakness in Treasury bond yields, weakness in high yield bond prices, and weakness in many commodities tied to economic activity. The movement across asset classes tells us that this is about something fundamental. The increased volume tells us that this is connected to larger, institutional market participants, particularly those involved in macroeconomic investment.
We saw this clearly in the aftermath of the Federal Reserve meeting and announcement. Going into the announcement we were seeing some decent buying flows, as measured by the number of stocks trading on upticks versus downticks. Upon the announcement we saw very strong selling flows on very enhanced volume. That told us that fresh participants had come into the market (institutional flows) and that they were aggressive sellers (hitting bids in the ES futures). Among the people I speak with, the consensus was that the decision to continue to shrink the balance sheet at the current pace was effectively a monetary tightening just as we're seeing global economic weakness. Market participants anticipated that this would exacerbate the weakness.
As I mentioned to the traders at SMB in their morning meeting, this is the time to ask the right market question. If the Fed decision was indeed a game changer, we should not see a meaningful retracement of the decline from the pre-announcement highs. In other words, if the lower prices post-Fed cannot attract significant value buying from higher time frame participants, then we have to assume that the macroeconomic sellers are in control of the market.
Sure enough, we did get some early buying and sure enough it could not retrace a significant portion of the post-Fed decline. That set us up for a further leg of weakness on Thursday. Finally, later in the afternoon on Thursday we saw some decent buying flows come into the market, and we held the afternoon lows in late session trading. Those pre-Fed highs remain a significant level and I will be watching buying versus selling flows this morning to see if we can get any buying more substantial than the typical short-covering. The only way we start to put in a bottom is if prices get to the point where longer time frame participants come into the market, attracted by bargain prices. That would give us very strong upticks among stocks, not just waning downticks.
These are the questions that I find helpful in active trading: who is in the market (volume); what are they doing (buying versus selling flows); and where are they doing it? An ancillary, important question is: To what degree are buying and selling flows meaningfully moving the market? This is the question of efficiency. As we saw post-Fed, we can have buying flows, but if they cannot retrace a significant portion of the prior decline, we can anticipate that those buyers will be the ones trapped on the next leg down. Can the sellers take us below yesterday's lows? That's a good question to ask going into today's open. Trading psychology is not just about the trader's psychology; it's also about reading the psychology of market participants.
Further Reading: