Category: Commentary

Financial markets constantly swing between sentiment extremes – from fear of missing out to fear of losing, from complacency to second-guessing yourself, from enthusiasm to apathy. The majority of people tend to lean in the wrong way at pivot points. I like to look for anecdotal evidence of the latter on social media. For example, in the midst of the selloff on Thursday, I posted the following poll on Twitter:

About an hour after posting it, the market rallied hard. At the time, the results were predominantly in favor of “there’s no reason to be long here”. I didn’t have a time machine. I just noticed that indexes were down a few days in a row, an increasing number of stocks were finding support, the McClellan indicator reached levels that led to a bounce in the near past.

The same scenario repeated last week when many index and sector ETFs were had overbought RSI readings and more and more stocks were breaking down. Most people were super complacent at the time. Here’s a poll I posted on June 7th, shortly before the stock market dived.

As Jesse Livermore said in his infamous book: “Remember, the market is designed to fool most of the people most of the time.”

People like to compare trading with poker. They have a lot in common. Both deal with probabilities. Both accept that there is never 100% certainty. What matters most is risk and reward over time. Statistics, pattern recognition, cognitive psychology, and studying past wins and losses is extremely useful in both games.

In both disciplines, psychology matters more than fundamentals. In poker, you might win with a weaker combination of cards than your opponents if you manage to convince them that you hold something strong. In trading, a current sentiment often overrules underlying fundamentals in short-term perspective – a stock with high short interest could double and squeeze short sellers out of the game before it ultimately reverses lower and head near zero.

In both games, participants operate with a different time frame in mind. Some poker players might be willing to create an illusion that they like to bluff. They could intentionally lose a few small bets early in the game, so they could win big later in the game. In trading, some people operate intraday, others are swing traders, market makers, value investors, etc.

There are many similarities, but they are also two very different games.

Poker is a zero-sum game. Every dollar won by one is lost by another. Trading/investing might be a zero-sum game, but it is not. Markets often rotate periods when almost everyone is a winner with periods when almost everyone is a loser.

In poker, you know exactly what is the probability of having a winning combination of cards. In trading, the probability of a setup being profitable and its potential reward to risk could vary significantly based on the market environment. For example, a breakout setup has a much higher likelihood of making more money in a strong general market that is rising above all its major moving averages – 10, 20, 50 and 200-day. The same setup is prone to failure or delivering much smaller profits in a declining market that is falling below all it major moving averages.

Professional poker players know the exact risk and potential reward for each bet. They are willing to take a bet with 20% probability to win if the potential reward is let’s say ten times their risk. They accept that with a 20% probability to win, they will lose four out of five times. The one out of five times they win will more than compensate for their losses.

In trading, taking setups when they have a much lower probability of delivering leads to overtrading, deep drawdowns and eventually to frustration and loss of confidence. This could lead to second-guessing a setup and under-trading when a more accommodating market environment comes around.

In poker, you are dealt one hand. You don’t get to choose. In trading, you could choose to play whatever setup you want. You could buy breakouts when they are more likely to work and deliver bigger profits. You could use a different setup or stay on the sidelines when the market environment is not favorable for buying strength.

Last weekend, we talked about the inability of bears to push the market lower and how they missed their chance. Price and sentiment are deeply related and impact each other. In a short-term perspective, lower prices often lead to more negative sentiment, which leads to even lower prices and sometimes panic selling. The Fed hinted that it might further raise the overnight interest rate later this year. The S & P 500 broke below the widely watched 204 level ten days ago, only to rally from there ferociously and get back near all-time highs. From failed moves often come fast moves in the opposite direction.

For a second quarter in a row, we see equities rally near the end of earnings season Coincidence or maybe people prefer to put money to work after major trend-changing events are out of the way? Stocks gained across the board last week. The rally was well represented including various market caps and sectors – Semiconductors, Financials, Energy. Consumer Discretionary, Healthcare, etc.

We talked about the extreme bearishness last weekend. The percentage of bulls among AAII money managers was super low. The picture hasn’t changed much, even after the rally last week.

So what do we have here?
1. The S & P 500 is near the top of its past 18-month price range.
2. Many managers are underinvested.
3. The 52-week high list has started to improve.

The combination of the above-mentioned factors means that there’s a pretty good chance that we see a continued strength next week. We might easily see an upside breakout in the S & P 500 that would later fail and lead to choppiness during the summer. This is just one likely scenario based on the current combination of price action and sentiment.

The bulls are still in control. Quite a few stocks broke out last week, but I still see plenty of long setups on the SL50 list of hot momentum stocks and beyond.

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