Tuesday, December 31, 2019

Where Can We Find Market Opportunity?

Here's an end-of-year musing about market opportunity:

As of Monday, we had fewer than 40% of stocks in the SPX trading above their 3 and 5-day moving averages, but over 70% trading above their 20, 50, 100, and 200-day averages.  That's a nice proxy for a market that is short-term oversold in a consistently rising market.  When that has happened in the past, what have we seen going forward?  (Data from Index Indicators).  

Going back to July, 2006, the start of my database and a period that covers many market conditions, we've only seen 14 occasions when this has happened out of well more than 3000 market days.  Right away, I find that interesting.  The kind of consistent strength we've seen of late is not common.  

Also interesting is that six of the occasions occurred in 2009 and 2010 (right after a major bear market) and six occurred in 2013 and 2014 (during the runup to the early 2018 high).  In other words, this pattern has tended to cluster during bullish periods following prolonged market weakness.  An important potential implication is that early 2018 to the 2019 lows was a bear market (much more evident in overseas stock indexes and small caps) and what we're seeing now is a fresh bull market.

So where is the opportunity in all this?

I note that when we've been short-term oversold in a consistently bullish market, there has been no consistent upside edge over the next five trading sessions (6 up, 8 down).  Over the next 20 sessions, there has been an upside edge (10 up, 4 down), with an average gain of twice the rest of the sample.  Fifty days out all 14 occasions were higher and significantly more so than the rest of the sample.

My guess is that the great majority of traders will get caught in the chop of no edge over coming days and fail to capitalize on the longer-term edge that is there.  This is for two reasons:

1)  People who identify themselves as traders feel a need to trade - What if the greatest edge in a particular market is buying and holding for a few weeks?  We're not talking about an eternity.  To the "daytrader", "swing trader", and "active trader", that is not who they are and what they want to do.  In an important psychological sense, they trade to feel productive and active, not to maximize returns.  I predict if you had a great system that was consistently profitable with excellent risk-adjusted returns and that traded a few times per year with holding periods of weeks to months, the majority of traders would not follow it.  

2)  Traders are universally overleveraged - This is true at hedge funds, which seek limited downside and large positions, and it is true at prop firms, which are allowed to highly leverage capital for intraday trading.  The result of this overleverage is that traders cannot take heat.  They can't participate in an edge of weeks to months, because there is no way they can hold through choppy price paths.  In short, they hit their pain thresholds (their stop out levels) well before their edges can be realized.  In theory, they hope to trade the longer-term edge with shorter-term trades in the direction of the edge, but this rarely works.  A longer-term edge is different from a sequence of shorter-term trades without demonstrated edge.

What if the greatest edges in the market come from playing a game that few traders want to or are able to play?

What if most of the psychological frustrations and emotional upheavals that traders face come from trading crowded time frames and strategies with limited edge?

What if success comes from trading the time frames that objectively present edge and not the time frames we're most comfortable with?

What if the path to success isn't sizing up shorter-term trades with fleeting edge, but staying modestly sized to participate in longer-term edges?

What if the great majority of trading that goes on, with shockingly small odds of ongoing success, is a massive waste of time and energy with a dead-end future?

No brokerage firms, self-anointed market gurus, trading firms, or trading coaches have a vested interest in contemplating the above questions.  They profit from the (hyper)active trading and the replacement of older, failed traders with starry-eyed rookies.

That's sad, because edges *are* there in markets.  But they're like gold:  best mined where the masses aren't digging.

I wish readers a Happy New Year filled with the activities that most bring happiness, fulfillment, and success!