Friday, April 17, 2015

Quick Insights With Deep Meanings

J.C. Parets on the value of homework.

Mark Yusko on the power of our social environment.

Derek Hernquist on backtesting.

Brian Shannon on investing's key lesson.

Urban Carmel on the market's sentiment.

Ambrose Evans-Pritchard on deflation.

Steve Burns on the greatest challenge in trading.

*  Think about the meaning of this:  Since 2014, when SPY daily volume has been in its lowest quartile, the next 20 days in SPY have averaged a loss of -.06%.  When SPY daily volume has been in its highest quartile, the next 20 days in SPY have averaged a gain of +2.71%.  

Further Reading:  Evaluating Your Trading
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Thursday, April 16, 2015

Sleep and Performance: The Quality of Our Nights Affects the Quality of Our Days

I find that a surprising proportion of what sets traders up for success during the day is what has happened the previous night.  We know from research that the proper quantity and quality of sleep aids concentration and learning and that disordered sleep can impair our cardiovascular health.  Sleep also has a beneficial impact on our mood and is associated with improved thought and memory.

It is fascinating that sleep disturbances are present in over half of patients with psychiatric problems--a far greater percentage than in the general public.  This has led to the observation that sleep disruptions are not only symptoms of problems such as anxiety, but active contributors to those.  One in five patients with depressive disorders are suffering from sleep apnea--disrupted sleep often associated with snoring. 

One study found that financial decision making was meaningfully impaired when subjects were sleepy due to poorer judgment about the task being undertaken.  It is when tasks are complex and challenging that we're most likely to be impaired by poor sleep.

Here is an excellent article from Maria Konnikova on how our performance is impacted by how we wake up in the morning.  Sleep inertia, she reports, significantly affects our cognitive functioning.  It appears that being process-driven in how we sleep is as important to our functioning as being process-driven in our work during the day--and indeed may set us up for either success or failure in our ability to work in disciplined and productive ways.

Further Reading:  Three Things to Improve Your Life Now
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Wednesday, April 15, 2015

Historic Market Strength or the Start of a Bear Market?

Jesse Felder looks at the stock market from the vantage point of historical valuation and finds us in rarefied territory.  Using other measures, Jesse Colombo arrives at a similar conclusion.  This strikes me as tremendously relevant for investors.  From a timing vantage point vis a vis shorter-term traders, I have more questions.  Prior to the large drops we saw in 1998, 2000, and 2007, for example, we saw a ramping up of volatility (VIX) and stocks making fresh new lows.  In other words, rises in volatility and weakness in leading sectors preceded those bear markets.  I'm not seeing those things at present, but the possibility that we're operating on borrowed time strikes me as a valuable one to entertain.  I'm just not sure we can expect historically normal market cycles when we have extraordinary global monetary policies. 

An extraordinary wealth of economic information and perspective is offered by Jeff Miller at Dash of Insight.  Measures he tracks suggest a healthy degree of strength in the economy.  He also raises the issue that bear markets tend to occur late in hiking cycles, not early.  Again, it may be difficult to extrapolate from past cycles to this present, extraordinary one, but Miller also notes that overvalued markets can become quite further overvalued before they run into trouble, citing data from Capital Speculator.

What we see is that intelligent market observers see the market quite differently.  My synthesis of all this is that we are historically overvalued *and* we're not yet seeing worrisome economic or market weakness.  Perhaps the best synthesis of all, however, is to go to websites such as the above and track down the original sources of data and the links from recent posts.  You are guaranteed to find intelligent perspectives that will broaden your own.  

Further Reading:  Creativity and Trading
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Tuesday, April 14, 2015

A Simple Strategy for Developing Yourself as a Trader

Here is a simple formula for developing yourself as a trader:

Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they're generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them.  Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people.  That is how imitation turns into innovation.  

Take a look at who you're following in social media.  If you're spending much time reading material from those you don't want to internalize, you'll wind up with little cumulative development.  A great exercise would be to curate the $STUDY stream of StockTwits and immerse yourself in the educational offerings of only those you'd like to emulate.  

You can't elevate your game unless you surround yourself with the best out there to challenge you, inspire you, and inform you.  You win by studying winners.

The same is true for stock picking.  How many people truly study the best performers during any given period and reverse engineer that performance?  There are common features of best and worst performers among stocks and markets, just as there are common features of best and worst traders.  You learn to select the best trades and investments by studying the best trades and investments.

Kudos to @ivanhoff and @howardlindzon for their recent offering on identifying the next Apple among market performers.  The greatest investments don't start as the most optically appealing choices in many cases.  Similarly, great trades to the long side often start as scarily weak markets--October, 2014 being a recent case in point.  If you study one winning idea after another, however, you begin to see common threads.  You immerse yourself in winning trades and, after a while, you recognize patterns as they emerge.

It's great to focus on our mistakes and correct our errors.  Reducing the negatives of performance, however, will never in itself generate elite positives.  If you want to perform at high levels, you have to study--and internalize--high level performance.

Further Reading:  The Success Pyramid
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Monday, April 13, 2015

Opening the Week With New Ideas



*  Here are three charts that I use to track demand and supply in the broad stock market.  I decompose the time series for the NYSE TICK (number of stocks upticking vs. downticking at each moment of the trading day) into a measure of Buying Pressure (top chart; a measure of upticks); Selling Pressure (middle chart; a measure of downticks); and Balance (bottom chart; the daily net of upticks vs. downticks).  In recent sessions, we've seen relatively restrained buying interest and also relatively restrained selling.  This is typical of low volume, low volatility markets.  On a net basis, we've generally seen more buying than selling pressure and stocks have drifted toward their highs over this period.  This is as much due to a relative absence of sellers as the positive presence of buyers.  Institutional players--those that drive volume as buyers or sellers of baskets of stocks--have been quiet of late, creating few surges of either buying or selling activity.

*  When academic reviewers took a look at the profitability of traders, they were shocked by how poor the results looked.  Here's my psychological look at what separates the winners from the losers.

*  More evidence that active fund managers as a group fail to outperform their benchmark indexes.  In fact, managers in every category fail to outperform.  You would think that half would outperform by sheer chance.  As the article emphasizes, however, the odds of such across-the-board underperformance occurring by chance are ridiculously small.  It's not that managers lack a positive edge.  They actually seem to have a significantly negative one.

*  It's very difficult to not find good posts on the Quantocracy site.   

*  It's also very difficult to not find something good in the weekly top clicks at Abnormal Returns, including an unusually good study of moving average rules--what works and doesn't work.

The $STUDY stream from Stock Twits invariably contains some gems.

*  Here are some coming resources from Adam Grimes, including a primer on how to study markets with quant tools.

 *  Great post from SMB on what golf teaches us about trading.

Have a great start to the week!

Brett

Sunday, April 12, 2015

The Three Paths to Success in Financial Markets

I propose that there are, at root, three basic paths to success in financial markets that correspond to three kinds of market participants.  These are very different approaches to markets and require quite different skills, knowledge, and talents.

The first path to success in markets is the path of the statistician.  The statistician is one who identifies the probabilities of outcomes as a function of current and past conditions.  A statistician, for example, might notice that two currencies are trading out of line with each other because of temporary flows attributable to mergers and acquisitions and place a bet that these will return to their historical relationship.  The idea for the statistician is to construct a portfolio that consists of many distributed bets, each of which has a favorable probability of paying off.  

The second path to market success is the path of the theorist.  The theorist is a big picture thinker who identifies an antecedent set of conditions that, over time, should drive the price movements of financial assets.  Macro money managers, those who look at geopolitical events and macroeconomic developments such as central bank policy shifts, are classic examples of theorists.  Their approach to markets is top down:  understand the big picture and then define a diversified set of bets from that understanding.  For instance, the theorist will notice that central bank policies are notably more dovish--providing more liquidity--in some countries than others and will buy stocks in those countries and sell stocks in the more hawkish regions.

The third path to success in financial markets is the path of the trader.  The trader is a pattern recognizer who exploits quick-developing shifts in sentiment, supply/demand, and relative movement.  A trader, for example, might notice that episodes of selling pressure in a a few, visible large capitalization stocks are not accompanied by significant selling pressure across the broad market.  When the selling slows down in the large caps and the broad market begins to catch a bid, the trader quickly joins that reversal for a move higher in the broad index.  Diversification is achieved, not necessarily by making many independent, simultaneous bets, but by making many independent short-term bets over time.

These three paths are extremely different.  Whereas the theorist is deductive in thinking, moving from big picture understanding to individual trades, the trader is inductive, noticing relatively minute patterns in order flow or price movement and generating trade ideas from those.  The statistician is highly analytical in a quantitative way, emphasizing prediction.  The theorist is more interested in a synthesis of information to achieve understanding.  The trader is more likely to be adept at intuitive pattern recognition--in Kahneman's terms relying on fast, rather than slow thinking.

These differences call on very different skill sets, knowledge bases, and personality strengths.  The action orientation of the trader is quite different from the analytical, cerebral orientation of the statistician.  The theorist needs confidence in his or her big picture understanding of the world.  The statistician relies on objective odds to take subjective appraisal entirely out of the trading process.  Statisticians gain expertise from intensive quantitative research; theorists gain expertise from the qualitative assembly of many different facts and trends; traders gain expertise from immersion in market patterns.

While it is popular to speak of "hybrid" traders that combine elements of these different paths, my experience is that a successful combination of approaches is much less common than is typically recognized.  Indeed, it is much more common for trading problems to emerge:  a) when market participants don't clearly identify their path to success and hence meander among different approaches; and b) when they attempt to blend paths and ultimately don't play to their strengths.

A classic example of this is when big picture macro traders become overly concerned with limiting their risk and end up behaving like short-term traders.  Similarly, statistical, quantitative traders can allow their priors to bias their research processes, skewing their results over time.  Traders with a good feel for markets can suddenly trade in tone deaf ways when they become locked into big picture views.  What generates success for one path can undermine success in the others.

Many market participants fail over time because they lack a consistent path to success and because they lack the self-understanding to chart the path that is right for them.  In markets as in relationships, success often requires a commitment to one path and a willingness to leave other ones behind.

Further Reading:  Three Winning Trading Practices
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Saturday, April 11, 2015

The Market Is Not Getting Stronger, But Is It Getting Weaker?

The recent post tracked the diminished strength of the stock market, with fewer stocks making new highs over time.  But is a market with reduced strength necessarily one with increasing weakness?  This is a very important question, as it gets at the heart of when breadth is and isn't a problem for the market.

Above we see a chart of SPY from the start of 2014 to the present.  In red, we see the number of stocks across all exchanges that registered fresh one-month lows each day.  (Raw data from the Barchart site.)  Notice that we're only looking at new lows--a measure of weakness.  We are not combining the new highs and lows, which can muddle the views of strength vs. weakness.

What we see are sharp elevations of new lows around important cyclical bottoms.  What we also see is that new lows begin creeping higher before markets top out during these cycles.  This was dramatically the case during the second half of 2014 but also occurred leading up to the March top of this year.  While new highs have been waning per the recent posts, notice that we are seeing *very* few new lows most recently.  The market has not been getting stronger in terms of breadth, but neither has it been weakening.

On Friday, we saw 168 shares post new monthly lows across all exchanges.  That is well below the median value of 350.  When we have had fewer than 200 stocks post new monthly lows since the start of 2014 (N=58), the next five days in SPY have averaged a gain of +.34% vs. an average gain of +.13 for the remainder of the sample.  While a market without weakness might appear "overbought", in fact it is healthy in the short run.  In order for the broad stock market to roll over, we have to see some leading stocks and sectors display weakness.  At the moment, we are indeed "overbought", but not weak.

Further Reading:  Breadth and Market Cycles

Friday, April 10, 2015

Three Views of the Breadth of Stock Market Strength



Here are updated charts for what we might call the breadth of market strength and weakness.  (Raw data from the excellent Stock Charts site.)  Any individual stock can give a buy or sell signal according to rules from a technical trading system.  The top chart reflects Wilder's Parabolic Stop-and-Reverse (SAR) system; the middle chart tracks a system based on Bollinger Bands; and the bottom chart follows a system derived from Lambert's Commodity Channel Index.  The charts reflect the balance between buy signals and sell signals for all NYSE stocks on a daily basis.  They thus capture the breadth of strength and weakness for the general market.

As a whole, the signals tend to top out ahead of price during intermediate-term market cycles and bottom shortly ahead of price.  Of the three systems, the SAR tends to be the fastest moving (greatest lead times); the CCI the slowest.  When all are in sync, turning lower or turning higher, we generally find ourselves in the relatively early phase of a trending move.  I find the interplay among the signals to be helpful in identifying where we're at in those intermediate-term cycles. 

Note that SAR has recently turned negative, despite the recent price strength.  The Bollinger Band measure is coming off a high reading but remains positive.  The CCI system recently gave a high reading, which has preceded the most recent market strength.  It has fallen off that high but remains neutral.  As a whole, the signals are showing reduced breadth of market strength, but not net weakness--consistent with the waning breadth readings noted in yesterday's post.    

Further Reading:  Tracking the Breadth of Market Strength
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Thursday, April 09, 2015

Weakening Breadth and Rising Volatility in the Stock Market




Here are the reasons I am cautious about the stock market at this juncture:

1)  We are seeing good buying activity in stocks, as gauged by the NYSE TICK which has been making new highs on a cumulative basis.  Among the large caps (top chart), that buying activity is no longer able to give us fresh price highs.  (Credit for the top three charts to Index Indicators).  Note that breadth in the large caps has continued to dwindle throughout 2015, with fewer 100-day new highs vs. lows.

2)  We have seen greater recent price strength among mid-caps (second chart from top) and small caps (second chart from bottom), as we're hovering near price highs.  Despite this, the breadth specific to mid-caps and small-caps has also been waning, with fewer shares making new highs vs. lows in April than March.

3)  If you look at the cash VIX, it seems as though volatility remains crushed, as VIX is sub-15.  Actual volatility, however, as measured by average true range over a rolling 100-day period, has been higher during 2015 than during the vast majority of the prior two trading years.  Rising volatility in stocks historically has been associated with weakening markets, not strengthening ones.  Indeed, volatility picked up at market highs in 2000 and 2007 well before the subsequent bear markets.  While I don't expect that kind of bear market activity currently, any downside break from here would likely see greater volatility than recent corrections.

I also note that the volatility of realized volatility (vol of vol) has been higher recently than at any time since 2013.  The recent rise in realized volatility and vol of vol helps to explain why short-term traders have had difficulty trading U.S. stocks:  We've had movement, but not trend.  It's been a choppy, volatile range trade.  Buying strength or selling weakness--trading with a fear of missing out--has been a consistent way to lose money.  Viewed on a longer time scale, however, this market appears to be one of narrowing breadth--even among those smaller cap sectors that have been strongest.  That keeps me cautious.

Further Reading:  Macro Themes Impacting Stocks

Wednesday, April 08, 2015

The Importance of Understanding WTF We're Doing as Traders

I noticed that Bruce Bower, via SMB, has posted on the topic of what a winning trading methodology looks like and has released an e-book on the topic.  Bruce emphasizes that a methodology must be grounded in a replicable process and that this process must fit well with the personality and skill sets of the trader.  A very important observation from Jack Schwager in his Market Wizards series is that successful money managers have quite different skills, personalities, and workstyles.  These result in very different trading styles.  What creates success is not adherence to a particular style, but the ability to exploit market inefficiencies in a manner consistent with one's own abilities.

Replicability as a process and fit with a trader's skills and personality are necessary for a successful trading methodology, but not sufficient.  Bruce points out that the method must also manage risk effectively and filter the many possible decisions into ones that offer a reward that is superior to the risk incurred.  In short, a successful method must possess an "edge":  positive expected returns over time that justify the risks incurred.

But there is one other ingredient in a successful methodology that tends to be overlooked:  understanding.  

If you think of a trading methodology as a core aspect of a business plan, the element of understanding becomes clear.  A good business plan doesn't just describe a business with a process and a fit with the owner.  Nor does it simply limit risks and pursue greater rewards.  The good business plan starts with an understanding of the consumer and the drivers of demand in the marketplace.  A startup business meets an identified need.  Entrepreneurs must understand their markets.

Too often I see trading plans/methods that describe "setups" that are devoid of market understanding:  a shape on a chart, a reading on an indicator, a news development, a data release, etc.  Missing from such an approach is a clear identification of what drives prices and how one's methodology will uniquely exploit such drivers.

A very worthwhile text is this regard is Expected Returns from Antti Ilmanen.  Ilmanen identifies specific factors that uniquely impact the pricing of markets, such as value, momentum/trend, carry/roll, volatility, seasonality, liquidity, and the like.  Bender and colleagues break down factors into value, size, volatility, yield, quality, and momentum.  If we think of trading methodologies as business plans and factors as defining opportunity sets, then the solid methodology should be grounded in an explicit understanding of the factors  being targeted and the ways in which the trading approach uniquely exploits those factors.

A simple example would be a breakout trading style that defines periods of market balance and pursues directional moves that emerge from this balance.  That would be a strategy for exploiting momentum and possibly trend.  That would be quite different from a value-oriented long/short strategy that buys undervalued companies and sells stocks of similar companies that are more richly valued.

Three simple tests for a sound trading methodology would be:

1)  Can you clearly identify the factors that your methods/plans will be exploiting?
2)  Can you clearly explain why your methods uniquely exploit these factors?
3)  Can you demonstrate with research or trading evidence that the methods you're trading indeed do uniquely exploit the factors targeted?

If you were investing in a business as a potential venture capitalist, you'd ask those questions of anyone pitching their business to you:  Can you identify the business opportunity?  Can you clearly explain how your proposed business exploits that opportunity?  Can you produce evidence that your business indeed does exploit that opportunity?

If you wouldn't invest in a business plan that lacked clear answers to these questions, why would you invest in a trading plan similarly devoid of understanding?

Traders are entrepreneurs:  We're most likely to trade with confidence and conviction when we possess a deep understanding and belief in what we're doing.

Further Reading:  The Proactive Personality of the Trader
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