Breadth Inversion

A month ago today stocks hit levels of exuberance that generally unwind through price and/or time.  For short term traders this was a warning to be on alert for further deterioration.  Through following magnitude of moves by stocks across multiple time frames, the evidence shows accumulating negatives that have resulted in the acceleration to the downside.  Today this acceleration has inverted readings across multiple time horizons.

Breadth Inversion

Clearly Uncertain

I view the market in a binary manner.  Either it is tradable or it isn't.  If the market isn't tradable no further analysis is required.  If it is tradable, how tradable must be assessed.  Within this spectrum there are many shades of gray with the occasional black and white.  With a short term holding period the behavior of the general market structure has a significant impact upon my results.  Additionally, having a holding period for one set up with a 3-5 day time horizon and another with a 5-10 day time horizon means I juggle my perspective frequently. I place heavy reliance upon how my existing and recent trades are functioning.

When my analysis suggest the backdrop of the market is extended but stocks continue to set up and a handful of quality setups continue to break out, my focus tends towards heightened risk awareness and decreased exposure.  When faced with conditions that I'm on the fence about, such as when breadth is extended or waning, indices are trudging sideways, results are muted, my averages are not being met, etc...  I will quarter my account and cap positions at 4 max exposing ~1% of account to risk during such periods. 

QTT

QTT is a breakout today that meets my standards.  Under differing conditions this is the type of trade I would look to maximize my potential upside through my sizing algorithm while keeping risk within norms, but currently I'm more focused on trading clearly through risk management, maintaining my R/R norms and W/L ratio, than meeting my avg. gain/loss per trade in dollar amount.  Decreasing size never hurts when clearly uncertain.

The Market is so Bad...

How bad is it?

N/A

So bad my data host crashed.

No Data

Weekend Review 02/26/2017

One of my personal objectives this year is keeping money.  This seems like a patently obvious notion --and it is-- yet this has been a notable blind spot in my track record which I'm looking to rectify.  In practice this means being more disciplined and selective of the periods I will trade and how heavily I will expose capital.  In order to better quantify these periods I've begun to increase emphasis upon my % Win/Loss and Avg. Winner v. Avg. Loser to determine when my risk of ruin is drifting upwards as well as a risk/reward quadrant that aligns my trading philosophy more closely with my trading objectives.

One thing I've noted as the month of February comes to a close is that my Avg. Winner/Avg. Loser ratio has begun to decrease.  This is coinciding with the overall market reaching a zone that I consider to be extended.  A metric I pay close attention to is the percentage of stocks greater than 70 over multiple time frames, the 20, 40, and 200 day period.  As the number on all three time periods has clipped 70 over the past month of trading my near term expectation is an upcoming pullback across the shorter period with the possibility of carrying over into the higher time periods.  There is already evidence of this occurring over the 40 day period.

% Stocks > 20 Period Moving Average

% Stocks > 40 Period Moving Average

% Stocks > 200 Period Moving Average

Additionally the breadth trends I follow have been waning for some weeks now so the overall market is entering a phase that I consider to be higher risk with lower reward on my time horizon.  At these levels I'm becoming increasingly skeptical and focusing more on capital retention then appreciation.  I'll lean more towards reducing position size and expectation along with avoiding margin.   Continued erosion of these numbers would result in a breadth flip that would increase my cautiousness and begin to look at exposing capital on the short side.

Ratio of Stocks > 25%+ in a Quarter

Stocks > 13% over 6 Weeks

Beware of DOW

I rarely speak of the DOW because I rarely think of the DOW. It doesn't really exist to me because none of its components are in my trading universe. Ignoring it however is a mistake in my analysis because it is the granddaddy of all indexes. It is the one every John Doe Retail listening to the nightly news will hear about hitting a new all time high today. It is the index that will have them going to sleep tonight believing all is well in the market, but it's also the index that informs when something isn't quite right.

I consider a leading DOW as an indicator that my trading universe is lagging and since it is compromised mostly of small cap and momentum stocks it suggest that in the least it is currently a risk off environment or a period of distribution. With only 30 components a smaller amount of effort is required to misdirect the eye by pushing the needle and nudging the DOW to new highs while masking the relative weakness in the Russell and Nasdaq.

$INDU:$RUT

$INDU:$COMPQ

These are the times to be more alert and vigilant to a potential change of character in the market. A number of high fliers have been having some extreme volume sell-offs after earnings and many others are showing wide ranging intraday price movements indicating increased volatility which is a sign of distribution. Today TSLA, QUAD, MELI, and JCOM got to visit the woodshed and after hours it looks like SCTY, NDLS, and WFM will be joining them tomorrow morning. At this juncture market risk is beginning to increase and playing with this awareness is prudent speculation.

All is not foreboding however, as the leadership of tomorrow is taking shape today. Two that have been entered into my watch list are ECOM, and VOYA.

ECOM

VOYA

Trading Is Not A Zero-Sum Game, It Is -EV

Trading and Poker as a zero-sum game is the new efficient market theory. I can't count the number of times I've heard that trading is a zero-sum game repeated without any fact based evidence what-so-ever. Let's look at the definition of a zero-sum game first:

a zero-sum game is a mathematical representation of a situation in which a participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

So first let's disprove poker.

Buy into a 2/4 limit hold 'em with a $100 rack and post on the big blind. For sake of argument let's assume this is a 2-1-1 blind situation. If the first three hands are discarded, 4% of the rack is gone. If this is a full game of ~8 players and a hand count per hour of 35 you should be blinded 4 times. Without playing a single hand approximately 16% of equity will be lost in an hour.

Now to disprove trading.

I have a $1500 account. I buy 100 shares of XYZ at $10 for a total of $1000 and a commission of $7. I now have $1000 of stock and $493 in cash. I sell $XYZ the next day for $10 and a commission of $7 to you who has a $1500 account but with $1 commission. After this trade I have $1486 and you have $1000 in stock and $499 in cash. Let's repeat. I now have $1000 in stock and $479 in cash and you have $1498 in cash. If this repetition continued further, even though I bought and sold the same number of shares for the same price, soon enough I won't even be able to buy the same number of shares.

As long as there is a rake in poker and commissions in trading the game will always be -EV. The typical claim that trading is a zero-sum game is concluded briefly with, “For every winner there is a loser.” However, even this is not completely true as shown in the trading example. Further there is plenty of evidence that the game of trading is really a wealth transfer from the many to the few. A number of account studies have shown unequivocally that 90% of them are net negative and the owners of these accounts have a strong tendency towards the disposition effect: cutting winners short, letting losers run, and adding to losers but not to winners.

This is just one of many market maxims that when not vetted and taken at face value can lead to erroneous conclusions and outcomes, poor habits and thinking. One that I've recently thought about is “Trade what you see, not what you think.” The problem with this is that we now know through behavioral sciences that both are faulty and can not be relied upon unquestioned. When looking at a chart our eyes are subject to optical illusions and blind spots, and our thinking is subject to misidentify a trend based upon a sequence of 2 in a row among other behavioral biases.  Not only are they problematic individually, they can become more so when used in tandem. The moral of this story is: question first, verify second, believe third.  Reality based, evident backed trading trumps assumptions and maxims.

Anticipation

If there is an environment cleverly schemed to take advantage of people's behavior it's casinos. Walk into any casino and immediately you're hit by flashing lights and the sounds of bells and clinking coins. Once the door closes the tinted windows make it difficult to distinguish night from day in an attempt to make time cease to exists. Even if you looked you'd be hard pressed to find a clock anyways but don't worry about getting too tired because the pumped in oxygen will keep you alert.

If you care for a game of skill where your knowledge will give you an edge you'll have to walk the gauntlet of the games of chance and maybe you'll get lost and decide to throw down a few bucks on the wheel and have a cocktail because the room you;re looking for is usually hidden in a corner away from it all or in a separate part of the casino down some hallway. And when you've finally called it a day you may just toss down a lucky buck at the slots on the way you. It's all cleverly thought out to milk the cash from the cow.

The most cleverly designed machine of cash extraction is the slot machine. For every dollar the expected return is a few tenths of a percentage less but that doesn't seem to keep the herd from sitting down and using three at a time. Slots are specially designed to exploit what I discussed about in a previous post, anticipation and the false expectation of a series after two data points. When the first 7 hits the anticipation builds and when a second the pleasure response begins to fire even more in expectation of that third seven. What's more nefarious about these machines for those that play them is that this anticipation occurs long before before pulling the lever, it begins entering the door and that's in part why they are at the entrance.

I don't play slots but I did mention being influenced by a few traders I follow on twitter who were taking positions a week back. At the time I was trying to deduce what they were seeing and these two behaviorism were what I choose to explain it to myself. The reason I bring this up again is because they were at it again today as one began making inference that he was taking positions and the other was talking about taking light positions here. So today I wanted to return again and chart their mentions.

Tracking Twitter Trend

We live in unprecedented times where even if you lived on the tundra as long as you have a net connection you can get access to world class traders who will engage with you and are willing to take time to teach you through webinars. I don't expect myself to be aware of all the nuances they see or understand, however that doesn't mean I shouldn't take the time to process what they say. In order to make it understandable to myself I chose to use what I've learned through modern neuroscience and casinos so that it becomes meaningful and sticks, but next time I might use a Grimm's Fairytale, a fractured fairytale, or those loveable magpies Heckle and Jeckle. The point being, be aware of what they say and take notes and internalize it because as traders we're lucky to have it.

Now, on to breadth. Today was a key day as indicated by the Russell which outperformed today and showed great strength closing near the highs of the day. I'm still of the belief that if there is going to be a sustainable rally small caps need to take part otherwise money just keeps flowing like water into the stale bread leaders. New leadership comes from small caps so today was very positive.

Russell

In addition today the secondary indicator I use crossed over again.

Secondary

Lastly, the 10 day differential of buying to selling has been improving. Granted the underlying buying pressure has been modest, but the heavier distribution that the market has seen over the past few months has been waning as well. This become clearer when looking at the raw numbers.

10 Day Differential

Raw Numbers

The main focus now is honing in on stocks that are showing relative strength because if the market will begin a new leg up the correction over the past few months should start showing up on the charts and quality set ups should stick out like a sore thumb.   

Pros Vs. Joes

Years back there was a program called Pros Vs. Joes that pitted mostly middle aged former professional athletes against mostly middle ages former high school all-start in feats that ranged somewhere between Battle of the Network Stars and American Gladiators.  It was a tepid program at best and I willfully admit to watching an entire marathon one Saturday afternoon because I needed something to distract myself after finishing a turn of Civ III, or a cigarette or a beer.

I didn't know whether to cringe at the deterioration of the Pro or laugh at the near futility of the Joe or feel completely ashamed of myself watching this while drinking a beer, smoking a cigarette and playing Civ.  Suffice to say that in most of the competitions the Pro still outperformed the Joe, but on occasion the Joe outplayed and outlasted his competition.

What's all this leading up to?  In some ways the market is a contest between the pros and the plumbers.  But sometimes the Joes get the call right which brings me to this weeks sentiment survey.  Typically when fear ramps up among individual investors it is time to put on the contrarian hat and be prepared to act on the opposite side.  This weeks AAII Sentiment Survey shows a 13.6% increase in bearishness over the previous week which results in the highest reading since 10/06/11 of 42.1% while bullishness decreased 10% to 25.4.  In contrast the Investor Intelligence survey shows no decrease in bearishness over the previous week (20.4%) and also shows only a modest drop of 4% in bullishness from 43% to 38.7%.

What we have here is a very clear difference of opinion between the Pros and the Joes.  With this divergence and the belief that when the AAII survey gets bearish it's time to begin to get bullish, the edge here would appear to go to the Pros, but it's also good to remind ourselves that on occasion the Joe does make that trey.

As a side note it does beg the question, "With deteriorating breadth, bearish chart patterns, and macro woes in China and Europe why are the Pros so nonchalant?"