Sunday, August 31, 2014

What We Can Learn From Sector Correlations in the Stock Market

Above you can see a proprietary index of stock market correlation that I have been working on in recent weeks.  The index looks across multiple stock sectors and multiple time frames and tracks the correlation of daily price moves.  In my modeling, correlation has been one of the most reliable predictors of prospective price moves in SPY over a several week horizon.  Indeed, going back to 2012, when correlation has been in lowest half of its distribution, the next 20 days in SPY have averaged a gain of .56%.  When correlation has been in the highest half of its distribution, the next 20 days in SPY have averaged a gain of 2.06%.

As market cycles age, fewer shares participate in the upward movement, as the weakest companies and industries first retrace their gains, followed by the stronger ones.  This causes the divergences we see among breadth measures and is directly measurable by correlation metrics that cover multiple market sectors.  As you can see from the chart, correlation has come down from its early August peak and is currently at levels associated with weaker next 20-day returns.  

My research has recently extended to intraday measures of correlation to see if they are predictive of shorter-term cycles in markets.  I also plan to study longer time frames and broad bull/bear market cycles.  I suspect there is also fruitful ground that could be covered by studying the correlation of movement of individual stocks within sectors as a way of anticipating sector rotation.  The interplay of correlation and volatility appears to provide useful metrics in tracking the trajectories of market cycles and the dynamics of momentum and reversal.

Further Reading:  Stock Market Buying and Selling Power
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Saturday, August 30, 2014

Getting by Giving: The Power of Servant Leadership

I was recently contacted by a company that I had worked with several years ago.  They were undertaking a large project and wanted me to play an important role.  As we discussed the project, I grew excited.  It was an opportunity to make a meaningful difference for a group of people I liked.

Toward the end of the conversation, there was an awkward pause from my contact at the firm.  He said, "I guess we need to talk about your compensation."  His tone suggested that he was surprised that I hadn't raised the matter.

My response was immediate and honest.  "I haven't given the matter any thought.  You've always dealt with me fairly.  Whatever you feel is appropriate will be fine."

For years, I've been told this is no way to do business.  And for years, I haven't lacked for business.  Indeed, in a career that will hit its 30th anniversary next year, I can only identify one occasion in which the other side did not behave fairly in such a situation.  In business as in romance, it's amazing how well relationships work out when each side prioritizes the other.

Servant leadership is the notion that one best leads by meeting the needs of others.  As Hess points out, our stereotype of successful leaders is that they are strong, charismatic figures who bend others to their wills.  Rather, he finds, effective leaders lead by example, prioritizing employees and ensuring that their work is meaningful.  "Humble wins," he observes.  When employees are emotionally engaged, they are more loyal and productive.  "In fact," Hess notes, "the relationship between high performance, high employee engagement, and how you treat employees is compelling.  My research clearly demonstrates that employee satisfaction drives customer satisfaction and loyalty."

A fascinating New York Times article on Adam Grant suggests that giving may be the secret to getting ahead.  What Grant has found in his research is that employees are more productive when they perceive a giving purpose to their work.  In one study at a call center, where employees are notoriously unmotivated and turnover is extensive, he brought in a speaker who described the benefits that he had received from the funds generated by the calls.  Over the subsequent months, productivity among the telemarketers skyrocketed.

As the article points out, Grant's research suggests that "The greatest untapped source of motivation...is a sense of service to others; focusing on the contribution of our work to other people's lives has the potential to make us more productive than thinking about helping ourselves."

An interesting study found six servant leadership themes among successful work groups:  1) holding self and others accountable for results; 2) supporting and resourcing others; 3) engaging in honest self-evaluation before assessing others; 4) fostering collaboration; 5) communicating with clarity; and 6) valuing and appreciating others.  The intriguing finding is that servant leadership enhances teamwork:  people give their best when their leaders are giving.

Some of the most successful money managers I've known and worked with have thrived in team contexts.  They bring on junior talent, mentor their apprentices, and in turn benefit from the productivity of those junior teammates.  Contributing to a team and each other's growth provides a motivation in trading that transcends daily profits and losses.  As in the military, discipline is much easier to sustain if you know you're responsible for your buddies.

Adam Grant points out that we can approach our work as a taker (trying to get as much as we can from others); as a matcher (trading with others by giving and getting), or as a giver (seeking ways to help others).  In a world of ever-growing interdependence, when people enter the giver mode, the pie becomes larger for all.

Further Reading:  Living the Purposeful Life
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Friday, August 29, 2014

Landing a Job at a Trading Firm

I've been part of the hiring process for many of the trading firms where I've worked.  Perhaps that is why I receive a fair amount of mail from people seeking trading jobs and careers.  Most of those job inquiries are particularly ineffective.  They do not contain the information that any quality trading firm would need to interest them in an application.

The sad truth is that there aren't many resources to help traders navigate the job hunt.  Of course, many traders prefer to remain independent.  That provides them with maximum control over their money management and the highest payout.  Still there are advantages to joining a trading firm, including access to superior technology for screening/researching ideas and executing trades; the social and learning benefits from working with talented peers; and, most important of all for some, access to significant trading capital.  

A while back I wrote about pitfalls one experiences in joining a proprietary trading firm.  There are also potential pitfalls associated with hedge funds and other money management firms, including instability of investor capital, risk management policies that may not fit your trading style, relatively low payout structures, and constraints upon the instruments and strategies traded.  

Regardless of the type of firm, the big question is:  do the resources gained from affiliation with a trading organization outweigh the costs?  If the affiliation brings you needed capital, access to markets, superior technology, and significant professional development among colleagues, it can be spectacularly successful.  If the affiliation takes more in overhead than it provides in tangible resources, it's not a worthwhile proposition.

So how does one navigate a job search with a trading firm?  Here is one key to-do and one key to-not-do:

1)  To Do - Build a trading track record.  It may not be with a large account at all, but show a strategy and show results.  Smart applicants assemble a "pitchbook", where they describe their background, summarize their strategy, illustrate sample trades, and provide detailed performance metrics.  A pitchbook with a resume and cover letter will get attention.  It is professional and displays what you know and what you do.

2)  To Not Do - Beg. Whine.  Tell people how very motivated you are.  Talk a lot about passion but say little about actual, concrete trading expertise or accomplishments.  Boast about your ideas and acumen, but have no track record to support your claims.  All the above comes across as less than professional and meets a rapid fate in the circular filing cabinet.

It's not uncommon that I'll hear from traders eager to find a firm that will give them a chance at success.  The stark reality is that trading firms don't give chances; you have to earn them.  You don't apply to the New York Yankees without a history of successful baseball play; you don't try out for a Broadway performance on the basis of a passionate interest in theater; and you don't apply to a professional trading firm without evidence that you can provide professional results.

And if you don't yet have training and trading results?  Then a sound strategy can be to learn specific trading-relevant skills that can make you valuable to a trading team as a junior member.  The team can provide you with training, mentorship, and experience and you can provide the team with needed support.  A young friend interested in managing money recently put himself through a rigorous CFA program, while holding a full time job *and* teaching himself programming and quantitative analysis.  Those skills and experiences will make him all the more valuable to teams managing long-short equity books and "macro" portfolios.  Starting as a junior analyst or assistant to a trader is a great way to get a foot in the door for eventual money management.

This is where the right educational programs can be useful.  The MBA in finance or the master's degree in financial engineering won't make you a trading whiz, but they will teach you skills, expose you to the broad industry, and provide you with a network of alums who can make all the difference in a job search.

One way or another, you need to acquire skills and experience to set yourself apart.  Make yourself a valuable resource, build and work a professional network, and opportunities are most likely to come to you.

Further Reading:  Steps Toward Joining a Prop Firm
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Thursday, August 28, 2014

The Four Pillars of Trading Process

We commonly hear that traders should develop and stick to "a process".  But what is a trading process?  I would argue that, across trading styles and time horizons, there are four components essential to any complete trading process:

1)  Preparing - What you do to identify and exploit opportunity in markets, including observation, research, idea testing, trade structuring, portfolio construction, and trade planning.

2)  Performing - What you do to initiate and manage positions in the market, including sizing, risk management, entry and exit execution, and adjusting to the ongoing stream of news, data releases, and market movements.

3)  Reviewing - What you do to examine individual trades and overall trading to learn from successes and mistakes and to reexamine ideas about markets.

4)  Revamping - What you do to translate your reviews into concrete goals and actions that make you more prepared and aid your future performance.  

Together, these process elements embody a kind of deliberate practice that yields ever-expanding expertise.

As the Buffett quote above implies, when a trader develops intrinsic gratification from processes of discovery and mastery, it is much easier to weather the ups and downs of short-term performance.

The most common shortcoming I see among traders is not that they let their emotions run away from them and lose their discipline.  Rather, they truncate the third and fourth elements above and spend almost all their time preparing and performing.  As a result, they rarely conduct the thorough reviews that lead to ongoing learning--and they even more rarely translate any cursory reviews into systematic efforts at self-improvement.  

Preparing and performing require immersion in markets.  Reviewing and revamping require a step away from markets to reflect upon preparation and performance.  Joined together, the process elements yield a sense of growth, development, and ongoing adaptation to changing markets.

When success is measured in terms of mastery, one can profit handsomely even during periods of trading loss.  That is an important trading edge.

Further Reading:  The Essence of Trading Process
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Wednesday, August 27, 2014

PIRCH and Writing Our Life Stories

On a trip yesterday to Oakbrook Center, Margie and I came across PIRCH, a store featuring high end home appliances and furnishings.  As you can see from the above company "manifesto", this is not your usual retail outlet.  Even more than Apple stores, PIRCH has been designed as an interactive, inspirational shopping experience.  From the friendly cafe that features free coffee from espresso makers sold in the store to the Sanctuary room where you can actually shower in a beautifully designed environment, PIRCH engages consumers by creating memorable experiences, not by selling them products.  The philosophy is simple:  "Until you know what's possible, you don't know what you want."

As the company expands, it seeks people who are different from normal salespeople.  "Everyone’s first priority at PIRCH is to create joy for everyone we touch – customers, colleagues and partners," according to the company's site.  Not exactly your usual search process.

So what does all this have to do with psychology, trading, and markets?

Just this:  We may be the sum of our experiences, but not all experiences are created equal.  Alexander and French recognized that change processes can be accelerated by "corrective emotional experiences." We process most deeply that which we feel most deeply.  That is why special relationships keep special places in our hearts over the years.  We forget so much of daily minutiae, but a single deeply felt experience lasts a lifetime--and can influence us over a lifetime.  We are not the simple sum of our experiences; we're the weighted sum of our most powerful experiences.

If you examine the lives of successful people, you'll generally encounter stories of individuals who successfully generate positive experience via performance activity, often channeled through the early influence of mentors, coaches, and teammates.   

If you examine the lives of troubled people, you'll often find stories of trauma, violence, and terrifying experience.  Negative experience stands out--and influences behavior--every bit as much as positive experience.  Indeed, the most rapid form of learning is that created by traumatic stress:  a single experience of danger can shape thoughts, feelings, and behaviors for months and even years.

Most life experience is neither highly positive nor negative--and that's a good thing.  It would be exhausting to be dealing with constant inspiration, thrills, traumas, and frustrations.  

But what PIRCH realizes is that if you want to leave a mark, you have to make an impact.  And it has to be a distinctively positive impact.

That same principle suggests that, if you want to guide your own development--as a trader or as a human being--you have to make sure that you create more positive experiences--and more powerful positive experiences--than negative ones.  "Above all else, do no harm" is good Hippocratic wisdom, but to imprint the soul eventually we have to do good.  Distinctive, powerful good.

A valuable self-assessment might begin with a few questions:  In any given week or month, which of your experiences truly count?  Which will remain with you next week, next month, and next year?  And which count in a truly positive way, in a way that concretely makes you a better person?  

In writing your life story, make sure it makes for good reading.

Further Reading:  Mirroring and Corrective Experience
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Tuesday, August 26, 2014

Why Quiet Markets Can Be Hazardous to Your Wealth

If you click on the above chart, you'll see the rolling 50-day average of volume in SPY and the rolling 50-day average of daily trading range in SPY.  What is clear is that:  a) volume is closely correlated with index movement (the daily correlation over this period is .84); and b) volume and volatility have been crushed in the past several years.

The excellent Quantifiable Edges site points out that, since 2012, low volume on market strength has not been bearish.  Traders looking for volume confirmation of market strength have missed an important dynamic of this bull market.

Eldad Nahmany points out a very interesting study in which subjects found that having nothing to do was an aversive state--so aversive that they preferred painful activity to no activity.  The implications for trading in quiet environments are significant:  With little movement to stocks, traders needing movement might gravitate toward bad trades over no trades.  Such overtrading may not simply be a matter of poor discipline or lack of trading plans.  Rather, it would be the result of a failure to tolerate inactivity. 

As I've pointed out in other contexts, we are never alone and we are never without activity.  There are simply times when what we have is our own company and the activity of our own thoughts.  How well we tolerate our own company may be an important--and poorly appreciated--predictor of trading success...especially in quiet markets.

Further Reading:  Are We Headed for a Stock Market Crash?

Success in Trading: Why Mindset Matters

Psychologist Carol Dweck makes an important distinction between fixed mindsets and growth mindsets.  When we praise a child's fixed qualities, we anchor their self-concepts to those qualities and, ironically, create a less resilient set of behaviors going forward .  When we praise process--such as trying hard at something--we encourage the behaviors that ultimately lead to success.  

In a fascinating study, Dweck gave two groups of children a relatively simple puzzle test.  One group was praised for their intelligence; the other group was praised for their effort.  Then both groups were allowed to select a second set of puzzles to work on.  When praised for effort, 90% of the kids chose the harder set of puzzles to work on.  When praised for intelligence, the majority of children selected an easier set of puzzles.  The children who anchor their sense of self to a fixed quality behave in a conservative way to protect that self-image.  The children who anchor themselves to what they do, simply do more.

"Emphasizing effort gives a child a variable that they can control," Dweck explains.  "They come to see themselves as in control of their success.  Emphasizing natural intelligence takes it out of the child's control, and it provides no good recipe for responding to a failure."

Indeed, when given difficult puzzles and then given the opportunity to work further on them, children praised for effort tend to persist.  Children praised for intelligence tend to give up.

This casts a fresh light on the common observation that traders are in trouble when they become more concerned about being smart than about making money.

If we seek self-validation from markets based on our ability to outsmart the crowd, we will be psychologically vulnerable during inevitable periods of drawdown.  If we are process-anchored to our growth, development, and effort, we can generate positive emotional experience even during challenging times.  

How do you respond to setback?  As challenge?  As threat?  By redoubling efforts?  By abandoning them?  Simple differences of mindset may account for large differences in the development of expertise.

Further Reading:  Emotional Resilience in Trading
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Monday, August 25, 2014

Grit, Self-Control, and Mental Toughness: The Psychology of Trading Process

Shout out to Abnormal Returns for excellent links posted today, including this post on 7 habits of people with remarkable mental toughness.  As Angela Duckworth's research attests, sheer grit--the ability to persevere under adverse conditions--is a central element of success across career fields and performance domains. 

The notion of grit has so captured the interest and attention of students of success that Duckworth's second factor has gone largely unnoticed:  self-control.  Duckworth explains: "Self-control is the voluntary regulation of behavioral, emotional, and attentional impulses in the presence of momentarily gratifying temptations or diversions."  Grit refers to the ability to persevere over time.  Self-control is more of a moment-to-moment, day-to-day phenomenon:  the ability to resist temptation and distraction and stay focused on bigger picture goals.

Indeed, Duckworth's review finds that self-control is as central to positive life outcomes as such variables as general intelligence or socioeconomic status.  Interestingly, not all who possess self-control also display grit and not all gritty people exhibit strong self-control.  It is the two in concert--the ability to weather temptations in the short run and setbacks in the long run--that appear to predict success.

When you see how grit and self-control work together, you can appreciate why so many successful traders are process-driven traders.  By focusing on the process of good trading rather than the daily outcomes, traders rehearse both self-control *and* grit.  In other words, a process orientation to trading is daily training in the dynamics of success, a kind of behavioral priming.  By defining and following a robust process during good times and bad, we literally train ourselves in grit and self-control.

Further Reading:  Why Grit is Important to Trading
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More Rules for Life and Trading

A while back I submitted five rules for life to a website of the same name.  Here were my rules nearly 10 years ago:

1)  In life, do good and do well.  Real success comes from pursuing your talents and enriching the world with their expression.

2)  They lead best who follow their calling.  Those who follow a genuine calling set an inspiring example with their actions.

3)  Not all who rave are divinely inspired.  Passion without wisdom is mere noise.

4)  True love never dies; it has to be killed.  Love is making another's happiness your own.

5)  Be your ideals; in some measure you're already who you want to become.  Conscious living is striving to be who you are when you are at your best.

Those rules have pretty well stood the test of time for me.  Here are a few more rules I'd add at this juncture:

6)  You can't save damsels who love their distress.  Saving people (and organizations) that aren't ready for change is one of life's more frustrating experiences--for all involved.

7)  To make dreams come true, you first have to wake up.  Dreams and visions mean little if you're not out of your bed and working toward them.

8)  Everything in life is use it or lose it.  What didn't you do today?  This week?  This month?  Those are the things you're losing.

9)  You are what you eat--and you are always eating life experience.  Life is a mirror; we internalize the things we do and the people we know.  Choose your diet wisely.

10)  When you are open to opportunity, opportunity opens to youWhen you put yourself out there with everything you've got, great things can happen.

So that's it; five more rules for life--and, of course, for trading.  

What makes trading, like any performance field, great is that it teaches us life lessons at the same time that it hones our skills.  Great activities yield wisdom as well as knowledge.

Further Reading:  Life Lessons From My Cat
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Sunday, August 24, 2014

Priming as Performance Preparation

The recent post took a look at the power of visualization as a performance tool.  Interestingly, however, it appears that not all people are equally endowed with visualization skills.  Those who possess strong imagery skills are most likely to benefit from visualization methods, particularly if there is a good fit between the type of imagery used and the desired performance outcome.  How can professionals access peak performance if they are not especially skilled at generating visual and kinesthetic images?

Priming is well known in the research literature as a phenomenon in which exposure to an initial stimulus subconsciously impacts the response to a subsequent one.  This has become a marketing staple, as images and messages can cue people to purchase a variety of products and services.  The creativity study described in a recent post is an excellent example of priming:  spending time thinking like a child primed later, creative thought processes.

What if behavioral priming, as in the creativity example, is the body equivalent of mental imagery?  We can rehearse a desired behavior through visualization, or we can rehearse it by performing preparatory tasks that call upon the relevant skills.  For example, if I want to make sure I have a caring, loving conversation with my spouse about a sensitive topic, I could start by spending caring, loving time with my children.  If I want to enact a plan in a disciplined manner, I could start my day by enacting my morning routine in a regimented fashion.

The power of visualization is generally attributed to the fact that vivid imagery acts as a surrogate reality.  Performing an act in the mind has the power of performing it in real life, both for purposes of rehearsal and motivation.  There may be equally powerful ways of generating surrogate reality, however.  When we create behavioral priming exercises, the preparatory activities call upon desired thoughts, feelings, and skills and ready them for use in a future situation.  In that sense, we can think of behavioral priming as a form of "workout", where we strengthen the "muscles" of specific, desired action sequences.

If we imagine using priming consistently, then we can see what we're really doing is building and reinforcing habit patterns.  Performing smaller activities that recruit desired modes of thought, feeling, and behavior is an excellent way of improving access to those modes for larger, more difficult activities.  That is why coaches of athletic teams typically push their players to perform in challenging practice situations and why soldiers will drill under conditions of live fire:  priming good performance in practice increases the likelihood of good performance in real time.

From a priming perspective, what we enact in the heat of battle is a function of what we have accessed during our preparation.  If our preparation is haphazard, we have actually primed for haphazard performance.  If our preparation requires focus, we prime our ability to concentrate.  Structuring our preparation time as priming time helps ensure that practice indeed makes perfect.  In an important sense, we are always priming our brains:  the key is turning our priming into task-relevant preparation.

Further Reading:  The Psychology of Preparation
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Visualization: Becoming the Director of the Movies in Your Head

Past posts have focused on the quality of our self-talk as an important factor in performance.  The dialogues in our heads can give us energy or rob us of it.  They can distract us, or they can focus us.  

In truth, however, we don't just think in words.  It's a multimedia show in our heads, not just a language stream.  Amidst the self-talk is the screen show we play:  the images we create of ourselves and our world and the life scenarios and scripts we run through.

Most of the time, the images in our head appear randomly, triggered by various events, feelings, and memories.  This is particularly unhelpful when negative life events--whether they be conflicts in relationships or losses in markets--stir old, hurtful experiences and lead to a cascade of even more negative thoughts, images, and feelings.  At such points, we often wonder why we have "overreacted" to events.  In truth, we never overreact.  We merely respond to the present and the past it evokes. 

Have you ever felt that others have taken advantage of you or treated you unfairly and then obsessively rehearsed in your head all the things you might do or say to them?  Or have there been times when you've been uncomfortable speaking up in a situation and mentally rehearsed, again and again, what you might say and how you might say it?  At such points, the thoughts and feelings from past and present coalesce into a movie in our heads.  For a time, that movie becomes our experience.  It can evoke the same physiological reactions as actual interactions and confrontations.

When performance professionals make use of visualization as a preparation technique, they become the directors of the movies in their heads.  Instead of allowing the inner show to play randomly, triggered by various life events, they take control of the script and the camera.  In an important sense, their inner multimedia shows are triggered by a desired future, not an unpleasant past.

Check out this post on visualization and how seeing can become believing.  Particularly intriguing is the example of Natan Sharansky, jailed for 9 years and placed in solitary confinement.  He used the time to play chess against himself purely through visualization.  After his release, he defeated world champion Garry Kasparov in 1996.  Indeed, the phenomenon of blindfold chess is specifically designed to strengthen a chess player's capacity for intentional visualization.  If Sharansky can overcome the most negative reality of imprisonment and isolation and create a new, powerful performance reality in his head, perhaps we do not need to be hostage to our own internal dramas.

Visualization has become a staple for improving athletic performance, with evidence of effectiveness.  Interestingly, an examination of how athletes successfully use visualization suggests that they are mentally rehearsing key elements of performance process, not rehearsing outcomes such as winning races.  It may well be that visualization is an aid in deliberate practice and a bridge between intention and action, overcoming tendencies toward procrastination.  Mental movies of skill may be far more effective--psychologically and in performance--than mental rehearsals of success and, in fact, may be useful precisely because they reinforce experiences of competence and worthiness.

A performance mindset begins when we decide to become the directors of our internal movies and not just the viewers.

Further Reading:  Visualization Techniques for Traders
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Saturday, August 23, 2014

A Fresh Look at the Balance Between Strong and Weak Stocks

Here's an update of the Bollinger Balance measure described in the August 8th post.  This takes a look at every NYSE stock and calculates the number closing above their upper Bollinger Bands minus the number closing below their lower bands.  (Credit to the Stock Charts site for the data).  You can see how the measure topped out in early June and steadily weakened going into the price highs of late July.

Note also how the measure hit a low point just ahead of the price bottom early in August.  Since that time, we've had a rally to new highs in SPY, but the balance measure is well below its June peaks and has started to roll over.  This fits with the new high/new low data recently posted, showing that the current rally has been somewhat selective in its ability to generate fresh price highs across the broad range of shares.
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Quantitative and Qualitative Perspectives to Start the Weekend

*  Thanks to a savvy portfolio manager for this economist's perspectives on dining out;

Interesting evidence of momentum effects on a day trading basis; I'm currently applying the measures of buying and selling pressure as filters to improve this trade; 

*  A wise trader passes along this perspective on what options ratios are telling us;

*  Here's a great exercise that will show you how easy it is to overfit backtests of data; see also this excellent paper on how to distinguish good, bad, and ugly backtests;

*  There's evidence that tweets predict stock prices; it's interesting to see that IWM sentiment is quite high in the Stock Twits measure, though the Russell 2000 Index has recently underperformed; QQQ sentiment is also quite high at 70% bulls and 30% bears;

*  Overvalued stock market?  Excellent perspectives on CAPE ratio from Meb Faber; a sharp money manager (with a high Sharpe) also passes along this view of the CAPE from Brad DeLong;

*  Abnormal Returns asks:  Is the market for apps saturatedOne of the more interesting trading apps is Google-funded RobinHood, which promises free commissions;    

Stock market correlations rise in times of market stress; might correlation regimes be an important sentiment measure?  See also this view of correlation from China's market

Have a great weekend!

Brett
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Friday, August 22, 2014

A Look at New Highs and Lows During the Stock Market Rally

Above we see a different measure of stocks making new highs vs. new lows than the usual 52-week figures posted by the exchanges.  This measure takes all common stocks and looks at the number making fresh three-month highs minus those making fresh three-month lows.  (Data from the Barchart site).

In general, the new highs top out ahead of price during intermediate-term market moves and new lows either lead price lows (at important bottoms) or are coincident with those lows (at corrections).  Note how we recently peaked in new highs following the August lows; note also how the current levels are well below the levels recorded at the July peak, despite new highs in SPY.  This partly reflects continued relative weakness among small cap shares, with the Russell 2000 Index well below its March and July highs. 

Also lagging July highs are energy shares (XLE), consumer staples stocks (XLP), industrial issues (XLI), and utilities stocks (XLU), as well as homebuilders (XHB) and retail stocks (XRT).  Thus far the stock market rally has shown itself to be durable--and increasingly selective.
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When is the Stock Market Overbought and Oversold?

Abnormal Returns posted a few particularly good links yesterday; check out the study of how returns early in the market day predict those later in the day.  I'll have more to say about that topic later this weekend, as it dovetails nicely with recent observations regarding who is participating in markets.  Also worth a read is Adam Grimes' post regarding the dark side of technical analysis.  A lot of market folk lore falls short of wisdom.  As we saw a while ago, cognitive biases have a way of entering many forms of market analysis--even those that appear to be rigorously quantitative.

The bottom line for the above posts is that there are worthwhile patterns out there in markets, but it is hazardous to outsource the identification of those.  Nothing substitutes for doing the work yourself and seeing, in your own experience, what works and doesn't work.  That not only yields knowledge, but also produces the genuine confidence required to trade noisy and risky financial markets.  It's tough to hold an position through normal adverse movement when the idea is not truly your own. 

Let's perform a data exercise that challenges what we know.  When is a market overbought or oversold?  Many market indicators included in data services will highlight those levels, perhaps above 70 and below 30 in an oscillator that moves between zero and 100.  But do we really know that those are meaningful levels?

I went back to 2006 and took a look at the percentage of SPX stocks trading above their 5-day moving averages.  (Data available via Index Indicators).  I broke the market down into quartiles based upon the day's closing level of VIX.  Here's what we get:

The lowest volatility market quartile averaged 59% of stocks above their five-day moving averages, with a standard deviation of 19.  The next lowest volatility market quartile averaged 54% of stocks above their moving averages, with a standard deviation of 24.  The third volatility quartile averaged 51% of stocks above their moving averages, with a standard deviation of 27.  The highest volatility market quartile averaged only 45% of stocks above their moving averages, with a standard deviation of 32.  

We know that volatility has a directional component in the stock market, so the averages are not so surprising.  Note, however, those standard deviations.  If we define overbought and oversold as fixed indicator levels--say, 30% is oversold--then we're accepting a reading of about half a standard deviation in high volatility regimes and a reading of almost 1.5 standard deviations in low volatility periods.  

At the recent lows, we got to a point where about 10% of SPX stocks were trading above their five-day moving averages when VIX was trading around 17.  That was a much rarer occurrence than if the same reading had occurred with a VIX north of 30.  Same indicator reading, two different meanings.

What is a warm day?  45 degrees on the Fahrenheit scale is a warm day in Connecticut winter and a cool day in the summer.  Context matters:  what is overbought and oversold highly depends upon the market season.  An important part of interpreting any piece of market data is knowing the season you're in.

Further Reading:  Honing Your Trading Process
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