Sunday, July 09, 2023

Developing Your Uniqueness as a Trader

We commonly hear that a key to trading success is being disciplined and remaining grounded in a robust process.  That is true, but it is only part of the truth.  If we're disciplined in doing the same things as other people, we will simply be more consistent in achieving mediocre returns.  Having worked with many traders and trading firms over the years--and especially having participated in the recruitment of traders at those firms--I can say with confidence that distinctively successful traders view markets in distinctively unique ways.  They don't just have better answers; they ask better questions.  Unusually successful traders simply look at different things than average traders and look at markets in different and distinctive ways.

An important start toward cultivating our uniqueness is acquiring fresh data sets.  In trading the overall stock market, one data set that I have found to be promising is the percentage of stocks within each sector trading above various moving averages.  (Data from the excellent site).  So, for example, I track the percentage of stocks within the energy sector (XLE), consumer discretionary sector (XLY), consumer staples sector (XLP), health care sector (XLV), etc. that are above their respective 20-day moving averages.  This information tells us, not just if the overall market has been strong or weak, but which parts of markets have been particularly strong or weak.

Collecting new data enables us to ask new--and sometimes much better--questions.

So, for example, what have we seen going forward in the overall market (SPY) when consumer discretionary stocks greatly outperform or underperform consumer staples stocks?  Is there unique information in relative breadth strength and weakness?

Sure enough, when the percentage of consumer discretionary stocks above their moving averages has been much greater than the percentage of consumer staples stocks over the past three years, we see notably weak returns over the next five trading days in SPY, but particularly strong returns over the next 20 days.  Interestingly, this is a pattern we also see following unusually strong breadth thrust moves in the overall market:  a tendency to consolidate/pullback in the next few days, followed by upside momentum.  It makes sense that a relative breadth thrust among consumer discretionary stocks would display such momentum, as investors are counting on the kind of economic growth that sustains discretionary spending.

By contrast, when a large percentage of utility company stocks have been trading above their 20-day moving averages, the next 20-day returns in SPY have been negative, compared with solidly positive returns when few utility company stocks have been trading above their 20-day averages.  The flight to the safety of yields has not been a promising medium-term indicator of returns for the overall market.     

How about when traders aggressively move into small cap stocks?  When the number of stocks in the SP 600 small cap index trading above their 20-day moving averages has been quite high, next 5-10 day returns in SPY have been negative, before subsequently going significantly higher.  Once again, this is a pattern similar to that observed with general breadth thrusts.

And the current market?  We've seen solid breadth among the industrial stocks (XLI) with the great majority of shares trading above their 20-day moving averages.  Interestingly, over the past three years, that has led to short-term follow-through in SPY, but relatively weak returns over a next 20-day period.  And recent breadth strength among real estate stocks (XLRE)?  That, too, has been associated with relative weak SPY returns over a next 20-day horizon.  Those developments, on top of recent narrowing of outperformance by XLY over XLP has me cautious on the market.  Notice how the patterning of strength and weakness across sectors provides multiple perspectives on overall market performance as well as the performance of each sector.  When the weight of historical evidence lines up with what we're seeing in current price action, we have the makings of a promising trade.

This is but one example of how we can develop distinctive returns by studying distinctive market information.  I also collect databases of stocks making new highs and lows on a one- and three-month basis; stocks displaying buy and sell signals on various technical market indicators; etc.  All are ways of understanding when moves tend to reverse and when they tend to continue.  Trading success starts with looking at unique things, asking unique questions, and relying on objective data for answers.

Further Reading:

Trading With Breadth, Strength, and Momentum