Weak Market: What Comes Next?

 

We've seen a stock market that has been rather weak over the last couple of weeks.  Higher interest rates at the long end have particularly impacted rate-sensitive sectors, such as utilities and real estate, and have provided support for the U.S. dollar and dollar-related carry trades.  Speculation has shifted from imminent recession to an environment of "sticky" inflation and rates that are likely to be "higher for longer".  So is the recent pullback in stocks an opportunity to participate in the longer-term uptrend, or is it a warning to preserve capital?

Let's step back a minute.

I observe two problems among market participants.  The first is to construct trades without underlying robust ideas.  Traders who look to charts for "setups" are particularly guilty of this mistake.  The second problem is to generate big picture, top-down narratives based on fundamental data, but not anchor these themes in well-analyzed trades that provide favorable reward relative to risk in a shorter-term time frame.  My experience with successful market participants is that they are both investors and traders.  They generate robust bigger picture ideas through unique, rigorous analyses and they then translate those ideas into good trades by rigorously assessing shorter-term risk-reward.

In the terms of Daniel Kahneman, success in markets requires both deeper, slower thinking and faster, flexible thinking.  In practice, this means having consistent strategies but flexibly adapting the implementation of those frameworks based upon current conditions.

So now let's look at the current market:

I notice that, across the NYSE universe, we have seen over 1500 stocks making fresh monthly lows and fewer than 1000 registering new three-month lows.  That is what we would expect during a correction in a rising market.  When one-month lows *and* three-month lows are high (bear market), next ten-day returns since 2010 have been negative.  When one-month lows have been high and three-month lows have not been significantly elevated, next ten-day returns have been distinctively bullish--significantly above average.

In short, context matters.

When analyzing market returns, it's not enough to examine one time frame.  We want to see how the shorter time frame fits into the market's larger picture.

Let's take a second example.  This past week, looking across the NYSE universe, we have seen very few stocks giving buy signals on two technical trading systems, the Wells Wilder Parabolic SAR and the Bollinger Bands.  These systems assess strength and weakness across shorter (SAR) and medium (Bollinger) time frames.  When the number of stocks providing buy signals on the SAR has been weak but the number of stocks giving buy signals on the Bollinger measure has been relatively strong, next ten-day returns since 2019 have been flat to negative.  When we have had few buy signals on both technical systems simultaneously, next ten-day returns have been solidly bullish.

Again, context matters.

Across a number of these kinds of analyses, we see favorable average near term returns after selloffs in rising markets.  That's the perspective from the slower, deeper analyses.  Now, going forward, if we see selling pressure that cannot result in lower prices, we can speculate that bears are trapped, will need to cover, and we could bet on higher prices going forward.  Conversely, if we see that buying pressure is limited and/or cannot drive price meaningfully higher, we can entertain the idea that this time, indeed, may be different and follow that up with further analyses and possibly very different bets.

The most successful traders I work with look at new and different things and they look at things in new and different ways.  Over time, unique returns cannot come from consensus thinking.  

Further Reading:

The Momentum Curve

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