Two Questions to Ask in a Weak Stock Market

 

I'm looking forward this week to speaking with developing traders at SMB Capital, where I will share many of the lessons I've learned working with successful portfolio managers and teams at top hedge funds.  For those interested in hearing some of those lessons, I'll also be talking with My Investing Club at 4:15 PM ET on Thursday the 28th; the link to register is here.  

As a rule, it's important to know what is happening at time frames larger than the ones you're trading and also to know what is happening at time frames shorter than your typical holding period.  The larger time frames place your trade idea into perspective, addressing whether--bigger picture--we are in range markets, trends, etc.  The shorter time frames provide you with the concrete information needed to turn a good idea into a good risk/reward trade.  So, for example, I might have the idea that stocks have entered a downturn due to "higher for longer" interest rates.  I might then wait for weak bounces at lower price highs to exhaust themselves to enter trades on the short side.  

When we become locked into single time frames, we can find good ideas but trade them poorly or we can find good trades that ultimately don't play out when they are swamped by what is happening in the bigger picture.  Success in markets requires the deeper thinking of idea generation *and* the faster thinking of trading.

The most successful traders, however, go beyond deep and fast.  They also see broadly.  They don't just look at their stock or market; they look at other stocks and markets to place what they see in context.  Specifically, there are two questions traders ask to think broadly:

1)  Is the price action I'm seeing correlated with what is going on in different markets?  Is this a move specific to a stock, sector, or overall stock market, or is there a bigger macro picture impacting currencies, rates, and international markets?

2)  Is the price action I'm seeing accompanied by significantly different volume, volatility, and breadth than we've been experiencing recently?  This gives us an idea of whether the market move is the result of new, larger participants entering the marketplace, which could help sustain a trend.

In the case of the recent stock market weakness, note that this began with the Fed announcement and subsequent conference call.  During that trading session, we saw sustained negative levels of the NYSE TICK that we had not experienced recently.  Following that session, we've seen very negative breadth and an expansion of stocks making fresh one- and three-month lows.  Most importantly, during this decline, we've seen a significant rise in longer-term interest rates and strength in the U.S. dollar.  In other words, the macro picture was perceived to have changed as a result of the central bank communications and larger institutions have acted upon this information.  Seeing such dynamics in real time is essential to both trading and investing.

I look forward to building on these ideas in my group coaching sessions this week.  If we can view markets deeply, quickly, and broadly, we'll be best positioned to know what to do and why we're doing it.  A good trade requires vision; great trading requires flexibility of vision.

Further Reading:

Short Term Trading With NYSE TICK - A Three Part Series

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Why Traders Are Losing Money In Recent Markets

 

We detect strength in the stock market and we buy.  We detect weakness and we sell.  Both occasions lose money.  What is going on?  In this post, we will take a look at market behavior and how market patterns themselves create trading psychology challenges.  The common assumption is that, if we can just maintain a good mindset, we'll be able to identify market patterns and make money.  This post will show that this is a gross simplification.

I examined the last three years of daily data, focusing on the SPY and the percentage of stocks in the Standard and Poors 500 Index trading above their 5 and 20 day moving averages.  (Data from the excellent Barchart site).  I divided the data set into quartiles and specifically examined what happens following periods of very strong (top quartile) and very weak breadth (bottom quartile).

When the percentage of stocks trading above their five-day moving averages was in the top quartile (approximately 74+%), the next five days in SPY averaged a loss of -.14%.  Note that this was during a period in which SPY rose by approximately 30% and the average daily gain was +.20%.  When the percentage of stocks trading above their five-day moving averages was in the bottom quartile (approximately less than 33%), the next five days in SPY averaged a gain of +.57%.  In other words, going with strength after a five-day period lost a trader money regardless of their mindset.  Buying stocks,after five days of weakness--when it's scariest to be jumping into the market--was solidly profitable and more than doubled average returns.

Hmmm...

So now let's examine average returns after 20 days of strength and weakness.  When 20-day returns have been strongest (over 73% of stocks trading above their 20-day moving averages), the next 20 days in SPY have averaged a loss of about -.31%.  This is eye-opening, as the average 20-day gain during this period was +.79%.  Conversely, when 20-day returns have been in their weakest quartile (fewer than 37% of stocks trading above their 20-day moving averages), the next 20 days have averaged a whopping gain of +1.85%.  Going with strength systematically lost traders money; fading weakness achieved superior returns.

In short, traders lose money when they focus on trend and momentum.  They are expecting strong and weak returns to continue into the future.  What actually happens on average, however, is reversal.  Stocks behave in a cyclical way.  When markets *do* display momentum and trend, it is generally because longer-term cycles are dominant.  The up or down phase of a longer-term cycle overwhelms any reversal tendencies in the short run.  (Note how this opens the door to forecasting market movement as a function of the interaction of multiple cycles:  a topic I hope to address soon).

The market tends to frustrate the expectations of traders.  It is human nature to extrapolate the future from the past.  This--regardless of a trader's psychology--will lose money over time.  Drawing and following trendlines, going with breakouts, waiting for "price confirmation" to enter market moves:  all, over time, lose money.  It is not just our psychology that undermines our trading.  It is our assumptions.

Further Reading:

How to Lead a Visionary Life

The Secret to Overcoming Adversity

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How to Lead a Visionary Life

 

The great risk in life is to live reactively, bouncing from activity to activity without plan or purpose.  When we live purposeful lives, life becomes meaningful--and that gives us energy.  Suppose we were to begin our days, weeks, and months by posing questions:

*  What is the one thing I most want to accomplish today in my personal life and in my work life that will make the day successful?

*  What is the one thing I most want to accomplish this week in my personal and work lives that will make the week successful?

*  What is the one thing I most want to accomplish this month in my personal and work lives that will make the month successful?

*  What is the one thing I most want to accomplish this year in my personal and work lives that will make the year successful?

That's it:  Every day, every week, every month, every year is guided by a singular vision.  What one thing will lead you to look back on each day, week, month, and year and feel pride in what you've accomplished?  

Once we have a vision, we cannot live on auto-pilot.  The one thing you most want to accomplish becomes your mission statement--it pushes you and inspires you.  The risk isn't trying and falling short; it's never trying and never finding out what we're capable of.

Further Reading:

Making Your Passion Your Purpose

The Profound Psychological Benefits of a Purposeful Life

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The Secret to Overcoming Adversity

 

Margie and I recently toured Eastern Europe and finished the trip with a tour of the concentration camp at Terezin.  During the 3-1/2 years of the camp's existence, thousands of inmates were killed or died of untreated diseases.  What I found most memorable were the displays of artworks created by the inmates during their internment.  Music, painting, drama, sculpture:  all were of vital importance to the inmates.  Despite inhuman conditions of crowding and frequent abuse and torture, prisoners focused on creating works of beauty.  That many of these works are with us today attests to the success of their quest.     

For me, it was a powerful reminder that, no matter how bad our situations become, we always can rise above them through creative expression and achievement.  When we create--a painting, a book, a scientific theory, even a trading system--we rise above what is and realize a vision of what can be.  Indeed, the more we face loss and setback, the more important it becomes to create and immerse ourselves in meaning and beauty.

The secret to overcoming adversity is to transform your life into a work of art:  to become so focused on creating what is beautiful and meaningful that everything else becomes secondary.  Our relationships can become masterpieces; our careers can become paths for pursuing a vision of what is possible.  All of us become artists when we approach life creatively and find the beauty in each facet of life.      

As I was leaving the courtyard of Terezin where prisoners were herded into barracks, I noticed a smooth, round, quartz-like stone on the ground.  I took the stone home with me, and it now sits on my desk where I do my writing.  It's an immediate reminder of the horrors that I saw--and also the soaring human spirit that transcended the evil.  

Every life setback--including setbacks in markets--is an opportunity to rise above loss and create the future.  We tap into our Divinity when we become Creators.

Further Reading:

The Role of Creative Insight in Trading Success

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