Market Strength—Further to Go or Topping? March 12, 2010
Posted by smarttradepro in Current Issues.Tags: at least a moderate pullback, markets heading even higher., pullback is relatively weak
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Back on February 2nd we looked at the broad market indexes and saw that during a short advance over the first few days February the more speculative Russell 2000 and more notably the Nasdaq 100 were lagging the large caps.
That led to the conclusion that we would get another down leg—we did, though it was a short-lived panic low just a few days later.
Fast forward from early February to today—the opposite is happening. Since the low closes of the indexes on February 8, the Nasdaq 100 and, more spectacularly, the Russell 2000 have outperformed their large cap brethren. We can see this clearly in the performance chart from Stockcharts.com. This chart compares the percentage price movements of the different indices.
This rally shows true optimism—buyers are opting for the higher returns of the more speculative indexes despite the possibility of higher risks there. Also, some combination of the major indexes has closed up for 9 straight days. The S&P 500 has been up 8 of the last 9 days. There was only a miniscule down day on Monday, March 8; however, both the Nasdaq 100 and the Russell 2000 were up. Historically, this type of persistence has been the harbinger of a rally extending, not topping out.
In the short term, however, the market is getting overbought by many measures including some standard momentum oscillators like stochastics. Some indicators are not showing overbought like RSI, which is still in high neutral territory.
Some sort of near-term correction is fairly inevitable. The depth of the rebalancing pullback will likely foretell the intermediate direction of the market. Let’s look at a chart for key levels.
The 1086 zone in the S&P 500 cash index represents a swing low and a 0.618 Fibonacci retracement from the 2/5 low to the 3/9 high. A break below that would certainly signal a high probability for a test of the February 5th lows and beyond. The more likely scenario, though, is that we get a smaller rebalancing pullback that does not even test the 1086 zone. Were this to happen, it would signal continued intermediate strength that could last through tax season.
The bottom line for the market is that we’re certainly due for at least a moderate pullback to relieve the short-term overbought conditions. The nature of the upcoming pullback will help us gauge the strength of the current intermediate-term move. If the pullback is relatively weak, we will most likely see the markets heading even higher.
Great Trading,
D. R.
The Banking Sector: Still at the Top of the Perception Ladder March 5, 2010
Posted by smarttradepro in Current Issues.Tags: public outrage at banks promises to grow into a much bigger phenomenon.
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Last week I wrote about the historically high pace at which US banks have been decreasing their loan volume recently.
I didn’t expect the depth and breadth of comments that I received about the banking industry in general and about the article in particular.
The public outrage at banks currently “just below the surface” promises to grow into a much bigger phenomenon.
Why the Fervor?
Actually, I think it’s a fairly simple explanation. Banks got into such big trouble by taking huge risks (e.g., relaxing mortgage requirements and making speculative investments outside of “traditional” banking areas). The whole current financial infrastructure almost ground to a halt thanks to their epic collapse.
Taxpayer dollars and massively favorable regulatory changes then bailed them out. This led to the environment in the last 12 months where the game is so one-sided that Rocky, our family’s Havanese dog, could have turned a profit if he ran a bank by borrowing money from the Fed at 0% interest and buying Treasury notes returning 2+% interest. And, oh yeah, no need to write down any of those bad mortgages; we’ll change the accounting rules so your balance sheets still look peachy.
So the big banks’ journey started “24 hours from extinction” and arrived at its familiar destination of huge bonus payouts in less than 18 months.
The problem is that the banks took that journey on the backs of taxpayers.
Taxpayers’ Reward?
So how have the banks rewarded the heavily leaned-on taxpayers for their rescue? With better rates? With reduced fees? With bridge loans to allow small businesses to make payroll in tough times?
How about the opposite?
Banks have dropped savings account rates to basically zero interest. Bank fees have escalated, as have interest rates on credit cards. And what about a loan for anyone with a balance weaker than Cisco? Forget about it.
Politicians posturing for fall re-election will find a convenient “fall guy” in the banking sector. A public that is mad as heck will be more than happy to stand back and cheer.
Beyond the Outrage: Banks’ Other Challenges
Moody’s estimates that about one third of ALL mortgages in the country are under water (the property is worth less than the loan). And the Obama administration is looking at banning foreclosures until each individual case is reviewed by the government assistance agency (Home Affordable Modification Program—that’s a mouthful) to make sure the foreclosure candidate is not eligible for assistance. Talk about the foreclosure process grinding to a halt!! And if this little ditty is enacted, it won’t be long until the worst cases find folks paying no mortgage or rent while they wait months—or dare I say years—for their case to be reviewed. And the banks will be left holding the bag.
On top of that, my friend Jim W. wrote some interesting thoughts in a recent e-mail to me. Jim was a commercial lender for years but now consults with banks, so he speaks as a banking insider. Banks are seeing the structural appetite for loans changing radically—consumer appetite for debt is declining. This is a dramatic shift from the half century plus culture of debt-based consumerism. Combine this new trend with the likelihood of moderated real estate prices, and we could see an underperformance of the banking sector for years or possibly even for decades.
Conclusion
While my analysis last week was for a banking “catch-up pop” in the intermediate term (less than a year time frame), I think it will be a volatile catch-up and then drop cycle. I know many folks who have been playing banks, even day trading them over the last 18 months. It’s a bit alarming to me that banks are so volatile now that traders can treat them like tech stocks.
As traders, we can look for the volatility in bank stocks to continue and provide some nice catch up moves. Watch out for violent drops though when the government announces unfriendly legislative moves for the banking sector (and announce they will).
As investors, keep in mind the longer term prognosis for banks is not so good.
Buyer beware (or at least be nimble!).
Great Trading,
D. R.
End of January Market Swoon – Some Perspective February 26, 2010
Posted by smarttradepro in Current Issues.Tags: Banks are decreasing their total loan value, there is opportunity here
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The graphic on the front page of today’s Wall Street Journal was striking.
In fact, it was so striking and the story so compelling and important that I “stopped the presses” on the article I was writing and wrote this one instead. Everyone needs to understand what the graph is telling us.
Let’s look at that front page image from this morning’s WSJ.
The graph shows the year-over-year change in total loan value outstanding. It simply answers the question, “Are banks holding more loans in dollar terms this year versus last?”
The answer: banks are decreasing their total loan value at a pace not seen since WWII.
Perhaps there is an even more important conclusion from the chart: every green year meant that total lending was expanding. That is, cumulative loans have been in a positive trend since the end of WWII. With the exception of the 1990 recession, the bank loan amounts have been in a long term up trend.
The accompanying Journal article talks about at least three factors causing the total loan value to drop at the steepest rate in the last half-century:
- Heightened regulatory requirements, especially the increase in the amount of cash reserves banks are required to keep on hand for each dollar loaned. (Remember that to slow down growth recently, China raised reserve requirements for their banks.)
- Tightening lending standards by the banks. (If you can lend less of your cash, you need to be more choosy about who gets it—and, oh yeah, you just got burned by lots of borrowers who didn’t repay.)
- Weak demand from potential borrowers. (No surprise here!)
So What?
The bank lending situation brings up two important items of note for traders and investors. The first relates to the broader market and the second concerns the banking sector.
In the broader market, if banks aren’t lending, then the sector of the economy that creates jobs—small and medium sized businesses—is not growing. It’s tough to see how a sustained recovery can occur in this scenario. It’s also important to note that after the lending downturn of the early 1990s shown above (which ended in 1992), the market took 27 months to make an overall gain of 10%. Today’s markets are much more volatile than back then, but this delay in market upturn is indicative of the long time it takes the economy to recover after a severe credit contraction.
Secondly, the banking sector’s recovery since the March 2009 bottom has reflected these decreasing loan numbers. Remember, banks generate their revenue from their loans. While the broader market has recovered 50% of the value lost from October 2007, the banking sector has recovered little more than 25%, as you can see in the chart below.
25%, as you can see in the chart below.
Knowing this can serve us in two ways. First, we can be fairly sure that there will be little chance for a sustained market recovery as long as bank loan amounts continue to contract. Second, there is opportunity here for a long term investment play. Banks won’t lag forever; when they finally start making up ground versus the broader market, there will be great opportunities for banking to outperform other sectors in your portfolio.
Great Trading,
D. R.
Perception, Deception and Debt – More Volatility to Come February 24, 2010
Posted by smarttradepro in Current Issues.Tags: volatility in the equities markets to continue.
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In last week’s discussion on Greek debt, I concluded that uncertainty and hence volatility would remain in the market for some time to come.
As the mainstream press latched onto the situation, the latest revelations have done nothing to change that thinking.
Deception
The most interesting report came in a New York Times article over the weekend that revealed—gasp—Wall Street banks have helped create another debt bubble. This one in Greece.
In summary, investment banks (which are now just “plain ol’ banks”), most notably Goldman Sachs, created customized derivatives or swaps to effectively loan large sums of money to Greece (and other countries in the PIIGS mess). All of this was perfectly legal, even if it wasn’t disclosed.
In essence, Greece swapped future revenues from airports, highways and the national lottery (also known as their safest and most reliable future revenue streams) for a chunk of cash then. Since the transaction was classified as a sale and not a loan, the immediate infusion of cash helped Greece meet some European Union financial guidelines in the short term (back in 2000 and 2001) and pass the problem on to future regimes.
Let’s recognize these maneuvers for what they are: an under-the-table use of financial and accounting gamesmanship that allowed a bubble to grow out of control and off the financial radar screen.
Understand, America has developed “passing the problem to future administrations and generations” to an elevated art form, so I won’t cast any stones. Additionally, the European Union debated the very issue of making such swaps more transparent in back in 2000, but decided against any new reporting requirements. Finally in 2002, disclosure requirements for these types of swaps (and the entities formed to facilitate them) began to appear.
The current “second wave” debt crisis is almost certainly deeper and wider than we currently imagine. Additional volatility and uncertainty will continue as the media uncovers more revelations about the situation.
Perception
And now for a fun guessing game on perception. Let’s look at the debt of two different governments.
| (All $ in Millions) | Annual GDP | Outstanding Debt | 2010 Budget Deficit |
| Government A | $2,000,000 | $75,000 | $40,000 |
| Government B | $400,000 | $443,000 | $50,000 |
Here’s the set-up: Country A has a GDP of $2 trillion, $75 billion in debt and will have a projected budget deficit of $40 billion for this year.
Country B has an economy 1/5 the size of A, has almost 6 times more outstanding debt and will add 20% more debt this year to their bottom line.
Whose bonds would you imagine have the higher priced insurance against default? Which one does the market view as riskier?
Considering the numbers provided, wouldn’t it seem that Government B would have the higher risk for defaulting on its bonds?
Alright, this was a trick question. Government A is actually California. And Government B is Greece.
As strange as it may seem, California had the higher default insurance up until two months ago. California was viewed as a worse credit risk than Greece!
What changed? One thing—perception.
Until December, California had to pay more for bond insurance than Greece did. California’s problems had been in the news for a long time by that point and were very high in the public’s awareness. Since the first of the year, Greece’s debt problems have been in the news more. Now that more people are aware of the issues, the price for insuring against Greek default has risen dramatically.
What a strange game. If one wanted to speculate in government bonds today, it looks to me like buying California bonds and selling Greek ones might be the way to go.
Resolution
In the end, the two primary Greek creditors (France and Germany) will not allow it to default. For the EU, Greece falls into the same category that the American banks and AIG did last year—“too big to fail.” A default on Greek debt would send the EU into a tailspin that most would consider catastrophic. That could lead to the end of the economic conglomerate and create severe financial hardships for member countries in terms of cost of capital. So the member countries will do everything in their power to keep that from happening.
If Greece is too big to fail, then what about California? It’s five times bigger… Some opine that the California debt insurance is as high as it is because the US federal government has given no indication that it will step in to help. But I think that it is a rather safe bet that the U.S. governmental powers-that-be will not allow a California default under any circumstances short of financial Armageddon.
So in the meantime, someone is enjoying the benefit of writing really high-priced California risk insurance.
Until the EU creates some concrete plans for resolution the PIIGS debt problem, look for the volatility in the equities markets to continue.
Great Trading!
D. R.
PIIGS in a Poke: Why Traders Should Care About European Debt Trouble February 12, 2010
Posted by smarttradepro in Current Issues.Tags: What Does This Mean for Traders and Investors?
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It’s fitting that our title phrase (an acronym takeoff on “pigs in a poke”) had its origins in Europe because we will focus on Europe today.
In the Middle Ages supposedly, meat was scarce but cats were not, which played into one common marketplace scam. At the market, vendors would offer for sale a suckling piglet squirming in a bag. After getting the bag back to the cottage, the poor peasant would discover that rather than containing a piglet to raise and feed the family, the bag actually contained a valueless cat.
The ruse was so prevalent or at least so infamous that several other phrases besides “buying a pig in a poke” (to make a purchase without proper inspection) arose from the practice. “Let the cat out of the bag” (reveal the secret), and “left holding the bag” (receiving nothing for your efforts or stuck with the final responsibility) point to the pervasive nature of this con game.
In modern day Europe, some countries are playing out a different kind of “pig in a poke” game. In the modern case, the PIIGS are Portugal, Italy, Ireland, Greece and Spain. All of these sovereign countries run the risk of a government default on their national debt. (More on that PIIGS acronym later.)
Many are blaming the European Union for accepting these countries prematurely, their own macro version of accepting a pig a poke. With 20/20 hindsight, that may indeed seem to be the case, but it’s hardly helpful now. More important is that the EU allowed these countries into the union on promises that they would shore-up their financial woes instead of waiting until they were financially sound.
Greece is the poster child for this problem and hence the first to face serious risk of default. Their profligate spending, especially as it relates to labor unions and publicly paid positions has left the country with a debt burden from which it has little chance of recovering through normal economic growth. At this point, no one wants to lend Greece more money to feed that insatiable deficit spend/borrow cycle. The problem has grown to the point where lenders are demanding a 4%+ margin of interest versus the much safer German bund.
The Wall Street Journal has a very informative visual depiction of the debt problem and how the perception of the ability (or inability) to repay has grown in the PIIGS countries.
Since this graphic comes out pretty small in the newsletter, allow me to provide a brief summary: the red represents Government debt as a percentage of Gross Domestic Product. The blue represents the credit default swap spreads, indicating the premium that institutions are requiring now to insure sovereign debt.
So What Does This Mean for Traders and Investors?
Every so often, something will embed itself so deeply into the markets’ psyche that every little flinch causes the market to react. This was the case with crude oil in the spring and summer of 2008. Every little speck of news relating to oil made the oil price jump. The same is happening now with the PIIGS debt crisis. The mere fact that Germany is considering a plan to offer Greece loan guarantees caused Tuesday’s markets to spike upward (the Dow rose 150 points).
Until this crisis is resolved, news speculation and rumors will have a big effect on the currency, bond and equity markets. So it’s critical to understand that no matter what your technical indicators say, if Germany balks or otherwise equivocates on guaranteeing Greek debt, markets are going to dive. Conversely, positive news will cause a pop. This is certainly going to keep volatility and uncertainty high.
Some are opining that France and Germany are going to let Greece default. Those two countries, however, are the number one and two top foreign holders of Greek debt with $75 and $43 billion respectively, so this seems unlikely.
Because the European Central Bank is not permitted to provide direct assistance, such aid will have to come from individual countries (acting in concert with the EU), or perhaps, though less likely, from the International Monetary Fund itself. All of these moving parts makes the Greek debt relief situation a very complicated undertaking, which in turn leads to much “will they/won’t they” speculations and rumors. Are you ready for the volatility?
In short, these conditions make for a traders’ market as opposed to a trending market. Expect snap back rallies and quick dives to be equally likely. Consider which of your systems thrive in these kinds of conditions and which tend to be hurt by them. Taking profits quickly and protecting against overnight and weekend gap risks would be a prudent course of action until there are more concrete commitments out of Europe.
And now back to that PIIGS acronym. In an instance of political correctness run amuck, Barclays Capital and the Financial Times, among others, have been forbidden to use the acronym! The use of the porcine reference has been called pejorative and hence the PC police have stepped in at those organizations to prevent possible offense. Orwell’s 1984, here we come…
Great Trading,
D. R.
The Late January Swoon: A Bump in the Road or Something More? February 5, 2010
Posted by smarttradepro in Current Issues.Tags: A Bump in the Road or Something More?
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The broader U.S. market indexes all made new 52 week highs in mid-January. Then, in the last two weeks, they have given back all of the ground they gained in the previous 10 weeks—since the first of November.
The markets were certainly due for a pullback from overbought conditions. The pressing question for traders, however, is, “Was this rapid drop just a temporary rebalancing or the first leg of deeper drop?” Let’s take a look at some key technicals to gain some perspective.
Bump or Dip?
First of all, look at the magnitude of the late January drop in the chart below. It cuts through two key support structures: a 10 month trend line and the 50 day moving average.
Now it’s trying to approach the 50 day simple moving average (SMA) from below. The next few days will give us some key input as to whether the 50 will act as resistance. This same technical condition exists for the Dow, Russell 2000 (small caps) and the Mid Cap index. However, the QQQQ (NASDAQ Index) is still far from retracing to its 50 (actually, it’s still more than 2 percent below its 50 day SMA).
This gives us an interesting disconnect: tech is not rebounding as enthusiastically as the broader market.
Foreign Market Performance
What about other markets? Let’s compare the major U.S. indexes along with a few representative international indexes to see if their relative performances give us any clues.
This is a “performance chart” from Stockcharts.com. This type of chart shows how several indexes or stocks are performing in relation to each other. For our purposes, I wanted to see the relative performance of the selected domestic and foreign indexes since January 14.
As I mentioned earlier, the S&P 500, Dow, Midcap and Russell 2000 have all had similar performance. You can see that they are the top four lines in the chart above and those four indexes all have had the best relative performance during the market pullback and subsequent two day recovery early this week.
Globally, the worst performers have been Latin America, Emerging Markets, Europe, China and, as previously mentioned, the NASDAQ. These are not encouraging signs for the bulls, and the recent tech sector and foreign market relative weakness is significant for me.
Summary
Sustained S&P 500 price action above its 50 day SMA (especially if the QQQQ can climb up there) will provide a case for the intermediate term upside scenario. Based on the technicals and weak geographic participation in our little two day rally, however, that upside scenario is looking like a lower probability outcome right now.
If the S&P 500 cannot sustain this rally with a strong up week including a couple of closes above its 50 day SMA, we’ll most likely look back at this current rebound as a temporary pause in a bigger down move.
Great Trading,
D. R.
More Thoughts on Cause and Effect January 29, 2010
Posted by smarttradepro in Current Issues.Tags: it’s common to question the rules or guidelines that were supposed to direct the process., Whenever we sense a disconnect between cause and the expected effect
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The article I wrote last week on cause and effect in trading the markets covered a subject that many wrestle with judging by the large number of e-mail responses. Many were complimentary (thanks to all of you—I’m blushing). Several were also very introspective describing the personal struggle that can result from unexpected or unpleasant results in spite of doing the right things.
In last week’s article, I mentioned three responses that tend to occur when expected results fail to follow correct actions. Whenever we sense a disconnect between cause and the expected effect, it’s common to question the rules or guidelines that were supposed to direct the process. That questioning often leads to the following sentiments:
- The rules really aren’t good and don’t serve me.
- I no longer need to follow the rules exactly, or at all.
- At least I can tweak the rules to feel like I have some sense of control.
Let’s look at these individually. As you read, consider if any of them are issues for your trading or investing.
The rules really aren’t good and don’t serve me.
This one is pretty easy to identify and is quite common. This thought process leads people to dump one system and jump to another or do the same with market gurus. These folks are looking for the system or guru with “THE answer.” This also leads people to jump from trading stocks to futures to forex to options and then back again, searching for the instrument with the right characteristics. This same reasoning causes people to abandon good solid strategies in search of the Holy Grail. EVERY system or strategy will go through rough patches leading to drawdowns.
What to do about it! We need to understand our system’s strategies more deeply and then we have to understand statistical randomness just a bit. Just because a system has traditionally won 61% of the time in the past with winners 15% bigger than losers doesn’t mean those characteristics will apply to every 3 trades. Or every 10. Or every 50. Van’s Definitive Guide to Position Sizing does a great job of emphasizing the importance of understanding variability, especially the amount of scatter that exists in a given system’s trade results. Systems with more scatter produce a wider variety of results over a given time frame. If we understand that statistical concept and couple it with an understanding of how our individual systems work in different market conditions, then we can experience the expected variation in results without the desire to drop the system and look for another.
I no longer need to follow the rules exactly, or at all.
This is an advanced stage capitulation that usually comes after believing the rules don’t work and that tweaking them won’t really help either. At this point, the trader or investor decides that they might as well do what feels good because following what were supposed to be the “right” rules didn’t work often enough to matter.
What to do about it! This one is easy: if you find yourself in this “throw your hands in the air” mode, stop for awhile. Do a bit of introspection. Have you given your strategies a long enough time to work? Are you using proper position sizing that will allow you to stay in the game long enough to let your strategy’s edge take effect? It’s far better to re-evaluate than to flail at the markets! If a plan didn’t work (and some of them won’t), that doesn’t mean every plan will fail. Evaluate what was useful and what was not, then correct and continue.
At least I can tweak the rules to feel like I have some sense of control.
I don’t know anyone who has avoided this trap! Making changes too early, too often and to too many variables are mistakes that almost all traders make at some point in their careers.
What to do about it! Stop tweaking! Seriously though, when you start using a new system or strategy, write down the number of trades you’ll make before doing any tweaking. The bare minimum should be 30 to 50 trades; 100 is better, especially if the system has more than a few variables. It’s okay to review performance more frequently, say monthly or quarterly (or every one to two weeks for day traders). But if you do these more frequent reviews, only use them to assess performance, not to make changes. Always be sure to take into account the overall market environment and market type when assessing performance or contemplating changes.
Once again, remember that no one trade is important (as long as you position size properly and honor your stop loss)—it is just useful data as part of the larger whole. Allow yourself and your strategy the luxury of time. Cause and effect in trading and investing does exist—patterns repeat themselves, and the psychology of buying and selling will make sure that they do. But seeing those patterns repeat may take more samples than we expected initially. Understand this going in, and you’ll be way ahead of the game.
Great Trading,
D. R.
Cause and Effect: Thinking Differently for Traders and Investors January 23, 2010
Posted by smarttradepro in Current Issues.Tags: Trading Is Not Engineering or Accounting
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When I was training to be a chemical engineer, decision making was quite “black and white”: Learn the rules of the physical world and then apply them. Learn how molecules combine and separate. Learn how mass and energy get transferred from place to place. Learn what is economical and what is not. And lastly, study hard and get good grades.
Once I was out and practicing engineering in the real world, things weren’t always so cut and dried. Outside influences often complicated things. The world of “black and white” became a world with many shades of grey. In a pristine lab environment (like back at school), molecules always combined the same way. But in the real world, contaminants could get in the system and reduce yields or create new and undesirable products altogether.
Equipment that was rated at “x” horsepower would always seem to run a little less efficiently because some field condition (normal wear, extra bends and turns, fluctuating temperature and humidity) would strip away efficiency.
In the end, the best engineers in the real world of processing plants were those who could deal most effectively with problems and conditions not found in the text book. And it will come as no surprise to most that raw intelligence was not directly correlated to success on the floor of a chemical plant. The best engineers had a certain savviness or what my Dad would call “horse sense” about the best engineers.
And I have found a very similar quality in the best traders and investors that I’ve gotten to know. They don’t have to be the most book-smart folks (though a few are), but they have a certain grounded grasp of the big picture that allows them to adapt, correct and continue with self-assured ease.
This group of characteristics that turns the average thinker into someone with good common sense or “street smarts” is somewhat difficult to sum up in a few sentences. But let’s look at some of these concepts or decision making loops that may be most easily modeled.
Trading Is Not Engineering or Accounting
Before we jump into some key decision making characteristics, let’s be clear on the differences between the learning paths for trading and the path for traditional knowledge-based professions like engineering, accounting or medicine.
I’ve often heard professional traders lament that those desiring to learn their craft see a few mouse clicks and some fairly elementary math and assume that they, too, can be consistently successful traders and investors in matter of days or weeks. Some pro traders will respond to this sentiment with a saying like, “A highly paid doctor or lawyer had to study for years before getting compensated handsomely. Who would expect to get paid like me after studying just a couple of weeks or months?”
And while part of that thought process is correct (the fact that there are knowledge based aspects to both trading and accounting), there is also a major fallacy in the argument.
Acquiring and demonstrating minimal proficiency in the basic knowledge set needed for engineering or accounting or law or medicine will lead to a well-paid position for the vast majority of participants. Not so for traders.
The learning path for a trader is more like that of a professional poker player. Demonstrating knowledge and proficiency in the basic skills only gets you a seat at the table, it doesn’t assure you of an income. While the poker-trading analogy isn’t perfect, their paths of progression are much more related than that of an doctor or an engineer and a trader.
Let’s look at one key area that makes trading very different from doctoring or engineering: the search for certainty or “What happens when you do everything right and it still turns out wrong?”
Doctors, engineers and indeed most professions live in a cause and effect world. If you do A, then a very high percentage of the time B will follow. There are notable exceptions, when a treatment doesn’t work or a product line gets contaminated, but by and large if you do the correct action, you get the correct result.
Trading is quite different. A trader can have the perfect set-up and entry, execute everything perfectly and still have the trade result in a loss. While traders lose money in this situation, that’s a problem perhaps but probably not the biggest problem. The largest problem for most people is the mental disconnect between cause (doing everything right) and effect (losing money). That result conflicts with their classical education which does not equip them with the tool set required for managing uncertain outcomes.
If we do things exactly right and still only get the desired result 60% of the time (or 50% or even 40% in long term trend following systems), traditional cause-and-effect thinking can easily make damaging conclusions. Since cause and effect seem only causally (no pun intended) related…
- The rules really aren’t good and don’t serve me.
- I no longer need to follow my rules exactly. (or at all)
- I can tweak the rules so I am in better control (or at least feel like I’m in control)
When a trade or group of trades doesn’t come out well, our typical human reaction to solve a problem kicks in. Almost all traders and investors tweak their systems and strategies prematurely, based on too little data (too small of a sample size). So many people have been trained in an education system that teaches us to solve a problem if we don’t get the desired outcome with pure cause and effect thinking. Dealing with highly complex systems with great levels of uncertainty is just not in most people’s basic educational background or experience.
So what?
The good news is that cause-and-effect thinking works in most areas of our personal and professional life. And it is deeply rooted in our need to be right. It does not, however, serve traders well.
A useful solution to overcome our mental “cause and effect” disconnect is simple to describe, but it’s very difficult to adopt for the long term: broaden your view of trading results. We must allow our trading and investing strategies to play out long enough to reach their expected profitability. Fretting and wringing your hands over the results of every trade is not very useful and can lead to premature judgments and tweaking.
Each trade should be evaluated ONLY in terms of whether or not we followed our trading rules without regard for the dollars and cents results. Reset your cause and effect decision process only after you have a group of 30 or 50 trades (or an even higher number if you trade more frequently). Then you can evaluate cause and effect on a statistically valid data set, not on any one trade or group of trades that have so many more outside influences than one can ever hope to control.
Reviewing only large data sets creates a discipline that serves several purposes:
- It reduces stress by telling our mind that no single trade matters very much, as long as we follow our rules.
- It reduces the variability of results over time because we’re only adjusting our system or strategy after an appropriate interval of time.
- It greatly increases the chances of profitability because we do fewer of the systematic things that cause losses.
No one trade is important (as long as you always respect your stop loss)—it is just a useful data point as part of the larger whole. Allow yourself and your strategy the luxury of time. And don’t be surprised if lower stress and greater profitability follow close behind.
Great Trading,
D. R.
2009 – The Year in Review Part II – January 15, 2010
Posted by smarttradepro in Current Issues.Tags: Volatility Highs and Lows
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Volatility Highs and Lows
Last week we talked about how the central bank liquidity creation has been the major driving force in the markets during 2009.
All of that money thrown into circulation has given us our current “sugar high” and will also provide us some accompanying side effects, most notably wild volatility swings.
This week, pictures are worth a thousand words! Let’s look at a couple of charts that tell the volatility story really well. First, here is a compressed daily chart (meant to show trends rather than detail!).
I wanted to show the full volatility cycle so my apologies for cramming so much data onto the chart.
A massive volatility contraction originated in 2000 and continued over into the first part of 2007. While you don’t see 2005 and 2006 on this chart, you can see in the next chart that the ATR lines extended basically low and flat from 2005 into 2007. Then in mid 2007, volatility picked up considerably as the market moved towards its top in October of 2007.
The fear in the markets in the fall of 2008 sent volatility to all-time highs, both in absolute terms and in relative terms. When you view ATR as a percentage of price, at its height, the market was moving more than 8% per day on average!
As you can see from the chart, the market stayed in a state of extreme volatility for about nine months with volatility not waning until May of 2009.
Then a funny thing happened: volatility continued to drop. And it dropped so far that we’ve only had a handful of days in the whole last decade that were as low as what we saw at the end of December. To see that longer term perspective, let’s look at the same chart using weekly bars instead of daily ones.
Does anyone remember the volatility levels when the Internet bubble popped in 2000? Relate that to the higher volatility caused by the recent collapse of the real estate/credit bubble. Pretty dramatic increase, wouldn’t you say?
The other very interesting take away from this chart is the extent of the price retracement so far. Yes, 2009 was a year of double digit returns, but we have gained back barely more than 50% of the drop from October ’07 through March ’09.
Volatility cycles are pretty well documented occurrences in the market, so while I’m generally not much for grand predictions, I will say one thing: as sure as day follows night, we’ll get a volatility expansion after this volatility contraction. A market stretched to the upside on contracting volume will either lead to a blow-off top or a nasty short to intermediate correction. So hang on to your hats ladies and gentlemen because, either way, we’re likely to see some pretty wild swings from here.
2009 – The Year in Review January 12, 2010
Posted by smarttradepro in Current Issues.Tags: The single biggest issue driving the markets in 2009: Central Bank liquidity creation.
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“The law of unintended consequences pushes us ceaselessly through the years, permitting no pause for perspective.” —Richard Schickel, author and journalist
What a year 2009 was! We went from “The world is going to end!” at the beginning of March to many believing that the problems were all behind us by the end of the year.
So here’s an insightful (I hope) and possibly cynical review of the past year…
The single biggest issue driving the markets in 2009: Central Bank liquidity creation. There’s not even a close second. While this cash dump started in 2008, it really didn’t hit its stride until this past year. I’ve referred to this numerous times as a “sugar high”; the market has been given the equivalent of calories with no nutritional value. Every time this has happened in the past the corrections have been ugly. In just the last decade, money was flooded into the market to avert Y2K, to bolster the economy after 9/11, and, perhaps most inexplicably, to keep the real estate bubble afloat in 2007.
As in our dietary analogy, after the spurt of energy gained from eating too much sugar, both the body and the markets tend to crash after the stimulant is digested.
With the markets, it’s near impossible to tell how long it will take to digest the liquidity. An unprecedented amount of money was created by central banks all over the world. With a unique environmental influence like that hitting the markets, many analytical tools become less useful. When we move out to the far edge of the “bell curve of experience,” normal patterns of action and reaction don’t apply. In science and engineering we call these edge effects—operating in areas that are not well-defined by the normal models. And whether looking at pipe flow or ecological boundaries, standard models break down at the edges.
So what? Now more than at any time since the 1930s, we need to dig many layers below the pabulum that passes for financial and economic news. It’s not enough to know that the stock market has been going up. Key macroeconomic measures like unemployment rates are still not in sync with the cries of “Recovery!”.
But, only rash or imprudent people step in front of freight trains! Heading into 2010, the market momentum carries on. Regardless of what caused it, we can’t ignore the market realities. This market move has many of the earmarks of a brand new liquidity bubble. As such, it could go on for some time and may have massive and abrupt upward excursions before it ends (the first trading day of the year was a micro version). Take advantage of the trend momentum, but please protect your accounts! Everyone must have a workable exit strategy. This is no time to think that “buy and hold” has all of a sudden started working again!
For our friends in Europe, Mexico and elsewhere, Happy Kings Day! We hope your gift giving and receiving is a joyous occasion. The Bartons will be enjoying a modest Epiphany celebration in Delaware right along with you!
I’d like to thank everyone that wrote in kind words about my reflective article, “A Great Way to Approach Markets.” Your support is much appreciated! Next week we’ll take a look at the single most important trading and investing effect caused by the massive influx of liquidity. Until then…
Great Trading,
D. R.
