Financial Markets Are Full of Surprises – for Some More than Others

Morgan Housel is out with an interesting post, basically claiming that if you study past history you will learn a lot about history, but very little about the future. The lessons from the past financial crisis are not going to help us with the next financial crises. Life is full of surprises. There is very little we can do to be fully prepared for them. As an ancient proverb goes “when men make plans, gods are laughing”.

He makes some good points. The events and processes that caused the last market correction or bubble are probably never going to repeat in their literal form. Does this mean that studying financial history is futile?

You can learn more relevant lessons that are more likely to pass the test of time if you dig deeper; if you go straight to the source of market corrections and booms – human psychology. When it comes to fear and greed, nothing ever changes. What caused fear of losing and fear of missing out 100 years ago causes the same emotions and reactions today and it’ll cause the same attitude 100 years from now.

The reasons for market corrections might change, the names of the winning and losing stocks might change, but human emotions and psychology are likely to remain the same. One of the best and the most unbiased reflection of human emotions is price action. Technical analysis continues to be an underappreciated tool for risk management, market timing, and equity selection.

What we know with almost 100% confidence is that there will be other big market corrections and bubbles in the future. They will probably be caused by events and processes no one can predict. Most people will react similarly to wild price gyrations. Some will view market crashes and booms as irrational exuberance, others will be prepared better and see in them incredible opportunities.

How is the Boom in Passive Investing Changing Financial Markets

WSJ is out with a post calling stock picking a “dying business” and declaring passive investing the winner.  And the facts about money flows are on the Journal’s side, but as usual, they are greatly exaggerating things by posting data out of context.

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds

As Howard Lindzon would say “there’s no such thing as pure passive investing, just fifty shades of active investing”. What’s more interesting to me are the potential consequences of this rising passive investing tsunami:

1.The more money flows to passive investing, the faster markets are likely to become. This will lead higher correlations among stocks and more volatility, which means bigger and quicker corrections; it also means bigger and quicker recoveries. Take a look at the bear market of 2000-2002. As harsh as it was, there were plenty of stocks the kept making new all-time highs during that period and delivered some real alpha. Then, compare it to the correction in 2008, 2011, even early 2016. We saw a lot higher correlations during the most recent corrections. Most stocks went down together; then, they recovered together. Is it a big surprise then if leveraged ETFs are becoming the weapon of choice of more and more active traders?

2. More opportunities for savvy stock pickers. A rising wave (bull market) will lift all boats, including the crappy ones, creating multiple great short targets. A swift correction will bring down strong businesses to super-attractive valuations.

3. A decrease in hedge funds’ fees. 1 & 10 might become the new 2 & 20. If you find a great money manager, 2 & 20 is a small price to pay, but the majority of investors are likely to demand and try to negotiate lower fees. Finding a great money manager is like finding the next Amazon before it happened. The trouble is that in most cases, people won’t stick long enough to see a big difference.

The Worst Performers of Last Year Are Crushing 2015’s Best Performers in 2016

If you needed more proof that 2016 is a big mean-reversion year, take a look at the performance of the 10 best performing S&P500 stocks from 2015 year-to-date. On average, those 10 stocks were up 72% in 2015. In 2016, their average return is lagging the S&P500 by being up 4.3%. One of them was acquired in September 2015, so I am showing only 9 for 2016.

a

Take a look at the 10 worst S&P500 performers of 2015. On average, they lost about 60% in 2015. Year-to-date, they are up 17%.

b

The 9 Hottest IPOs of the Past Year

The IPO pond has dried out in the past year, but it has remained an incredible source of trading ideas. Due to their small float and newness, some new public companies tend to significantly outperform during rising markets and significantly underperform during market corrections.

Here’s a list of the nine hottest new stocks for the past year. Many have already had their run and are due for a pullback. Others are setting up again.

1

A Good Trader Should Be Able to Adjust to Changing Markets

A good trader should be able to adjust to changing markets. 2 to 20-day swing trades work beautifully in steadily rising markets. We experienced those for the most part from February to August 2016. Intraday trades are the real money makers during corrective markets. Volatility spikes during corrections and when volatility spike, three things usually happen:

1) Stocks trade in much wider daily ranges than usual. The intra-day moves are humongous and there’s plenty of liquidity behind them. Upside and downside moves that used to take 5-10 days are taking 2-3 hours during corrective markets.

2) There are many reversals. Many breakouts and breakdowns fail. Stocks gap up one day and then gap down the next. Such environment makes 2-20-day swing trades more challenging. Even if you trade in the direction of the general market’s trend (which is obviously down during corrections), you will have to go through numerous high-magnitude squeezes until you get paid properly. The only way not to get shaken out from normal price reactions is to use a very wide stop and a smaller position size.

3) Correlations between stocks and different asset classes rise as well. This means that stocks bounce and dive together regardless of individual company’s merits.

Speaking of rising correlations, what makes a strong impression in the current market pullback is how many stocks are holding extremely well and don’t pay attention to what the indexes are doing:

Small-cap biotechs, many of which don’t have any earnings or revenue, continue to break out and gain ground. In a typical market correction, those are among the hardest hit stocks.

Chinese ADRs, which are super volatile in general, continue to show relative strength. Again, this is usually among the most pressured group during corrections. Not this time.

Quite a few high-beta, momentum stocks are holding well, as well. A quick look at my SL50 momentum list shows numerous breakouts this week – GIMO, ANET, LOGM, FNSR, ZLTQ, etc. Those types of stocks tend to underperform during corrections.

All of the above makes me consider the current correction just a 5-8% garden variety pullback within a bull market. Maybe, it is too early to judge and fear will accelerate when prices go lower. No one really knows. Just thinking out loud and sharing a few observations.