How Expectations Turn Into Reality

There is a lot of placebo effect in capital markets.  Just like the price of Nike sneakers consists of tangible value (they provide all the benefits other sport shoes provide) and intangible value (the fame of the brand), the price of any stock reflects underlying fundamentals, expectations about future growth and current sentiment. Each of those three elements can have a positive or negative contribution towards the price of any stock at the different stages of its life cycle.

Investors often act on expectations of how certain events and processes will affect prices. Those events might not change the underlying fundamentals at all, but they can change expectations. When expectations change, prices change. When prices change, expectations change. Yes, some catalysts can start a process of self-reinforcing feedback loop. It works in both directions – up and down.

Technical levels (previous zone of support and resistance, recent bottoms and tops, Moving averages) are not events in the typical sense of the word, but they also impact expectations.

They often work as self-fulfilling prophecies – when enough eyes are looking at the same level and act, expectations could turn into reality.

It doesn’t always work so flawlessly and honestly often such obvious levels of potential buying interest don’t work at all.

Such types of mean-reversion trades are alluring for their good risk to reward, but they can be really tricky. Stocks will often overshoot the obvious levels only to stop a good number of market participants and reverse higher. In other cases, they will reverse higher a few per cents before the obvious level of potential support is reached. leaving behind those who waited for that level.

In general, mean-reversion setups are dangerous. You need to know your weaknesses very well and practice flawless discipline to even consider playing them. Small stops provide good risk to reward, but will take you out often in such setups. Mental stops could be disastrous for those who can’t act on them. Overall, it is better to not play mean reversion at all or to play it with very small positions.

What Do Charts Mean for Me

Charting (Technical Analysis) is like reading footsteps. It doesn’t only reveal the past. It gives clues about the likely direction in the near term future. It provides an understanding of likely future behavior, based on deeply ingrained psychological biases and personal incentives. When elephants dance, they leave traces. When institutions buy, they can’t hide their hands. Here is what I said about the subject in my chapter of The StockTwits Edge:

Financial markets move in cycles that are defined by institutional capital
allocation. When institutions buy or sell, they do so in volume and leave clear
traces for the experienced eye…

The bulk of the directional market moves tend to happen in just 10 – 15% of
the trading days. The rest is nothing more than noise in a range. I am looking for
the event that signals the beginning of a powerful, new trend. How does this
signal look like? Simply said – it is high-volume price expansion:

 High volume (at least 3 times the 20-day average daily volume);
 Price expansion (at least 2 times the average true range for the last 20
days and a minimum of a 10% move)…

Such combination of price and volume action guarantees institutional
involvement. My logic is simple – when institutions buy, they leave traces. They
are heavy, slow buyers; therefore I have enough time to enter and exit as they
build their position.

BTW, Peter Brandt has a good post on the subject and as usual, his perspective is worth perusing.

What If Newton Was a Trend Follower

Issac Newton is probably one of the most brilliant men ever lived on this planet, but even he lost a fortune when the so called South Sea Bubble bursted. Shortly after the crash, he reportedly declared that:

“I can calculate the motion of heavenly bodies, but not the madness of people.”

Mebane Faber has an interesting paper on Bubbles that is well worth closer examination:

Across twelve market bubbles we find that a trendfollowing system would have improved return while reducing volatility. Most importantly, it would have reduced drawdowns significantly leading to the most important rule in all of investing – surviving to invest another day.

Bubbles happen much more often that most people expect. They also lasts longer and become bigger than most expect.

A fellow student of bubbles, Jeremy Grantham at Grantham, Mayo, Van Otterloo and Co. (GMO) has collected data on over 330 bubbles in his historical studies. He points out in a recent research piece “Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever”, that one of the key difficulties is distinguishing when a bubble is indeed occurring, and when there actually is a paradigm shift. When is this time really different?

During a typical bubble, an asset appreciates several hundred to several thousand per cent in a short period of time and then it comes all the way back where it started and even below in many cases. If you just buy and hold, you end with no gain at the best case scenario. But what happens, if you apply a simple trend following strategy, which always involves an entry and exit plan based on some derivative of price. In his research, Faber uses 10-month simple moving average as a benchmark.

Our research demonstrates that a trendfollowing approach improved returns in every bubble (except one) and reduced volatility and drawdown in all twelve of them.

There are different derivatives of price that could be used as a trailing stop in trend following – Average True Range, Trend lines, Simple and Exponential Moving Averages. The purpose of a trailing stop is to keep you long enough in a trade, so it could make a difference in your overall performance and also to protect your gains after the trend inevitably ends.

The subject of figuring out where to add to a position and where to take partial profits is way more nuanced and I am not going to elaborate on it here.

Price is not the only entry criteria I use, but price is the only exit criteria I respect.

There is a Difference Between What People Say and What They Think

For many, there is a difference between how you think you will act in certain conditions and how you actually act when the time comes. The term used to describe this condition is called empathy gap.

There are two basic scenarios in which empathy gap can impact your performance as a trader/investor:

– you don’t cut your losses when they hit your pre-established exit level. This is the single biggest reason, so many people struggle in the capital markets. One solution to the issue is to enter exit orders, immediately after you initiate an opening order (caution: it does not work with illiquid names, where market makers can easily shake you out);
– you don’t take the signals from your watchlist when they are triggered. Some stocks can really move fast after they pass their tipping point. When that happens, many traders feel like a deer in headlights and are not willing to pay the market price. They’ll put a limit order, hoping that the desired stock will come back and their order will be filled. The best stocks don’t come back. Don’t be afraid to pay the market price for proper breakouts.

In his latest post, Steve Martin reveals that:

In today’s information overloaded world, evidence suggests that 95 per cent of our decisions are made without rational thought. So consciously asking people how they will behave unconsciously is at best naïve and, at worst, can be disastrous for a business.

This is one of the reasons why I think that survey based sentiment measures have little value. Market sentiment is reflective. It mirrors short-term price action and recent performance. For example, people who have had a number of consecutive successful long trades are likely to be much more optimistic about the markets in general than people who have been on the sidelines.

I realize that there are some hedge funds that claim that sentiment could be a leading indicator, but I have a feeling that in their case they are confusing correlation with causation. The truth is that price and sentiment live in a systemic relationship, meaning that they mutually impact each other in real time. Price changes when perceptions of risk change, but also perceptions of risk change when price changes. Since I don’t have a reliable method to catch changes in sentiment, my starting point for finding new ideas is always price.

Focus on Strength

3 back to back green days for the market averages with $QQQ breaking above its 50dma intraday and reaching levels not seen since August 2nd. None of the macro issues have been resolved, but they never will be. For better or for worse, the market has a short-term memory and is capable of rallying in any environment.

The mainstream media continues to mass produce apocalyptic news, because this is what attracts the most attention and sells the most. When the current challenges are solved, it will come up with something else to worry about. It always does. People do what they are incentivized to do, and TVs and newspapers are incentivized to produce noise. The good news is that you can fully ignore it when it comes to making your trading and investing decisions.

Focus on strength, take your entry signals and diligently cut your losses. Loss cutting is not practiced only to protect capital against major drawdowns, but also to consider opportunity cost – there are always other stocks that are breaking out or down. If one idea does not work, just move to the next.

Take a glance at $STMP, which has become the latest posterchild of why relative strength matters. When a stock is up 3% and advancing while the market averages are down 2%, take a note. This stock is likely to outperform when the market turns north. BTW, $STMP is extended at this point and this is not the place to chase it.

Let’s take a look at the breadth:

25 stocks closed at all time high: $STMP $FCFS $PSMT $MJN $EDU $UAN $ORLY $ATHN $QSII $CPA $RL $AZO $CERN $PGN $LQDT $AKRX $ELGX $NI $WPRT $DLTR $SO $ACTG $MLNX $CASY $HITK

Other Stocks that are less than 5% from their all-time high: $VRUS $MAKO $KEYN $STAA $AMZN $MA $ALXN $JAZZ $ULTA $HANS $EVEP $MG $TNH …

120 liquid stocks gained 5% or more today. 35 of them reached new 20day high. Some of them: $SQNS $SIMO $NVDA $BSFT $TLEO $CRUS

330 liquid stocks reached 20-day high at some point today: $ARMH $CMI $URI $BMC…

Look, things can change in a blink of an eye. Chasing stocks that are up 3 days in a row is not wise. Taking gains relatively quickly and keeping your overnight exposure light still makes a lot of sense.