Six Market Insights from Brett Steenbarger

Brett Steenbarger is a well-renowned market psychologist and trading coach. He is the author of numerous books including The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), and Trading Psychology 2.0 (Wiley, 2015). He is one of the most influential thought leaders among traders. Dr. Steenbarger shares his thoughts on markets, trading patterns, and psychology on his website Traderfeed. He can be followed on StockTwits and Twitter @steenbab.

Here are some of his insightful thoughts on markets and life:

1. The right questions lead to better answers.

Every action we take is preceded by a question. If we ask the right questions, not only we’ll get the right answers, but we are also likely to sustain a positive change in behavior. Imagine, however, that we start the day by asking questions such as: “What one important thing am I going to achieve today?”
“How can I best contribute to my team today?”
“How can I maximize my energy level throughout the day?”
“What one special thing can I do for my spouse today?”
“What will I do today that will push my boundaries and make me grow?”

Notice that these questions are not implicit. They frame one’s use of time, and they begin with overarching priorities and values. When the implicit question is about “What can I get done now?”, we are pushed by the demands of the present. When the question is “What will make today special?”, we are pulled toward our priorities.

2. Can we really expect great results from a series of ordinary days?

Our daily experience is what we process each day, and that is what we internalize–for better or for worse. The work we perform, the people we interact with, the activities we engage in: that provide our psychological diet. 

What we do in life and who we do it with shapes our experience–and our experience shapes how we view ourselves. 

3. Don’t try to be perfect

As a psychologist, I’ve worked with many high-achieving perfectionists. They often accomplish a great deal but experience more than their share of stress and distress in the process.

When outcomes are less than ideal—and in financial markets, that’s a near-certainty—there is plenty of room for second-guessing and self-criticizing.

For the perfectionist, so much time can be spent focusing on the rear-view mirror of imperfect performance that opportunities are missed in the present.

4. Good judgment requires experience and experience requires bad judgment. Mistakes are lessons.

If everything in life either provides you with blessings or lessons, you will always profit, even when you lose money.

Viewing life through the lens of blessings and lessons means that you approach the world with a sense of gratitude.

Perhaps we don’t suffer because of losses; perhaps suffering results from an absence of gratitude. It’s the lessons that ultimately bring the blessings.

There are a number of emotional and health benefits associated with gratitude, but perhaps the greatest benefit is that it promotes resilience.

It is through adversity that we stretch our boundaries and discover hidden reserves and talents.

As long as we take risks prudently, whether in romance or in markets, losses can become gifts once we seek and uncover their educational value.

5. Most people believe that they’ll be happy only after a certain goal is achieved. The reality is that you are more likely to achieve success if you feel happy on a daily basis.

When we are feeling fulfilled and enjoying life, there’s no reason to place capital at risk for any reason other than genuine opportunity. If that fulfillment and joy are missing, however, it is tempting to reach for the trade as we reach for the ice cream.

When we feel down, we think that success will bring us happiness when in fact, the opposite is true – happiness will bring us success.

6. If you want to change your life, change your habits first.

I’m not sure people can make positive changes in their lives without first changing their internal dialogues. Can we really sustain new patterns of behavior if we’re sustaining the same old thought patterns?

We eat well, sleep well, exercise–do a lot of things to maintain our hardware. That won’t get us where we want, however, if we’re running faulty software.

Keeping a journal can be a structured method for changing our self-talk. Not many traders actually use journals that way. But we really can reprogram ourselves.

 Everything in life can be approached with intention and purpose or it can be approached mindlessly and routinely. In carrying out daily activities with self-direction, we strengthen our ability to stay mindful and purposeful for life’s greater goals.

Related reading: 15 Insights from Trading Psychology 2.0

Do Moving Averages Matter?

Some say that moving averages don’t matter because they just represent the average price for a given period. If enough market participants and algos believe they matter, their actions will impact the market. It is not what you believe matter that matters. It is what the market believes. The market doesn’t consist of just you. It consists of many people, institutions, and algorithms. Time and time again, the market has shown that moving averages can play a pivotal role in a trend. Moving averages are not flawless. As it is with any other tool in the market, they only work well in certain markets. They are just one way to make sense out of a noisy market. They work better in trending markets and not at all during range-bound choppy markets.

Five Market Insights from James Mai of Cornwall Capital

James Mai is one of the founders of Cornwall Capital. His fund was featured in Michael Lewis’s The Big Short book as one the organizations that made a fortune during the subprime crisis. Cornwall Capital was started in 2002 and it has netted 40% per year.

Cornwall Capital seeks highly asymmetric trades where the potential reward is multiple times bigger than the risk taken. They often buy long-term (1-2-year) out of the money options to take advantage of special situations that are underpriced by the options market. This strategy sounds similar to what Jim Leitner does.

Markets tend to over-discount known risks which create amazing long-term opportunities

Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.

Option markets tend to assign a normal distribution to almost everything. This makes paying for a long-term gamma extremely cheap in some situations. I covered Scott Bessent who talks about that as well.

We had already seen cases where the option market assigned normal probability distributions to situations that clearly had bimodal outcomes.

The first thing we checked was whether the Altria options still assumed a normal probability distribution, despite the presence of a bimodal event. Sure enough, the Altria option prices still implied a normal distribution, which meant the out-of-the-money options were way too cheap. Since our work suggested a greater likelihood for a bullish outcome, we bought the out-of-the-money calls. The calls appreciated sharply when one of the key cases supporting the rating downgrades was thrown out on appeal shortly after we initiated our investment. We made about 2.5 times our money on the trade. Although we made a large return for a short holding period, in hindsight, we sold far too soon.

Options are priced lowest when recent volatility has been very low. In my experience, however, the single best predictor of future increases of volatility is low historical volatility. When volatility gets very low in a market, we consider that a very interesting time to start looking for ways to get long volatility.

Often, the longer the duration of the option, the lower the implied volatility, which makes absolutely no sense. We recently bought far out-of-the-money 10-year call options on the Dow as an inflation hedge. Implied volatility on the index is very low. The Dow companies would be in the best position to pass along higher prices. There is also an interest rate bet implicit in buying long-term options that can be quite interesting when interest rates are very low, as they are now. By being long 10-year call options, we are taking exposure on the risk-free rate implicit in the option pricing models. If interest rates go up, the value of the options can go up dramatically.

Option models generally assume that forward prices are predictive of the future movements in the spot price. Academic research and common sense suggest that this relationship is often invalid.

The best performing stocks in the first stage of a market recovery are usually the ones that were hit the hardest during a correction.

The low-quality names tend to outperform early in the cycle, and the high-quality names tend to outperform toward the end of the cycle.

Why the so-called boring businesses with low, but steady growth tend to do very well long-term

Beta is measured based on daily relative price changes, which can be a very poor indicator of long-term relative price changes.

Volatility is a terrible proxy for measuring potential price change over longer intervals of time. For example, if an asset price changes by a constant percentage each day, its volatility will be zero. One of our strategies is called cheap sigma and is predicated on the idea that markets sometimes trend and that volatility will dramatically understate the potential price move of markets that trend.

The trend is your friend if you want to be a buyer of premium.

Option prices will tend to be priced too low in smoothly trending markets.

Option math works a lot better over short intervals. Once you extend the time horizon, all sorts of exogenous variables are introduced that can throw a wrench into the option-pricing model.

Great setups don’t come up that often

The reality is that we have a business model in which we dig 50 dry wells for every idea we explore that leads to a trade in which we find conviction.

We are comfortable losing 100 percent of our premium four times in a row, as long as we believe that a 25-times payout is likely to occur if we make the same bet 10 times consecutively.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards. John Wiley and Sons. Kindle Edition.

Buying the Blood on the Street Is Easy Only in Hindsight

In his latest post, Frank Zorrilla makes an astute observation that the four best-performing ETFs year-to-date were all down several years in a row heading into 2016.

The best performing single ETF’S this year have been KOL (+108%), GDXJ (+107%), EWZ (+83%), and GDX (+72%).

Recent data by Dimson, Marsh, Staunton database, showed median country returns of 8.74% (all years) and 15.94% after three down years in a row, both suggest that you will double the median return of all years if you own a country ETF that is down three years in a row.  It’s a very rare occasion that only happens 3% of the time.

If you take a closer look at this year’s top ETF gainers, you will notice that they were not down three years in a row. They were down 4 or 5 years in a row in the midst of a powerful bull market. Anyone who thought they were a great bargain in early 2014 or early 2015, bought too early and saw another 40% to 60% decline before there was finally a more sustainable relief rally. It doesn’t matter if you just manage your own money or other people’s money. You cannot lose 50% on a position in a bull market and remain in business.

The best performing industries in any given year are usually the ones that surprise the most. What are the type of industries no one expects to substantially outperform? The ones that were down a lot several years in a row and the ones that were up the most several years in a row. In the first case, no one really cares about those industries. They are not simply hated, they are ignored. In the second case, no one believes that their upside run can continue any longer.

There is not one sure recipe for finding the best performing industries every single year. Sometimes, they come from the bottom of the pit. Other times, they come from the top. We have to be flexible and willing to continually adjust to ever-changing market cycles.

Take a look at the long-term charts of the above-mentioned sectors. Each candle represents one year of price action.

ewz

kol

gdx

ibb

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.